What's the Best State for Small Business Taxes?
Posted Saturday April 18, 2009 in Business
It’s tax season, and I’m as interested in how much the government is taking out of my pocket as the next guy. So I was intrigued to learn of a new small business-focused ranking of state tax burdens from Wall Street Journal Small Business reporter Kelly Spors. Now, I’ve started two businesses in famously high-tax California, and I’ve never found taxes to be a big enough problem that any of my time was justified in thinking about them rather than running the other parts of the business. But I know that a lot of businesses that have been around longer and are in more of a sustaining than a growth mode have real concerns about tax burdens, so I was looking forward to reading and learning from this report. Unfortunately, the ranking is comically sloppy.
The Small Business & Entrepreneurship Council’s Rankings
The Best to Worst Tax Systems for Entrepreneurship and Small Business rankings the WSJ mentioned come from a lobbying group called The Small Business & Entrepreneurship Council. The council says they’ve put these rankings forward to help compare states and advise state leaders in policy.1
What a Ranking Should Do
These are good goals; entrepreneurs should take taxes into account during planning, and politicians should take business growth into account when levying taxes. The problem comes when the SBEC suggests that politicians should try to score better on their rankings to help small businesses. That implies that your SBEC Tax System score predicts future small business success in your state. Do they?
That’s a question I can answer statistically, using something called r2. r2 is a common measure of correlation. While we all know that correlation doesn’t imply causation, it’s still a good hint that one thing causes another (or that they’re both caused by something else). Even better, a lack of correlation almost always means you don’t have causation. r2 answers the question “what percentage of the change in one thing is explained by the change in another thing?” Values of r2 range from 1 - meaning that 100% of the change in one thing is explained by the change in another thing - to 0 - meaning that none of the change in one thing is explained by the change in another thing - to -1 - meaning that as another thing changes, one thing changes in the opposite direction.
So, using r2, how much of state small business success does the Tax System score explain? Using measures from the Small Business Administration,2 I found that, at their best, the Tax System scores predicted 0.08% of the difference in number of small businesses between states. In the statistics business, they call that totally unrelated.
On a lark, I also looked at the US News rankings of state schools and saw how well those predicted the difference in number of small businesses between states. School rank was actually pretty strongly correlated - it explained about 50.5% of the difference in small business success between states. So, quality of the best public university in the state is more than 600 times as good a predictor of small business success than is the SBEC Tax System.3
Problems With the Math Behind the Ranking
Digging deeper in the rankings, it’s not surprising that they aren’t highly correlated with small business success. The rankings are built by adding a bunch of things together that shouldn’t be added together - they’re basically adding apples and oranges and saying that you come out on the other side with a strawberry. They look at the percentage tax you pay at the personal and business level on income and capital gains, which is a rate per dollar. They add on the tax you pay for gas and diesel, which is a rate you pay per gallon. They then add on measures of the presence or absence of certain other kinds of taxes - a 1 if the state has it and a 0 if they don’t. Remember high school chemistry or physics, where the teacher kept on yelling at you if you don’t keep track of your units? That’s what happened here - the rankings are in something like true/false dollar-gallons per year. It’s important to watch your units; after all, 7 dollars is a lot nicer to have than 7 pesos.
The SBEC also fails to take into account the relative importance of the various taxes. For instance, they give states 1 point for having an inheritance tax, and then score unemployment taxes on a per-dollar rate, so that that an unemployment tax rate of 2% gets you 2 points. Well, last I knew, you pay that inheritance tax just once, on the value of the estate at just one point in time,4 but you pay that unemployment tax every time you cut a paycheck.
So What’s the Best State for Startup Taxes?
According to the SBEC, the highest state tax rate is California’s 10.5%. Let’s assume, as a very worst case scenario, and without any evidence, that there is a direct, linear relationship between tax rate and chance of failure - so this 10.5% tax rate increases your chance of failure by 10.5%. A few states have a 0% personal tax rate, so if you had an LLC or S Corporation that paid no minimum taxes and moved from California to, say, Alaska, you’d at most increase your chance of success by about 12%.5 Will giving up your existing personal network decrease your chance of success by more? Probably. Will giving up the market knowledge that you have from working in the market do the same? Probably. For startups, the best state is the state you’re in, the state where you already have the resources and contacts. Getting the business off the ground, not minimizing taxes, is job 1.
1 The SBEC’s favored policies are here
2 There’s a small catch here - the SBEC released Tax System rankings in 2008 and 2009 only, while the SBA’s data only goes up to 2006. I used the 2009 SBEC and 2006 SBA data for my comparisons here, which should be reasonable as it’s unlikely any state completely changed its tax mix in the interim.
3 If you want to check my math, download it here
4 And, technically, you don’t pay the inheritance tax - your kids do. You get to pick whether or not you like them enough to care.
4 That is, being in California reduces your chances from the standard indexed 100% to 89.5%, and moving to Alaska increases them back to 100%.
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