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Progressive Taxation: Not so Bad for Business After All

January 21, 2008 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

The facts are in and conservatives have it wrong.  States with progressive tax systems do at least as well as states with more regressive tax systems in economic performance, business climate, and general livability.

Tax systems can be progressive, regressive, or proportional.  A tax system is regressive if taxes, as a percentage of income, are higher for low income households than for high income households.  A tax system is progressive if the opposite is true--that is, taxes as a percentage of income are lower for low income households than for high income households.  In a proportional tax system, taxes as a percent of income are about the same for low and high income households.

Proponents of proportional or progressive taxation argue that members of a society should pay taxes in proportion to the benefits they derive from that society.  For example, a successful business person with a high income owes his success not only to his own initiative, but to the education system that produces a trained workforce, infrastructure that allows goods and services to be transported from one place to another, and a legal system that enforces contracts and protects property rights.  Principles of accountability and tax fairness dictate that the burden of paying for public services and infrastructure should be at least proportional to the benefits derived from those services.

Proponents of proportional or progressive taxation tend to favor the income tax.  The income tax is by far the most fair of the major state taxes because it taxes people based on their ability to pay.

Income tax opponents claim that progressive taxes hurt a state's economy by making it an unattractive place for businesses to locate.  The argument here is that high income individuals will tend to locate their businesses in states where the tax burden is shifted away from high income households.  Under this theory, economic development will tend to favor those states with regressive tax systems as opposed to proportional or progressive tax systems.

To test this assertion, the progressivity of the tax systems in each of the fifty states was correlated with six different state rankings of economic performance and business climate.  The progressivity of a state's tax system was determined based on data from the 2003 edition of Who Pays? A Distributional Analysis of the Tax Systems in All 50 States from the Institute for Taxation and Economic Policy (ITEP).

Only six of the fifty states--Delaware, California, Montana, Oregon, Maine, and Vermont--have progressive tax systems based on the ITEP data.  The state and local tax systems in the remaining 44 states--including Minnesota--are regressive.  Minnesota has the eleventh most progressive (or least regressive) state and local tax system in the nation.

State performance data
Three of the state performance indices used in this analysis are from the 2004 Development Report Card for the States prepared by the Corporation for Enterprise Development.  The DRC is a well respected report that has been used by business and labor groups in Minnesota as well as by state government.  The strength of the Development Report Card (DRC) is that it tends to measure output (e.g., average annual pay and pay growth, the rate of business failures, poverty rate) as opposed to input (e.g., the level of government spending or taxes).  The DRC consists of three separate indices, each of which is used in this analysis.  These three indices are:

  • Economic performance.  This index measures how well a state's economy is "providing opportunities for employment, income, and an improving quality of life."  A state's score on the economic performance index is based upon 28 factors which measure employment, earnings and job quality, equity, quality of life, and resource efficiency.
  • Business vitality.  This index measures the competitiveness of existing businesses and the extent to which new businesses are contributing to job growth.  A state's score on this index is based on nine factors, including the rate of business closings, industrial diversity, job growth due to new businesses, and the number of initial public offerings.
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    Development capacity.  This index measures a state's capacity for future economic development and is based on 31 factors that measure the strength of a state's education system, infrastructure and financial resources, and technology and innovation assets.

The fourth index is the "competitiveness index" from the 2004 Metro Area and State Competitiveness Report from the Beacon Hill Institute.  This report attempts to measure the extent to which a state "has in place the policies and conditions that ensure and sustain a high level of per capita income and its continued growth."  The state competitiveness index is calculated based on 42 factors which measure the extent to which government policies, infrastructure, technology resources, and human resources within a state foster a competitive business environment.

The fifth index used in this study is the 2005 "Camelot index."  The Camelot index is published annually by State Policy Reports.  This index is based on the premise that "fewer taxes are better than more, small class sizes are better than large, low death rates are better than high, and so on."  The Camelot index uses 26 factors that measure the elements of a state's quality of life ranging from economic health to government fiscal management.

The sixth index is the "livability rating" from State Rankings 2005: A Statistical View of the 50 United States from Morgan Quitno Press.  This report is perhaps the most well-known of the various state rankings used in this analysis.  The livability rating is based on 44 factors designed to take into account "a broad range of economic, educational, health-oriented, public safety and environmental statistics."

The rankings for all fifty states on tax progressivity/regressivity and for each of these six indices are presented in table 1.  A ranking of "1" denotes the state with the most progressive tax system and a "50" denotes the state with the most regressive tax system.  On each of the state performance rankings, a "1" denotes the state that did best on the index and a ranking of "50" denotes the state that did worst.

Methods
To test the relationship between (1) state and local tax progressivity and (2) state economic performance, business vitality, and livability as measured by the six studies, the state rankings on progressivity were correlated with the state performance rankings from the six studies cited above.

The relationship between the progressivity ranking and each of the six performance rankings was determined using a common statistical measure known as the correlation coefficient.
 
If a progressive state and local tax system was detrimental to a state's performance, we would expect a negative correlation coefficient; that is to say, as a state's progressivity ranking declines (i.e., the tax system becomes more regressive relative to other states), the state's performance ranking should improve.

Findings
This chart shows the relationship between (1) state and local tax progressivity rankings and (2) state performance rankings based on each of the six studies.

Download Chart (pdf)

In each of the correlations, the direction was the opposite of what would be expected if progressive taxation was detrimental to state performance.  There was a slight tendency of states with more progressive state and local tax systems to perform better on each of the six state performance indices.

Why is this?  One explanation is that states with the most progressive tax systems are better able to finance the educational and transportation infrastructure and the public services that a modern economy requires because they don't shift a disproportionate share of the burden of paying for these investments to households with the least ability to pay.  The loss of high income households due to progressive taxation is offset by an increased ability to pay for public investments.

The message of this research is clear.  The income tax and other forms of progressive taxation do not need to be sacrificed for economic prosperity.  In fact, we can have both a prosperous economy and a tax system that does not shift a disproportionate share of the tax burden to those with the least ability to pay.

 

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