Kansas is slipping in an important national ranking with large implications for businesses and economic development.

Kansas dropped one place to 32nd, second to last among its neighbor states, in the Tax Foundation’s 2010 State Business Tax Climate Index just released this week.

The index ranks South Dakota #1, the most “business-friendly,” and New Jersey comes in last, as it was in the 2009. Nebraska ranks 33rd, last place among Kansas and its neighbors. Missouri ranks 16th and Colorado 13th. Oklahoma fell to 31st, a 13 place drop from its 18th rank in 2009.

The Index measures the competitiveness of states’ tax systems and ranks them based on the taxes that matter most to businesses and business investment: corporate income, individual income, sales, property and unemployment insurance taxes. Scores are weighted based on relative importance or impact of the tax to a business. The final ranking is an indication of how well a state’s tax system encourages investment by maintaining a broad tax base and low rates.

Businesses, and the jobs they bring, locate and relocate based on how favorable conditions are for long-term growth. Some conditions, like availability of deep-water ports or weather, are beyond human control so the report stresses that lawmakers need to make wise decisions about what they can control.

“Although the market is now global, the Department of Labor reports that most mass job relocations are from one U.S. state to another rather than to an overseas location.” State lawmakers should be concerned about global competition for jobs and capital, but they need to be more concerned with companies moving from their state to a neighbor.

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Kansas received good marks, 6th place nationally, for its approach to unemployment insurance taxes. Individual income taxes (21st) and sales taxes (24th) were also better than average. Property taxes ranked 32nd.

Oportunities for improvement

The state’s worst mark in the index is for corporate taxes, a 40th place rank. The state has problems with several factors used to calculate this component of the index: tax credits, treatment of net operating losses and an “other” category that includes the taxation of “throwback.”

Proponents of tax credits and other incentives say they’re good for luring businesses to a state. But Padgitt says tax credits or other special incentives mask bigger problems. “They’re often used to make up for a bad broader tax policy.” He also notes that credits and other tax exemptions often result from lobbying efforts on behalf of small segments of the private sector. This allows government to control and distort business development.

Kansas tax law allows businesses to carry operating losses forward for 10 years but allows no carry back of losses as other states do. So, if a business has a $1 million profit in 2009 and a $1 million loss in 2010 it can’t pay taxes based on the true average income.

When businesses make sales into states where they do not have sufficient operations to justify taxation, businesses can end up with income that is not taxed by any state. Kansas is one of 24 states that have “throwback” rules to capture taxes from income not taxed in other states. The rules determine where the income is derived and throw it back into a state where it will be taxed.

The problem with brackets

The state’s top corporate income tax rate of 7.05 percent kicks in at $50,000. The index penalizes states with tax brackets for individuals or corporations. The report’s author, Kail Padgitt, and other economists agree that an ideal tax system should be simple, transparent, stable, neutral to business activity, and pro-growth. Brackets cause problems with all of these ideals.

Brackets add complexity to tax codes and therefore increase costs for businesses to comply with or find ways around the tax law. Government also spends more time and taxpayer money enforcing the law.

Brackets hide the real costs of the tax. Even though corporations in a higher tax bracket pay the tax bill, individuals bear the costs. Taxes, like other operating expense are either passed on to the consumer or reduce the businesses ability to compete. “These costs come in the form of either lower wages to workers or lower returns to stockowners.”

Brackets are not neutral and can be a disincentive to growth. Before expanding and hiring new employees a Kansas business making just under $50,000 annual taxable income would have to also consider the effect of an additional 3.1 percent surtax on income above $50,000.

“The bottom line is taxing corporate income will not necessarily affect income distribution in what some think is a desirable direction,” Padgitt said. “The tax code should not be used a tool of fiscal policy but as a neutral revenue raiser.”

Senator Les Donovan (R-Wichita), chairman of the Senate Assessment and Taxation Committee, owns a large auto dealership in Wichita. He says it’s frustrating to see Kansas continue to receive poor marks in the Tax Foundation index. The Legislature recently reduced the corporate income tax rate and has provided a number of incentives for business.

Donovan says there are several major obstacles in the way of a more friendly business climate in Kansas. He says some elected leaders don’t seem to understand the importance of a business-friendly environment and controlling spending.

“The ones who want to use the money, especially the governor – and especially our last governor, Sebelius, – really didn’t have a grasp of how this works,” Donovan said in a phone interview.

Unrestrained spending leads to calls for increased taxes. The Michigan Legislature in just one day, September 17, proposed 21 bills calling for new or increased taxes, many on businesses. Such changes, if enacted into law, would likely drop Michigan from its current 17th ranking.

Personal income tax changes, mostly increases, accounted for much of the shifting in the index. So-called “millionaires’ taxes” were also levied on high-income earners (often on income far less than $1 million) in Hawaii, New Jersey and Oregon.

Some states’ rankings improved without changes in tax laws because other states are implementing changes, mostly tax increases, that are not favorable to economic development. Kentucky’s ranking improved the most – up 14 spots from 34th in 2009 to 20th in 2010.

Oklahoma fell because the Tax Foundation was able to gather much more detailed nationwide data on local-option sales taxes, as high as four percent in some municipalities and much higher than local sales taxes in most states.

The report’s author has recommendations for state legislators considering tax policy changes. “When policymakers are considering tax changes in their states, they should remember two rules: Taxes matter to business, and states do not enact tax changes – increases or cuts – in a vacuum.”

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Here’s more on the Tax Climate in West Virginia and New Hampshire.

2010 State Business Tax Climate Index