Attempts to rank states based on the level of business taxes rarely take into account the benefits that businesses receive from tax-funded public investments. In a report published by the Council on State Taxation (COST), analysts at Ernst & Young (EY) have filled this void by ranking states based on the level of state and local taxes paid by businesses in each state relative to the level of public expenditures paid for with tax dollars that benefit businesses. Based on this measure, Minnesota business taxes are low relative to business taxes in most other states and to the national average.
Businesses benefit directly from many forms of public expenditures. Consequently, state rankings that take into account the taxes that businesses pay but ignore the benefits that businesses receive from government services and infrastructure are incomplete. According to the COST report,
…the business tax burden can be evaluated by comparing business taxes paid to benefits received by businesses due to government spending. Because government spending can reduce businesses’ non-tax costs, if two businesses pay the same amount of taxes but one receives larger benefits from government spending, the true tax burden is not the same for both businesses. Calculating the business tax-to-benefit ratio estimates the extent to which businesses are “getting what they paid for” from their tax dollars.
EY uses a methodology developed by economists at the Federal Reserve Bank of Chicago to allocate tax-funded expenditures between households and businesses to reflect the benefits accruing to each group. Certain categories of expenditures, such as health and human services, were assigned entirely to households while other categories, such as public safety and highway infrastructure costs, were apportioned between businesses and households. Regarding the allocation of education spending, the report notes that:
While economic theory suggests that individuals are the primary beneficiaries of education due to higher wages, business owners can benefit if an educated workforce generates higher returns to capital. Returns to capital would increase if workers do not completely capture productivity gains through higher wages or an educated workforce improves the productivity of capital… A review of the literature finds that a 1% increase in the share of workers with a college education in a city increases output by 0.5 to 0.6 percentage points. If businesses are able to capture some or all of the additional productivity from increased education, they are deriving benefits from this type of government spending.
Both in Minnesota and nationally, education is the largest single category of state and local public expenditures; consequently, assumptions regarding the distribution of education benefits between businesses and households have a large impact on the distribution of overall benefit of public expenditures accruing to each group. EY analysts calculated the share of total tax-funded expenditures that benefits businesses under three different assumptions: (1) tax-funded education spending does not benefit businesses at all, (2) 25 percent of education spending benefits businesses, and (3) 50 percent of education spending benefits businesses.
The chart below compares Minnesota to the national average in terms of the ratio of state and local business taxes to tax-funded state and local spending benefitting businesses under each of three assumptions regarding the distribution of benefits resulting from education expenditures.
Both nationally and in Minnesota, each of the ratios illustrated in the above chart are greater than 1.0—an indication that state and local business taxes exceed the level of tax-funded spending benefitting businesses, regardless of the assumption regarding the percentage of education spending that benefits businesses. However, under all three assumptions, Minnesota’s business tax-to-benefit ratio is below the national average. In other words, Minnesota business taxes are below the national average when measured relative to state and local spending that benefits businesses.
The graph below shows the same information for all fifty states and the District of Columbia. Based on the assumption that no education spending benefits business, only fourteen states have a lower business tax-to-benefit ratio than Minnesota, while 35 states and D.C. have a higher ratio. Minnesota’s ranking relative to other states is similar based on the 25 percent and 50 percent education assumptions.
Minnesota’s business tax-to-benefit ratio is less than the average ratio among the four adjacent states (Iowa, North Dakota, South Dakota, and Wisconsin) and approximately equal to the adjacent state average if the North Dakota outlier is excluded,* regardless of what education assumption is used.
The COST report measures business taxes in the fifty states based on solid data and innovative yet sensible methodologies. The findings of this report stand in stark contrast to claims from Minnesota-based advocacy groups which contend that Minnesota is a high business tax state. Part 1 of this series examined COST data which shows that Minnesota’s business effective tax rate is equal to the national average, while business taxes per private sector employee are below the national average. Part 2 examined COST data that showed that Minnesota ranks among the ten lowest states in the nation in terms of business taxes as a percentage of total state and local taxes.
Perhaps the most important contribution of the COST report to the study of business taxation in the fifty states is the analysis of business taxes relative to the benefits that businesses receive from tax-funded spending. After taking into account the benefits that businesses receive from state and local government expenditures, business taxes in Minnesota are fairly low relative to the national average and most other states.
*As noted in the first installment of this series, North Dakota is an outlier among states in that it has extremely high business taxes as a result of severance taxes on energy production.