Small Businesses Don't Choose Low-Tax States

Illustration by 731 Lexington, Photo: Comstock/Getty Images

State lawmakers often argue that their tax policies for small businesses need to be more favorable than those in other states. A mellow tax regime, the argument goes, will attract entrepreneurs from other states, enhancing employment and economic growth within the state.

That oft-repeated bit of political theater ignores a basic reality: State taxes do little to influence where entrepreneurs choose to operate. That’s because no state has the “best” tax policy for all entrepreneurs. Rather, different states have tax policies that suit certain types of companies.

The states that are best for new businesses are not the most favorable for existing small businesses. Those that are best for new C corporations aren’t best for new sole proprietorships, partnerships, or S corps. The most advantageous states for people starting service firms aren’t the best for people starting manufacturing ventures. And those most desirable for R&D-intensive firms are not the most favorable for low-tech businesses.

Consider the case of two startups—a new distribution center and a new capital-intensive manufacturing venture. (Note to readers: That’s a “capital-intensive” manufacturing startup, not a “labor-intensive” one, because many states tax the two at different rates.) A 2012 Tax Foundation/KPMG report (PDF) shows there is almost no correlation between states’ effective tax rates on the two types of businesses. State taxes that are low for one are not low for the other. For instance, Louisiana has a 1 percent total effective tax rate on new, capital-intensive manufacturers—the lowest in the nation. Yet it imposes a 50 percent rate on new distribution centers, making only seven states heavier taxers of these types of startups. By contrast, neighboring Mississippi has the sixth-lowest tax rate for new distribution centers but only the 39th for new, capital-intensive manufacturers. Is your head spinning yet?

And states with the lowest tax burdens aren’t the ones with the highest fraction of their population starting businesses. High-tax states, it seems, often have other advantages that offset the disadvantages of higher taxes. Consider, for example, California and Nebraska. According to the analysis I mentioned above, Nebraska has the lowest tax burden on new businesses. California, by contrast, was ranked a lowly 45th on this measure. If the favorability of the state tax regime drove new-business creation rates, Californians would start businesses at a much lower rate than Nebraskans.

The opposite, however, is true. Entrepreneurial activity is much more prevalent in California than in Nebraska. The Kauffman Index of Entrepreneurial Activity (PDF) shows that from 2009 to 2011, the fraction of working-age Californians employed by others who went into business for themselves every month was 44 per 10,000 people, but for Nebraskans it was just 26 per 10,000 people.

Even when a state has the most favorable tax policies for a particular type of business, the policy does little to influence where people start companies. Other than the small number of metropolitan areas that span multiple states (such as Washington, D.C., or Kansas City), most would-be entrepreneurs can’t choose between states in which to start their companies without relocating. And few people switch states to start businesses. Only 2 percent of Americans change states every year, according to U.S. Census data. And less than 0.5 percent of Americans both change states and start businesses annually, Small Business Administration research (PDF) shows.

While comparisons of state taxes might make for good political arguments or help list-makers tout their research, they have little bearing on where people start companies. Our politicians might consider that the next time they say state X is going to lose entrepreneurs to state Y because the latter has more entrepreneur-friendly tax policies.

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