State and local business taxation: Is there a better way?

Chicago Fed Letter, Dec 2004 by Mattoon, Richard

Matt Murray from the University of Tennessee presented joint work on restructuring the state corporate income tax.4 Murray highlighted the following five key issues: defining the taxable base (what businesses and types of income should be taxed); establishing nexus for taxation, including establishing substantive nexus (the power to tax) and enforcement nexus (the power to compel collection); making a choice between separate and combined reporting of the corporate entity; determining the distribution of the tax base for multijurisdictional firms-apportionment and allocation rules; and determining whether to use a throwback rule where sales to non-tax states are included in the sales factor numerator in the state where the sale originated.

When it comes to defining the taxable base, Murray said, the key is to be guided by neutrality. The inclusion or exclusion of certain types of income should not lead to economic distortions. In the case of nexus, Murray favored using an economic presence nexus standard. This would tax income where it is earned, which occurs at both origin and destination. Murray also favored the use of combined reporting, where firms file a combined tax return for a unitary group of companies. This would help eliminate some of the distortions that can occur through transfer pricing, the assignment of royalties, and the sharing of overhead when separate reporting is used. Further, in the case of apportioning the tax base of multihjurisdictional firms, Murray cautioned that allocation can create distortions by allowing firms to assign income to low tax states. Finally, Murray argued that throwback rules create inconsistencies in the tax base by assigning income to a state that may not have had a role in producing the income.

Federal tax reform

Next, Rudolph Penner, senior fellow at the Urban Institute, discussed federal tax reform. Penner noted that in the early 1990s proposals ranged from the adoption of a flat-rate income tax to the creation of a national sales tax. Some bipartisan interest was shown in a progressive consumption tax. Efforts were also made to reduce the tax burden on capital. However, the removal of a tax on capital would cause the after-tax rate of return on investments to rise and that in turn would lead to a rise in discount rates. As the discount rate increases, the value of existing capital declines. Another transition issue is the potential to have to compensate corporate taxpayers for prepaying taxes. Corporations can accumulate many types of tax credits and future tax savings that are often treated as assets on the balance sheet. Tax reform that wipes out these assets would require very high levels of compensation that would force any new tax structure to initially carry very high marginal rates, which would be politically unpalatable.

Penner noted that much of tax reform is geared toward social engineering rather than business tax improvement. Estimates suggest that social tax expenditures (foregone tax revenue) in the federal budget now equal 5.3% of gross domestic product (GDP). In contrast, special credits for business equal 1.2%. In addition, many tax reform efforts are complicated or temporary. The 1997 tax reforms added many exemptions and credits with little clarity, and recent tax cuts for dividends, capital gains, and estate taxes have all been passed as temporary measures.