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Fed Explores Relationship between State Taxes and Corporate Investment

Friday, October 12, 2001

As Congress and the Bush Administration look at national economic stimulus packages, debate is beginning in some states to enact similar measures to reverse the direction of their local economies. Various tax cuts for businesses invariably are included in the states’ discussions. The most recent edition of the Federal Reserve Research Roundup (3rd Quarter, 2001) includes a timely review of a recent working paper from the Federal Reserve Bank in Boston that looks at the relationship between corporate investment decisions and state and local taxes. 



The Research Roundup article by Monique Morrissey follows in its entirety (reprinted with permission from the Financial Markets Center ): 

State Corporate Taxes. According to a Boston Fed working paper, firms’ “user cost of capital” – a theoretical construct defined as the annualized cost of purchasing an additional unit of capital – varies little from state to state despite wide differences in state marginal tax rates. The implication: state and local taxes may have little impact on corporate investment decisions. 



Adapting the capital budgeting model of Robert Hall and Dale Jorgenson, Charles Ian Mead examines the adhesives, electronic transformer, pharmaceutical and semiconductor industries between 1963 to 1997. Mead finds that changes in the federal tax code created substantial year-to-year fluctuations in the overall user cost of capital that tended to swamp any differences among states in a given year. For one reason, state and local taxes are roughly one-eighth the size of federal corporate income tax rates; so even wide differences in state marginal tax rates have little practical import. Other factors, such as the deduction of state and local taxes from the federal tax base, tend to smooth out variations between states. 



Mead’s paper ignores many complicating factors, such as discretionary incentives negotiated between a firm and state or local officials. But he still provides a readable, interesting discussion of state business tax practices. (Charles Ian Mead, State User Costs of Capital, FRB Boston Working Paper 01-3)



The FRB Boston Working Paper is available at: http://www.bos.frb.org/economic/wp/wp2001/wp013.pdf 

The complete online issue of the Federal Reserve Research Roundup (3rd Quarter, 2001), which includes a survey of many research papers from the Fed, can be downloaded from: http://www.fmcenter.org/pdf/roundup01Q3.pdf