Businesses’ 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. liability can differ markedly across states, and policymakers often pay attention to this competitive tax landscape. What is less often remarked upon, however, is the variation of tax treatment within a given state. Different industries and activities can face radically different tax burdens within the same state due to non-neutralities in the tax code.
While there will naturally be variations in tax burdens due to differing business models, a good tax code is one that is relatively neutral across different industries. This is not the norm among states, as our recent Location Matters study demonstrates by calculating the effective tax burdens of eight model firms. Decisions that seem small can have outsized impacts on specific industries.
To see evidence of this, we can look at the state of Minnesota, where effective overall rates for mature corporations, as a percentage of in-state net income, range from 6.7 percent for capital-intensive manufacturers to 54.9 percent for distribution centers.
The mature capital-intensive manufacturer experiences the most competitive rates in the state. It benefits from the state’s single sales factor 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, with essentially none of its profits subject to the 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. . It also benefits from the state’s choice to exclude manufacturing equipment from the 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. .
The mature data center benefits from similar elements but sees a higher sales tax burden because business electronics, including data servers and other equipment, are included in the sales tax. However, its low liability in other tax categories balances this out and produces an effective burden of only 8.7 percent for this firm.
Rates begin to ramp up with the shared services center. This firm faces a high effective rate of 33.9 percent that can be partially explained by the state’s large taxable wage base and high maximum rate for unemployment insurance taxes. Shared services centers have more employees than other model firms, with low- and moderate-wage employees comprising a significant share of overall business costs, and those have considerably more exposure to UI taxes than do other businesses that are more capital-intensive or have higher profits per employee.
The 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. is even more significant for this model firm and is a major driver of tax costs for the distribution center. As a property-heavy firm—it is, after all, a warehouse facility full of inventory—the distribution center bears the full brunt of high property tax rates. In fact, property taxes make up over 78 percent of the mature distribution center’s 54.9 percent overall tax burden. As that effective rate ranks 45th in the nation, it makes the state particularly unattractive for that business model, even if the state can be attractive for other businesses.
These non-neutralities in Minnesota largely arise from a combination of high property tax rates and 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. design decisions, but corporate tax incentives can add another variable into the mix. Although tax credits commonly cause a disparity between new and mature firms, targeted incentives can also create a clear divide among industries. Among new businesses in Nebraska, for example, overall effective tax rates for model firms range from negative 0.6 percent to 43.9 percent.
A new technology center in Nebraska benefits from investment 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, which, when combined with job credits, completely cancel out the property tax obligation and create an overall burden of only 0.5 percent for the firm. Research and development (R&D) facilities see an even bigger effect: the refundable credits available for new firms are large enough to cancel out all other tax obligations, leaving the firm with an overall tax burden that is actually negative.
All firms except data centers are eligible for the state’s job creation credits, but the shared services center and labor-intensive manufacturer see more benefit from this program than other firms because of their large number of employees. Even so, the credits received by the shared services center are only able to subsidize a middle-of-the-road tax burden because the firm experiences high property tax burdens. And not all businesses in the state are as fortunate; the distribution center ends up with an overall effective tax rate of 43.9 percent in Nebraska. Any decrease in its income tax obligation from credits is dwarfed by the property tax burden, as abatements in the state are highly discretionary.
Non-neutrality is, unfortunately, the norm in state business taxation, but significant neutrality is, in fact, achievable. In Idaho, which features middle-of-the-road tax burdens, effective rates are relatively comparable among industries, ranging from 11.1 percent to 22.1 percent for mature firms. Although the state has some uncompetitive tax elements like a throwback rule, unfavorable sourcing of service income, and the inclusion of equipment in the property tax base, it has low overall property tax burdens and exempts manufacturing machinery and R&D equipment from the sales tax. While Idaho could make some improvements to bring down overall burdens, it treats industries fairly similarly across the board. Other states, like North Carolina, have low rates across the board.
Some differences in tax treatment are to be expected simply because of the nature of differing business models, but states should take care that they do not exacerbate this difference and—intentionally or unintentionally—favor some industries over others. States can enhance tax neutrality across industries by reforming tax structures that penalize certain business activity, for instance by excluding business inputs from both sales and property tax bases. They would also do well to lean less on generous incentives and focus more on creating a tax code that provides for low and competitive burdens for all comers.
Note: This is the third 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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