Statement Before the Senate Finance Committee of the Pennsylvania State Senate On Pennsylvania’s Business Tax Structure

May 11, 2004

On behalf of the Tax Foundation, I want to thank you for the opportunity to speak about Pennsylvania’s business tax climate. Pennsylvania ranks 19th in the Tax Foundation’s State Business Tax Climate Index (Hodge, Scott A.; Moody, J. Scott, and Wendy P. Warcholik, “State Business Tax Climate Index,” Tax Foundation Background Paper, No. 41, May 2003), where the best ranked state is Wyoming at number 1 and the least favorably ranked state’s tax system is Mississippi.

The Tax Foundation’s State Business Tax Climate Index can help business leaders and government policy makers identify the features of our state tax system that are superior to comparable features in other states and to identify where we have room for improvement.

Published one year ago, the research included all rates and data as of the end of 2002. Its essential finding in regard to Pennsylvania is that the state had a better than average business tax climate index ranking. I will be updating the study over the next couple months.

My name is Thomas Armstrong. I am an Adjunct Scholar for the Tax Foundation, a non-profit, non-partisan research and public education organization that has monitored fiscal policy at all levels of government since 1937.The Tax Foundation is neither a trade association nor a lobbying organization. Our goal is to explain as precisely and as clearly as possible the current state of fiscal policy in light of established tax principles, so that you, the policy makers, have the information to make informed decisions.

The State Business Tax Climate Index measures the impact on business of five major elements of the tax system, using five equally weighted indexes that measure the economic impact of: corporate income taxes, individual income taxes, sales and gross receipts taxes, state fiscal balance and tax base conformity. The state’s business tax climate is measured on a scale of zero (the worst) to 10 (the best). The scores are all comparative, so that changes in other states affect Pennsylvania’s scores. This reflects the economic reality that tax competition is always at work among the states.Once the Climate Index in calculated, states are then ranked. Pennsylvania’s neighboring states were ranked as follows: Delaware (15th), Maryland (31st), West Virginia (39th), New Jersey (40th), New York (44th) and Ohio (47th).

State Business Tax Climate Index and Rank, 2002

Business Tax Climate Index
Total Score

Rank

Delaware

6.58

15

Pennsylvania

6.38

19

Maryland

5.53

31

West Virginia

5.10

39

New Jersey

5.09

40

New York

4.80

44

Ohio

4.45

47

U.S. Average

5.97

Note: The higher the Business Tax Climate Index Total Score, the more favorable the state’s tax system is for business. The state with the highest score was ranked number 1, and the worst score ranked 50th.

Source: Hodge, Scott A.; Moody, J. Scott, and Wendy P. Warcholik (May 2003). “State Business Tax Climate Index,” Tax Foundation Background Paper, No. 41.

Taxes matter. Taxes matter a great deal to business. Taxes reduce profitability. If the tax cost goes up, the cost is passed along to consumers through higher prices, to workers through lower wages, or to shareholders through lower dividends or share values. Taxes affect business decisions, location, competitiveness, job creation, job retention, and the long-term health of the state economy.

If any state imposes a greater overall tax burden than a neighboring state, business will cross the border to some extent to a lower tax jurisdiction. Lower-tax states seeking higher growth and job creation can lure businesses out of higher-tax states. The Tax Foundation recognizes that there are many additional factors that affect business decisions. Some examples are proximity to raw materials or transportation centers, regulatory or legal structures, the quality of the education system, the skill of the workforce, and the intangible state’s “quality of life.”

Policy makers have some control over these factors. What is recognized is that policy makers do have direct control over how friendly their tax system is to business.

The ideal tax system is where individuals and businesses base their economic decisions solely on the merits of the transactions, without regard to tax implications or, in other words, tax neutrality. No tax system is completely neutral. However, a tax system should have a minimal impact upon any economic decision. Decisions should not be micro-managed or even dictated by a tax system.

