EXECUTIVE SUMMARY

Texas Business Climate: Taxes, Technology, and Trends

Preface
What does it mean when we say that we are becoming a technology-based society?  What does it mean to be in the information age?

The answers to these questions are both social and economic. The natural resources which traditionally generated national wealth are giving way to a whole new category of products and services. As a way of making this point, the following illustration is helpful:  If we were to weigh a dollar's worth of Gross Domestic Product in 1950 it would come to about 2.2 pounds. By 1980, however, it would weigh only eight ounces.

Or take the automobile industry - long a leading indicator of productivity. An industry leader estimates that the current value of the electronic components in a car equals about 30 percent of its total cost. Within ten years, that figure will rise to 50 percent, and by 2010 it could be as high as 70 percent .

According to a recent Business Week article (March 31, 1997), "In the past three years the high tech sector has contributed 27 percent of the growth in GDP. "  This is nearly double that of the next closest sector (residential housing). And, during 1996, "a stunning 33 percent of GDP growth has come from information-technology industries. " 

These are remarkable statistics. What they tell us is that raw materials are worth steadily less in proportion to their "information-driven" value. This is true for two reasons:  First, semiconductors and software have a higher component value of each finished product; and, secondly, the value of technology in producing finished products is driving production costs down.

In economic terms, wages paid in the technology industry are significantly higher than those of other industries. This can help drive the living standard for communities with strong technology sectors. What we are seeing is a permanent shift in our economic structure.

This two-part report explores the growth of the technology industry in the U.S. and in Texas and explains its importance to the overall economy. The summary report contains an overview of the importance of technology and the major findings of a survey of technology executives in Texas. It is supplemented with more detailed analysis and background material.

The contents of this study may provide answers to the question of how Texas can further benefit from this major economic shift.

The Economic Importance of Technology
Growth in the technology sector (defined in this report as technology manufacturing, software and computer-related services, telecommunication services, and business services) has been dramatic. Investment in technology is the driving force behind economic growth in the U.S. and is the clearest indicator of what makes a state successful economically. This represents a major transition in how we should think about growth, employment and the creation of wealth. Those states whose technology firms invest heavily in research and development (R&D) outperform all other states in employment growth.

Not only is technology the most rapidly growing industrial sector, it is directly responsible for the retention of jobs and the growth of non-technology employment. An investment in technology makes it possible for businesses to have ready access to increased production efficiencies. By making a commitment to technology growth, a state can ensure that all of its businesses - technology and non-technology - can successfully compete in national and international markets.

Background
Defining "technology" is no easy matter. The emergence of a "technology sector" is a recent phenomenon. The federal government's standard industrial classifications (SIC codes) do not allow for easy aggregation of technology industries. It is also difficult to distinguish between "technology" and "non-technology" businesses based on whether they are manufacturers or users, because technology now spans all companies in some way.  

This study suffers from this difficulty as well. Since different sources use different definitions of technology, direct comparisons of data sets are not always possible. This study expands the definition used by the American Electronics Association (see Appendix to the full report) to include business services as a whole.

However difficult it may be to arrive at a precise definition of technology, the benefits of this sector are rippling throughout the economy. The U.S. is becoming less dependent on heavy manufacturing and agricultural exports to drive the economy. The wealth and prosperity of Texas, for example, were originally the result of abundant natural resources:  oil, cotton and cattle. More recently, lower oil prices and increased foreign competition in agricultural products have permanently changed the state's economic landscape. The recent emergence of the information and technology sectors has counterbalanced losses in other sectors. The successful growth of International Business Machines (IBM), Texas Instruments and Electronic Data Systems (EDS) proved this new industry would be profitable for American companies.

As industries grow, they tend to cluster in certain areas. Clustering occurs when companies in a particular industry physically locate near each other. A cluster of companies can include competitors, suppliers, customers, and distributors. For example, automobile manufacturers centralized operations in Detroit, while aircraft manufacturers located in Seattle. In Texas, Austin developed a base of semiconductor manufacturers, the Dallas/ Fort Worth Metroplex developed a telecommunications corridor, and Houston became a leader in medical services. San Antonio, in turn, developed thriving trade and services sectors, especially with Mexico.

There are important reasons why new and expanding companies locate in a particular area. The loyalty of the firms' founders to their region is a key element. The location of a particular technology industry in an area also generates business clustering of support industries. An industrial cluster creates demand for local suppliers who can quickly provide materials and services. An industry concentration also allows both labor and capital resources to flow more freely between firms within the region.

