A few weeks ago, I had the privilege of testifying before members of the New Mexico Legislature on policies that could generate greater economic growth and foster more stable revenue streams for the state.
I heard a particular comment raised more than once this afternoon: there are many factors that go into why a business might locate in a particular state. As the comment said, location decisions are not just about how competitive a state’s tax climate is. Concerns also include access to infrastructure, the availability of skilled labor, crime rates and the strength of the state’s education system.
Economic theory and the academic literature are clear, All other things being equal (all else equal): firms are attracted to jurisdictions with lower taxes. And when the tax burden shrinks, the economy grows because firms have more revenue to reinvest in productivity. However, not everything is often equal. There is more to life, business and location decisions than just taxes. I couldn’t agree more on this one.
Among other things, companies care about an educated workforce – the greater the human capital, the greater the productivity of the company. Companies care about access to infrastructure and efficient delivery of their goods to market. They look after government services including police, fire and emergency services. Individuals and families care about school quality, climate and affordable housing. The weight each person places on these factors will vary greatly. But what businesses need to stay open, and what every family needs to stay in their home, is money. This is how tax policies come into play.
Although each places different emphasis on the importance of different tax policies, tax policies do affect how much discretionary income a business owner has to hire another employee. Tax policies do affect how much income a person has to buy a new appliance or save for a home. At one point taxes do matter.
It would be a mistake to throw up our hands and assume that tax policies are irrelevant. California, for example, is a place that seems to have it all: beaches, mountains, a wide variety of climates. It has seaports, airports and extensive multimodal infrastructure networks. It has fertile land, generous welfare benefits and a rich history as a destination of opportunity. Yet, according to the U.S. Census Bureau, the state has seen net negative inward migration every year since 1990. Arizona, meanwhile, is witnessing a population boom, benefiting largely from the exodus from high-tax California. Arizona’s sustained efforts to promote regional competitiveness have paid dividends: The income tax brought in 185 percent more revenue in 2019 than it did in 1992 (adjusted for inflation) despite — or perhaps because of — significant rate cuts. In addition, Arizona’s inflation-adjusted collections have grown nearly twice as fast as population growth.
Between 2018 and 2019, 71,547 more households left California for other destinations in the United States than moved to California from elsewhere in the country, according to data from the Internal Revenue Service. Approximately 52 percent of these households migrated to a state that borders New Mexico. Arizona gained 14,397 former California households with $1.2 billion in adjusted gross income. Texas gained 14,242 households, Colorado gained 4,762 households, and Utah gained 2,993 households, for a total net migration of $2.5 billion in adjusted gross income. New Mexico is 13th on the list of destinations for net inward emigration from California. Only 1,143 California households (1.6 percent) chose to move to the Land of Enchantment, New Mexico.
Why hasn’t New Mexico benefited more from emigration like Arizona has? Between 1997 and 2021, Arizona’s real gross state product increased by 100 percent, while New Mexico’s grew by only 41 percent. Why do Californians drive through or fly over New Mexico to get to Texas? Texas is a larger state in terms of population and land mass, but it’s far from a panacea. With larger size comes an increased scale of potential challenges.
According to the Tax Foundation’s annual report State Business Tax Climate Index, New Mexico is limited by states with greater tax competitiveness. In the overall assessment of the structural competitiveness of the states, New Mexico ranks 28th in 2022. Relative to its neighbors, Utah ranks 10th, Texas 14th, Colorado 20th, Arizona moves to 15th from 23rd and Oklahoma is 26th. As components of the overall ranking, New Mexico ranks in the top 10 for its property insurance and unemployment structures. However, the general uncompetitiveness of the state is primarily due to its poorly structured personal income tax system; its relatively high individual and corporate tax rates (5.9 percent); and its economy-distorting sales tax that covers too broad a base and leads to unusually large tax pyramid effects. These factors interact to incentivize firms to locate (or relocate) outside of New Mexico, where it is cheaper to do business.
The globalization of supply chains often takes the blame for why manufacturing moves from different states, but according to a report by the US Department of Labor, most mass job relocations are from one US state to another. Could tax competitiveness play a role in where people and businesses, including those migrating from California, decide to locate?
Another comment I heard during testimony offered skepticism about the value of various ranking systems, including Index. Clearly, criticism of interstate ranking systems is not limited to members of the legislature. Some contributors to the academic literature on government taxation offer a similar critique of business and tax climate studies. They argue that comparative reports such as Index do not take into account the full range of important factors that directly affect the business climate in the country. However, a careful examination of these criticisms reveals that the authors believe that taxes are not important to business and therefore dismiss the studies as simply designed to support low taxes.
The State Business Tax Climate Index is intended to be an indicator of which countries’ tax systems are most hospitable to business and economic growth. The Index it is not intended to measure economic opportunity or freedom, or even the broad business climate, but rather the narrower one tax climate and its variables reflect this focus. We do so not only because the Tax Foundation’s expertise is in taxes, but also because every component of the Index is subject to immediate change by state legislatures, thereby creating the potential for significant changes in tax competitiveness from one year to the next.
For example, it may take years or even decades for states to reap the economic benefits of educational policy changes or infrastructure improvements, however valuable they may be. But policymakers can change their tax codes now in ways that bring both long-term and more immediate economic benefits. Contrary to Peter Fisher’s 1970 view that the effects of taxes are “small or non-existent”, our study reflects strong evidence that business decisions are significantly influenced by tax considerations.
Although Fisher does not believe that tax climate is important for states’ economic growth, other researchers find the opposite. Bitlingmeier, Eatington, Hall, and Orazem (2005) find in their analysis of several business climate studies that a country’s tax climate does affect its rate of economic growth and that several indices can predict growth. Specifically, they concluded, “The State Business Tax Climate Index explains growth consistently. This finding was confirmed by Anderson (2006) in a study for the Michigan House of Representatives, and more recently by Kolko, Neumark, and Mejia (2013), who, in an analysis of the ability of 10 business climate indices to predict economic growth, concluded that State Business Tax Climate Index gives “positive, significant, and statistically significant ratings for each specification” measured by them, and specifically cites Index as one of two business climate indices (out of 10) with particularly strong and robust evidence of predictive power.
Of course, taxes are not the only factor in the location decisions of individuals, families or businesses. Each participant in an economy has a variety of preferences and weighs each against the utility of another. Currently, tax policies may not register at the top of the priority list. However, taxes paid by businesses (whether large or small) will ultimately be a problem for everyone, as they are ultimately borne by the people through lower wages, higher prices and reduced shareholder value.
States do not enact tax policy in a vacuum and ignore this fact to their detriment. Any change in a country’s tax system makes its business tax climate more or less competitive compared to other countries and makes the country more or less attractive for business. Ultimately, anecdotal and empirical evidence, together with the cohesiveness of the recent literature around the conclusion that taxes matter greatly for business, show that Index is an important and useful tool for policymakers who want to make their countries’ tax systems business-friendly.