Will Low Taxes on Business Make the State’s Economy Grow?

“Won’t lower taxes on business make our state’s economy grow?”

The question came from a gentleman who had just read through my column last week on closing the loopholes large companies use to avoid paying taxes.

The short answer is, “No”.

We have been told so often a state must have a “good business tax climate” for its economy to grow. We have begun to accept it as the truth.

Economists generally agree on the characteristics of a “good” tax. The tax should be simple. It should be productive. It should be neutral - not cause one business to gain at the expense of another. It should be fair and transparent.

But a “good business tax climate” has come to mean something else in the political jargon of today – low or no taxes on business.

The promise is held before us: the lower the taxes, the healthier the business climate, the more the economy grows.

States are lured into competing against each other to see which can have the “best” business tax climate. Fear is generated when politicians argue any tax increase will scare business away. Business-funded think tanks construct “ Indexes ” so each state can see whether it is winning or losing in the competition for economic growth.

However, there is one small problem. The Indexes are never linked to actual economic growth. They measure the level of taxes and then leave us with only the promise of growth.

The Tax Foundation’s 2007 State Business Tax Climate Index is typical. The report claims 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.  The only way to get a perfect score from the Tax Foundation is to have no tax at all.

Is the Tax Foundation’s promise real? Do the states with the “best” business tax climates actually bring business growth and prosperity?

To answer the question, I compared the Tax Foundation state business tax climate ratings with the latest average annual (1997-2004) growth rates in state gross product reported by the U.S. Department of Commerce, Bureau of Economic Analysis. Here is what I found:

  • California, one of the 10 ‘worst’ tax states, has a higher annual average growth rate than its neighbor Oregon, which is one of the 10 ‘best’ states.
  • New York, one of the 10 ‘worst’ tax states, has a higher annual average growth rate than Delaware, one of the 10 ‘best’ states.
  • New Hampshire, at the top of the Tax Foundations ‘good’ list, has identical growth rates as its next door neighbor, Vermont, which is at the bottom of the list.
  • Wyoming and Montana, both among the 10 ‘best’ tax states, rank last and next to last in growth rates among the Rocky Mountain States.
  • The two states with the highest average annual growth rates, Arizona and Idaho, both rank in the bottom half of all states when it comes to their “business tax climates”.
  • Texas, which ranks in the top 10 tax climate states, has a 40% slower average annual growth rate than its neighbor, Arizona, which ranks 28th in tax climate.
  • And lastly, in our own neighborhood, Wisconsin which has a better “business tax climate” than Minnesota but has a slower economic growth rate.

One can only conclude that business has not been paying a lot of practical attention to the Tax Foundation’s Business Tax Climate Index. Something besides tax level attracts business and fosters growth and development.

Robert Tannenwald, Vice-President of the Federal Reserve Bank in Boston, may have a point when he suggested states might make their economies better by enhancing public services valued by business.

Perhaps the overall business climate improves when states compete not to have the lowest taxes, but the best schools, the best community colleges, the best universities, the most rational health care, the lowest crime rate, the cleanest environment, the best transportation network.

Low taxes alone do not necessarily result in a healthy, vibrant economy.