Tax burden is a high profile consideration in making a capital investment decision despite the fact that non-tax costs of doing business in a given location are typically far more significant to a projects’ internal rate of return or net present value.
The Tax Foundation offers some perspective on the relationship between tax burden and foreign direct investment.
“Q: Do businesses really decide where to locate based on taxes? How important is this compared to other factors, such as wages, cost of living, and travel costs?
A. Taxes do factor into business location decisions. For example, a growing body of academic research indicates that foreign direct investment (FDI) can be quite sensitive to the corporate tax rates imposed by a state or country. One recent study of the effects of corporate income taxes on the location of foreign direct investment in the United States found a strong relationship between state corporate tax rates and FDI—for every 1 percent increase in a state’s corporate tax rate, FDI can be expected to fall by 1 percent.1
A new study of income tax rates in 85 countries by economists at the World Bank and Harvard University found a strong effect of both statutory and effective corporate tax rates on FDI as well as entrepreneurship. For example, the average rate of FDI as a share of GDP is 3.36 percent. But a 10-percentage point increase in the statutory corporate rate can be expected to reduce FDI by nearly 2 percentage points.”
Historically, the Tax Foundation State Business Tax Climate Index has been the standard for making state-to-state tax burden comparisons. The methodology used by the Tax Foundation creates a relative index based on five specific component indices that are weighted in the final calculation – 1) corporate tax, 2) individual income tax, 3) sales tax, 4) unemployment tax and 5) property tax. Most third-party business rankings rely on the Index in their assessment of cost-of-doing-business.
Recently, Ernst & Young LLP partnered with COST (Council on State Taxation) to create a new study that provides a state-by-state comparison of tax liabilities that new investments would incur. The results are reported to reflect the type of analysis that businesses use to evaluate site selection decisions. This analysis focuses only on business tax burden and does not include any consumer tax liabilities.
Understanding the actual state tax burden is important in economic development. But, understanding what capital investors are reviewing as they contemplate which locations to include on a short list for due diligence is critical. Without that understanding, it will be difficult to effectively position your community for consideration.
It is important to understand the data, methodology and study limitations of the rankings published by both the Tax Foundation and E&Y/COST. As an economic development professional, you need to be sufficiently conversant with both these reports that you can confidently explain the ranking results for your state.
You should have answers to these 5 key questions –
1. Where does your state rank relative to other states?
2. What are the key drivers of that ranking?
3. Why are the rankings different between the two studies?
4. What is your state’s strategic approach to tax legislation?
5. Have there been any recent relevant changes in the tax code of your state?
You often only get one chance to make an impression on a potential capital investor or a site selection consultant. Andy Levine (Voice of Your Customer post) counsels that you need to be ready with a solid command the facts about your community and state in order to take advantage of it. You can expect questions about your state tax burden, so be sure you are ready with data based answers.
What is Your Experience?
Have you used either of these national state tax ranking reports in conversations with site selection consultants or capital investors? If you have, what kind of questions do you have to deal with most often? What misperceptions regarding the rankings have you encountered? Please leave a comment and share your experience. By sharing typical questions and answers we can all be better prepared.
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