Dispelling the Myth: Why State Tax Breaks for Businesses Do Not Spur Economic Growth

Many US politicians conjecture that corporate taxes influence businesses to invest in states that offer the lowest rates. Underlying this theory is the belief that increasing business growth in the state is tied to economic growth. However, in “Taxes, Incentives, and Economic Growth: Assessing the Impact of Pro-business Taxes on U.S. State Economies,” the authors show that tax breaks are not the major factor triggering business location decisions and that a reduction in corporate tax rates is not associated with an increase in economic growth within the state. Explicitly, there is no direct evidence that lowering state tax rates for businesses causes increased economic development, lower unemployment, and income redistributions spurred by the business community. Rather, other factors integral to corporations play a more critical role in investment decisions.

Existing literature claims that businesses are sensitive to changes in tax rates enforced through state fiscal policy. These claims rely heavily on assumptions: 1) all businesses are operating in a perfect market in which they rationally choose to locate where they are able to maximize their profits, and 2) lower tax rates reduce the marginal cost of doing business so that, all else equal, businesses are able to increase their profitability and spend more on job growth and/or higher wages. These assumptions, however, do not hold under two conditions: 1) if taxes are passed on to consumers through higher prices or lower wages, or 2) the tax expenditure is immaterial relative to the company’s total revenue and does not affect their location decisions.

Additionally, large estimates of the magnitude of a corporation’s sensitivity to taxes may not account for other factors that impact business location decisions such as the quality of public service provision, the price of capital, the quality of human capital, and transportation costs. Importantly, existing literature is largely silent on the response of businesses to national tax policy as opposed to state policy.

The authors use panel data from 1977 to 2005 for all 50 states to explore each state economy’s response to a reduction in the tax incidence for businesses. Tax incidence is measured using a host of variables that are summed as a percentage of gross state product (GSP), including corporate net income taxes, property taxes, corporate licensing taxes, and occupational and business licensing taxes. To account for an imperfect market in which taxes are passed on to consumers rather than absorbed by the business, the authors measure the impact of non-business (personal) taxes in all 50 states as a percentage of GSP.

The data is analyzed using the Arellano-Bond GMM estimator, which proves beneficial in measuring complex impacts that arise between policy actions and state economic outcomes. The state economic variables include: 1) the real growth rate of GSP; 2) the change in the employment rate; 3) the change in the net job-creation rate; 4) the growth rate of per capita real income; and 5) the rate of entrance and exit for business.

The study reveals that business taxes are positively associated with the growth rate of GSP, meaning that decreasing the tax rate may prove harmful to the state economy. Furthermore, employment is only modestly affected by state policy. Major responses to the employment rate are driven by national policy, as opposed to state policy. One implication of this result is that states should focus on increasing the requisite human capital through investments targeted to educational attainment rather than trying to increase employment rates through business growth.

Additionally, an increase in business taxes of 10 percent is associated with an increase in business exit of 0.04 percent. Even though this number is positive, it is relatively small and economically insignificant when considered with other factors tied to investment decisions for businesses.

The non-business effects, though mixed, were more closely aligned with existing theory. A one percentage point decrease in the GSP of non-business tax receipts is associated with an increase in the growth rate of GSP by 4.55 percent. However, the magnitude of the increase in growth is small in comparison to the reduction required in GSP to attain this growth.

Overall, this study unravels the theory that tax cuts benefit state economies by attracting businesses. States must consider other factors that are valued more highly by businesses than their tax incidence. Factors such as human capital and capital investment costs are popular drivers behind location and investment decisions for businesses that states may be able to address. Furthermore, states suffer a loss in corporate tax revenue by offering tax cuts as an incentive that may result in a reduction in the provision of public services such as education and public health. US policymakers must stop the rhetoric that tax breaks from the state appeal to businesses and instead divert more time to exploring other interventions that are actually effective in improving the state’s economy.

Article Source: Soledad A. Prillaman and Kenneth J. Meier Taxes, Incentives, and Economic Growth: Assessing the Impact of Pro-business Taxes on U.S. State Economies. The Journal of Politics; Volume 76, Issue 2, April 2014, Pages 364-379.

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