South Dakota's tax system is most welcoming to economic activity while New York's tax code ranks 50th as the least hospitable, according to the Tax Foundation's most recent edition of the State Business Tax Climate Index, which ranks the tax systems of the 50 states.
"States do not enact tax changes in a vacuum. Every tax change will affect a state's competitive position relative to its neighbors," said Scott Hodge, president of the Tax Foundation, a nonprofit organization that monitors fiscal policy at the federal, state, and local levels.
The goal of the index, according to the foundation, is to focus lawmakers' attention on the importance of good tax fundamentals: enacting low tax rates and granting as few deductions, exemptions, and credits as possible.
This broad base, low rate approach is the antithesis of most efforts by state economic development departments that specialize in designing packages of short-term tax abatements, exemptions, and other give-aways for prospective employers who have announced that they would consider relocating. Those packages routinely include such large state and local exemptions that resident businesses must pay higher taxes to make up for the lost revenue.
"The temptation is for state lawmakers to lure high-profile companies with packages of tax bonuses, but that strategy often backfires if the company does not prosper," said Kail Padgitt, Ph.D., the author of the 2011 edition of the index.
Even states with excellent business tax climates trot out extra tax incentives. This year, when Northrop Grumman announced it would relocate its headquarters to the Washington, D.C., area, a bidding war ensued. Even though Virginia was the prohibitive favorite because it has a more hospitable tax climate than Maryland or the District of Columbia and because Northrop Grumman is already its largest private employer, all three jurisdictions spent a great deal of time and effort assembling massive packages of tax and spending incentives, which the firm quite rationally accepted from Virginia.
Best/Worst tax climates
The ten states that had the best tax climates on the first day of the 2011 fiscal year (July 1, 2010), were South Dakota, Alaska, Wyoming, Nevada, Florida, Montana, New Hampshire, Delaware, Utah, and Indiana.
"The top eight tax systems all raise sufficient revenue without imposing one or two of the three major state taxes – sales taxes, personal income taxes, and corporate income taxes," said Hodge.
The ten states with the least hospitable business tax climates are, from 50th to 41st best: New York, California, New Jersey, Connecticut, Ohio, Iowa, Maryland, Minnesota, Rhode Island, and North Carolina.
The worst state tax codes tend to have:
- Complex, multi-rate corporate and individual income taxes with above-average tax rates
- Above-average sales tax rates that don't exempt business-to-business purchases
- Complex, high-rate unemployment tax systems
- High property tax collections as a percentage of personal income
The methodology of the index is centered on the idea of economic neutrality. If a state's tax system maintains a level playing field for businesses, the index considers it neutral and ranks it highly. However, each state's final score depends on a comparison with the other 49 states.
The overall index is composed of five specific indices devoted to major features of a state's tax system: the state's major business tax, whether a corporate income tax or a gross receipts tax; the individual income tax; the general and selective sales taxes; the unemployment insurance tax; and asset-based taxes including property taxes. Each of these five indices is composed of several sub- indices.
Each state's laws and tax collections were assessed as of July 1, 2010, the first day of the 2011 fiscal year. Newer tax changes are the subject of commentary in an appendix but are not tallied in the scores and rankings.