Sunday, August 14, 2011

Does "business tax climate" affect entrepreneurship?

Perhaps a little, but not in the direction that most folks would expect.

My own state of New York is the poster child for demonstrating that the conventional wisdom on this is wrong. We are perennially ranked as worst in business friendly tax climates, but a national study has also consistently ranked our state as first in entrepreneurship in recent years. (And yes, the study uses per capita statistics to adjust for population, so we don't get any breaks on that score!)

Here's a graph that puts the picture in perspective. (Click on the graph for a higher resolution view.)

<--Less Business Friendly - Tax Climate - More Business Friendly -->

The horizontal axis in the graph above shows the "State Business Tax Climate Index" computed by the Tax Foundation. As you move from left to right on the horizontal axis, the Tax Foundation asserts that the tax climate gets more and more business-friendly.

The vertical axis in the graph above shows the State Entrepreneurship Index, computed by the University of Nebraska-Lincoln's Bureau of Business Research (UNL-BBR), recently featured in an article in Bloomberg Business Week. Here is how the UNL-BBR describes their index:

The State Entrepreneurship Index combines five key components -- a state's percentage growth and per capita growth in business establishments, its business formation rate, the number of patents per thousand residents and gross receipts of sole proprietorships and partnerships per capita -- to build its state-by-state rankings.

States near the top of the graph above (plotted in green) had the highest levels of entrepreneurship, while states near the bottom (plotted in red) had the lowest levels of entrepreneurship.

My own state of New York is at the top left corner of the graph--tops in entrepreneurship, but worst in "business friendly tax climate."

As you can see, there are many factors other than business tax climate that affect entrepreneurship, but--if there is any relationship at all--it appears to be a negative one. The correlation coefficient between the tax climate index and the entrepreneurship is -.13. Thus, on average, the more "business friendly" the tax climate, the lower the entrepreneurship index in the state.

Of course, there are many deviations from that rather weak relationship. Variations in business tax climate account for less than 2% of the variations in the entrepreneurship index.

And, to be sure, the old saw applies: "Correlation does not establish causality." I am certainly NOT making the case that states should go around making their tax systems deliberately less business friendly purely on the grounds that it will encourage entrepreneurship.

But there appears to be little support for the opposite proposition--that is, there is no evidence that states with business friendly tax systems (as measured by the Tax Foundation) encourage entrepreneurship (as measured by the UNL-BBR). Other factors appear to be more important.

Update: I have added more thoughts in a followup post here.


  1. I think there is a pretty decent causal argument to make. Taxes don't cause business, but maybe businesses cause taxes. If I'm a state where businesses like to gather for some reason other than the tax code, I'm going to raise taxes to take advantage of that.

  2. I wonder what constitutes an entrepreneur for the purposes of the study? If it's primarily small start-ups then the business tax codes may not be as big factor as it would be for bigger companies. I live in California. My wife and I operate two small companies neither if which pay any business tax because both are Sub-Chapter S corps. I have no idea what the breakdown is, but if a large percentage of small businesses are Sub-Chapter S then it seems to me it would make the issue of how business taxes affect entrepreneur sort of moot.

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  4. Wew~ I've been reading different scatter diagrams lately, and I found this one interesting! The states have been recognized and acknowledged in this diagram based on two perspectives. How did you gather the data?

  5. That's because New York itself is already a center of commerce

    Small Business Tax