The impact of corporate tax policy on state trade flows.

• Author: Johnson, Austin P.

State politicians are well aware of the importance of having a robust economy in order to be reelected. The economic vote is well documented in the literature and the intuition is naturally understood among politicians (Lewis-Beck and Stegmaier 2013). "It's the economy, stupid," which harkens back to the 1992 U.S. presidential election, has become a common slogan that is reiterated on media outlets in almost every election cycle. Therefore, economic growth is of great importance to elected officials, especially executives, and most states have entire departments dedicated toward advancing economic development within their boundaries (Eisinger 1988). Business tax cuts are a direct approach to economic development, although current empirical research on this topic is mixed at the state level.

A variety of mechanisms for spurring state economic growth through tax cuts have been suggested in the literature. First, it has been argued that cutting taxes can attract business from other regions, enriching the low-tax state. A potential problem is that subsequent reciprocal tax cuts in other states to attract businesses could lead to a race-to-the-bottom (Basinger and Hallerberg 2004; Grieco 1988; Plumper, Troeger, and Winner 2009). However, there is virtually no evidence for this type of excessive fiscal competition at the state level during the recent financial crisis. Second, lower taxes are thought to increase the profit retention of existing resident businesses, which in turn spurs further growth-enhancing investment (Eisinger 1988). For example, retained revenues paid out in dividends can then be reinvested into debt or equity markets, aiding other businesses. Alternatively, the retained earnings can be reinvested in the business's own operations, leading to business expansion that includes increased production and a larger payroll. A third possible economic growth mechanism is that tax cuts lead to spending cuts, which could free up resources for the private sector (Browning and Johnson 1984, Friedman 1967). These mechanisms all describe ways in which tax cuts can benefit the economy, and are therefore attractive as policy instruments.

Tax cuts are also desirable from the perspective of the businesses they affect. Businesses have become increasingly capable of voting with their feet--also known as capital mobility--and moving to a state with a more favorable business climate. Capital mobility is a well-documented issue in the political economy literature, and taxation can be a potential instigator of capital mobility (Andrews 1994, Cerny 1990, Jensen 2013, and Kurzer 1993). Capital mobility frequently has a negative connotation, but the movement of capital can prove to be the salvation of businesses teetering on the edge of bankruptcy, saving numerous jobs in the process. Incentives have been found to be effective at attracting mobile capital, such as manufacturing (Head, Ries, and Swenson 1999), but there has been a lack of adequate data to empirically test how incentives alter the location of firms with much regularity (Arauzo-Carod, Liviano-Solis, and Manjon-Antolin 2010). During my review of the literature, I have found no research that has rigorously considered capital mobility in response to tax incentives at the state level. Many corporations today are capable of acquiring information and talented consultants for the purpose of restructuring business operations. Assuming they comply with their fiduciary duty to shareholders, corporations are likely to restructure their operations in such a fashion that minimizes their effective tax rate (ETR). Relatively higher business taxes may therefore trigger businesses to leave a relatively higher-tax state for a relatively lower-tax state. Finding evidence for this behavior has proven elusive at the aggregate level until now.

In the remainder of this article, I discuss the current literature on taxation and state economic growth, argue for using trade flow data as a measure of economic activity in the United States, test for the influence of taxation on economic activity, and conclude with a discussion of the pertinent empirical findings. My findings indicate that pro-business state tax policy matters for growing existing businesses and attracting new ones.

Taxation and Economic Growth

The literature that examines how taxation influences state economies has focused on how taxation directly influences gross state product (GSP). Over the last 10 years, six articles have examined the influence of taxation on U.S. state economic growth at the aggregate level. This body of research has produced mixed findings, and it is widely acknowledged that empirical model specification and methodology are largely responsible for this variation (Reed 2009).

Specific details on the different methodological approaches for all six articles are listed in Table 1. As can be seen from the table, one of the major factors that leads to differing results relates to how tax revenues are aggregated across studies. Studies that aggregate all taxes together when calculating the total tax burden are consistent. Bania, Grey, and Stone (2007) and Reed (2008) both found that an increase in the total tax burden, a measure that aggregates all state-level taxes together, can harm growth. Similarly, Atems (2015) found evidence that an increase in the total tax burden of a state can harm bodi internal growth and the economic growth of nearby states. The consistency of the results changes after scholars begin to dissect tax revenues into their constituent components. Ojede and Yamarik (2012) segmented taxes into income, sales, and property taxes, and found drat increases in the latter two categories hurts growth (income taxes were statistically insignificant). In contrast, Prillaman and Meier (2014) split tax revenues into business and nonbusiness categories and created two sets of models. One set of models was "trimmed" for outliers (Prillaman and Meier 2014: 371), and the authors found evidence that nonbusiness taxation severely hinders economic growth but business taxation...