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

Chicago Fed Letter, Dec 2004 by Mattoon, Richard

Michigan, Illinois, and Indiana

Next, Doug Roberts of Michigan State University (and former state treasurer for Michigan) spoke about Michigan's single business tax (SBT). Adopted in 1975, the SBT was an effort to introduce an origin-based business value added tax (based on a benefits received principle) to replace a business tax structure that tended to produce revenue booms and busts. The SBT replaced seven existing business taxes with one broad based/low rate (2.35%) tax, which could be computed in one of two ways. A firm could either pay a 2.35% tax against its tax base (calculated as compensation, profits, depreciation, and interest paid) or pay a 1.175% tax on the basis of total gross receipts. In the latter case, the maximum tax base could not exceed 50% of gross receipts.

Roberts credited the passage of the SBT to a convergence of strong political leadership with a state fiscal crisis. However, over time revisions to the SBT have significantly reduced its revenue raising ability. Currently, the tax is being phased out; it is scheduled to expire on December 31, 2009.

Roberts suggested that many misperceptions have made the SBT unpopular. The first is that it is a small business tax. In reality one-tenth of 1% of all firms in the state account for 27% of the revenue raised, and 2% of all firms pay 60% of the tax. Conversely, 27% of all firms have no SBT liability, with 44% of all firms paying less than $1,000 per year in SBT taxes. The tax also drew opposition from special interest groups that may not have been previously subject to corporate taxation or disliked paying a tax when their businesses lost money.

Replacing the 27% of general fund revenues the SBT provides will be difficult. Options include keeping the SBT and overweighting the profits factor, enacting a small SBT and combining it with an independent corporate income tax, or enacting both a gross receipts tax and a corporate income tax. The greatest challenge will be political, Roberts concluded, because any change will likely affect a large number of firms currently paying little or no tax.

Then, Fred Giertz of the University of Illinois and the National Tax Association described recent developments in Illinois, which he characterized as a low state tax/high local property tax state. Illinois has a moderate corporate tax rate of 4.8% plus a 2.5% local personal property replacement tax for local government with a sales tax on many business inputs. The corporate tax rate is limited by the state constitution to a ratio of 8:5 to the personal income tax rate. The property tax is particularly problematic for business. Not only does the state have generally high property tax rates, the state's largest county (Cook) has a classification scheme that taxes business property more than residential property. Giertz concluded that Illinois has a reasonably good business tax structure, with the exception of the property tax burden and the tendency to offer too many types of tax credits.

Recent economic conditions have placed greater stress on Illinois's revenue sources. The state had an outright decline in total revenues for three fiscal years and current revenue growth remains sluggish. In addition, Governor Blagojevich has maintained his campaign pledge of avoiding increases in the sales or income tax base, while maintaining service levels in K-12 education and health and welfare. This has led to a reliance on creative solutions to fund the budget, including borrowing, tax amnesties, fund transfers, sale of state assets, and the use of one-time federal aid. Recently, the focus has turned to higher taxes and fees on business. Businesses have faced a range of fee increases, as well as taxes on out of state gas purchases, and trucking and gambling tax and fee increases. Giertz predicted that efforts will continue to shift the property tax burden toward business.