The Tax Foundation’s State Business Tax Climate Index attempts to measure the degree of neutrality of a state’s tax system. States with a higher index score (and a better ranking) have a higher degree of neutrality than states with lower index score (and a lower ranking). If a state’s economy has relatively greater neutrality, the economy is comparatively efficient, producing more jobs and yielding higher incomes.

While Pennsylvania has an above average ranking, Pennsylvania’s tax system is not neutral. The five major elements of the Tax Climate Index will be discussed relative to neighboring states for possible areas of improvements.

Major Index #1 – Corporate Income Taxes
It is well established that the extent of corporate income taxation can affect the level of economic activity within a state. With this effect in mind, the Tax Foundation constructed a Corporate Income Tax Index that compares each state’s top corporate tax rate, the level of taxable income at which the top tax rate kicks in, the number of brackets and the average width of the brackets.

The Corporate Income Tax Index measures the “tax impact” of a state’s corporate income tax system on the next dollar of income earned. A state with a low score indicates the corporate tax code is poorly designed and represents an impediment to business activity.

Once the Corporate Index in calculated, states are then ranked. Pennsylvania is poorly ranked at 35. Neighboring states are ranked as follows: Maryland (19th), New York (21st), Delaware (27th), New Jersey (29th), West Virginia (31st) and Ohio (46th).

Corporate Income Tax Index, Rank, Rates & Brackets, 2002

Corporate Income Tax Index Score

Rank

Rates & Brackets

Maryland

8.75

19

7.00% > $0

New York

8.63

21

7.50% > $0

Delaware

8.33

27

8.70% > $0

New Jersey

8.25

29

9.00% > $0

West Virginia

8.25

31

9.00% > $0

Pennsylvania

8.00

35

9.99% > $0

Ohio

4.78

46

5.10% > $0
8.50% > $50K

U.S. Average

7.67

Source: Hodge, Scott A.; Moody, J. Scott, and Wendy P. Warcholik (May 2003). “State Business Tax Climate Index,” Tax Foundation Background Paper, No. 41.

Many states, including Pennsylvania, levy other taxes on corporations, such as the Capital Stock and Franchise Tax. Many of these are “wealth taxes” with a tax base consisting of capital assets, stocks, and property. This edition of the State Business Tax Climate Index does not take into account these “wealth taxes” unless the tax base closely resembles a traditional corporate income tax.Pennsylvania’s Capital Stock and Franchise Tax is not included in the Corporate Income Tax Index.

Pennsylvania’s Capital Stock and Franchise Tax is 6.99 mills, virtually tied as the highest rate in the nation and significantly above the U.S. average of 0.75 mills for 2002. Thus, Pennsylvania’s Corporate Income Tax Index and ranking calculations understate the negative impact upon C-corporations with tax liability within the Commonwealth.

Major Index #2 ­ Individual Income Taxes
Individual income taxation can affect business decisions within a state. Poorly designed tax systems can reduce both the quantity and quality of the labor pool and impact negatively the profits and business climate of pass-through entities, including S-corporations, partnerships, and sole proprietorships.

The Tax Foundation constructed an Individual Income Tax Index that compares each state’s top marginal tax rates, the starting points of their top tax brackets, the number of brackets and the average width of brackets. A state with a low score indicates the income tax code is poorly designed and represents a harmful impact upon the state’s business activity.

Once the Individual Income Tax Index in calculated, states are then ranked. Pennsylvania is positively ranked at 8. Neighboring states are ranked as follows: Ohio (27th), West Virginia (29th), New Jersey (30th), Maryland (31st), Delaware (34th) and New York (35th).

Individual Income Tax Index and Rank, 2002

Individual Income Tax Index Score

Rank

Pennsylvania

9.00

8

Ohio

3.57

27

West Virginia

3.31

29

New Jersey

3.18

30

Maryland

3.13

31

Delaware

2.85

34

New York

2.67

35

U.S. Average

5.00

Source: Hodge, Scott A.; Moody, J. Scott, and Wendy P. Warcholik (May 2003). “State Business Tax Climate Index,” Tax Foundation Background Paper, No. 41.

