While high top taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rates may provide “sticker shock” for corporations looking for a state to call home, they are just one of several important drivers of businesses’ tax burdens and tax compliance costs. The tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , and more broadly, the structure of the tax code, play a large role in business taxes and, in some cases, can cause states with low statutory rates to impose high effective burdens, and vice versa.
Our recently released Location Matters study helps to illustrate this phenomenon. With Location Matters, we design eight model firms and place them in each state (as both a new and mature firm, since new firms are eligible for many incentives denied to long-established firms), calculating their tax liability.
For many businesses, a state’s chosen method of formulary apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. , the definition of its tax base, throwback provisions, sourcing rules, and incentives, can be just important as the base—or even more important. Such factors can exacerbate a bad tax code, improve a code that is already good, or help compensate for uncompetitive rates.
Firms with nexus in more than one state must apportion their profits, using states’ rules to determine what portion of their income can be taxed in each state. The setup of these formulas can have a dramatic impact on tax obligations. Historically, states required profits to be apportioned using a ratio of the company’s property, payroll, and sales in each state, known as the evenly weighted three-factor apportionment formula. In recent years, states have increased the weight of the sales component, with 29 states relying on it completely (known as single sales factor apportionment). This sales emphasis benefits businesses that primarily do business out of state, as very little of their profits will be subject to the state income tax.
Iowa, for example, has a high corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. top rate of 9.8 percent, but the capital- and labor-intensive manufacturing firms in our study see almost all of their income exempted from corporate income taxation because of the state’s single sales factor apportionment. On the other hand, Montana has a lower top rate of 6.75 percent but employs an equally-weighted three-factor apportionment formula, creating an above-average corporate income tax burden on mature operations of the same type.
Even beyond corporate income apportionment, tax base decisions can be impactful. A sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. that includes business inputs—even at a low rate—can considerably add to the cost of new investment and the final price of products as the sales tax cascades through the supply chain. Capital- or equipment-intensive firms see the biggest impact from these inclusions. Because of this, a mature data center located in Utah only pays 0.3 percent of its net income in sales taxes, while it would owe 6.3 percent if located in Florida. Even though the two states have similar average combined state and local sales tax rates of 7.19 and 7.08 percent respectively, the burden is greater in Florida because of the state’s inclusion of many more business inputs in the base.
Similarly, property taxes that include equipment or inventory can make a huge difference for businesses with significant capital investment, and thus affect location decisions. For distribution centers, for instance, property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. es are the most significant tax type by far, frequently responsible for more than two-thirds of a firm’s overall burden. States like Indiana and Kansas impose unusually high property tax burdens on mature distribution centers in significant part because of inclusions beyond just land and buildings.
Throwback rules may be less commonly understood among the general public than other structural elements, but businesses are no stranger to their function. In fact, throwback rules are shown to affect business location decisions in certain industries due to their dramatic effect on taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . When corporate income is apportioned among states for tax purposes, it is possible for some income to be earned in states which lack jurisdiction to tax the corporation, generating what is known as “nowhere income” that is not taxed by any state. Under a throwback rule, sales of tangible personal property are “thrown back” into the numerator of the origin state’s sales factor, even though the state would not otherwise be able to claim that income.
While this system was created with the intention of avoiding taxing less than 100 percent of business income, throwback rules often end up taxing more than 100 percent of business profits, and it can make the cost of operating out of a given state anomalously high. Manufacturers who have a large number of out-of-state sales experience this effect: nine out of the 10 highest tax cost states for mature capital-intensive manufacturers have throwback rules, and all 10 of the highest cost states for mature labor-intensive manufacturers impose them.
Tax incentives are slightly different than other structural elements in that they allow select businesses to circumvent parts of an existing tax code through property tax abatements and income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s for things like investments and jobs. Such incentives generally benefit only newly formed businesses and favor some industries or activities more than others.
This phenomenon is especially apparent in Kansas, which provides generous incentives for manufacturers through the Promoting Employment Across Kansas (PEAK) program. New capital-intensive manufacturers in Kansas see the second-lowest tax burden in the nation for their firm type, but the benefits drop off for preexisting manufacturers, increasing the effective tax rate by almost 10 times and leaving those companies with the highest effective taxes in the nation among similar firms. Alternatively, Hawaii provides such generous incentives for both new and mature research and development (R&D) operations that those firms actually see negative effective taxes, but the state does not provide similar benefits for any other industry.
In short, there is far more to a state’s effective tax burden than just the top rate. Structural elements like apportionment, base inclusions, throwback rules, and incentives can all have tangible effects on a business’s overall effective tax liability because they determine how much of a business’s income and purchases are subject to state taxation. While low rates are important, lawmakers looking to improve their state tax code should ensure that poor tax structure is not undermining competitive tax rate or exacerbating high rates.
Note: This is the first of a four-part series highlighting key takeaways from our Location Matters report. To view the report in full, or examine any particular state or industry, click here.
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