A Pennsylvania 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. that was set to be fully phased-out by 2014 may now be extended for two additional years. Last week, legislators passed a number of tax changes including an extension of the state’s set-to-expire corporation capital stock tax. Though the budget has been signed by the Governor, the tax package still awaits his signature.
The new phase-out schedule is below. If you’re unfamiliar with how mill rates are used to calculate tax liability, see this tutorial.
|Year||Current Law||New Law|
|2013||0.89 mills||0.89 mills|
|2014||0 mills||0.67 mills|
|2015||0 mills||0.45 mills|
|2016||0 mills||0 mills|
Why such a big fuss over such a tiny tax rate? First, capital stock taxes are distortive because they discourage the accumulation of capital. Second, the tax is overly complicated and thus has high compliance costs, which are a drain on economic resources. And third, lawmakers’ failure to follow through on the full phase out makes it difficult for businesses to plan for the future. I’ll address each in turn.
First, capital stock taxes (often referred to as franchise taxes), are poor policy by nature due to the incentive structure they create. These taxes are levied on a firm’s level of assets, meaning the more capital stock a company acquires as it expands, the more it owes. Pennsylvania is effectively disincentivizing businesses from acquiring assets and other things they would use to expand production and technology. The ultimate goal of a small business is to expand into a larger one—the last thing a government should do is create a tax structure that punishes this activity. By disincentivizing expansion, the full productive potential of the economy can’t be reached.
What’s worse is that there is no cap on the amount of tax a company can pay. And let’s not forget that this is on top of the state’s 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. of 9.99 percent (the second highest in the country) and is levied on the worth of the business, regardless of the firm’s cash flow in a particular year. If it’s been a bad year, the capital stock tax will still be owed in proportion to the firm’s value (though the state has tried to mitigate this issue by including a five-year average of net income within the base calculation, but this only adds unnecessary complexity–getting rid of the franchise tax entirely would be better).
Second, the Pennsylvania franchise tax is overly complicated to calculate, and firms wasting time on tax compliance could be using those time and monetary resources more effectively elsewhere. Take a look at the base formula below—it requires both the calculation of an average income measure and a net worth measure. The law also allows firms to choose which 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. formula they’d like to use, further complicating the calculation (see the state’s 2012 Tax Compendium for details).
Capital stock 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.
Most companies subject to this tax only pay $300 or less. In 2009, of the 379,303 firms that paid the tax, 312,327 owed $300 or under, meaning that these high per-firm compliance costs are hardly justified for such a small amount of revenue (see page 225 of the most recent Comprehensive Annual Financial Report for further detail). The ambiguous definition of income has even been disputed in state courts and the Department of Revenue in the past. When a state has to waste resources interpreting its own tax code, it’s a fairly good sign the tax could use reform.
Finally, this isn’t the first time state politicians have halted a planned sunset of the tax. In 2009, Keystone lawmakers pushed a planned phase out back from 2011 to 2014. This latest extension would raise taxes on businesses by $58.4 million in fiscal year 2013-2014 alone. This could have serious effects on balance sheets if firms have already planned for the tax’s repeal. Take a firm with a capital stock of $5 million. Under the existing tax regime, that company would have planned to pay nothing in 2014 and 2015. With the tax extension, the firm would now be required to come up with $3,350 and $2,250 in 2014 and 2015 tax payments, respectively. That may not seem like a lot for a company that has $5 million of “net worth,” but much of that is likely tied up in illiquid business assets and thus tax must be paid using valuable cash flow.
Luckily, only 20 states levy these destructive taxes, and some seem to realize their detrimental nature and are moving to eliminate them entirely. West Virginia is set for phase out by 2015, Missouri’s will be eliminated by 2016, and Kansas repealed theirs in 2011. Let’s hope Pennsylvania doesn’t make a continued habit of dragging this one out.
Two of the tax provisions passed this year in Pennsylvania move in the right direction. One is the gradual chipping away of the state’s inheritance taxAn inheritance tax is levied upon an individual’s estate at death or upon the assets transferred from the decedent’s estate to their heirs. Unlike estate taxes, inheritance tax exemptions apply to the size of the gift rather than the size of the estate. , which we recently covered here. The other is reform to the state’s Net Operating Losses provision of the corporate income tax.
States levying a corporate income tax should account for the fact that some firms operate in inherently cyclical industries and this could force them to face a higher tax liability than less cyclical industries, even if the two have similar average profit margins over a period of years. Net Operating Losses (NOLs) deductions account for this (called “carryback” and “carryforward”) and the ideal system would not limit the amount “carried back” or “carried forward.” Pennsylvania limits carrybacks to 20 years and $3 million (but doesn’t allow carrybacks at all). The new legislation would increase the carryforward cap to the greater of $5 million or 30 percent of 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. in 2015, which is a good start (however they’d be better off not limiting that amount at all and allowing carrybacks, as well). For more information on NOLs, see pages 13 and 35 of our 2013 State Business Tax Climate Index.Share