Pennsylvania’s Capital Stock and Franchise Tax is not included in the Individual Income Tax Index as well. Pass-through entities, including S-corporations, partnerships, and limited liability companies that do not have a manufacturing, processing, or research exemption are subject to the Capital Stock Tax. Thus, Pennsylvania’s Individual Income Tax Index and ranking calculations understate the negative impact upon pass-through entities due to the Capital Stock Tax within the Commonwealth.

Pennsylvania’s state-level income tax has the lowest income tax rate in the nation, and its broad base and lack of exemptions enables the state to raise significant revenue with a low rate. This establishes the best possible business tax climate for a state with an income tax. Critics from other states that do not permit localities to levy their own income taxes point out with good reason that local income taxes are prevalent in Pennsylvania. The Index compares only state-level taxes.

Major Index #3 ­ Sales and Gross Receipts Taxes
Sales and gross receipts taxes impact a state’s business tax climate in two important ways. First, a state’s relatively high sales tax rate reduces the demand for in-state sales as consumers will purchase more items from out-of-state, catalog or internet purchases. The result is lost profits for in-state firms and lost jobs for the state.

Even more harmful to the business tax climate are sales and gross receipts taxes levied upon business-to-business transactions. As businesses pay for sales or gross receipts taxes on purchase of vertically integrated business inputs through the production stage, sales taxes are being charged on previously levied taxes, which results in tax pyramiding.

Tax pyramiding results in some industries being taxed more heavily than other industries; therefore, a non-neutral tax system is imposed within a state. While the State Business Tax Climate Index does not directly measure the degree of sales taxes collected upon business-to-business transactions within Pennsylvania, it has been argued that at least 36 percent of sales tax revenue is collected from the sale of business inputs.

The Tax Foundation constructed a Sales and Gross Receipts Tax Index from two sub-indexes, one which compares the rate itself in each state and one that compares state law in regard to the five common categories of business-to-business transactions that may or may not be exempted: agricultural products, services, machinery, computer software, and leased or rented items. A state with a low score indicates a relatively high effective sales tax rate with little relief from tax pyramiding.

Once the Sales and Gross Receipts Tax Index is calculated, states are then ranked. Pennsylvania is negatively ranked at 39. Neighboring states are ranked as follows: Delaware (1st) with no sales tax imposition, New York (14th), Maryland (16th), New Jersey (30th), Ohio (34th) and West Virginia (47th).

Sales and Gross Receipts Tax Index, Rank and Rate, 2002

Sales and Gross Receipts Tax Index Score

Rank

General Sales and Use Tax Rate

Delaware

10.00

1

0%

New York

7.02

14

4%

Maryland

6.79

16

5%

Ohio

5.49

34

5%

Pennsylvania

5.30

39

6%

New Jersey

5.73

30

6%

West Virginia

4.53

47

6%

U.S. Average

6.27

Note: Delaware does not impose a sales or gross receipts tax, and so it receives an Index Score of 10.00 and a rank of 1. Local government sales or gross receipts tax add-ons are not included.

Source: Hodge, Scott A.; Moody, J. Scott, and Wendy P. Warcholik (May 2003). “State Business Tax Climate Index,” Tax Foundation Background Paper, No. 41.

Major Index #4 ­ State Fiscal Balance
A state’s overall fiscal situation is a major concern to business. If there is a likelihood of future state tax changes, thereby shifting tax differentials between states, this will affect future business relocation decisions.

The Tax Foundation constructed a State and Local Fiscal Balance Index composed of two sub-indexes. One compares the current size of the combined state-local tax burden (taxes as a percentage of income). The higher the burden is, the lower the score. The other measures the probability of future tax changes by considering the ten-year trends in tax growth and income growth. A state with a low score indicates that tax revenues grew faster than income over the last ten years, and the state and local tax burden as a percent of income is a relatively high percentage.

Once the State Fiscal Balance Index in calculated, states are then ranked. Pennsylvania is above an average state ranked at 21. Neighboring states are ranked as follows: Delaware (6th), New Jersey (11th), Maryland (27th), West Virginia (38th), New York (41st) and Ohio (46th).

