November 8, 2021

Pro-Growth Tax Reform for Oklahoma

Executive Summary


Oklahoma policymakers have been focused on tax reform for many years, always keeping an eye on the state’s neighbor to the south. Legislators succeeded in reducing rates for both individual and corporate income taxes, but Oklahoma is far from alone in this pursuit. In an increasingly mobile economy, states are rightly becoming more concerned about their tax competitiveness, and many have similarly moved to reduce rates—and to make structural reforms, besides.

Although the recent rate reductions are an important step forward, many elements of Oklahoma’s tax code remain an impediment to its competitive standing. Fortunately, Oklahoma finds itself in a good position: the state is in need of pro-growth tax reform at the very same time that it has a revenue buffer to help absorb transition costs from tax policy changes.

In the following pages, we identify a number of deficiencies in Oklahoma’s tax code and outline possible solutions for reform. Several of the proposals could be adopted on their own because they have minimal revenue impacts, but others are possible through revenue triggers or tax swaps that shift reliance onto less distortive taxes, or by forgoing a certain amount of revenue growth. Overall, our recommendations would create a more neutral tax code that would encourage long-term growth in the state.

A Menu of Oklahoma Tax Reform Solutions

Corporate Income Tax Reforms

Oklahoma’s corporate income tax currently features a flat, 6 percent rate that is set to drop to 4 percent in tax year 2022. While this is a competitive rate, several structural elements work against the low rate, penalizing businesses that sell both into and out of the state. The following recommendations would create a more competitive corporate tax environment that would encourage long-term investment in Oklahoma.

Repeal the throwback rule. Oklahoma’s throwback rule punishes businesses that sell out of state, encouraging them to relocate to—or at least locate distribution facilities in—other states. With studies suggesting that, over time, tax avoidance strategies eliminate most or all revenue gains from throwback rules, repealing the throwback rule would be a sound investment in Oklahoma’s economy.

Shift to single sales factor apportionment. Many states have shifted from traditional three-factor apportionment. As long as Oklahoma retains its current apportionment formula, it will tax in-state investment more heavily than other states. In order to compete in the changing tax landscape, the state should consider following suit and adopting single sales factor apportionment.

Lock in full expensing of capital investment. Commendably, Oklahoma conforms to the recent federal policy of allowing corporations to fully deduct the cost of their machinery and equipment purchases in the first year. But with the current federal treatment scheduled to expire, Oklahoma would be well-advised to lock in the current system, decoupling from future changes to federal law and instead providing permanent full expensing.

Individual Income Tax Reforms

Oklahoma currently has a six-bracket individual income tax with a top rate of 5 percent, which is set to decline to 4.75 percent in 2022. This rate is competitive, although the state sees stiff competition from neighboring Texas, with its lack of an income tax. While full income tax repeal would be difficult, the state has a number of responsible options for income tax rate reform short of complete elimination.

Consider options for rate reductions that build on previous reforms. Oklahoma lawmakers could select from a menu of options for prioritizing continued income tax relief. In this publication, we explore the implications of several options, including:

  • Creating a single-rate income tax with a $10,350 standard deduction, simultaneously eliminating the state’s marriage penalty.
  • Phasing in income tax rate reductions using revenue triggers.
  • Adopting a 3 percent top marginal income tax rate, in an across-the-board cut, paid for with moderate sales tax base broadening.
  • Moving to a 2 percent or lower top marginal income tax rate paid for by sales tax base broadening and higher sales tax rates.
  • Shifting to a consumed income tax, which would eliminate the tax’s current penalty on saving and investment.

Sales Tax Reforms

Oklahoma’s state-level sales tax rate of 4.5 percent is relatively modest on its own, but local option sales taxes ramp up the average combined sales tax to 8.95 percent, the sixth highest rate in the country. As the state’s reliance on sales taxes is higher than average among states, it is especially important that the sales tax is as stable and neutral as possible. The following recommendations would move the state in this direction and provide revenue that could pay for additional tax reform in other areas.

Moderately broaden the sales tax base. An ideal sales tax is levied on all final consumption, but Oklahoma currently exempts most consumer services from taxation. While expanding the sales tax base to capture all goods and services is not politically feasible, moving toward a broader base would modernize and stabilize the sales tax base while facilitating income tax rate relief. Meaningful but responsible base expansion could provide an estimated $732 million of revenue at current rates to pay down income tax rate reductions or other reforms.

Maintain local revenue neutrality under base broadening. Any sales tax base expansion the state uses to pay down reforms will yield sizable increases in tax collections on the local level. To avoid an extra tax burden for residents, the state should limit local sales tax collections in some way if the base is expanded, whether that takes the form of a levy limit, a rate cap, or a change in local aid formulas.

Change to market-based sourcing of services. Oklahoma currently imposes sales tax on tangible goods in the place they are purchased. It should extend this same treatment to services instead of adding complexity by taxing them where the income-producing activity occurs, an approach which puts in-state producers at a competitive disadvantage.

Property Tax Reforms

While Oklahoma’s effective property taxes are comparatively low, the burden falls most heavily on commercial entities, which, in addition to general ad valorem taxes, are also subject to franchise taxes and compliance-heavy tangible personal property taxes. Reforming the ad valorem tax in several key areas would help Oklahoma become a more competitive business destination.

Adopt a de minimis exemption for taxes on tangible personal property. Many small businesses face negligible tax liabilities but are still forced to go through a costly filing and compliance process. Exempting a certain amount of business machinery and equipment from taxation and making this exemption a filing threshold would take these small businesses off the tax rolls with minimal revenue loss.

Repeal the inventory tax.  Oklahoma has already agreed to exempt short-term inventory for businesses in the state. It should build on this effort and consider a full repeal of its inventory tax, either with a local phaseout or state revenue transfers. This would make the state more attractive to retailers, distribution centers, and any other inventory-heavy businesses.

Eliminate the franchise tax. Franchise taxes are levied on a business’s net worth instead of its ability to pay. As such, franchise taxes cause economic distortion and hit businesses especially hard in times of economic downturn. Oklahoma limits this damage by imposing a low rate and capping payments at $20,000, but the franchise tax still functions as a nuisance tax: businesses must track asset values and remit these taxes at the cost of considerable time and effort. Many states have shifted from such taxes, and Oklahoma should follow their lead, removing a tax that burdens businesses without providing much revenue for the state.

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The 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.

A 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.

A 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.

Full expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs.

An individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.

A 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.

Base broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability.

Apportionment 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.