Academic journal article Economic Perspectives

State-Local Business Taxation and the Benefits Principle

Academic journal article Economic Perspectives

State-Local Business Taxation and the Benefits Principle

Article excerpt

In recent years, interest in state and local taxation of business has been fueled by concerns over the possible deleterious effects such taxes may have on economic development and, in particular, on the ability of a jurisdiction to provide jobs for its residents. Much ink has been spilled over whether or not fiscal factors have a significant effect on firm location decisions. However, without analyzing why business taxes are on the books in the first place, it may be impossible to properly evaluate the impact of such taxes on business location. In this article, we advance the proposition that general business taxation should be structured so as to recover the costs of public services rendered to the business community.

Economic development may be but one objective of tax policy. Other objectives, such as fairness, economic efficiency, and sound expenditure policy, are also important. For example, a local community may want to structure its taxes to discourage business activities which produce noxious side effects; state government may wish to restrict business activity in such a way as to promote monopoly power of home enterprise(s) serving an out-of-state clientele. Even in the absence of such motives for growth controls, business taxation may be desirable to recover the cost of government services provided to businesses within a jurisdiction. Not only does this promote fairness, by recouping the costs of such services from those who ultimately benefit from them, it also enhances economic efficiency by causing the prices of goods and services to reflect their full costs of production. Such prices enable people to make appropriate choices among consumer goods. Business benefits taxes similarly promote appropriate choices between private and public goods. Without recovery of the costs of business services, voters may not support otherwise worthy public services provided to business. Alternatively, the voting public and their representatives may believe that business taxes can be ratcheted skyward as a way to subsidize those public services provided to households.

One objective of this article is to develop a comprehensive framework for evaluating the efficacy of state-local business tax structures. This framework will then be applied to existing practices within the U.S., with specific focus upon the Seventh Federal Reserve District, which encompasses Iowa and major portions of Illinois, Indiana, Michigan, and Wisconsin. We will argue that the primary basis for general business taxation is to recover the costs of government services rendered to the business community. It follows that if general business taxes exceed or fall short of the cost of providing government services to business, the business tax structure is not neutral with respect to the location of business activity in general. Furthermore, it will not be neutral with respect to consumption patterns for consumer goods and the composition of spending on private goods and public goods.

It should be emphasized that, even where there is correspondence between business taxation and business expenditures, there may remain non-neutral location incentives for specific firms. This will be the case if the business tax structure is not neutral across firm types or if there are wide disparities among firm types in terms of service benefits received from government. In effect, what is true on average may not be true for particular firms. These issues should be considered when designing the optimal business tax structure.

We begin by providing a framework under which businesses might be taxed to optimal effect. Following definition and measurement of current state-local business taxation, we discuss alternative business tax structures. Among these alternatives, the benefits principle is identified as the best by far. Turning to the specifics of how to implement the benefits principle, today's practices are held up against the theoretical standard that business tax revenues should roughly cover direct public service costs. …

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