Business Location Decisions: A Qualitative Cost-Benefit Analysis

1 Business Location Decisions: A Qualitative Cost-Benefit Analysis Introduction Many of California s policymakers and citizens have concerns about the state s economy, its reputation as anti-business, and its potential to lose business to other states. This report will delve into such concerns by exploring how business location decisions are made. First, claims that California businesses are moving out of state will be examined followed by a review of California s performance on Business Climate Indexes (BCI s). Theory will then be compared to reality by investigating the predictive power of BCI s and probing additional cost and benefit factors important to business location decisions. Texas, often portrayed as California s key competitor, will be employed in a comparative case study to provide real-world illustration of the various benefits and costs weighed in business location choices. Finally, this review will conclude with thoughts on how to best understand BCI rankings and business location decisions in a California context and their implications for policymaking. Out of State Migration s Impact Anecdotes often arise regarding the tendency for California businesses to be pushed out of state by high taxes and a generally hostile environment. However, the evidence suggests that businesses are not actually leaving California in large numbers. In reality, changes in state-wide job totals result almost entirely from sources other than out-of-state business migration (Kolko, 2010). These sources include job creation from new businesses or expansion of existing businesses and job destruction from the closure or contraction of businesses. As illustrated in Figure 1 produced by the Public Policy Institute of California (2006), only 1.5% of job losses over the ten-year period examined derived from businesses leaving the state, a very small share of the overall pie. Furthermore, that 1.5% of job losses was largely offset by the 0.9% of overall job creation derived from jobs moving in to California (PPIC, 2006).

2 Figure 1: Sources of Job Creation and Destruction (PPIC, 2006, pg. 2). As suggested by this evidence, anecdotes about particular businesses moving out of state may seem persuasive but it s important to take a broader view to construct a realistic picture of employment change. Job growth and destruction numbers are highly sensitive to the time interval selected: the longer the interval being viewed, the more employment change will result from changes internal to the state. As illustrated by Figure 2, the job gains and losses coming from in-state business contraction/expansion and births/deaths can vary widely from year to year (Neumark, Zhang, and Wall, 2005). If only a small time interval is examined, net changes from jobs moving in and out of state may appear significant. However, the long-term picture of several years clearly demonstrates that changes from jobs moving in and out of state have a very minor overall effect.

3 Figure 2: Employment Change Results from Different Business Dynamics (Neumark, Zhang, and Wall, Oct. 2005, pg. 9). Business Climate Index Rankings Although business migration results in little net job loss at the state level, moves within state are reasonably common and even out-of-state migration can be more common than average for particular industries and regions. In order to better understand these business location decisions, the relevant costs and benefits must be explored. As a starting point, Business Climate Index (BCI) rankings can be a helpful tool. These rankings are constructed as a measure of how attractive a particular location is to businesses. In general, BCI s tend to focus on either the costs of doing business ( taxes-and-costs indexes) or human capital and quality of life measures ( productivity indexes) (Kolko, Neumark, and Cuellar Mejia, 2011).

4 California s rank on major BCI s can range anywhere from the top to the very bottom of the list when used as a comparative measure amongst the fifty states. However, California s rank becomes more consistent when we break the indexes down into the two basic types: taxes-and-costs and productivity indexes. The state tends to rank at the extreme bottom of the list on taxes-and-costs indexes while it ranks at the top of key productivity indexes. California s rankings have a wide variance across all BCI s but taxes-and-costs BCI s are generally considered more seriously as genuine predicators of a location s ability to foster business activity. And it is on this basis that California has gained its reputation as one of the worst states in the U.S. for business. Despite this reputation, California s employment, wages and output consistently grow at approximately the national average (Kolko, Neumark, and Cuellar Mejia, 2011). This disparity suggests that we must look beyond the factors included in taxes-and-costs BCI measures to understand California s economic performance. Location Costs & Benefits: Texas vs. California Although overall BCI rankings do not present a clear picture of California s business climate, parsing out some of the particular measures that comprise BCI s can help paint a clearer picture of the costs and benefits relevant to business location decisions. Here we will compare real-world numbers for Texas and California. Because Texas is often portrayed as California s direct competitor for jobs, the state provides a valuable counterpoint to realistically illustrate what costs and benefits a location can offer businesses. However, it should be noted that the particular nature of each business and its industry will determine how sensitive location decisions are to variation in the costs and benefits covered here (i.e., the importance a business places on each category) (Kolko and Neumark, 2007). Taxes and Costs Indexes: What Benefits & Costs are Relevant? The major direct costs of doing business typically include land/property, labor, and materials. The relevance of these costs depends on the specifics of the business in question. For example, a manufacturing business will be more sensitive to the cost of material inputs than a firm whose main