Industry clustering, however, is only one factor in why businesses locate where they do. A survey performed for this report shows that technology companies choose their physical location based on several other important factors, notably the tax environment in which those companies are forced to operate.

Understanding what factors contribute to corporate growth and location decisions is of obvious value to state policy. Without a clear perspective on why businesses choose specific areas - on what creates a "technology-friendly" atmosphere - states may find themselves at a permanent competitive disadvantage.

Technology Employment
The technology industry has been responsible for increasing economic growth and prosperity in the U.S during the 1990s. Currently, the technology sector outperforms the rest of the economy, with the performance gap widening over time. Between 1990 and 1999, for example, the technology sector is expected to grow 48 percent, as compared to 24 percent in the remainder of the economy.

Millions of Americans are employed by the technology industry and related sectors. The level of employment growth in the technology industry has been unprecedented in recent decades. The above graph illustrates technology employment growth between 1990 and 1995 for ten states. Texas leads the nation in creating the most technology jobs during this time. Business Week estimates that as many as nine million Americans are employed in technology-related jobs.

As a result of this rapid growth, the largest U.S. manufacturing employment sector in 1995 was the technology industry (over 1.9 million people).Computer software led all technology sectors in employment growth, increasing the number of workers 39 percent between 1990 and 1995. According to the Federal Reserve District Bank in Dallas, 36 percent of GDP growth in 1996 was attributed to computer-related sales.   In addition, the average wage for a technology worker ($46,986) is 70 percent higher than the average private sector worker. This is one reason communities compete to attract technology companies.

The importance of the technology sector is not restricted to growth in technology-related industries. The sector is a leading source of growth in the non-technology industry as well. An analysis of the technology sector in 11 states reveals a strong relationship between non-technology growth in a state in given year with growth in the state's technology sector in the prior year (Arizona, California, Connecticut, Florida, Georgia, North Carolina, Oregon, South Carolina, Texas Virginia, and Washington).

The findings show that, on average, a $1 million increase in technology sales in one year leads to a $3.8 million increase to the total economy the following year. Each dollar of technology sales by a company creates additional income and expenditures in other technology and non-technology companies. In economic terms, the technology industry's multiplier effect is 3.8, which is well above the average industry multiplier. Spending by technology firms also supports growth in the local economy by (1) providing the community with high wage jobs, (2) attracting and supporting local technology supply businesses, and (3) spending money within the region.

Contingency table analysis shows a strong relationship between investment in a state's technology sector and growth in its other industries. As a result of an investment in technology, there is a 93 percent chance that the state's overall economy will grow in response to the investment.

The Importance of Technology in Texas
Compared to the state's total sales and employment growth, the technology sector has outperformed the economy as a whole. Technology sector employment growth increased at an annual rate of 2.9 percent between 1985 and 1995, while non-technology sector employment grew 1.9 percent annually. During the same period, technology sales averaged 12.4 percent growth per year while non-technology sales grew 5.4 percent annually.

Technology is the fastest growing Texas export. In 1996, 44 percent of Texas exports to other states and abroad were from the technology sector, while in 1990, technology accounted for 36 percent of state exports. In 1993, electronic equipment surpassed chemicals and allied products as the single top Texas export. By 2001, technology is expected to surpass non-technology as Texas's top export, comprising more than a 50 percent share of total state exports.

Texas technology employment has grown at almost twice the rate of the state economy between 1985 and 1995. Certain regions of the state have experienced even more dramatic increases. Eighty-six percent of total Texas technology sales is accounted for by the state's six major metropolitan areas:  Dallas, Fort Worth, Houston, San Antonio, El Paso, and Austin. These areas are better able to support the full range of infrastructure (e.g. educational resources, technology clusters, major transportation corridors, and suppliers) which technology companies require.

The distribution of technology employment varies significantly by industry type in each of the metropolitan areas. Dallas leads the state in most areas, which is reflective of its overall dominance in technology employment. The city represents approximately 36 percent of the state's electronic industry employment, 34 percent of telecommunications, and more than 58 percent of instruments and medical devices. Like Dallas, Austin is strong in electronics equipment (33 percent of total state employment). Houston leads Texas cities in industrial machinery (33 percent).

The Austin MSA accounts for over 7 percent of the state's technology sales and an estimated 10 percent of the state's technology employment. Dallas and Houston MSAs combined account for the majority of Texas technology employment - with 31 percent and 26 percent of employment, respectively. The San Antonio and Fort Worth MSAs each account for approximately 7.5 percent of the state's technology employment.

