How to sell your state to Corporate America

April 1, 2011, 9:01 PM UTC

Would Caterpillar ever consider Sioux Falls?

FORTUNE – During what’s poised to be one of the toughest budget seasons for state and local governments, locations that were once brushed off by some of America’s biggest corporations might just have found a new comparative advantage for attracting business.

Indeed, assets like good schools, adequate infrastructure, affordable neighborhoods and mild weather are attractive to corporations looking to expand or relocate. But so are taxes. And as many states grapple with troubled public finances, the few that say they’re in relatively better fiscal positions will increasingly turn to a newfound weapon of choice in the battle for corporate America: the health of their balance sheets.

In the latest example, Caterpillar (CAT) CEO Doug Oberhelman has taken notice of states like Nebraska and South Dakota, whose governors have ramped up efforts to get the Peoria, Illinois-based maker of bulldozers and excavators to relocate. In a March 21 letter to Illinois Gov. Pat Quinn, Oberhelman says he’s unhappy with the state’s business climate and points to “several letters” he’s received from other states welcoming Caterpillar.

While he didn’t say exactly what bothered him, his letter comes a little over two months after Illinois significantly raised individual income and corporate taxes to deal with its desperate budget crisis. The state’s corporate income tax will rise by 30%, from 7.3% to 9.5%, becoming the fourth-highest state corporate income tax in the United States, according to the Tax Foundation, a Washington-based think tank. It also increased its individual income tax by 67%, from 3% to 5%.

“Before, I never really considered living anywhere else, and certainly never considered the possibility of Caterpillar relocating,” Oberhelman writes, adding that his company isn’t threatening to leave Illinois. “But I have to admit, the policymakers in Springfield [Illinois] seem to make it harder by the day.”

Oberhelman’s letter highlights a growing Darwinian mentality among some governors trying to take advantage of fiscally weaker states. Governments commonly wine and dine major companies into relocating or expanding into their areas. But those efforts, as even a Caterpillar spokesman acknowledged, appear to have intensified in recent months as many governments struggle to balance budgets. Quinn could not be reached for comment, but his office says the state is working with Caterpillar about their concerns.

It’s anyone’s guess as to how this game of survival of the fittest could play out. But Nebraska Governor Dave Heineman bets that oft-overlooked states like his will start getting some serious notice from corporate America. Home to the creation of Kool-Aid and billionaire investor Warren Buffett’s Berkshire Hathaway (BRKA), Nebraska is one of several states that recently asked Caterpillar to consider for its business.

In an interview with Fortune, the Nebraska governor says he sees Illinois’ financial woes as an opportunity. After all, he says, Caterpillar isn’t the only company unhappy with the state’s higher taxes. Heineman adds that Nebraska is talking to other companies that have been looking to expand or relocate elsewhere, but he declined to give names.

“We have a target-rich opportunity right now,” he says.

Before Illinois raised taxes, Nebraska ranked close to Illinois in the Tax Foundation’s Business Tax Climate Index, which compares how corporate, individual income and other taxes impact businesses. Higher taxes may have downgraded Illinois’ ranking from 23 to 36 on the index, but Nebraska’s 29 ranking means it still has plenty of others to compete with — one being South Dakota.

The sparsely populated state of about 812,383 — slightly less than the city of Jacksonville, Florida — ranks highest in the foundation’s business tax climate index. Unlike most other states, South Dakota has no corporate income tax, personal income tax, business inventory tax or personal property tax. But while low taxes might be appealing, the relatively rural state has struggled to secure many large companies.

Governor Dennis Daugaard, echoing a Feb. 3 letter his office sent to Caterpillar, believes things could change as the state has balanced its budget for the year without having to raise taxes or dip into reserves. To be sure, South Dakota has a much smaller population than Illinois or Nebraska, so it’s hard to compare the taxing and spending climate of the three. Daugaard says that while South Dakota’s budget had to endure some major cuts, it’s better off than many others.

“There are many states whose financial difficulties are more than short term,” Daugaard told Fortune this week. “It’s so much easier in some cases to raise taxes than it is to make cuts. So I think some of these tax environments will be too burdensome for the household names and they’ll start looking.”

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