America is a land of taxation that was founded to avoid taxation.
– Laurence J. Peter

In the previous post I wrote about a survey that found that Iowa State University alumni entrepreneurs disproportionately started their companies in places other than Iowa.  While there are a number of reason for this, it seems likely that the business climate in Iowa, or lack thereof, must play some role.

But how do we measure business climate?  How do we gauge how friendly or unfriendly the environment in one state is for starting and operating a business versus another?  One method is to look at taxes.

My colleague Peter Orazem and former graduate student Joe McPhail have worked on a very interesting means of sizing up the business climates of states, and are in the process of updating their data.

This paper analyzes tax policies across states, with particular emphasis on marginal tax rates, or the tax rate that applies to the last dollar of the tax base (taxable income or spending).  Marginal tax rate is a term often applied to the change in one’s tax obligation as income rises.

The paper finds that there are persistent differences in distortionary tax policies across states which have caused persistent differences in capital investment across states.  There is evidence that there are low levels of labor productivity in states with the most distortionary policies compared to states with more favorable tax policies.  Iowa’s taxation ranks most negative among the 48 states, dead last,  in the analysis for its impact on labor productivity, and thus its impact on income, employment, and investment.

Taxes on property, corporate profits and consumption are the most damaging to labor productivity. Jointly administered income and capital gains taxes have smaller but still significant effects. Corporate taxes are particularly inefficient because they generate relatively little tax revenue per unit of lost productivity.

The overall effect of marginal tax rates on output per worker are substantial, reducing state labor productivity an average of 19.4%. They are responsible for substantial differences in the level of labor productivity across states: from a minimum negative impact of 11.8% in Nevada to a maximum of 27.6% in Iowa. States that rely more heavily on distortionary tax levies discourage capital investment, leading to lower levels of labor productivity and wages.

There are large and persistent differences in state tax policies as state taxes simply don’t change much over time.   The authors show that in theory, taxes on capital income, capital ownership, and sales will all lower labor productivity by distorting prices and returns to investment.  As implemented by the states, property taxes are responsible for 35% of the lost labor productivity while corporate taxes and sales and excise taxes are each responsible for 25% of the adverse effect. Income taxes and capital gains taxes have smaller negative effects, but as they are imposed together, their joint effects are also statistically significant and economically relevant.

The joint effects of tax policies are substantial, lowering labor productivity by an average of nearly 20% over the period 1977-2004. Tax policies have become more damaging to labor productivity over time, from -13.7% in 1977 to -24.5% in 2004.

Driving the negative effect is the reliance on rising marginal tax rates, apparently because of their greater distortionary effects on prices and returns compared to flatter tax rate structures. Tax policies can lead to substantial differences in equilibrium labor productivities across states, creating a gap of nearly 16 percentage points in output per worker between the least distortionary tax mix (Nevada: -11.8%) and the most distortionary (Iowa: -27.6%). Even though taxes differ in their relative efficiencies in generating revenue, with corporate taxes being the most costly and sales taxes the least costly in lost labor productivity per proportional increase in revenue, it is the highest marginal tax rate and not the type of tax that proves the most important for lost state labor productivity.

From an Iowa perspective, there are several observations:

  • While Iowa taxes don’t appear uncompetitive versus other states looking at individual rates, the net effect of their impact is significant because of their marginal effect, or impact on the last dollar of taxable income or consumption.  In effect, Iowa has the nation’s highest marginal impact on success (income, investment) which negatively affects wages, investment, and employment.
  • The impact of Iowa’s many tax credits and exemptions is to increase marginal tax rates.  A simplified tax regime with a broader tax base decreases this marginal impact and distortionary incentives to realize income, invest capital, and create jobs in other states.
  • State tax policy is relatively stable over the course of time.  One implication is that significant changes in state tax policies are apparently difficult to make.  The other is that if a state like Iowa can improve its competitive tax impact relative to other states, the improvement will likely persist over time.

Taxes are necessary to fund government services, but the structure of those taxes makes a significant difference in terms of the climate for investment and production.  Taxes matter.