State Fiscal Balance Index, Rank and Growth, 2002

State Fiscal Balance Index Score:

Rank:

State & Local Tax Growth vs. Income Growth
1992-2002:

Delaware

5.68

6

-0.68

New York

2.82

41

-1.05

Maryland

3.79

27

-0.37

Ohio

2.09

46

+0.58

Pennsylvania

4.04

21

-0.34

New Jersey

4.54

11

-1.09

West Virginia

3.03

38

+0.13

U.S. Average

3.89

Note: If tax growth exceeds income growth, the relationship will be positive. If income growth exceeds tax growth, the relationship is negative.

Source: Hodge, Scott A.; Moody, J. Scott, and Wendy P. Warcholik (May 2003). “State Business Tax Climate Index,” Tax Foundation Background Paper, No. 41.

Major Index #5 ­ Tax Base Conformity
Multi-state firms can face increasing tax compliance costs if tax systems do not conform to the federal tax system or other state tax systems ­ thus harming a state’s business tax climate.

To judge the degree of tax base conformity, the Tax Foundation constructed a Tax Base Conformity Index and Ranking for 2002 from six sub-indexes measuring whether a state has the following:

  • has no alternative minimum tax or AMT (PA has no corporate or individual AMT);

  • recognizes Limited Liability Corporations or LLCs and S-Corporations (PA recognizes both);

  • allows consolidated filings (PA does not);

  • incorporates the Internal Revenue Code or IRC (PA partially incorporates the IRC);

  • adopts most regulations promulgated under the Uniform Division of Income for Tax Purposes Act or UDITPA and the Multi-State Tax Commission or MTC (PA has partial adoption); and

  • allows deductions of foreign, federal and state taxes paid to other jurisdictions to avoid double taxation (PA does not allow these deductions on the corporate side but allows state and foreign deductions only on the individual side).

A state with a low score indicates a high tax compliance burden for firms.Once the Tax Base Conformity Index is calculated, states are then ranked. Pennsylvania is poorly ranked at 41. Neighboring states are ranked as follows: Ohio (36th), West Virginia (34th), New Jersey (49th), Maryland (44th), Delaware (37th) and New York (50th).

Tax Base Conformity Index and Rank, 2002

Tax Base Conformity Index Score

Rank

West Virginia

6.39

34

Ohio

6.32

36

Delaware

6.04

37

Pennsylvania

5.56

41

Maryland

5.21

44

New Jersey

3.75

49

New York

2.85

50

U.S. Average

7.01

Source: Hodge, Scott A.; Moody, J. Scott, and Wendy P. Warcholik (May 2003). “State Business Tax Climate Index,” Tax Foundation Background Paper, No. 41.

Conclusion
Pennsylvania has two choices. First choice, Pennsylvania’s tax system can be a mountain, where economic activity moves down the slope and out of the Keystone State into neighboring states due to a poorly competitive, non-neutral tax system. The second choice, Pennsylvania’s tax system can be a valley, where economic activity flows into the Keystone State from neighboring states due to a competitive, neutral tax system.

The State Business Tax Climate Index suggests two general solutions to improve Pennsylvania’s business tax climate. One solution is to repeal one of the three major taxes: either on corporate income, or individual income or sales, while still raising sufficient revenue. Generally, states in the top ten of the Index follow this model of taxation.

Pennsylvania has partially implemented this solution by phasing out the Capital Stock and Franchise Tax. Even though this edition of the Index does not include the Capital Stock Tax, eliminating this tax will improve the Commonwealth’s business climate.

The second solution is to keep all taxes simple and at low rates. For example, Colorado is the only state in the top ten that imposes all three taxes with a single low rate for individual and corporate taxes and a low 2.9 percent sales tax.

The Senate Finance Committee, the Pennsylvania Business Tax Reform Commission, and other interested parties are studying the choices. A favorable policy choice can mean more businesses, more jobs and more people in Pennsylvania.

I appreciate having this opportunity to speak with you, and I will be glad to entertain any questions that you may have.


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