State income tax reciprocity agreements and small businesses
| Date | 14 April 2014 |
| DOI | https://doi.org/10.1108/JEPP-07-2012-0037 |
| Published date | 14 April 2014 |
| Pages | 118-140 |
| Author | Don Bruce,Jon C. Rork,Gary Wagner |
| Subject Matter | Strategy,Entrepreneurship,Business climate/policy |
State income tax reciprocity
agreements and small businesses
Don Bruce
Center for Business and Economic Research and Department of Economics,
University of Tennessee, Knoxville, Tennessee
Jon C. Rork
Department of Economics, Reed College, Portland, Oregon, USA, and
Gary Wagner
Department of Economics, Old Dominion University, Norfolk, Virginia, USA
Abstract
Purpose – Small businesses play a vital role in job creation and economic growth, and previous
studies have noted that higher state tax rates may reduce entrepreneurial activity, growth, and hiring.
The paper aims to discuss this issue.
Design/methodology/approach – In this paper, the authors use a 1989-2005 panel of state-level
data to explore the effects of state income tax reciprocity agreements on several measures of small
business activity. Since a reciprocity agreement exempts non-resident income from a state’s personal
income tax base, it has the potential to reduce bar riers to entrepreneurial activity and lower tax
compliance costs.
Findings – The results indicate that reciprocity agreements appear to have reduced the tax-rate
sensitivity of entrepreneurial activity, which may lead to more small business and entrepreneurial
activity in states with more active agreements, other facto rs constant. This suggests that personal
income tax reciprocity agreements may be a credible policy tool to expand small business activity.
Originality/value – In this study, the paper sets out to determine if small business and
entrepreneurial activity is greater in states that have reciprocity agreements and if suc h activity is
dependent on the number of active agreements in place. Given recent nationwide efforts to ease
compliance costs for business through other initiatives such as the Telecommuter Tax Fairness Act
and the Streamlined Sales Tax Agreement, this study is the first to quantify how decreasing tax
compliance and eliminating barriers to labor mobility affects small business activity. The results
therefore have the potential to help shape debates in many states today.
Keywords Tax policy, Small- to medium-sized enterprises, Entrepreneurial opportunity,
Development policy
Paper type Research paper
1. Introduction
A number of recent studies, such as Neumark et al. (2008), Br uce et al. (2009), and Acs
and Plummer (2005), corroborate the long-standing view that small businesses play a
vital role in job creation and economic growth. In fact, as Neumark et al. (200 8) note, net
job creation over the period from 1992 to 2004 was highest at the smallest business
establishments, with all establishments of 249 employees or less being net job creators.
Thus, it is important to broaden our understanding of the role various economic ,
political, and institutional factors play in the formation and expansion of small
business activities.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/2045-2101.htm
Received 23 July 2012
Revised 6 December 2012
Accepted 6 December 2012
Journal of Entrepreneurship and
Public Policy
Vol. 3 No. 1, 2014
pp. 118-140
rEmeraldGroup PublishingLimited
2045-2101
DOI 10.1108/JEPP-07-2012-0037
The authors thank Kara Smith Mitchell fo r expert research assistance and John Deskins for
providing some of the regression data.
118
JEPP
3,1
Our work is similar in spirit to the literature on governmental efforts to attract
business activity. Hoyt and Garen (2005) provide a useful overview of this literature,
which has generally concluded that federal, state, and local tax poli cies influence
business location decisions. Bar tik’s (1991) exhaustive survey of 84 studies reveals
that most find a significant impact of overall taxes on business location. Phillips and
Goss (1995) clarify Bartik’s (1991) general conclusion with a more formal empirical
analysis, while Wasylenko (1997) refines the analysis and finds generally smaller (but
still significant) effects for taxes specifically levied on businesses.
It has only been in the last few years that researchers have begun to investigate how
state tax policies affect small business and entrepreneurial decisions. These studies
have yielded mixed results, but some have indicated that higher state tax rates reduce
entrepreneurial activity, growth, and hiring. For example, Bartik (1989) found that
higher state property, corporate, and sales taxes (on equipment) have negative effects
on small business start-ups. Chen and Williams (1999) showed that higher per-capi ta
sales taxes increased business failure rates in low-tech industries while higher
per-capita corporate income taxes reduced failure rates in high-tech industries.
Kreft and Sobel (2003) concluded that states with inheritance taxes beyond the
federal-level experienced slower growth in the number of sole proprietors. Georgellis
and Wall (2006) found a u-shaped effect of income tax rates on non-farm sole
proprietors as a share of the population, while Garrett and Wall (2006) found that
higher state corporate income tax rates reduced state rates of entrepreneurial activity.
Bruce and Deskins (2012) conclude that statetax policies do not tend to have important
effects on entrepreneurial activity. They discuss the lack of robust empirical evidence
as a point of contention for policymakers focussed on designing and implementing
pro-development tax systems at the state level.
One unexplored element of state tax systems that has the potential to influence
small business and entrepreneurial activities is the existence of personal income tax
reciprocity agreements with other states. These agreements are voluntary, bilateral
contracts between two states to exclude out-of-state (or non-resident) workers from
a state’s personal income tax base for as long as the agreement remains active (Rork
and Wagner,2012). In the absence of a reciprocity agreement, if an individual resides in
one state and wo rks in a different state, then this individual may owe state income
taxes in both their state of employment and their state of residence. A reciprocity
agreement eliminates the potential for “double taxation” becau se member states
apply personal income taxes only to residents of their state. Given t hat the earnings
of many small businesses and entrepreneurs are captured by state p ersonal income
tax systems rather than the corporate income tax (Bruce and Gurley-Calvez, 2008),
the lack of a reciprocity agreement with a neighboring state may be a significant
barrier to expansion.
In addition to removing barriers to growth, reciprocity agreements may also play
a role in sustaining the competitiveness of small businesses and entrepreneurs by
lowering tax compliance costs. For example, the number of individuals who commute
outside their state of residence for work purposes has increased 146 percent since 1970,
with over 3.4 million people crossing state borders for wo rk in 2000[1]. While this
growth helps businesses by increasing the size of their labor pool, it may also add
a layer of complexity to tax compliance, as non-resident workers in some states may be
required to file personal income tax returns in more than one state.
Given their inherent size, are small businesses at a disadvantage by increased
complexity in tax compliance? Does the potential labor pool shrink for states without
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State income tax
reciprocity
agreements
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