Closing Three Common Corporate Income Tax Loopholes Could Raise Additional Revenue For Many States, Rev. 5/23/03

CLOSING THREE COMMON CORPORATE INCOME TAX LOOPHOLES
COULD RAISE ADDITIONAL REVENUE FOR MANY STATES
by Michael Mazerov

The current economic downturn has opened up enormous gaps between revenues and expenditures in the budgets of the vast majority of states. Tax revenues are flat or declining, and spending pressures are growing as families with unemployed workers require state-financed medical assistance and income support. New spending demands associated with security and public health concerns are compounding the states' fiscal crises.

As they work to close these budget gaps, state policymakers are facing difficult decisions about whether to cut state services and/or raise taxes.[1] State officials may also wish to consider policy options that could increase the yield of existing revenue sources. In particular, they may wish to scrutinize their tax structures for unintended and unrecognized loopholes that allow some individuals and businesses to avoid paying their fair share of taxes, and then take steps to minimize such tax-avoidance opportunities.

State corporate income taxes are long overdue for a thorough examination. The corporate income tax laws of the majority of states are riddled with loopholes that permit many large multistate corporations to avoid paying tax on a significant share of their profits. The growing sophistication of corporations in exploiting these flaws has undoubtedly contributed to the declining significance of the corporate income tax in state tax structures over the past two decades. According to the U.S. Census Bureau, corporate income taxes supplied 10.2 percent of state tax revenue in the states levying them in 1979, but just 6.3 percent in 2000.[2] (See Table 1.)

The steady erosion of state corporate income taxes is revealed as well in estimates of the effective state corporate income tax rate. The effective corporate tax rate is the rate at which corporations actually pay tax on their profits, as opposed to the rate that is nominally imposed. The effective corporate tax rate is measured by dividing actual corporate tax collections by an estimate of "true" corporate profits. Top nominal state corporate tax rates are generally in the range of 6-10 percent; only five of the 45 states imposing corporate taxes (including the District of Columbia) have top nominal rates less than 6 percent. A recent report by the Congressional Research Service estimated, however, that the average effective state corporate income tax rate declined from 5.3 percent in 1979 to 3.8 percent in 1998.[3] (See Figure 1.)

Table 1
Share of Total State Taxes Contributed by Corporate Income
Tax, 1979, 1989, & 2000,
States with Corporate Income Taxes
	1979	1989	2000

All Corporate Income Tax States	10.2%	8.8%	6.3%

Alabama	5.8%	5.9%	3.8%
Alaska	31.5%	32.6%	30.8%
Arizona	5.9%	4.9%	6.5%
Arkansas	8.4%	5.1%	4.9%
California	14.5%	12.3%	7.9%
Colorado	7.8%	5.9%	4.7%
Connecticut	13.5%	16.6%	4.2%
Delaware	10.2%	13.7%	11.3%
Florida	7.3%	5.8%	4.8%
Georgia	9.2%	8.3%	5.3%
Hawaii	4.6%	4.0%	2.3%
Idaho	8.4%	6.9%	5.3%
Illinois	7.7%	9.1%	9.9%
Indiana	4.8%	4.8%	9.2%
Iowa	8.3%	6.4%	4.1%
Kansas	11.9%	7.9%	5.6%
Kentucky	7.9%	7.6%	4.0%
Louisiana	9.7%	8.7%	3.4%
Maine	7.4%	6.1%	5.6%
Maryland	5.5%	5.3%	4.2%
Massachusetts	13.4%	13.0%	8.1%
Minnesota	11.4%	7.6%	6.0%
Mississippi	4.9%	6.3%	4.8%
Missouri	6.5%	5.2%	3.1%
Montana	9.0%	7.7%	7.1%
Nebraska	6.7%	5.6%	4.7%
New Hampshire	24.2%	24.8%	18.4%
New Jersey	11.5%	12.5%	7.4%
New Mexico	4.8%	4.0%	4.3%
New York	10.5%	7.6%	6.6%
North Carolina	8.7%	10.7%	6.5%
North Dakota	8.9%	6.4%	6.7%
Ohio	10.9%	6.8%	3.2%
Oklahoma	6.2%	3.4%	3.3%
Oregon	12.0%	6.1%	6.8%
Pennsylvania	12.6%	9.2%	7.6%
Rhode Island	10.4%	6.7%	3.7%
South Carolina	9.2%	5.9%	3.6%
Tennessee	10.1%	9.1%	7.9%
Utah	4.7%	5.7%	4.4%
Vermont	8.9%	6.0%	3.0%
Virginia	7.7%	5.2%	4.5%
West Virginia	2.2%	10.8%	6.5%
Wisconsin	10.0%	7.0%	4.6%
Source: Census Bureau. Texas is omitted because its "earned surplus tax" — the functional equivalent of a corporate income tax — was not enacted until 1991. Texas is discussed in the remainder of this report, however.

