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February 25, 2013
Concerns About the Tax Foundation's State Business Tax Climate Index
by Robert Tannenwald

Full Text Published by Tax Analysts®

by Robert Tannenwald

Robert TannenwaldI don't watch Fox Business News. However, I made an exception in mid-January to hear Joe Henchman's take on Louisiana Republican Gov. Bobby Jindal's sweeping tax reform agenda. Henchman, for whom I have a lot of respect, is the Tax Foundation's vice president for legal and state projects. How did the proposal originate? According to Henchman, Louisiana officials were concerned about their state's mediocre ranking on the foundation's State Business Tax Climate Index (SBTCI). They asked the foundation to suggest reforms that would lift the state's ranking. The foundation obliged with several proposals, notably to eliminate the state's personal, corporate, and franchise taxes and to increase its sales tax. Jindal decided to run with it.1 According to the foundation, if the governor's proposal were enacted, Louisiana's SBTCI ranking would soar from 32nd to fourth.2

In addition to Jindal, other Republican governors, such as Sam Brownback of Kansas, Dave Heineman of Nebraska, and Susana Martinez of New Mexico, have used their state's low or mediocre SBTCI ranking as their statistical raison d'être for proposing the reduction or elimination of their state's income taxes. The SBTCI's influence extends well beyond that circle. For many years, policymakers and pundits have considered the SBTCI to be the method of choice for evaluating the competitive standing of state tax systems. The director of practically every state development office awaits the annual release of SBTCI rankings with the same bated breath that college and university officials await the release of the U.S. News and World Report's college rankings.

Despite the SBTCI's influence, some elements of its method trouble me. Especially disconcerting is the high weight it places on the personal income tax. The property tax should be weighted more heavily because it is by far the largest tax that businesses pay. Furthermore, SBTCI's policy implications seem to clash with those of the foundation's other published indicators of state business tax competitiveness. I'm particularly confused about the foundation's position on tax incentives. I have always believed that it regards tax incentives as a competitive liability. Although I still think it does, I'm no longer certain.

The SBTCI's Most Salient Guiding Principle:
Reducing Tax Distortions3

According to the SBTCI, a good state business tax climate minimizes tax distortions of economic behavior. In the long run, less distortion promotes economic efficiency, which generates a more profitable business environment. Thanks to Adam Smith's "invisible hand," that environment creates the greatest material good for the greatest number.

The foundation argues that states can minimize tax distortions in four principal ways:

  • Keep statutory rates low and flat. Tax rates interfere with the signals generated by unfettered private markets, the engines of economic efficiency. Graduated tax rates compound the distortion. For example, most people want to get ahead to enjoy a better life for themselves and their family. However, if rates are graduated, why bother to work hard to get that promotion if the taxes take a bigger bite out of an additional dollar earned?
  • Keep tax bases broad. Avoid tax preferences narrowly focused on specific industries, specific forms of economic activity, or specific companies. Although those preferences may stimulate considerable growth in their targets, they create greater expenses, both tax and nontax, for everyone else. Subsidized firms can afford to bid away scarce labor and capital from their unsubsidized competitors, driving up the costs of those inputs. The unsubsidized might have to pay higher taxes to maintain needed public services, like school, infrastructure, and public safety. In the end, the losses of the whole outweigh the benefits granted to the subsidized few.
  • Keep taxes simple. The simpler a state's tax system, the less time and money must be devoted to enforcing and obeying it.
  • Pay attention to all taxes, not just the ones businesses pay out of their checkbook. The burden of any tax can fall on businesses. For example, some employers might bear the burden of high personal income taxes levied on geographically mobile workers who possess scarce skills (like young software engineers). If their employer refuses to compensate them for their state taxes, they'll move to a lower-tax location. Conversely, businesses might be able to shift the burden of the taxes for which they are legally liable (business taxes) by raising prices or lowering the wages of geographically immobile employees. Whatever tax shifting takes place, taxes don't necessarily stick where they hit. So businesses take all of them into account when deciding where to locate.
SBTCI'S Design

With those principles in mind, the foundation identifies what it considers to be the five principal state and local tax clusters: the personal income tax; the corporate taxes (evaluating the gross receipts tax when states have substituted it for the corporate income tax); the sales tax (including both the retail sales tax and excise taxes); unemployment insurance taxes; and taxes on property (including taxes on realty, personal, inventory, capital stock, and transfers at death or by gift). The SBTCI has five components, each corresponding to one of these tax groups.

Each tax component has two subcomponents: one that evaluates the tax cluster's rate structures, the other its bases. Generally, the lower and flatter the rate structures, the higher the state's score on the tax cluster's rate subcomponent. The more neutral the tax bases (the more devoid of distorting exemptions, deductions, and credits), the higher the state's score on the tax cluster's base subcomponent. A state can pick up "simplicity points" for conforming relatively closely to federal definitions of taxable income.

