Startups near state lines gravitate to reduced property tax side • News Service • Iowa State University
AMES, IA — Researchers at Iowa State University have found that vastly different state tax rates affect where new businesses locate near state borders. Their study published in the journal Small Business Economics shows that the fourth largest distortion in the United States is between Iowa and its northwest neighbor.
“The likelihood of starting on one side of the border versus the other due to tax rates is 7.5% higher in South Dakota than in Iowa, but that may not be be not for the reasons that people think. Namely, property taxes seem to matter more than other types of taxes and providing certain incentives to some Iowa businesses may hurt others,” said economics professor Peter Orazem, who led the study.
Orazem explained that he and his team focused on state borders because this approach helps control unobservable local factors that would influence new businesses on both sides of the border, such as an exceptionally strong local economy, better access local to labor or venture capital, or an exceptionally supportive local business community.
To collect their data, the researchers looked at the individual and combined effects of four types of state taxes (i.e. US Business Statistics under the US Census Bureau.
“The reason we were particularly interested in start-ups is that they may consider setting up in multiple locations. They will be more sensitive to different tax rates compared to an established business that would have to move all of its equipment and employees or find new workers if it jumps state lines,” Orazem said.
The researchers found that a state with a one point higher tax rate in each of the four tax types will have a “small but statistically significant” 3.2% lower probability of attracting a startup compared to its neighboring state. The biggest distortion of startups due to US tax rates is Wyoming’s 8.6% advantage over Idaho. Wyoming’s state revenues are largely subsidized by taxes and royalties from fossil fuel production in the state, which eases the pressure to tax other types of businesses.
Orazem and his team pointed to the likelihood of businesses starting up on one side of the border or the other collapsing when two neighboring states have similar tax structures. For example, Rhode Island has the highest tax rate in the United States, but neighboring Connecticut has the third highest tax rate, essentially erasing what might otherwise be a disadvantage.
The study also found that property taxes have the greatest negative effect on the rate of new businesses. Orazem explained that this is because new businesses can pay property taxes even if they don’t generate any revenue.
Gain a competitive advantage
As director of the Midwest Markets and Entrepreneurship Program at ISU, Orazem said he and his colleagues are still trying to figure out what drives and stops businesses from setting up shop in Iowa and the region.
“Tax policies are one of the reasons people have specified South Dakota as a relatively faster growing state in the Midwest. So, even though the study doesn’t focus on South Dakota, we were curious to see a difference, which we were doing.”
But Orazem pointed out that many of the strategies implemented in Iowa to try to stay competitive with South Dakota aren’t necessarily the most effective.
“The weird thing about Iowa is that we tend to have high marginal tax rates, but then we give tax breaks to some businesses and not others. For example, we have around 450 special exemptions for sales tax,” Orazem said. “Perhaps we should stop offering special offers in general, but reduce tax rates where they really matter, like property tax rather than income tax.”
Orazem said he hopes the study’s findings will open discussion, but acknowledges that state tax reform is difficult.