The importance of technology within a city is made most obvious by examining the percent of total city employment. The Austin MSA, for example, contains the highest percent of technology employment, with almost 20 percent of its workers employed in this sector. Dallas is also reliant on technology employment, with an estimated 18 percent of total workers employed in technology.

When examining employment growth by Texas region, the differential between technology and non-technology firms is less dramatic. Central Texas experienced the most significant rate of growth in technology employment, increasing technology employment more than 70 percent between 1985 and 1995. Despite its impressive technology sales growth, the Upper Rio Grande region saw even more rapid increases in non-technology employment.

Developing Tax Policy: Survey and Case Studies Highlights
The following section highlights several important new surveys of technology growth and expansion. The University of Texas conducted a survey of technology executives (both in Texas and elsewhere) and a series of case studies. A separate study conducted by Ernst & Young compares the tax climate of various states. The findings provide the basis for a new approach to tax policy and an understanding of the competitive position of Texas.

The Competitive Environment
Competition for new industries and corporate expansions is at an all-time high. Cities and regions offer generous incentives to attract and retain industries. Because every state - and most local jurisdictions - has its own policies, businesses must examine a variety of factors before making decisions on expansion or relocation. These factors range from property and corporate income taxes to utility rates along with a host of other tangible and intangible variables.

Global technology competition is increasing, and the U.S. is a world leader in technology output. But this position cannot be taken for granted. International competition for technology companies is increasing as more countries are offering generous incentives for expansions and relocations. This is one reason most global technology players establish operations in countries with a low tax rate to support their international business operations. Attracting and retaining technology firms in the U.S. is vital to the nation's competitiveness, yet it offers the least incentives for technology companies in the world.

Comparing the competitiveness of U.S. states with each other is useful in determining which tax policies are most effective in competition for technology. The tax policies of the most successful states should act as guidelines for national technology incentives.

By developing indices of economic growth in the 11 states and the U.S. , it became possible to compare the technology sector's contribution to a state's gross product (GSP). South Carolina leads in technology contribution to the GSP, where it is forecast to grow 78 percent between 1990 and 1999. South Carolina was followed by Oregon, North Carolina, and Washington. Texas ranked seventh among those states surveyed.

Technology employment is forecast to grow more rapidly in Oregon than any other state surveyed, increasing 73 percent between 1990 and 1999. Georgia (69 percent growth), Arizona (59 percent), Florida (59 percent), and Washington (52 percent) follow Oregon in sector employment growth. At a predicted 44 percent technology growth rate, Texas ranks seventh among the 11 states in the sample.

While Texas currently ranks first in new technology jobs created between 1990 and 1995 and second in total jobs and exports in 1995, these do not provide a reliable predictor of the future. Texas is ranked only nineteenth in forecasted technology output and employment growth between 1990 and 1999, indicating a sizable slowdown in technology job growth through 1999 in Texas compared to other states. And while Texas is highly competitive in specific technology sectors, it is lagging in others.

Tax Burden
Tax policy is one of the more important tools in assessing competitiveness. Because many technology companies are capital-intensive, pay high wages, or require large tracts of land, variations in type of tax as well as tax rates can significantly affect the ability of businesses to compete nationally and internationally.

A tax burden index was used to compare state tax climates. Five technology industries were analyzed - computer manufacturing, semiconductor manufacturing, biotechnology, telecommunications, and software development. Of the 13 states analyzed (previous list plus California, Colorado and Utah), Washington has the least burdensome tax policy for semiconductor manufacturers and biotechnology firms. Oregon's tax policy ranks first for telecommunications and software development firms. South Carolina has the least burdensome tax policy for computer manufacturers.

Texas Competitiveness by Technology Industry
Texas's tax policy is competitive for computer manufacturers (Texas ranks second), biotechnology firms (Texas ranks fifth), and software development firms (Texas ranks sixth). The combination of relatively high property taxes and low income taxes places Texas eighth in overall tax burden, while Oregon ranks first. Consequently, the Texas tax climate is not as well suited for capital-intensive industries, such as telecommunications. Texas is more competitive in technology industries that require human capital. Due to strong incentive policy, however, Texas has attracted capital-intensive industries despite its lower tax competitiveness for these companies.

If Texas's tax climate is not conducive for semiconductor manufacturers and telecommunications firms, why have so many of these companies located here?  There are at least three reasons which did not fall within the scope of this study. They are: 

(1)  No analysis was conducted of local tax incentives or economic inducements.
The increased aggressiveness of cities and economic development organizations has resulted in significant property tax abatements. These abatements can have a measurable affect on a company's overall tax burden, but they are not easily documented. Measuring the impact of tax incentives on the location decisions of Texas companies is difficult; these abatements vary between cities and even within cities depending on the individual project. Communities are also not required to disclose incentive plans.

