A study released several weeks ago by an accounting firm and recently touted by North Carolina politicians as evidence of the state’s attractiveness to business is fundamentally flawed and offers little useful information to policymakers considering tax changes, according to a new report published today by the John Locke Foundation.
Ernst & Young conducted the study for the Council on State Taxation (COST). Focusing on 2003, the study purported to find North Carolina near the top of the states in various rankings of the cost of business taxation. Last weekend, Gov. Mike Easley touted the finding in a press release, which was followed by other favorable comments about the state’s business-tax climate by politicians and the news media.
But Dr. Roy Cordato, an economist and vice president for research at the Raleigh-based John Locke Foundation, was already examining the Ernst & Young/COST study and said he was surprised at the conceptual errors it contained. “This study ignored entire categories of taxation paid by business and some of the most basic principles of public-finance economics in coming to its conclusions,” Cordato wrote in a new Spotlight briefing paper on the issue released today. “It would not be an exaggeration to say that the Ernst and Young study is worthless as an analysis of the business-tax environment in North Carolina and other states.”
Cordato found that the study, unlike two other national rankings of business costs released in 2003, did not include data on individual income taxes or most of retail-sales taxes in its computations of tax burden. This was puzzling, he said, because most businesses in North Carolina and in the nation are unincorporated and pay individual rather than corporate taxes on the income earned, while the burden of taxes on both personal income and retail sales is actually shared among business owners, customers, and workers — making such taxes a critical element of the fiscal environment affecting business activity and economic growth.
Small businesses, Cordato wrote, are particularly affected by the taxes left out of the Ernst & Young study. They account for about half of employment in North Carolina and have generated 80 percent of net job growth in recent years. “A model for measuring business taxation that leaves out a major tax liability for these firms is obviously of limited value in gauging whether a particular state is relatively congenial or hostile to business investment and growth,” he said.
Because of the study’s selective use of data, states that rely primarily on property taxes — including those with land-intensive industries such as oil production, mining, and ranching — scored poorly on the resulting “business-tax” rankings while those relying more on income and sales taxes, such as North Carolina, scored well. In most other studies of state fiscal policies, the trend lines are almost precisely reversed — states with high marginal tax rates on income, sales, and capital gains are often rated by both researchers and businesses as adverse environments for growth.
Cordato found, for example, that a 2003 study by the Washington-based Tax Foundation gave good marks on taxes to states such as New Hampshire, Wyoming, and Washington that the Ernst & Young study had rated as among the most heavily taxed states. Similarly, a 2003 study by the Small Business Survival Committee ranked places such as Nevada and Texas as low-tax states while Ernst & Young ranked them as middle- to high-tax states.
Within the Southeast, North Carolina was the lowest-tax state in the Ernst & Young study but near the top in tax burden in the Tax Foundation study and ranked significantly worse than all other states in the region did in the Small Business Survival Committee study. North Carolina’s marginal tax rates on income are among the highest in the United States, and its combined retail sales tax rate now exceeds that of most of its neighbors.
With other research demonstrating the adverse effects of high marginal tax rates on state economic growth, Cordato argued that “North Carolina policymakers should take no comfort from the Ernst & Young study. Initiatives to reduce the tax burden would have significant and positive effects on North Carolina’s prospects for economic recovery and development.”