Losing Out on Corporate Taxes

The state of state corporate income taxes is a mess.
by | January 18, 2011
 

The United States has one of the highest corporate tax rates in the world (35 percent). In fact, it is second only to Japan, which taxes corporations at a hearty 39.5 percent. Yet, as you may have heard, several high-profile, high-profit U.S. corporations get away with paying no federal income tax. Is this the case at the state level as well?

The answer appears to be yes, according to the Institute on Taxation and Economic Policy (ITEP), which recently released its report on state corporate taxation between 2008 and 2010. While the average state corporate tax rate is around 6 percent, the companies in the ITEP study (265 profitable Fortune 500 companies) were paying an average of 3 percent on their U.S. profits. Instead of coughing up $82.6 billion in state corporate income taxes, they paid only $39.9 billion over the study's two-year period.

To gain more insight into the state of state corporate taxes and what states could do to improve their rate of return, I talked to Matthew Gardner, ITEP executive director and author of the report.

Corporations are paying on average only half a state's corporate tax rate. There's no suggestion that they're doing anything illegal. Why is this happening?

The first reason is that state lawmakers persist in enacting targeted tax breaks for specific industries or companies without any evidence that these are effective economic development strategies. Second, companies that do business in multiple states are creating their own tax loopholes. For instance, they shift income from higher tax states to lower tax states. The third factor is the "pass-through effect" of federal tax cuts. Every state's corporate tax is built on federal rules. When Congress passes a new tax break that narrows the federal tax base, it does the same thing to the state. In 2004, for instance, Congress enacted a tax break designed to encourage U.S. manufacturing. But the difficulty with this at the state level is that even if the tax break does encourage manufacturing, there's no guarantee that manufacturing will take place in your state. States can't use these tax breaks to encourage economic development in their own state. If you asked lawmakers in Illinois whether they should enact a tax break for Indiana, they wouldn't see that as a smart idea. States need to decouple from specific federal tax breaks.

Of the many shelters and incentives states offer, which would you say states get the least bang for their buck from?

Accelerated depreciation. The difficulty with tax breaks for depreciation is that they typically give companies tax breaks for what the companies were planning to do anyway. They are not changing corporate behavior at all. This is the real difficulty with corporate tax cuts as an economic development device. Lawmakers always believe -- or are led to believe -- that when they give companies tax breaks those companies will expand employment or build a factory or simply not leave. But it's impossible for a lawmaker to know whether the corporation is telling the truth or just hoping to get a tax reward for something it was planning to do anyway. Illinois had a special legislative session in December in which Sears was given a tax break in return for not leaving the state. It's pretty clear it was quid pro quo. But did Sears intend to leave? You can't tell.

What about performance measures for tax breaks?

If lawmakers insist on using corporate tax breaks to create jobs, they can attach job creation requirements. They can insist that a company create a certain number of jobs that pay a certain salary level; they can attach clawback provisions which say, "If you don't meet the terms of agreement -- if the jobs don't get created or the wages aren't what they were supposed to be -- you don't get to keep the tax breaks." Most states have enacted at least some requirements. It's a growing phenomenon and a welcome one. But even when states attach those standards, it's impossible to know if the jobs would have been created even if the tax break was not provided.

Of the several reforms you discuss in the report, which -- given the partisan nature of legislatures these days -- have the best chance of gaining traction?

The single reform that has been the most widespread is combined reporting. We know multistate corporations are very good at shifting income on paper from one jurisdiction to another in a way that is purely designed to reduce taxes. It's a shell game. We don't know the extent to which the shifting is being done, but we know anecdotally that it's widespread. Combined reporting, which calls for putting all income into what I call "one big pot," takes away the incentive to shift income from one state to another. More than half the states with corporate income taxes have this provision and more are discussing it. I was in Connecticut last week and they have a very real proposal on this. Maryland does, too. If every state enacted it, things would look better.

Are corporate tax breaks a valuable economic development tool?

It's important for state lawmakers to maintain a healthy skepticism about whether state corporate tax breaks can ever be a job creator. I say that because the tax environment is different at the state level than it is at the federal level. States have to balance their budgets. Any tax cut has to be paid for. In the current fiscal environment, when a state gives a corporation a $100 million tax break, it has to make this up somehow. It could be in the form of spending cuts -- less road construction or salary cuts -- or by hiking other taxes. This isn't an especially good approach to growing state economies. Moreover, the real losers in this zero sum game are often the other companies that are competing with the companies that get the tax breaks. It's profoundly anti-free market. There's nothing more antithetical to the free market than having the tax system pick winners and losers. State lawmakers lose sight of the fact that targeted tax breaks amount to social engineering.

Are there other steps states should take to improve their corporate tax system?

They could improve disclosure. Companies are only required to disclose minimal amounts of information about income and tax. As a result, lawmakers in any particular state simply do not know which profitable companies are paying tax to their state and which aren't. Asking lawmakers to reform the tax system without information is unfair. They need to know which companies aren't paying taxes and why. I can't think of any states where lawmakers have all that information. So even if lawmakers don't have the stomach to enact needed reforms, there's no reasons why they can't take steps to enact more steps for public disclosure of public tax payments.

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