The Design's Most Serious Flaw:
The High Weight on the Personal Income Tax

After the foundation grades every state on the five components, it computes each component's interstate variation. The wider that variation, the heavier the foundation weights the component in the overall index. The Tax Foundation reasons:

    Businesses that are comparing states for new or expanded locations must give greater emphasis to tax climates when the differences are large. On the other hand, components in which the fifty state scores are clustered together, closely distributed around the mean, are those areas of tax law where businesses are more likely to de-emphasize tax factors in their location decisions.4

Using that method, the foundation arrived at the following weights for its 2013 SBTCI:

    Personal income tax: 33.1 percent

    Sales taxes: 21.5 percent

    Corporate taxes: 20.1 percent

    Property taxes: 14 percent

    Unemployment taxes: 11.4 percent5

I know of no empirical evidence that businesses use variability as a yardstick for deciding which taxes are most important in choosing a location. If I were a rational, well-informed business executive trying to maximize my company's profits -- the kind of executive that states should try to lure and nurture according to the foundation's underlying philosophy -- I would gauge how each tax would increase my costs the most, regardless of how much the tax varied across the states. A small difference in a big chunk of my budget could make a big difference in my bottom line, while a big difference in a small chunk could affect my profitability only slightly. If I followed the SBTCI's weighting formula, I wouldn't be doing my job very well.

Since I would be unsure about tax shifting possibilities, I would assume initially that my company would have to bear the full burden of all business taxes. Furthermore, without any reliable evidence, I would assume initially that I would have to bear none of the burden of other taxes (household taxes) -- such as personal income taxes on wages and salaries, residential property taxes, and sales taxes on household purchases.6

Figure 1.
Composition of Total State and Local Business Taxes --
Fiscal 2011

Source: Ernst & Young LLP based on estimates from U.S. Census Bureau, State and Local Governmental Finances.

As shown in the chart below, according to Ernst & Young LLP, in state fiscal 2011, the property tax accounted for 38 percent of all state and local business taxes, the highest percentage of any tax. Individual income taxes accounted for only 5.6 percent of the pie. The property tax accounted for the largest percentage of state and local business taxes in 42 states and the District of Columbia. The personal income tax on business income accounted for the largest percentage in none of them.7

In one part of its SBTCI report, the foundation contradicts its theory that a tax's importance is proportional to its interstate variability. It notes that property taxes "matter" in large part because they account for a large percentage of state and local business taxes:

    Businesses remitted $619 billion in state and local taxes in FY2010, of which $250 billion (40 percent) was for property taxes . . . Coupled with the academic findings that property taxes are the most influential tax in terms of impacting the location decisions by businesses, the evidence supports the conclusion that property taxes are a significant factor in a state's business tax climate. Since property taxes can be a large burden to business, they can have a significant effect on location decisions.8 (Emphasis added.)

In short, the foundation's weighting scheme has no empirical foundation, conflicts with its stated underlying economic principles and other passages in its SBTCI report, and biases the SBTCI in favor of states with no personal income tax. Those states are automatically assigned the highest possible score on both their income tax rate and income tax base subcomponents, since a state that has no income tax has a rate of 0 percent and no income tax preferences.9

Which Indicator Should States Use?
Seeming Inconsistency in the
Tax Foundation's Guidance to the States

The foundation has published two sets of indicators of business tax competitiveness: the SBTCI and a compilation of indices based on the model firm approach. In the latter, the foundation, in conjunction with KPMG LLP, estimates how taxes in each state affect the after-tax profitability of seven representative firms, once assuming that the firms are eligible for state tax incentives and once assuming that they are not. Some firms are expanding; others experience no growth. Some are call centers, some are headquarters, and others are stores or other types of facilities. That is a very valuable study. It reveals how tax treatment varies not only across states but across different types of firms within a state.10

In explaining the value of this cluster of indices and how it differs from the SBTCI, the Tax Foundation explains:

    The State Business Tax Climate Index is a useful tool for lawmakers to understand how neutral and efficient their state's tax system is compared to other states and to identify areas where their system can be improved. However, this does not address the bottom line question asked by many business executives: "How much will our company pay in taxes?"11

The foundation constructed these model firm rankings so that "governors, legislators, and state officials can better understand and address their competitive position with other states."12 Using this new set of indicators, the foundation finds that tax incentives greatly improve a state's tax competitiveness for several types of firms. However, a state loses points in its SBTCI if it has a jobs tax credit, investment tax credit, or R&D tax credits. The foundation asserts in its SBTCI report that:

    Lawmakers create these deals [tax incentives] 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.13 (Emphasis added.)

Are tax incentives competitive assets or liabilities? Which is it? Is the foundation distinguishing between short-term competitiveness in one study and long-term competitiveness in the other?

In its study of model firms, the foundation analyzes only taxes for which businesses are legally liable, to the exclusion of other taxes whose burden might be shifted to them. Yet, in its SBTCI report, the foundation argues that businesses are concerned to some degree about all state and local taxes. Which taxes are relevant to competitiveness and which are not?

