By Jackson Brainerd
Wyoming and South Dakota topped the rankings for states' business tax climate in the 2015 State Business Tax Climate Index released last week by the Tax Foundation, a Washington, D.C.-based think tank.
The Index compares state' tax systems in terms of their friendliness to business and conduciveness to economic development.
The 2015 Index is based on the premise that taxes play an important role in where businesses choose to locate, and that states use their tax systems to compete with one another for those businesses. For that reason, the Index asserts that an analysis of state tax policy offers the best explanation for economic growth.
The report bases its rankings on five primary tax components: individual income tax (which accounts for 32.1 percent of each state’s score), sales tax (21.6 percent), corporate tax (20.6 percent), property tax (14.6 percent), and unemployment insurance tax (11.1 percent).
The Index’s top 10 states this year are:
- South Dakota*ᶜ
- Montana ˢ
- New Hampshire *ˢ
*Does not levy a broad-based personal income tax
ˢ Does not levy a state sales tax
ᶜ Does not levy a corporate income tax
The ranking system rewards states that have lower tax rates first and foremost. None of the top five states levy an income tax and three of the top 10 have no sales tax.
The Index also favors tax systems that are neutral and minimize complexity. Economic development and job creation tax credits are notable exceptions to the Index’s “lower tax rates = better business climate” rule because they lack simplicity.
Such measures “complicate the tax system, narrow the tax base, drive up tax rates for companies that do not qualify, distort the free market, and often fail to achieve economic growth,” according to the Tax Foundation. Preference for a straightforward approach to taxation also leads the report to advocate single-rate tax systems instead of graduated-rate or progressive tax structures.
The state with the largest improvement since last year’s Index was North Carolina, which moved from 44th to 16th because the state restructured its tax system. It replaced its multi-bracketed income tax system (with a top rate of 7.75 percent) with a single-bracket system (with a rate of 5.8 percent) and a standard deduction of $7,500.
It is important to note that the Index offers only one measure of economic well-being, which the Tax Foundation readily admits: “[The Index] does not purport to measure economic opportunity or freedom, or even the broad business climate, but the narrower business tax climate.”
A low score on the Index does not necessarily mean that a state’s economy is performing worse than its peers. For example, a Governing Magazine analysis of the 2013 Index found that there was no notable correlation between states’ Business Tax Climate Index scores and their unemployment rates.
For a look at other significant factors that influence state business climates, a 2011 NCSL Legisbrief is available online.
Jackson Brainerd is a research analyst in NCSL’s Fiscal Affairs Program.