Remarks to the Pennsylvania Senate Economy, Business, and Jobs Caucus

June 7, 2010

Thank you, Senator Mensch and Senator Boscola, for having me today. It’s a pleasure to be back here in Harrisburg. Pennsylvania is one of the states that keep us busy at the Tax Foundation – always lots of ideas and proposals on taxes, as you know.

Crafting Sound Tax Policy
When a state is crafting fiscal policy, it has to decide two things. First, how big should state government be? How much should it spend? The answer to this question is individual to each state: should you be a high-tax, high-service state, or a low-tax, small-government state? I’d be curious to hear your answers to that. According to our numbers, Pennsylvania has the 11th highest state-local tax burden in the country.

Once you have decided how much tax revenue you want to raise, the second question is how to raise it. Economists generally urge that tax revenue be raised in the way that does the least damage to the economy: broad bases and low rates. Tax everything once and only once, and don’t use the tax code to micromanage the economy.

It’s very tempting though, to do just that. We see this particularly in states with terrible tax climates, states that are unfriendly to business generally. Their tax systems are so awful that they have to offer bribes and exemptions and abatements and subsidies before anyone is willing to invest or create jobs. Such tax credit or incentive programs may be good for a headline (“Rep So-and-So brings new jobs to district”) but research indicates that they do very little for long-term job creation, they can cause serious misallocation of scarce capital, and they distract from solving the real problem: a broken tax system.

Pennsylvania’s Tax Structure
I think there are glimmers of this in Pennsylvania but it’s nothing like some other states. Each year, we at the Tax Foundation compile our State Business Tax Climate Index, which you can check out at www.TaxFoundation.org, where we compare states’ tax structures on over 100 different variables. With this data we’re able to rank the states on how business friendly their tax codes are, 1 being business friendly and 50 being New Jersey. Pennsylvania ranks 27th, about in the middle and better than all surrounding states except for 8th-ranked-Delaware.

The state’s low, flat income tax is a saving grace of the system, since it is simple and avoids needless complexity. Local governments cannot their own sales tax base, which means Pennsylvania has just one list of taxable and exempt products, while other states have dozens or hundreds.

You do many other things that promote a simple, neutral, transparent, and stable tax system. But let’s talk about a few areas of opportunity.

State Corporate Income Tax
The big one is the state corporate income tax. Pennsylvania has the second highest corporate income tax statutory rate in the United States. If Pennsylvania were its own country, it would have the highest overall corporate tax rate in the world at 41.5% (federal plus state, accounting for the state-local deduction).

Pennsylvania’s high corporate tax rate should be a red flag to lawmakers worried about the state’s economic growth, wage growth, and overall competitiveness. An important study released last year by economists at the OECD found that of the various taxes a country can impose, “Corporate taxes are the most harmful tax for economic growth.”The administrative and compliance costs of corporate income taxes are also considerable.

At the same time, the use of tax incentives, the abandonment of apportionment uniformity, the proliferation of tax planning opportunities, and the rise of pass-through entities like LLCs have led to a long-term decline in state corporate income tax revenues. For all the harm it does, the corporate income tax will raise only approximately $1.8 billion, compared to $8.6 billion for the sales tax, $10.3 billion for the individual income tax, $1.2 billion for the gasoline tax, and $1.5 billion for telecommunications taxes.

Your franchise or capital stock tax is due to expire in 2014, and that can’t come soon enough. A disincentive to capital formation, it’s a 1930s relic that most states have rightly junked.

Uncapping Net Operating Loss Carryforwards
On a related matter, Pennsylvania is one of only two states (New Hampshire being the other) that limit net operating loss carryforwards. The deduction for net operating losses helps ensure that over time, the corporate income tax is a tax on average profitability. Without the net operating loss deduction, corporations in cyclical industries pay much higher taxes than those paid by stable industries, even assuming identical average profits over time. Put simply, the net operating loss deduction helps level the playing field among cyclical and non-cyclical industries.

Film Tax Credits
Film tax credits are something many states have fallen in love with. At this point, over 40 states have a film incentive program, and they are getting so generous that a state has to just about write a check to be competitive. Film productions produce shorter-time-frame jobs and lower multipliers on investment than average. And it doesn’t build anything – the productions stop coming as soon as some other state makes a better offer. It’s seems strange that an industry with billionaire producers, millionaire actors, and some of the highest profit margins of any industry should be the recipient of such lavish state aid. Iowa’s film credit program recently imploded in scandal and misallocated funds, something that could happen anywhere given the lax oversight many tax credit programs receive. Given the intense competition for the handful of productions, keep your money, grab some popcorn, and enjoy the movies that your fellow states are using tax dollars to subsidize.

Mandatory Unitary Combined Reporting
Combined reporting is on the table here. Proponents say that it’s the only way to combat the exploitation of loopholes and excessive deductions – loopholes and deductions created in the tax code, of course. States that adopt combined reporting believe that they can extract revenue from more profitable out-of-state enterprises under a corporate umbrella than from those enterprises currently within the state. The record of mandating unitary combined reporting is mixed, but revenue windfalls are unlikely, particularly as corporate lawyers and accountants adjust their operations and tax planning to minimize the additional tax burden.

State Budget
Finally, there’s the state budget. Pennsylvania is one of the states that last year used one-time stimulus money to backfill their budgets, postponing meaningful steps to prioritize public expenditures. Consequently, the state now faces a built-in multi-billion dollar annual budget gap from those disappearing federal revenues. Governor Rendell earlier this year proposed using tax increases to bridge that gap, but even those weren’t enough to completely close it or address future budgets.

Key to this is reprioritizing expenditures, slowing the rate of state spending, and meaningfully addressing the state’s structural deficit. Take Arkansas, for instance. When an appropriation is enacted, the money isn’t immediately spent. Instead, a committee prioritizes each appropriation, and money is spent only to the extent that revenues are available. In Indiana, the governor and legislature there insisted on a budget balanced without counting one-time Medicaid money or federal stimulus aid.

And on the other side of the coin is Michigan, which has a great education system and great roads but a terrible tax system. So grads take their new degrees and use those roads to drive to jobs in other states.

Conclusion
Taxes matter. When recovery comes, all that unleashed capital and entrepreneurial spirit will have 50 choices domestically about where to go. Pennsylvania can get it. It can be considered a place to invest, with a welcome mat laid out to all comers – a simple, neutral, transparent, and stable tax system, with a structurally balanced budget.

Thank you very much for having me today. We’re always eager to help out with data, research, and analysis.


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