Why Minnesota Beats South Dakota: Taxes Invest in Public Goods

Reading (and questioning) the Small Business & Entrepreneurship Council's report on which states best conform to its ideological wishlist for policies that favor business reminded me of a report I cited a couple years ago in a discussion of South Dakota's upside-down tax system that taxes food but not gold. The latter report, by Dr. Robert G. Lynch, finds that the anti-tax, anti-government logic used by the SBEC to rank South Dakota #1 for entrepreneurship is flat wrong. Lynch argues that the public services provided by an adequate tax base add more value to the business climate than tax cuts that reduce public services:

Businesses need to know that they can rely on high-quality, well-administered public services to facilitate the conduct of their enterprises. Roads, bridges, and highways must be maintained in good repair; ports and airports must be large enough to handle transportation needs; sewage systems must be adequate to meet the needs of existing firms and expandable to service prospective businesses; snow removal and flood control must be reliable and timely; fire protection and police services must be ready when needed; the justice system must be professional, impartial, and quick to resolve contract disputes; and the schools and colleges must help to generate a skilled and well-trained workforce. A relatively crime-free state with high-quality public services—including good infrastructure and a highly educated workforce—will have an excellent business climate.

Minnesota, despite its relatively high business tax burden, is a good example of this. Compare Minnesota to its neighbor South Dakota, which has a relatively low business tax burden. As the Property Tax Study Project (2000) has noted, Minnesota has had higher per capita income after taxes, higher average hourly earnings, higher average annual pay growth, higher employment growth, more high school and college graduates per capita, better maintained roads and bridges, less income disparity, and a lower business failure rate than South Dakota. Indeed, Minnesota can be said to have a good business climate in part because of its relatively high tax burden, while South Dakota has a weaker business climate in part because of its relatively low taxes. Taxes are necessary to pay for the high-quality public services that make a state a good place to do business [emphasis mine; Robert G. Lynch, "Rethinking Growth Strategies: How State and Local Taxes and Services Affect Economic Development," Economic Policy Institute, 2004, p. 12].

Note that last part in bold: lower business failure rate. SBEC's argument is all perception; Lynch and I are looking at reality, actual business performance. Say what you want about how you think low taxes make a better business climate; when businesses fail at a higher rate in South Dakota than Minnesota, Minnesota clearly has the better business climate. The strategy of trying to attract businesses with tax breaks is likely to backfire:

...[I]t is unlikely that business decision makers are apt to be persuaded by “perceptions” rather than by the facts of business costs and benefits. In any case, firms that are driven appreciably by perception and are less attuned to the facts about costs and benefits are likely to be unsuccessful and few in number, as they tend to get driven out of business by their more savvy competitors. Attempting to attract such businesses by giving them tax breaks is probably not a wise investment on the part of state and local governments [Lynch, 2004, p. 11].

This EPI report is perfect counter-programming to the SBEC report. SBEC's chief economist Raymond J. Keating has a master's degree; Lynch is an actual Ph.D. Lynch and his fellow Ph.D. researchers at EPI get published in academic journals. SBEC is a right-wing advocacy group; EPI is a pro-labor group whose founders included reasonably intelligent former Secretary of Labor and fellow lefty Robert Reich.

As Dr. Lynch notes, we shouldn't always think of taxes as a "burden." They can be a way to save money... by subcontracting the government:

When tax cuts cause reductions in public services, firms may be forced to spend more on, for example, the education and training of their workers, health services for employees and their families, security for the workplace, and infrastructure. As a consequence, in the absence of adequate taxation, the provision of “public” services becomes an internal cost to firms. Moreover, the costs of providing these “public” services privately, in the relatively small amounts needed by individual firms, may be much higher than the costs of providing them collectively to all firms by government. For example, it may be cheaper for a city to provide police protection to all firms located within its borders than it would be for each firm to pay for its own security force. Thus, tax cuts and incentives may not reduce the costs of doing business but may, instead, contribute to rising costs by reducing publicly provided services [Lynch, 2004, pp. 5–6].

A business may not like paying taxes, but it would like hiring its own cops, teachers, and pavers a whole lot less.

Low-tax policy is a money loser for South Dakota in more ways than one. Consider that state and local taxes are deductible from federal income tax:

Typically, for every dollar of tax revenue lost by a state or local government due to tax cuts and incentives, firms increase their revenues by only about 60 cents. Due to the deductibility provisions of the tax law, the other 40 cents go to the federal government and other state and local governments in the form of higher tax payments. Ironically, therefore, state or local tax cuts and incentives subsidize competing jurisdictions by providing them with additional tax revenue [Lynch, 2004, p. 16].

So the next time you hear Governor Rounds or some right-wing advocacy group pontificating about how South Dakota's "low taxes" are good for business, tell them to look at reality in the form of Minnesota and Lynch's report.