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Fiscal discipline

 

Connecticut’s tax climate

Connecticut’s current tax system is generally considered to be competitive, though there is room for improvement. When asked what single change the state could make to encourage business growth and investment, 46% of respondents to CBIA’s 2008 Annual Membership Survey recommended reducing taxes, government spending, and the cost of doing business in Connecticut.

Recognizing the importance of a competitive tax climate and the temptation for some policymakers to try to tax their way out of the budget crisis, CBIA commissioned global professional services firm PricewaterhouseCoopers (PwC) to analyze Connecticut’s tax system and examine the impact of potential changes to the tax code on the state’s business climate.

The PwC report acknowledges that the state’s current economic and fiscal troubles have increased interest in potentially restructuring the Connecticut tax code, but it cautions that the impact of certain changes could be harmful to the state’s economy.

According to the report, Connecticut’s tax system has been structured to incent companies in key, wealth-creating industries—such as manufacturing, insurance, financial services, biopharmaceutical, and technology research and development—to locate and expand operations here. “Businesses take a lot of things into account when they are making investment decisions,” says John Stell, director in the national economics and statistics practice at PwC. “But the key factor is the expected return. A business is going to evaluate two questions: Can I cover my costs and generate a positive return on this investment? And if I can, where should I make the investment? On the margin, the tax system can be the difference between undertaking or abandoning the investment.

“You also have to realize that Connecticut competes regionally, nationally, and globally to attract business and investment, and one of the main tools it can use is its tax system,” says Stell. “If the next state offers a lower tax rate, an investor deciding between different locations might be enticed away from Connecticut, and that means fewer jobs.

“There has been a fair amount of research on the impact of tax incentives on investment decisions at the federal and state levels,” he adds. “It’s a complicated question, but at the state level, the more recent research has supported the notion that eliminating or curtailing state tax incentives will decrease investment within the state. That makes sense, especially when you consider how mobile investment has become, not only within the U.S. but worldwide.”

The need for stability

The PwC report identifies several characteristics of a competitive tax system, among them simplicity, low compliance costs, and attractiveness relative to neighboring states. One element of competitiveness—the stability of a tax system—is particularly salient now, given that changes to the tax code are being proposed to ameliorate the state’s budget situation. According to the report, tax systems should be stable from several perspectives. “If policymakers are constantly tinkering with the tax code,” says Stell, “it makes it difficult for businesses to make long-range decisions and could discourage investment in the state.

“In addition—and this speaks to Connecticut’s current economic situation—the burden of the tax system should not vary based on changes in external conditions, such as the state of the economy,” he says. “Tax burdens that increase in market downturns and ease during upswings might provide government with a steadier revenue stream, but they intensify the impact of economic cycles on businesses. In contrast, a countercyclical tax system, which recognizes that taxes are more difficult to pay in tough economic times, provides businesses with a more stable tax obligation.”

Business tax credits

One of the key potential tax changes the PwC report addresses—and one that has already been proposed by state legislators—involves limiting the use of business tax credits. Connecticut has instituted a series of tax credits that provide companies with incentives to increase activity in certain areas, including capital investment, research and development (R & D), job creation, and investment in urban areas.
Tax credits have been a main component of the state’s effort to incent businesses to locate, stay, invest, and create jobs here—and they’ve worked.

R & D tax credits, for example, have been instrumental in the growth of Connecticut’s bioscience industry. According to Connecticut United for Research Excellence (CURE), Connecticut bioscience companies currently employ more than 18,000 people and spend more than $6 billion on operations annually within the state. That’s up from 15,000 people and less than $1.5 billion in 1999.

The electronic data processing equipment tax credit, which allows corporations to deduct the property taxes they pay on data processing equipment from their corporate or insurance premium tax liability, was enacted to bolster Connecticut’s insurance industry in response to a significant loss of insurance jobs to other states during the 1990s. “By adopting the electronic data processing tax credit, we’ve enabled companies to keep their operations—and their jobs—in Connecticut,” says CBIA’s Rathgeber.

“Research has found that a 1% increase in a state R & D credit rate leads to a 3% increase in R & D over the long run,” notes Stell. “Studies have also found that investment tax credits have significant impacts on in-state investment. Much of the impact is attributable to state competition: If Connecticut lowers its credit rates, investment will flow to other states with higher credit rates.”

Crisis management for the long term

As the governor and state legislature work hard to find solutions to the budget crisis, CBIA urges caution when it comes to changing the tax code in ways that would make it more difficult for companies to succeed here.

“We must avoid increasing the tax burden on our primary industries, because those are the sectors we rely on for economic growth and job creation,” says Rathgeber. “As the PwC report demonstrates, changing our tax structure by curtailing or eliminating tax credits will reduce investment and deter growth and job creation. Given the troubled state of our economy—and the state’s budget—that’s really the last thing we need right now.”

Increasing the tax burden on businesses may seem like a revenue-side quick fix for closing budget gaps, but a lasting solution to the state’s fiscal problems will come only when Connecticut regains its economic footing and jobs return to the state. It is vital, then, that our state remain a desirable business location. The result will be a faster, stronger economic recovery—and a return to fiscal health.

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