Throughout its model firm analysis, the Tax Foundation notes how tax incentives discriminate between firms eligible for tax incentives and those ineligible, violating the principle of tax neutrality. In that analysis, the foundation suggests that there is a trade-off between neutrality and competitiveness, while in its SBTCI study it argues that in the long run, no such trade-off exists.

Conclusions and Suggestions

A great deal of thought and work has gone into constructing the SBTCI. As a former designer of indicators of state business tax competitiveness, I appreciate that all of them, including my own, have strengths and weaknesses. Here are some suggestions to the foundation for improving the SBTCI and the way it is presented.

First, compute and publish alternative SBTCI scores and rankings using different weights on the five tax components. In particular, try weighting the components according to the importance of the tax cluster in the mix of state and local business taxes. Academics examining all sorts of questions do similar robustness tests. If changing the component weights doesn't change state rankings that much, users of the SBTCI rankings will be all the more confident in their validity. If the rankings change, users can make their own assumptions about which weights are best.

Second, clarify the differences in policy implications for the SBTCI rankings and the model firm study. If differences exist, reconcile them, perhaps in a separate report.

Third, pursue your model firm studies. Great stuff!

Fourth, demonstrate how various states' SBTCI indices would be affected by two distinctly different strategies: base broadening and rate cutting (assuming no change in the tax structure of other states). A state's ranking should rise if it leaves its tax rates untouched and broadens its tax bases. How much? Even better, put all the raw data used in the computation of each state's SBTCI into a publicly available spreadsheet, so that anyone could perform this exercise.

One other suggestion -- an invitation for the foundation, really:

If you are still opposed to state and local tax incentives -- I am pretty sure you are -- band together with other advocates who question those incentives' value, including the Center on Budget and Policy Priorities. Both you and CBPP deserve much credit for criticizing tax preferences in statehouses around the nation, even in the face of powerful tax-preferred interests. Yet, although you share similar views on several tax questions, you are reluctant even to cite each other's work. Co-author a paper! Wouldn't it be great if policy advocates of all ideological stripes worked closely, openly, and effectively in areas of agreement, even while disagreeing in other areas? Now that would set an example for our intransigent, partisan legislators!

* * * * *

Economist's Roost is a new column by Robert Tannenwald. Tannenwald is the adjunct lecturer in public policy and budgeting at the Heller School of Brandeis University. He spent 28 years as an economist with the Federal Reserve Bank of Boston, from which he retired as vice president in 2010. He was the founding director of the bank's New England Policy Center. He has also served as senior fellow at the Center on Budget and Policy Priorities and an analyst in taxation at the Congressional Research Service.


1 See

2 Scott Drenkard, "Governor Jindal's Bold New Tax Plan," Jan. 11, 2013, reproduced on Jindal's website, available at Drenkard is an economist with the Tax Foundation.

3 This section, as well as the next, relies heavily on material presented in Scott Drenkard and Joseph Henchman, 2013 State Business Tax Climate Index, the Tax Foundation, Washington, Background Paper 64, Oct. 2012, pp. 2-4, 9-10, available at

4 Id. at p. 9.

5 Id. at p. 9.

6 If I assumed that through tax shifting, I would have to bear the burden of all state and local taxes, even those levied on workers and households (a wildly unrealistic assumption), I would still weigh the property tax much more heavily than the personal income tax. In every state fiscal year from 1992 (the earliest year for which census data are online) through 2011 (the latest year available), nationwide state and local property tax revenue significantly exceeded state and local personal income tax revenue. Thus, if I were concerned about my firm's bottom line, I would still be much more concerned about property taxes than personal income taxes. See U.S. Census Bureau, available at and

7 Author's calculations and Andrew Phillips, Robert Cline, Thomas Neubig, and Hon Ming Quek, "Total State and Local Business Taxes: State-by-State Estimates for FY2011," Council On State Taxation and E&Y, July 2012, available at COST and E&Y classify state and local taxes differently than does the foundation. For example, COST and E&Y lump excise taxes together with insurance and utility taxes, not with sales taxes. The foundation takes into account neither of those latter two types of taxes in computing the SBTCI. Consequently, it is impossible to compare the two allocations of tax categories precisely.

8 Supra note 3, at p. 24.

9 Id., p. 9. States with no corporate income tax get a perfect score on the corporate income tax component for the same reason. However, that component gets less than half the weight of the personal income tax component. A state with no general retail tax does not get a perfect score on the sales tax component because in constructing that component, the foundation lumps this tax together with excise taxes.

10 Location Matters: A Comparative Analysis of State Tax Costs in the 50 States, the Tax Foundation in collaboration with KPMG LLP, Washington, Feb. 29, 2012, available at

11 Id. at p. v.

12 Id. at p. 6.

13 2013 State Business Tax Index, pp. 3-4.


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