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ANALYSIS | New Jersey’s former state comptroller and budget director asks: Is there an easier and more equitable way to tax business?
The U.S. tax code has been significantly altered resulting in very significant reductions in taxes for corporations, including a reduction in the rate from 35 percent to 21 percent. It is estimated that tax savings will approach $1 trillion for corporations.
Importantly, these changes will also impact the corporation business tax, or CBT, that states levy as many state corporate tax codes either incorporate or reference many provisions of the federal tax code. I am not able to systematically identify all of the provisions that will affect either the CBT taxpayer or of each individual state—each will be impacted differently and consequentially.
Some changes to the U.S. tax code are obvious, including at least three major components that will impact state collection of taxes—(a) limitations on deductions and exclusions, (b) restructuring of international provisions and (c) changes to tax accounting rules. Each state will have other elements.
Depending on the type of corporation and how certain rules are interpreted corporations will either pay more taxes or in other instances save money, albeit in the aggregate one has to assume that states will collect less tax revenue. In any case the impact will be complex and there will be many legislative debates and initiatives to change current provisions of state tax codes to conform or adjust to the federal tax changes.
Corporations will argue for changes that favor them and of course the folks who worry about balancing the budget will worry about losing tax revenue. A recent excellent report by Ernst and Young (E&Y) suggests the likely result is increased corporate taxes but it depends on how a state chooses to conform to the federal tax code.
The E&Y report also contains extensive sections on the impact on the federal tax code on corporations, its impact on states, on various types of industry, and an itemization of specific provisions of the new law that affect the tax base.
Much has been written about the need to attract and retain businesses as states are in constant competition with each other usually to the detriment of one. A common practice in most states is to offer business tax incentives to either relocate or to retain a corporation that is “thinking” about or “threatening” to move for a better business climate. One could discuss the pros and cons of past efforts of individual states of offering these incentives but suffice to say the new federal changes will further exacerbate this issue.
Instead a better option: Take advantage of the situation and eliminate the current state corporation tax and replace it with a simpler tax—a gross receipt tax.
The CBT Is Sadly Outdated
Forty-four states have a corporate business tax, ranging from a 4 percent in North Carolina to a high of 12 percent in Iowa. Most corporations pay the tax based on net income. However, the effective rate is much lower thanks to deductions and credits which minimize income and reduces the tax paid. On average the corporate tax is 5 percent of the total revenue base of the state. Furthermore, looking at historical trends the corporation tax in most states has been very static and had grown minimally as a share of state revenues as contrasted to the income and sales taxes.
The CBT was designed as a franchise tax for the “the privilege of doing business” in the state at a time when nearly all business of any size was conducted by corporations. The economic landscape has changed over time and now the CBT is sadly outdated.
Business enterprises can be of many forms and sizes and pay anywhere from zero dollars to millions. The specifics of corporation tax law are complicated regarding form and what state they are located. There are “C” corporations—usually the big boys—the Mercks and General Electrics of the world—subject to the highest rate. There are “S” corporations (e.g., the auto dealers and many small businesses)—usually paying a flat maximum CBT depending on the state.
But, many businesses, such as limited liability corporations and partnerships (e.g., professional services, accountants and lawyers) are neither C nor S corporations and avoid the CBT entirely, usually paying a maximum flat fee. In these cases, distributions made to owners are taxed under the individual gross income tax rules. The changes in the federal tax code will lead to many changes in this arena—again either positive or negative depending on the state and the payee.
The corporation tax has several problems with its structure. Specifically:
- The taxable value of the entity is measured by “net income.” While net income may be conceptually appealing as a measure of economic value, in the real world of separate entity accounting, pass-through entities, and extensive deductions, it does not adequately measure business activity. Net income is hardly an objective measure. As a result, it has extensive loopholes that allow the tax to be evaded or reduced for certain corporations.
- The tax base has been shrinking for many years; businesses of all types and sizes are electing a non-corporate structure—taking advantage of limited liability and partnership forms—as a simple means of avoiding the tax.
- Governors and state legislatures are frequently enacting legislation to lessen the impact on certain corporations by implementing a series of incentives. Some corporations receive these credits and deductions—others do not.
- The tax is highly inefficient to administer by the state, and likewise for corporations to compute legal liability.
The last two points are illustrative of taxation at its worse—it is neither equitable nor easy to enforce or collect. Currently, there is an army of state government tax examiners, auditors and lawyers trying to understand how each corporation is attempting to limit its payments; and a like army of corporate financial wizards trying to understand the extensive and very complicated tax codes and how they can limit their liability—each state will be different.
The CBT is a “broken tax” that does not meet the needs of business or the state—and to adjust to the new federal tax code each state will have endless debates as to how they should conform to help one group or another. I suggest going back to square one and starting over—in short, the system cannot be “fixed.” It should be replaced with a much simpler business tax that has low compliance and administration costs; is not dependent on corporate form; and raises revenue from the broadest number of entities conducting business in each state.
I would argue for a true “franchise” tax on all business entities with the activity measured not by net income but by gross profits (receipts less deductions for cost of goods sold and normal employment costs). No credits, no other deductions for expenses, no loopholes—just a simple computation based upon an acceptable, recognizable and logical base.
Such an entity tax could, for example, effectively exempt small businesses with gross profits under some level (e.g. $500,000) and instead subject them to a small minimum fee.
Businesses with higher levels of gross profits would pay specific amounts ranging from $1,000 to $100,000 or more dependent upon the gross profits of the entity. There is a wide range of fee or rate schedules that can be designed to generate as much as the current CBT generates—or more or less depending on the overall tax policy of each state.
As with any proposal that dramatically changes the base for taxation, some will oppose it. The tax will be called unfair because it imposes a tax on all businesses regardless of profitability, or hurts small businesses. Critics will argue “pass-through entities” should not be taxed since the state captures that income at the individual shareholder level, but these entities already face an entity tax in some form. The real question—is there an easier and more equitable way to tax business?
These and other arguments could go on and on, and frankly are examples of why the present system is so complicated and why states are constantly legislating deductions and credits and other loopholes for certain corporations.
The goal of tax policy should be to treat all businesses, regardless of form, fairly. The current tax policy is riddled with loopholes and easy to manipulate, and allows businesses that are not incorporated to avoid entity-level tax altogether. A reliance on net income to measure profitability or activity while theoretically attractive to the purist is fatally flawed in practical application.
In my opinion the conclusion is clear—in most states the corporate income tax is broken and should be eliminated and replaced with a simple low tax on all business activity regardless of corporate form, levied on a logical and recognizable base not subject to easy manipulation. Unlike the CBT based on net income, the tax does not penalize profitability or distort business decisions. That’s truly business friendly.
Richard F. Keevey is a senior policy fellow at the School of Planning & Policy at Rutgers University and a visiting professor at the Woodrow Wilson School, Princeton University. He is the former Budget Director and Comptroller for the State of New Jersey, appointed by two governors from each political party. Keevey is a National Academy of Public Administration fellow.