(2)  Labor market factors were not taken into consideration.
The cost and availability of labor are key factors in site location. A state or region with an excellent tax climate may not have the educational and training infrastructure - or the wage structure - to attract new businesses. Texas has a large labor pool, an increasing budget for worker training, and a traditionally lower wage rate (Texas is a right to work state).

(3)  No cluster analysis was performed by sector or region.
Throughout this report, there has been an emphasis on the importance of clustering. We know that industries benefit from being in close proximity to one another. Skilled labor, supplier and subcontractor access, and availability of business services all play a part. Even when tax policy works against business relocation, the effect of clustering may continue to attract firms.

(4)  The additional tax incentives of maquiladoras and their benefits to Mexican border states were not taken into consideration.
The tax-preferred organizational form of maquiladoras provide additional incentives for the location of technology companies in the states that border Mexico. The economic impacts of these incentives were not quantified or incorporated into this study.

Survey Findings

The survey conducted for this report provides communities with insight into corporate tax sensitivities. The survey results and case scenarios represent the likely reaction of small (under 500 employees) and large technology companies to increases in various state and local taxes. Five types of taxes were included in the survey:  corporate franchise tax, gross receipts tax, business activity tax, personal income tax, and sales and use tax. The results of the survey are applicable to other technology states and also to states that wish to attract technology companies. The following conclusions have been derived from over 200 participating technology companies: An increase in the corporate franchise tax will burden technology companies more than an increase in any other tax An increase in the sales/use tax represents the least burden to technology companies Other than reducing taxes, investment tax credits and R&D credits will best encourage technology expansion in Texas Generally, Texas technology companies will react to major tax increases (50 percent or more) in the following sequence: 

(1) raise prices,
(2) decrease other costs and decrease employment,
(3) move some property out of Texas, or
(4) move entirely out of Texas

There are, however, distinct differences within the technology sector:  large companies react differently from smaller ones, as do exporters from non-exporters. For example, small technology companies will react differently from large companies when faced with a tax increase. In response to a 50 percent increase in property or use taxes, small companies are:

	more likely to raise prices,
	less likely to move property out of the state, and
	less likely to decrease employment

Large companies, however, indicated that their reaction to a tax increase (property, use, franchise, or sales) would be to decrease employment before raising prices. A 50 percent increase in property taxes will cause large companies to consider moving property out of Texas. Additionally, large companies competing internationally cannot increase prices.

The survey also reveals several other relevant points about technology companies, especially as it relates to exporters:

	In response to a 50 percent increase in property taxes, companies with a high percentage of employees outside of Texas will likely consider relocating
	In response to a 50 percent increase in use taxes, companies with a high percentage of Texas sales are less likely to decrease employment than a company with a high percentage of non-Texas sales

The propensity of small firms to pass tax costs to the customers indicates that these companies have high tax elasticity in comparison to large firms. As exporters, large firms face domestic and international competition, and must maintain competitive prices. Therefore, large firms will reduce employment in response to tax increases prior to raising prices.

This is especially apparent in companies that export. Faced with ever-growing international competition, an exporter typically will not pass additional costs of taxation to the consumer. Their approach to increased tax costs is highly inelastic, absorbing costs internally by reducing employment and shifting manufacturing production to other locations.

Exporters are a unique revenue source for the state economy, bringing new dollars into the state from other states and countries. These new dollars stimulate growth in Texas more than any other state revenues. Whereas service industries and non-exporters play a significant role, they cannot act as a catalyst to the growth of the overall economy. Because of the important role of technology exporters to economic growth, tax policy legislation must aim to promote and retain the growth of Texas exporters.

The expansion of the technology sector should not be seen as one target among many, but as the state's single most important economic development option. An awareness of the relationship between economic growth and taxation is a crucial element of public policy. The following recommendations should be seen as a way of sparking debate on how the Texas economy should grow.

Findings and Recommendations
This report examines various aspects of the technology industry, and discloses findings that will be familiar to most economists and businesses. Nevertheless, the observations and reactions of Texas's leading businesses provide a fresh perspective on how a state can encourage business growth. The following remarks - and especially the recommendations - are intended to provide guidance to legislators and others involved in designing public policy for economic development.

Findings

Technology companies seek tax predictability and tax stability.
Technology industries are not homogeneous in their response to tax issues. There are significant differences depending on a company's size, extent of export sales, or whether the firm is a primary or secondary employer.