Finally, it seems particularly noteworthy that during the strong economic expansion of 1995-2000, state corporate income tax revenue grew at just half the rate of federal corporate tax revenue — an average of three percent annually versus six percent annual growth for the federal corporate income tax. (See Figure 2.) Since corporate income tax rates at both the federal and state level were substantially stable throughout this five-year period, the relatively slow growth of state corporate tax receipts suggests that a significant share of corporate profit that is finding its way into the federal corporate tax base may be falling through the cracks at the state level.[4]

Closing Three Common Loopholes Could Help Stem the Erosion of the State Corporate Tax

Numerous changes are needed in most states' corporate income tax laws to reestablish this tax as a robust source of state revenue.[5] Three such changes seem particularly worthy of immediate consideration by policymakers, because the revenue that could be gained likely is substantial, the loopholes could be closed without having to make fundamental changes in the structure of the corporate tax, additional revenue could begin flowing relatively quickly, and a substantial share of the additional revenue would arise from the taxation of corporate profits that currently are escaping taxation completely. The three options are:

Amending the definition of apportionable "business income" to strengthen the ability of states to tax capital gains realized on the sale of corporate subsidiaries and other major assets, reversions from over-funded pension plans, damage awards in lawsuits, and other irregular or extraordinary income items.

Implementing these three policy changes could make a meaningful contribution to closing current gaps between revenues and expenditures in a large number of states and help stem the long-term erosion of the corporate tax base. Each of these policies has already been implemented in approximately half the states levying corporate income taxes. None of the three are mutually exclusive or overlapping; any or all of them can be implemented in states that have not yet done so. Table 2 summarizes which states have not yet implemented each of the three policy options.

When a corporation produces and/or sells goods in more than one state, each state requires the business to pay tax on just a portion of its nationwide profit. That taxable share is calculated by an "apportionment formula" embedded in each state's corporate income tax law. The most commonly used formula assigns some of the profit to the state(s) in which the corporation produces goods and some to the state(s) in which the corporation makes sales. However, a little-known federal law, Public Law 86-272, establishes a threshold level of presence or "nexus" a corporation must have in a state before it can be subjected to a corporate income tax on profit earned in that state.[6] Public Law 86-272 frequently blocks states in which a corporation merely makes sales from imposing an income tax on the states' respective shares of the corporation's profit (as calculated by the formula).

The "throwback rule" is a fallback provision of state corporate tax law that is intended to deal with this conflict between nexus law and state apportionment formulas. The throwback rule effectively allows a state in which a corporation produces its wares to tax the profit on any sales made by the corporation into states in which the corporation has insufficient presence to be subjected to a tax on its profit from those sales. (The sales are said to be "thrown-back" for tax purposes from the state in which the purchaser is located to the state in which the seller is located.)[7] If a state does not have a throwback rule in effect, 50-100 percent of the profits of its resident corporations frequently will be what tax officials call "nowhere income" — profit that is earned somewhere in the United States but not subject to tax by any state.[8]

Not surprisingly, the multistate corporate community generally opposes the throwback rule. Its spokespersons assert that through the enactment of Public Law 86-272, Congress has implicitly decreed that corporations should not be subject to taxation in states in which they have no or limited physical presence. Corporate representatives argue that it therefore is unfair of states to seek to counteract this result by arbitrarily deeming the profits earned from such sales to be earned in the states to which the sales are "thrown back." The state counter-argument is that the throwback rule predates Congress' 1959 enactment of Public Law 86-272 and that Congress neither prohibited the throwback rule in P.L. 86-272 nor has acted to block states from implementing the rule in subsequent years. State representatives also argue that corporations are not entitled to have "nowhere income," and that the throwback rule is a reasonable, second-best solution to unfair restrictions on their ability to impose taxes on corporations that are, in fact, earning profits by selling to their residents. While P.L. 86-272 may prevent states from taxing the profits of some out-of-state corporations making sales to their residents, states can tax profits attributable to sales made in other states by in-state corporations. If all states had the throwback rule in effect, the partial "swap" of corporate tax bases the throwback rule effectuates would be roughly equivalent.

	Enact Throwback Rule	Nullify PICs	Broaden Business Income Definition
Alabama			!
Alaska			!
Arizona	!		!
Arkansas		!	!
California			!
Colorado			!
Connecticut	!		See Appendix B
Delaware	!	!	See Appendix B
Dist. of Columbia		!	!
Florida	!	!
Georgia	!	!	See Appendix B
Hawaii			!
Idaho			!
Illinois			!
Indiana		!	!
Iowa	!	!
Kansas			!
Kentucky	!	!	!
Louisiana	!	!	!
Maine			See Appendix B
Maryland	!