5 product consists of intellectual property. When comparing California with Texas on these measures, we find that: Land/Property: Prices in California place a much higher cost burden on businesses. As a general proxy for the types of land/property costs businesses pay in each location, we can look at average home price data which show a value of $299,000 for California and $176,000 for Texas in 2011 (Statistic Brain, 2013). Labor: California also poses higher labor costs for businesses. The median household income for California workers was $53,367 in 2011 while workers in Texas made $49,047 (U.S. Census Bureau, 2011). Materials: The process of sourcing materials has become increasingly mobile and businesses can look for the best combination of direct material costs and transportation/shipping costs. However, businesses choosing a California location may still find their material input purchases subject to California sales & use tax, one of the highest in the nation at 7.5% in 2012 while Texas maintains a 6.25% rate (Tax Foundation, 2012). Corporate taxes, although indirect, are another key cost of doing business and California s corporate tax structure is often cited as one of the primary sources of discontent amongst the state s business community. Here again we see that California can be less attractive to businesses on this measure. California s corporate tax structure not only includes high tax rates but layers of complexity that can render the system unintelligible. For example, California s corporate tax is actually composed of three separate taxes (Hill, 2007). While California s tax rate for standard corporations is quite high at 8.84%, there are also separate rates applied to banks and financial corporations as well as two separate rates for businesses categorized as S-Corporations, a separate system of rates for non-incorporated businesses, and an Alternative Minimum Tax (Hill, 2007). In contrast, Texas has no general corporate tax and only a few additional provisions such as a gross receipts tax of 1% on income over $1 million (Tax Foundation, 2013).

6 Productivity Indexes: What Benefits & Costs are Relevant? In addition to the measures captured in taxes-and-costs BCI s, businesses must consider the types of benefits and costs aggregated in productivity BCI s. This second type of BCI focuses on human capital and standard-of-living related measures. We will again compare California with Texas on some key cost and benefit values to get a sense of how they might factor into business location decisions. The sorts of measurements included in productivity BCI s complicate the process of cost benefit calculations for business location decisions. For example, the standard-of-living in a particular location can also be measured as the cost-of-living. These terms aim to quantify location characteristics but they highlight the fact that what s seen as an attractive benefit to some potential employees, managers and business owners can be seen as a prohibitive cost by others members of the same population. This relationship illustrates two common challenges in cost benefit analysis: (1) defining costs and benefits to be included in calculations; (2) valuation of those costs and benefits, particularly when they include nonmarket goods such as community resources. Ultimately, there s no clear answer on how standard-ofliving and cost-of-living values should be incorporated into cost benefit analysis of business location decisions or whether the values should even be included. When comparing California with Texas on productivity BCI measures, we find that: Cost of Living/Standard of Living: California s cost-of-living index score is 36.7% higher than Texas score (MERIC, 2013). This means the average cost-of-living for employees, managers, and business owners in California is substantially higher than in Texas. However, as previously described, this same cost translates into local services that might attract members of those same groups. Total GSP Growth vs. Per Capita GSP Growth (2007-2010): California and Texas total GSP growth for 2007-2010 reflects a less than a 1% difference between the states (True Cost, 2011). In that respect, the economies appear to be growing at similar rates. However, per capita GSP

