How should a subnational corporate income tax on multistate businesses be structured?

INTRODUCTION

Declining corporate income taxes as a share of total state tax revenues since the late 1980s, combined with a perception on the part of some that tax planning is growing rapidly and excessively (Fox and Luna, 2002), has refocused attention on the state corporate income tax (CIT). The attention is a little surprising since the tax provides only about nine percent of total business tax revenue and is dwarfed by business property and sales tax payments (Cline et al., 2003), but the corporate income tax has to some extent (and perhaps unfairly) become a lightening rod for concerns about tax planning and corporate abuses. The result is that more than 15 states considered significant corporate tax reform in 2004 alone, making now a propitious time to reconsider the elements of a good CIT system.

This paper contributes to the current debate by providing a comprehensive economic evaluation of the best state corporate income tax structure. The appropriate tax structure is set in the context of very open economies and the increasing mobility of capital that characterizes the US state and national economies. The presumption in the proposed design is that states in fact want to collect corporate income taxes on both multistate and fully domiciled businesses, but want to do so in light of a very competitive environment for business and the tax base. This consideration moves neutrality to the forefront of our thinking on how best to structure the state CIT.

The paper is composed of seven sections after this introduction. The next sections provide the economic justification for state taxation of business and consider which businesses should be taxed. The following sections address key aspects of a corporate tax structure including the taxable business form, nexus, separate versus combined reporting, distribution of the tax base for multijurisdictional firms and throwback rules. The final section provides a concise summary of the paper.

THE ECONOMIC BASIS FOR TAXING BUSINESS

Many arguments have been put forth to justify the taxation of business and the use of the state CIT. We discuss and dismiss most of the standard candidates below while giving special attention to two of the more salient arguments--the benefit principle and the source-based entitlement principle. (1)

Most arguments offer specific rather than general justification for taxation of businesses, if a justification at all. The literature on optimal taxation and horizontal tax competition provides efficiency arguments for taxation of business, but only under restrictive conditions. (2) The notion that businesses are a convenient, low-cost mechanism for collecting tax revenues is an old story that may still have some validity when applied to large firms (especially public enterprises) in lesser--developed countries. But generally, not all firms will have low-cost compliance technologies relative to the compliance costs of individuals. Moreover, a form of fiscal illusion is created when taxes are collected by business enterprises (regardless of statutory burden or intent), as voters may underestimate the true costs of funding public services. Retained earnings can be effectively brought into the overall tax base through a corporate income tax when the personal and corporate taxes are not integrated. But under such a regime, taxes will be paid where corporate income is earned, not necessarily where the individual taxpayer receiving public service benefits resides, and the rate of corporate taxation may differ from the rate of personal taxation. Further, the corporate tax ensures that retained earnings are taxed, but at the cost of taxing income twice (via dividend distributions). The call for a balanced tax portfolio overstates the relevance of nominal, statutory tax burdens and ignores the efficiency consequences of business taxation. Externalities justify business taxation only to the extent that all businesses (or corporate entities) create similar negative spillovers relative to corporate profits.

There are a number of justifications that fail to account fully for tax shifting possibilities. First is tax exporting and/or rent extraction, which is simply not feasible with competition and mobility, absent a unique jurisdictional resource. Second is the pursuit of tax equity. Fairness cannot be achieved through a business tax without knowing the ultimate incidence of the levy and the unique circumstances of individual taxpayers. Third is the effort to tax the unique privileges granted to the corporate entity and those who lay behind the corporate veil. In practice, a unique tax on corporations will not necessarily be borne by the owners of corporate capital but may instead be shifted to consumers or workers.

The benefit principle is often seen as the best justification for the general taxation of business. (3) In this light, the familiar Tiebout model could be relevant since the mobility of capital is expected to result in a system where businesses are subject to benefit taxes. However, the Tiebout model, at least as normally envisioned, focuses on the production state without consideration of taxation in the destination state (as occurs to some extent with the corporate income tax). Further, the model presumes that heterogeneous firms would be able to sort across a large number of communities that offer different tax-expenditure packages, but the state CIT only allows 50 different taxing jurisdictions. Finally, businesses voting with their feet may be less direct than electoral voting as a mechanism for a widely disparate set of firms to articulate their varying demands in the political process.

The state CIT certainly does not fit well with the benefit principle. Only corporations pay the tax; many corporations derive benefits from public services but have no profits to tax (which introduces ability to pay into the benefit tax regime), and special provisions in the tax code mean similar firms pay dissimilar taxes. The movement towards exclusive sales-weighted apportionment further weakens the practicality of the benefit principle as production states forgo revenue on benefits provided to instate firms. Of course, the linkage with benefits associated with the destination state is not necessarily broken.

Unlike the benefit principle, which serves as a general justification for the taxation of business, Musgrave's (1986) source-based entitlement principle is a basis for taxing multistate enterprises under the specific construct of a state CIT. (4) Her argument is simple: states have the legal authority to impose and collect a tax on income that has its origin in the state, including income accruing to nonresidents. Residence-based taxation is dismissed as inappropriate at the state level, although the federal government can impose such a tax to achieve domestic equity and international neutrality goals. Source-based taxation of nonresident income remains a legitimate state entitlement.

Musgrave (1986) argues that corporate profits are the appropriate tax base. Further, she argues that uniform tax rates should be applied to this income, and no special considerations should be made for the circumstances of individual taxpayers since the entitlement encompasses source-based income, not people. Inter-jurisdictional equity requires uniformity of other tax code provisions including the tax base. This economic perspective on uniformity and neutrality is consistent with Constitutional provisions regarding interstate trade and taxation and various multistate tax compacts regarding uniformity and double taxation. At the same time, her approach does not allow for the highly independent control of rates and bases that exists within many federal countries, and certainly in the U.S. Further, the definition of source is problematic. According to Musgrave (1986), the options are corporate income at origin and some combination of origin or destination of use. In practice, a system of formula apportionment would be needed to account for the influence of supply and demand, as both contribute to income creation across jurisdictions.

The state CIT certainly does not mirror Musgrave's (1986) uniform system. Structural differences give rise to tax-induced distortions and higher costs of administration and compliance. These costs need to be considered when evaluating a business tax. This fits neatly under Slemrod's (1990) augmented optimal tax framework that includes costs of administration and compliance (i.e., the technology of tax collection) (5) These considerations influence our suggested design of the corporate income tax in the discussion that follows.

DEFINING THE TAXABLE BUSINESS

As is obvious by the name, the corporate income tax is generally not a tax on all businesses, but is typically imposed on C-corporations. This has been justified, at least in some cases, by the limited liability argument and the perceived need to ensure that retained earnings are taxed at some level (see above). Similarly, most other businesses have been viewed as "pass-through" entities (such as limited liability companies (LLCs), partnerships, and S-Corporations), where the income is reported by the owners that are responsible for paying tax on their share of the income.