Thursday, January 26, 2012

Montana's Tax Climate is Good, But It Doesn't Mean Much

As Chuck Johnson reports in today's Missoulian, the Tax Foundation just released a report ranking Montana number eight among the states in providing a business friendly tax climate (you can read Chuck's story here). That sounds pretty good, but unfortunately, it doesn't mean very much. Even Webb Brown, the president of the Montana Chamber of Commerce, told Chuck that our ranking should be taken with a grain of salt.

For one thing, if the tax climate has anything to do with business performance in a state, it's because of the impact of taxes on costs. As the story goes, businesses will move from, say, Idaho to Montana if tax costs are lower here than in our neighbor to the west. Of course, there are lots of different costs of doing business, so even if Montana levies lower taxes than Idaho, businesses may not come here if in some other respect -  labor costs, for example -  we're the more expensive state. In other words, what counts, if anything, is not whether our taxes are higher or lower than our neighbor's, but how much lower. And that's why rankings don't tell us much. True, they tell us who's above us and who's below us, but not how far.  Consider an extreme case in which all states had pretty much identical taxes - some just a little lower and others just a little higher than average. These small differences would clearly have almost no impact on where companies decided to do business, but nevertheless we could use them to rank the states. It's just that the rankings wouldn't mean anything.

So if we want to figure out how taxes affect business performance, the first thing we should do is junk the tax cost rankings and look at the tax costs themselves. That's what the Tax Foundation tries to do (albeit not very well) when it calculates a business tax climate index for each state. Unfortunately, when economists have studied this issue in the past, they have had a hard time showing that differences in state tax costs have much of an impact on state business performance. There are any number of reasons this might be true, but one important one seems to be that interstate differences in tax costs are pretty small when compared to interstate differences in other costs, such as labor, rents or transportation. And those bigger cost differences outweigh taxes in business location decisions.

You can get an idea about just how little the Tax Foundation's tax climate index tells us by calculating the correlation coefficient between the value of the index for each state and some measure of state business performance; I did this using the 2011 value of the Tax Foundation index and the growth of wage and salary employment between 2008 and 2010 as my performance measure. In other words, I was trying to find out if its tax climate had anything to do with how badly or well a state did on the job front during the Great Recession. Correlation coefficients range between -1 and +1; if a good tax climate leads reliably to good job performance, the correlation coefficient should be close to +1. But the one I calculated turned out to be -.07. The negative sign means states with better tax climates actually tend to have weaker job performance! But don't worry! It's not really that bad; the value of .07 is so small that statistically it's no different from zero. In other words, there is no correlation - none -  between a state's Tax Foundation score and how well it does in creating jobs or holding onto jobs in a major downturn. 

Republican legislators take note: during last year's session, you argued that the best way to create jobs in Montana was to eliminate regulations and improve the tax climate for businesses. Every indication is that that's an argument you'll be making again in this year's campaigns. You probably don't want to be confused by the facts, but the fact seems to be that that strategy simply won't work.