The export of technology products has the highest return of any business activity in which a state engages.

Lower corporate franchise tax and lower property taxes create the most favorable tax climate for technology companies. The use of investment tax credits and R&D tax credits are an effective way for a state to reward those businesses, which contribute most to the economy. This is a policy pursued by Oregon, Washington and South Carolina - with the effect that these states are the most competitive in the survey.

The loyalty of technology firms to Texas has important economic implications. From this survey result one can draw various conclusions. Those firms started in Texas (70 percent of all companies surveyed) are less sensitive to variations in taxation. This is supported by the high elasticity towards those survey questions that posited tax increases. A clear majority of technology firms did not choose the state because it represented the best tax option and for these companies economic factors diminish in relation to state loyalty. Nevertheless, Texas should work to avoid the out-migration of homegrown companies that affected California during the 1980s and 1990s as the result of an increasingly onerous tax burden.

Certain industrial sectors return more benefit to the economy than others. Comparing the performance of various sectors to the economy as a whole is an important tool in analyzing tax policy - as well as assessing the performance of each sector over time.

Companies not started in Texas may not demonstrate similar loyalty to the state. While Texas does not currently suffer from business outmigration, an increasing number of companies have relocated to Texas because of the tax friendly environment.

Recommendations

The recommendations fall into two categories. The first relates to what Texas can do to promote technology business through changes in its tax policy. The second considers broader economic development goals that will increase the state's competitive position in relation to both the technology and the export sectors.

1. Design a comprehensive tax strategy that encourages growth in the state's technology and export sectors

Based on the findings of this study, the strategy would encompass the following goals: 

	Emphasize a tax policy that promotes industries which create the greatest long-term economic impact to the state instead of promoting a business tax equal for all industries
	Consider R&D and investment tax incentives for technology and export-driven businesses
	Consider implementing a program similar to Oregon's Strategic Investment Program to promote capital-intensive technology industries
	Develop a competitive tax strategy for presentation to the 1999 state legislative session which ensures long-term tax consistency, and which emphasizes those taxes which promote expansion in the technology sector
	Support the growth of new technologies (such as the Internet) that provide productivity gains in other industries
	Internet taxation policy will certainly be a determinant in the location decisions of service providers. Variations in state and local policy have already prompted requests for national Internet tax legislation. Clarity in Internet taxation will be an ongoing issue for Texas.

2. The state's economic development strategy should similarly focus on the engines of economic growth. Rather than seeking to identify "winners and losers" among specific types of businesses, the state should further encourage the expansion and relocation of companies which contribute most to the economy (in sales and employment growth).

	Incentives need not be distributed evenly among sectors, but could instead be granted to industries with high economic return
	Create technology enterprise zones
	Provide technology employment credits
	Benchmark technology growth in Texas

Conclusion:  A Call to Action

The analysis performed for this report shows that technology serves as an engine of economic growth. The technology industry consistently outperforms the non-technology industry. Specifically, technology growth in one year creates economic growth in non-technology sectors the following year.

Technology exports are the leading driver of economic growth in a state. Each $1 million of technology exports creates an estimated $3.8 million effect in the rest of a state's economy by generating income and expenditures in other technology and non-technology industries.

Technology is the fastest growing export in Texas, comprising an estimated 44 percent share of total exports to other states and countries in 1996. In 1993, electronic equipment surpassed chemicals and allied products as the single top Texas export. By 2001, technology is expected to surpass non-technology as Texas's top export, comprising more than a 50 percent share of total state exports.

Texas must be cautious not to let its competitiveness diminish. While Texas ranked first in national technology employment growth between 1990 and 1995, and second in U.S. total technology employment and exports in 1995, these do not provide a reliable predictor of the future. Texas is forecast to rank only seventh in technology output and employment growth between 1990 and 1999, indicating a sizable slowdown in technology job growth through 1999 in Texas compared to other states.

While Texas is highly competitive in specific technology industries, it is lagging in others. The state's tax policy currently neglects certain key technology industries, especially capital-intensive businesses such as telecommunications. And the state should not rest on its previous success attracting computer manufacturers, biotechnology, and software development firms. Texas's competitive position for these industries will dramatically decline if the state ignores the importance of technology in future tax policy decisions.

It is in the best interest of policy makers, economic developers, and non-technology companies to support the above recommendations. The recommendations ensure long term economic competitiveness for Texas. Moreover, they are the best option for guaranteeing the growth of the non-technology sectors in the state.