7 growth is a more useful measure when examining the impact GSP growth has on citizen because it measures how much growth has occurred per citizen and how many more resources can potentially be distributed throughout the population. Consequently, California s per capita GSP growth of 28.5% compared with Texas 12.6% makes the state a much more attractive location for most citizens (True Cost, 2011). State and Local Spending (as % of GSP): Standard-of-living benefits provided by a location also depend upon the level of government spending to sustain local services. On this measure we find that California outpaces Texas at 22.92% (Chantrill, California, 2013) versus 15.83% (Chantrill, Texas, 2013) in 2012. Poverty Rates (as of 2010 Census): While poverty rates are high in both states, California s somewhat lower rate of 15.5% compared with Texas 17.4% provides a net benefit to the state s citizens (U.S. Census Bureau, 2009). Regulation: Regulation is another category that plays dual roles in business location decisions. California s stricter labor and environmental regulations mean wages represent an increased cost to businesses and energy, building, and material supply costs may be driven up by environmental laws. Regulation is often cited as a massive cost to California s overall economy (Tootelian, D. and Varshney, S., 2009); however, these same regulations provide benefits to the citizens (i.e., workers) in the form of higher wages earned and a healthier environment. Further Location Based Costs & Benefits We know location considerations go beyond the kinds of measures included in taxes-and-costs indexes and productivity indexes because they do not reflect California s actual ability to attract and retain business so further costs and benefits must be involved in business location decisions. Some of those potential costs and benefits are enumerated below. Strength of Product/Service Market: Strong regional markets for products or services are generally beneficial but the degree of benefit depends upon the type of business (e.g., local vs.

8 national or international product/service distribution). The presence of markets in a given area will be different for each industry but California s large population, the largest in the country, makes the state a big draw for business (U.S. Census Bureau, 2012). Availability of Educated Workforce: Californian is home to seven of Forbes Top 50 Colleges in the U.S. (Forbes, 2012) and provides a higher concentration of well-educated workers than Texas (U.S. Census Bureau, 2013). Figure 3 illustrates the higher density of individuals with a Bachelor s Degree distributed throughout California as compared to Texas (U.S. Census Bureau, 2012). Figure 3: Population with Bachelor s Degree or Higher (U.S. Census Bureau, Feb 2012). Agglomerated Markets: As firms in related industries co-locate, they benefit from agglomerated markets and production costs can decline significantly (Head and Mayer, 2003). California s Silicon Valley provides a perfect illustration of this concept. Technology firms are highly

9 motivated to choose this location because the infrastructure, buyer networks, and supplier networks are already in place for high-tech business needs. Furthermore, California has similar agglomerated markets related to green energy technology, entertainment and agriculture. Texas, on the other hand, is characterized by strong oil production and agricultural markets. Natural Resources: California s natural beauty and more moderate climate than Texas are significant state assets. California is home to the country s third most-visited National Park, Yosemite, and it s second most-visited State Park, Golden Gate (National Parks Traveler, 2006). Implications for Policymaking in California California seems to stack up poorly against Texas on taxes-and-costs BCI s as well as some productivity measures but the state s per capita growth is consistently strong. The costs and benefits catalogued in BCI s don t predict California s attractiveness as a business location and its steady economic growth which consistently keeps pace with or exceeds national growth (Kolko, Neumark, and Cuellar Mejia, 2011). In order to make sense of California s economic success, further location-based costs and benefits such as climate and industrial mix must be factored in. Only when these additional, non-policy related elements are accounted for can we begin to understand which BCI s or particular measures within those indexes have an impact on economic growth and, as a result, determine which policy approaches will best support growth (Kolko and Neumark, 2007). Research from the Public Policy Institute of California indicates that California s geography, climate, skilled labor, highly-valued universities, and public infrastructure all help the state defy raw BCI rankings. Figure 4 demonstrates the effect BCI measures have on wage and employment growth relative to the effect of other variables such as industrial composition (Kolko, Neumark, and Cuellar Mejia, 2011). The resulting picture clearly shows that factors outside of Business Climate Index rankings and largely outside the reach of policy have the largest effect on economic growth. However, when we control for

10 differences such as climate and industrial mix, tax-and-cost based BCI s are predictive of economic growth so business costs such as wages do have an impact (Kolko and Neumark, 2007). Figure 4: BCI vs. Other Factors in Economic Growth (Kolko, Neumark, and Cuellar Mejia, 2011, pg. 19). Ultimately, California benefits from offsetting factors that make the state a desirable location for business but its economic growth is still inhibited by high taxes and costs of doing business within the state. At a minimum, the costs that comprise taxes-and-costs BCI s should be given serious concern in policy discussions regarding California s growth and the future of its economy.

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