Kansas has accelerated its pace in the race to the bottom of the Tax Foundation’s State Business Tax Climate Index. The state ranked 35th this year, worst among neighboring states, and down three from 32nd in 2010. Kansas ranked 31st in 2009.

The Tax Foundation prepares the annual report comparing state tax policy as of July 1 and suggests policymakers use the index to pinpoint opportunities to change their tax systems to improve their states’ standing in relation to competing states.

The index is calculated from five component tax indexes: corporate, individual income, sales, unemployment and property.

Kansas dropped in all but one of the five component rankings. The largest declines were for property tax, down nine to 41st, and sales tax, down eight to 32nd. The corporate tax ranking improved from 40th to 35th.

The report notes that states face their stiffest competition from other states. “The Department of Labor reports that most mass job relocations are from one U.S. state to another, rather than to an overseas location. This means that state lawmakers must be aware of how their states’ business climates match up to their immediate neighbors and to other states within their regions.”

Policy makers are often tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform. Earlier this year Kansas Governor Mark Parkinson led efforts to offer incentives to Cessna and Hawker-Beechcraft to expand or keep operations in Wichita.

The report’s author, Kail Padgitt, noted that incentives have considerable risk. North Carolina gave Dell Computer $240 million worth of incentives, mostly in tax credits from state and local governments. “Unfortunately Dell announced in 2009 that it would be closing the plant after only four years of operations,” Padgitt said. “Lawmakers create these deals under the banner of job creation and economic development, but the truth is that if a state needs to offer such packages, it is most likely covering for a woeful business tax climate. A far more effective approach is to systematically improve the business tax climate for the long term so as to improve the state’s competitiveness.”

The report advises lawmakers to remember two important rules when making tax policy.

Taxes matter to business. Business taxes affect business decisions, job creation and retention, plant location, competitiveness, the transparency of the tax system, and the long-term health of a state’s economy. Most importantly, taxes diminish profits. If taxes take a larger portion of profits, that cost is passed along to either consumers (through higher prices), workers (through lower wages or fewer jobs), or shareholders (through lower dividends or share value). Thus a state with lower tax costs will be more attractive to business investment, and more likely to experience economic growth.

States do not enact tax changes (increases or cuts) in a vacuum. Every tax law will in some way change a state’s competitive position relative to its immediate neighbors, its geographic region, and even globally. Ultimately it will affect the state’s national standing as a place to live and to do business. Entrepreneurial states can take advantage of the tax increases of their neighbors to lure businesses out of high-tax states.

In a conference call today introducing the study, Tax Foundation President Scott Hodge said too many states have a corporate tax policy like Neiman Marcus when they need to be more like WalMart. “They maintain everyday high taxes and try to attract investment into their state by giving away expensive incentive packages to high profile, politically connected businesses.”

He said these types of incentives reveal underlying problems with the tax system and are very unfair to the indigenous business owners who must pay higher taxes to subsidize companies that are better connected.

The key to building a better business climate, Hodge said, is to get tax policy fundamentals right, what he calls the WalMart model, a flat, everyday low tax system. “This allows the market to come to you rather than you trying to chase the market.”

The index does not measure non-tax factors such geographic location, education system, workforce or quality of life measurements that contribute to a state’s overall business climate but focuses on tax systems which lawmakers control.

“The ideal tax system-whether at the local, state or federal level-is simple, transparent, stable, neutral to business activity, and pro-growth,” Padgitt wrote in the report. “In such an ideal system, individuals and businesses would spend a minimum amount of resources to comply with the tax system, understand the true cost of the tax system, base their economic decisions solely on the merits of the transactions, without regard to tax implications, and not have the tax system impede their growth and prosperity.”

Padgitt said as states see declines in revenue they typically cut aid to local governments. That can cause localities to increase property and sales taxes to maintain spending levels.

Scott said many lawmakers mistakenly believe that high spending on education and highways promotes a better business climate. Kansas lawmakers approved a one cent per dollar sales tax increase this year primarily to fund K-12 education and highways.

“The problem with this,” Hodge said, “is unless you have a good business climate that creates jobs for college graduates, all the education spending does is educate someone else’s workforce. And, if you don’t maintain a healthy business climate, better roads simply allow businesses and people to flee the state even faster.”

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Related links

2010 Tax Foundation report on KansasWatchdog: Kansas Becoming Less Business Friendly

McPherson County Refinery Bond and Tax Agreement Raises Questions

Randal O’Toole on Wichita’s WaterWalk and Government Planning

Tax Foundation 2011 State Business Tax Climate Index