The Tax Foundation’s 2014 edition of the State Business Tax Climate Index enables business leaders, government policymakers, and taxpayers to gauge how their states’ tax systems compare.

The 10 best states in this year’s Index are:

1. Wyoming
2. South Dakota
3. Nevada
4. Alaska
5. Florida
6. Washington
7. Montana
8. New Hampshire
9. Utah
10. Indiana

The absence of a major tax is a dominant factor in vaulting many of these ten states to the top of the rankings. Property taxes and unemployment insurance taxes are levied in every state, but there are several states that do without one or more of the major taxes: the corporate tax, the individual income tax, or the sales tax. Wyoming, Nevada, and South Dakota have no corporate or individual income tax; Alaska has no individual income or state-level sales tax; Florida has no individual income tax; and New Hampshire and Montana have no sales tax.

But this does not mean that a state cannot rank in the top ten while still levying all the major taxes. Indiana, which ousted Texas from the top ten this year (see p. 5), and Utah have all the major tax types, but levy them with low rates on broad bases.

The 10 lowest ranked, or worst, states in this year’s Index are:

1. Maryland
2. Connecticut
3. Wisconsin
4. North Carolina
5. Vermont
6. Rhode Island
7. Minnesota
8. California
9. New Jersey
10. New York

The states in the bottom 10 suffer from the same afflictions: complex, non-neutral taxes with comparatively high rates.

While not reflected in this year’s edition, a great testament to the Index’s value is its use as a success metric for comprehensive reforms passed this year in North Carolina. While the state remains ranked 44th for this edition, it will move to as high as 17th as these reforms take effect in coming years.

Minnesota, by contrast, enacted a package of tax changes that reduce the state’s competitiveness, including a retroactive hike in the individual income tax rate. Since last year, they have dropped from 45th to 47th place. New York and New Jersey are in a virtual tie for last place, and any change next year could change their positions. Other major changes are noted in the blue boxes throughout this report.

The 2014 Index represents the tax climate of each state as of July 1, 2013, the first day of the standard 2014 state fiscal year.

Table 1: 2014 State Business Tax Climate Index Ranks and Component Ranks

Introduction

While taxes are a fact of life, not all tax systems are created equal. One measure, total taxes paid, is relevant but other elements of a state tax system can also enhance or harm the competitiveness of a state’s business environment. The reduces many complex considerations to an easy-to-use ranking. (Our report looks at tax burdens in states.)

The modern market is characterized by mobile capital and labor, with all types of business, small and large, tending to locate where they have the greatest competitive advantage. The evidence shows that states with the best tax systems will be the most competitive in attracting new businesses and most effective at generating economic and employment growth. It is true that taxes are but one factor in business decision-making. Other concerns, such as raw materials or infrastructure or a skilled labor pool, matter, but a simple, sensible tax system can positively impact business operations with regard to these very resources. Furthermore, unlike changes to a state’s healthcare, transportation, or education systems which can take decades to implement changes to the tax code can quickly improve a state’s business climate.

It is important to remember that even in our global economy, states’ stiffest and most direct competition often comes from other states. The Department of Labor reports that most mass job relocations are from one U.S. state to another, rather than to a foreign location. Certainly job creation is rapid overseas, as previously underdeveloped nations enter the world economy without facing the highest corporate tax rate in the world, as U.S. businesses do. State lawmakers are right to be concerned about how their states rank in the global competition for jobs and capital, but they need to be more concerned with companies moving from Detroit, MI, to Dayton, OH, rather than from Detroit to New Delhi. This means that state lawmakers must be aware of how their states’ business climates match up to their immediate neighbors and to other states within their regions.

Anecdotes about the impact of state tax systems on business investment are plentiful. In Illinois early last decade, hundreds of millions of dollars of capital investments were delayed when then-Governor Rod Blagojevich proposed a hefty gross receipts tax. Only when the legislature resoundingly defeated the bill did the investment resume. In 2005, California-based Intel decided to build a multi-billion dollar chip-making facility in Arizona due to its favorable corporate income tax system. In 2010, Northrup Gumman chose to move its headquarters to Virginia over Maryland, citing the better business tax climate. Anecdotes such as these reinforce what we know from economic theory: taxes matter to businesses, and those places with the most competitive tax systems will reap the benefits of business-friendly tax climates.

Tax competition is an unpleasant reality for state revenue and budget officials, but it is an effective restraint on state and local taxes. It also helps to more efficiently allocate resources because businesses can locate in the states where they receive the services they need at the lowest cost. When a state imposes higher taxes than a neighboring state, businesses will cross the border to some extent. Therefore, states with more competitive tax systems score well in the Index because they are best suited to generate economic growth.

State lawmakers are always mindful of their states’ business tax climates but they are often tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform. This can be a dangerous proposition, as the example of Dell Computers and North Carolina illustrates. North Carolina agreed to $240 million worth of incentives to lure Dell to the state. Many of the incentives came in the form of tax credits from the state and local governments. Unfortunately, Dell announced in 2009 that it would be closing the plant after only four years of operations. A 2007 USA Today article chronicled similar problems other states are having with companies that receive generous tax incentives.

Lawmakers create these deals under the banner of job creation and economic development, but the truth is that if a state needs to offer such packages, it is most likely covering for a woeful business tax climate. A far more effective approach is to systematically improve the business tax climate for the long term so as to improve the state’s competitiveness. When assessing which changes to make, lawmakers need to remember two rules:

1. Taxes matter to business. Business taxes affect business decisions, job creation and retention, plant location, competitiveness, the transparency of the tax system, and the long-term health of a state’s economy. Most importantly, taxes diminish profits. If taxes take a larger portion of profits, that cost is passed along to either consumers (through higher prices), employees (through lower wages or fewer jobs), or shareholders (through lower dividends or share value). Thus, a state with lower tax costs will be more attractive to business investment, and more likely to experience economic growth.

2. States do not enact tax changes (increases or cuts) in a vacuum. Every tax law will in some way change a state’s competitive position relative to its immediate neighbors, its geographic region, and even globally. Ultimately, it will affect the state’s national standing as a place to live and to do business. Entrepreneurial states can take advantage of the tax increases of their neighbors to lure businesses out of high-tax states.

In reality, tax-induced economic distortions are a fact of life, so a more realistic goal is to maximize the occasions when businesses and individuals are guided by business principles and minimize those cases where economic decisions are influenced, micromanaged, or even dictated by a tax system. The more riddled a tax system is with politically motivated preferences, the less likely it is that business decisions will be made in response to market forces. The Index rewards those states that apply these principles.

Ranking the competitiveness of fifty very different tax systems presents many challenges, especially when a state dispenses with a major tax entirely. Should Indiana’s tax system, which includes three relatively neutral taxes on sales, individual income and corporate income, be considered more or less competitive than Alaska’s tax system, which includes a particularly burdensome corporate income tax but no statewide tax on individual income or sales?

The Index deals with such questions by comparing the states on over 100 different variables in the five important areas of taxation (major business taxes, individual income taxes, sales taxes, unemployment insurance taxes, and property taxes) and then adding the results up to a final, overall ranking. This approach rewards states on particularly strong aspects of their tax systems (or penalizing them on particularly weak aspects) while also measuring the general competitiveness of their overall tax systems. The result is a score that can be compared to other states’ scores. Ultimately, both Alaska and Indiana score well.

For the full PDF of the 2014 State Business Tax Climate Index, click here 

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