Does a "Good Business Tax Climate" Make the Economy Grow?

We have been told so often over the past several decades that a state has to have a good business tax climate in order for its economy to grow, that we have begun to accept it as the truth.

Economists have generally agreed on the characteristics of a “good” tax -- simple, productive, neutral, fair, transparent – but a “good business tax climate” has come to mean something additional in the political jargon of today – low, or no, taxes on business.

The promise is held before us: the lower your taxes, the healthier your business climate, the more your economy will grow. States are lured into competing against each other to see which can have the “best” business tax climate. Fear is generated that any tax increase will scare business away. Business funded entities construct “Indexes” so each state can see whether it is winning or losing in the competition for economic growth.

There is one small problem, however. 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 the 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. “Clearly a zero rate is the lowest possible rate and the most neutral base, since it creates the most favorable tax climate for economic growth.”

Is the Tax Foundation’s promise real? Do the states with the “best” business tax climates actually lead in the race for the Golden Fleece of business growth and prosperity?

Economists have argued the point using sophisticated models and arcane statistical manipulations. But let us do something more simple: compare 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 one finds.

New Hampshire, one of the 10 best tax climate states, and its next door neighbor, Vermont, one of the 10 worst tax climate states, have identical average annual growth rates.

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, which in turn has a higher annual average growth rate than New Jersey, that is, along with New York, one of the 10 worst states.

Wyoming and Montana, both among the 10 best tax states, rank last and next to last in growth rate 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, Illinois, which ranks 25th in “business tax climate” according to the Tax Foundation, has a slower average annual growth rate than Wisconsin, which ranks 38th in tax climate, which in turn is growing slower than Minnesota which is 41st in tax climate and one of the 10 “worst” when it comes to business tax climate.

One can only conclude that business has not being paying a lot of practical attention to the Tax Foundation’s Business Tax Climate Index. There is something besides tax levels that attracts business and fosters growth and development. Competing in a race to the bottom in taxes is not necessarily a winning strategy.

Robert Tannenwald, vice-president of the Federal Reserve Bank in Boston, may have a point when he suggests that 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 are not the only ingredient to a healthy, vibrant economy.