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Research shows that higher state business and personal tax rates mean fewer businesses, less employment, and reduced capital investment

We often point out the fact that Minnesota is one of the highest taxed states in the union. What are the effects of these high taxes? When it comes to business activity in our state, new research gives cause for concern.

In an article forthcoming in the Journal of Political Economy, titled ‘State Taxation and the Reallocation of Business Activity: Evidence from Establishment-Level Data’, economists Xavier Giroud and Joshua Rauh estimate the impact of state business taxation on business activity (an earlier version can be found here).

Higher business and personal taxes mean fewer businesses

Giroud and Rauh find that a one percentage point increase in the state corporate income tax leads to the closing of 0.4-0.5% of a C-corporation’s establishments in the state*. In other words, if a state increases the corporate income tax rate by one percentage point, from 5% to 6%, for example, C-corporations would close down one establishment out of 200-250 in the state. Remarkably, they find that half of these closures are offset by reallocation across states – that is, for each two establishments that are closed in the state, companies open one establishment in other states.

They find similar results, albeit smaller in magnitude, for pass-through entities with respect to the personal income tax**. Specifically, a one percentage point increase in the state personal income tax rate leads to the closing of 0.2-0.4% of a pass-through entity’s establishments in the state. Again, Giroud and Rauh find that about half of these closings are offset by the opening of new establishments in other states.

Higher business and personal taxes mean less employment

These results refer to the ‘extensive margin’, the closing and opening of establishments. Giroud and Rauh also study the ‘intensive margin’, changes in the number of employees within existing establishments.

Their findings are similar. For C-corporations, a one percentage point increase in the state corporate tax leads to a 0.4% reduction in the number of employees within their establishments; for pass-through entities (with respect to the state personal tax), they observe a 0.2% reduction. Again, roughly half of these effects are offset by increases in the number of employees in the firms’ establishments in other states.

Higher business and personal taxes mean less capital investment

Giroud and Rauh also examine changes in physical capital in the manufacturing sector.

They find that capital shows similar patterns to labor in its response to taxation, although not of a larger magnitude. This implies that firms respond to state taxes as much through changing the location of their labor inputs as through the reallocation of capital.

The bigger the business, the greater the effect

Giroud and Rauh are also able to examine the responses of firms to state taxes by the the size of the firm. Their results are stronger for firms operating in ‘footloose industries’ (industries whose activities are less concentrated in specific states), for larger firms, and – among the larger firms – for multinational corporations. The bigger the firm, the easier it is to move away from a high tax jurisdiction. It is smaller businesses who get hit.

What this means for Minnesota

To repeat, Minnesota is one of the highest taxed states in America. We have the fourth highest top marginal individual income tax rate in the country, at 9.85%, and the third highest corporate income tax rate in the country, at 9.8%As we find in our recent report, The State of Minnesota’s Economy: 2018, our state lags the national average in new business formation, job creation, and capital per worker. This new research suggests that these two may be causally linked.

Giroud and Rauh do offer some hope. Their analysis enables them to examine the impacts of tax increases and tax decreases. They find that the effects are approximately symmetric: while tax increases hurt business activity, the opposite is true of tax cuts. Lets hope Minnesota’s lawmakers take this on board.

*C-corporation profits are subject to the corporate income tax. Their shareholders are then subject to dividend or capital gains taxation when those individuals receive dividends or sell shares.

**The profits of pass-through entities – which include S-corporations, LLCs (limited liability companies) choosing to file taxes as S-corporations, and partnerships – are subject to the personal income tax: their profits ‘pass through’ to the owners who are then taxed at the personal rate.

John Phelan is an economist at the Center of the American Experiment. 

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