Tax Foundation Updates Flawed State Ranking

Member Group : Allegheny Institute

(October 15, 2013)–Each year the Washington DC based Tax Foundation releases its State Business Tax Climate ranking report. For the past several years Pennsylvania has done reasonably well according to the Foundation, ranking among the top half of all states. These favorable rankings have been a source of consternation inasmuch as they are inconsistent with the widely held view among Pennsylvania firms that the tax burden on business is an impediment to growth and expansion. Back in 2006, an Institute report (06-03) called attention to problems with the rankings and in 2009 we noted in an Issue Summary our misgivings about the Tax Foundation ranking scheme.

Again this year the Tax Foundation released its annual update of the Tax Climate index showing Pennsylvania ranked 24th best among the 50 states.

In the Tax Climate rankings, Pennsylvania fared well because the construction of the ranking index used a weighting methodology that fails to capture real world experience. The index looks at five different taxes that are deemed important to business decision making. These taxes, with their assigned weights, are as follows: individual income tax (32.4 percent); sales tax (21.5 percent); the corporate income tax (20.5 percent); property tax (14.5 percent); and the unemployment insurance tax (11.5 percent). The weights are based on the variability of the 50 states’ tax rates calculated as deviations from the mean with heavier weights assigned to taxes with greater variability. It is extremely unlikely that a company looking at state business tax climates would focus on or care about the variability of specific tax rates across all states. They would look at actual rates in the states they are considering and apply their own weighting scheme depending on their particular business operations.

Note that for the tax categories listed above Pennsylvania ranks as follows among the 50 states; personal income (16th), sales (19th), unemployment compensation (39th), property (43rd) and corporate income (46th). Thus, we see that the Tax Climate ranking methodology rewards Pennsylvania by assigning larger weights to its highest ranking taxes, i.e., personal income and sales and assigning smaller weights to its lowest ranking taxes, i.e., corporate, property, and unemployment compensation. This procedure causes Pennsylvania to rank reasonably high among states according to the Foundation’s traditional weighting system. Further, the Foundation rewards Pennsylvania for having some flat, single rate taxes that are "simple and neutral". Beyond this questionable methodology, the Foundation’s Climate report ranking does not take into account the possibility of many other taxes that states and municipalities might impose. For example, Philadelphia levies a two percent local add-on to the state’s sales tax. Pittsburgh levies a payroll preparation tax. Many municipalities and the state impose realty transfer taxes—and so on. In light of these and other factors, the resulting Pennsylvania tax ranking in the Foundation’s latest Climate ranking is not a useful measure of the state’s relative business tax climate.

At bottom, the fundamental problem with the Tax Climate index is that it is based on the state variability from the mean for each measured type of tax instead of looking at the actual tax burden faced by businesses in each state.

Bear in mind that, as we reported in early 2012, the Foundation had just released a new version of its comparative tax burden study called Location Matters: A Comparative Analysis of State Tax Costs on Business. This study offers a far superior ranking scheme for the tax burdens actually faced by businesses across the 50 states. As the Foundation says, the tax rankings are based on apples-to-apples comparisons. According to this ranking Pennsylvania comes in at 50th. Quite a difference and certainly more compatible with views expressed in surveys of Commonwealth businesses.

The Location Matters report provides a better analysis of the actual tax burden faced by businesses. In the Location Matters analysis, the Foundation attempts to look at what hypothetical businesses would pay in taxes in each state. The taxes studied are corporate income taxes, property taxes, sales taxes, unemployment insurance taxes, capital stock taxes, inventory taxes, and gross receipt taxes. Instead of constructing a weighted average, the index uses the national average burden for each tax as a benchmark (100) and looks at how far a state’s burden is from that average for each tax to come up with the score. For example, Pennsylvania’s overall score is 145.1 (50th). This implies that the effective business tax rate in Pennsylvania is 45.1 percent greater than the national average.

This approach by the Foundation is far more appropriate, looking at comparative tax burdens using the U.S. average as the benchmark instead of weighting tax rates by variability of rates across the country. Pennsylvania does not fare well in the more realistic rankings. In addition to ranking last in the overall rankings for mature businesses, the Commonwealth finished last with the following firm types: corporate headquarters (both new and mature), R&D facility (both), and retail store (mature). The Commonwealth was ranked 48th for a call center (mature) and 49th for a distribution center (mature). The only areas in which Pennsylvania scored well occurred in capital-intensive manufacturing (9th for new and 5th for mature) and labor-intensive manufacturing (26th for new and 15th for mature).

As mentioned above, the Commonwealth’s overall score for mature firms came in at 145.1 (50th) and for newly established firms 145.9 (49th, ahead of only Hawaii). An annual updating of the Location Matters report would be very helpful.

The Location Matters rankings are a vast improvement over the Business Tax Climate study and the weighting system of that study. It puts Pennsylvania’s business tax burden in the proper focus and reminds us that the Commonwealth has a lot room for improvement in its tax structure. It is quite disturbing that a year after having developed a superior business tax ranking scheme the Tax Foundation has once again published a business tax ranking using the old questionable methodology.

Jake Haulk, Ph.D., President

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