Empirical evidence on the revenue effects of state corporate income tax policies.

State corporate income tax (SCIT) revenues have declined significantly over the past 20 years, prompting vigorous debates about the likely causes of, and potential remedies for, this decline. Confounding the analysis is the activism of many states in modifying the structure of their SCITs, particularly the apportionment factor weights and statutory tax rates, to differentiate them from other states' regimes in attempts to attract new investment and/or retain economic activity within their borders. In this paper, we focus on the revenue effects of differences in tax policies among states.

Prior research on the determinants of SCIT revenues is sparse and the studies that have examined the effects of apportionment formula differences on state tax revenues have produced mixed results. Further, state tax codes differ in many other respects, notably in the definition of the tax base and in various accounting policies that affect the measurement of taxable income, which have been examined thus far only in piecemeal fashion. We contribute to the literature in two ways. First, we address the important methodological problem of endogeneity between SCIT revenues and state tax policies, specifically the apportionment formula weights and tax rates, using a two-stage least squares estimation approach. Second, we examine the impact of a broad array of state tax policy choices on SCIT revenues.

Using aggregate state-level panel data from 1982-2002, we estimate fixed-effects regression models of SCIT revenues as a function of state tax policies, controlling for factors such as organizational form, federal tax base changes, and general macroeconomic trends. We find that accounting for the endogeneity of apportionment formula weights in models of SCIT revenues is crucial; once appropriate controls are introduced, states with a double-weighted sales factor experience on average 16-18 percent lower SCIT revenues than states with an equallyweighted sales factor. With respect to tax rates we find a one percentage point higher statutory tax rate is associated with 11-12 percent higher SCIT revenues, with or without endogeneity controls.

We also find that several other tax policies are statistically and economically significant. Specifically, use of a throwback rule is associated with roughly 16 percent higher SCIT collections, and employing a broader definition of business income is associated with 15-21 percent higher SCIT revenues, although combined reporting surprisingly is not significantly associated with SCIT revenues. These findings are robust to a number of alternative specifications and sensitivity tests.

States struggle with the conflicting goals of raising revenue while remaining competitive with other states to attract business. Thus, apportionment formula changes and tax incentives are accompanied by base-broadening measures to thwart strategic tax planning. However, continued shortfalls in SCIT revenues are leading to calls for more drastic policy initiatives, such as repealing the SCIT, or replacing the current system with a uniform nation-wide system administered by the Federal government. Our results on the predicted impact of differences in state tax policies on SCIT revenues suggest that the latter policy prescription has merit.

INTRODUCTION

State corporate income tax (SCIT) revenues have decreased over the past twenty-five years relative to other sources of state tax collections (Wilson, 2006; Sullivan, 2007). As Figure 1 shows, SCIT revenues declined by about 50 percent over the 21-year period, 1982-2002, whether scaled by total state tax collections, federal corporate taxable income, or gross state product. In fact, many states currently raise more revenue from lotteries or tobacco and gasoline excise taxes than from the corporate income tax. Economists note with puzzlement that the decline coincides with increasing corporate profits as a share of national income (Cornia et al., 2005), and deviates from the trend in federal corporate income tax revenues. (1) The decline of the SCIT has sparked an active debate as to its likely causes and potential remedies (Pomp, 1998; Fisher, 2002; Fox and Luna, 2002; Hofmann, 2002; Mazerov, 2003a; Cornia et al., 2005; Wilson 2006; Mazerov, 2007a; Sullivan, 2007).

The leading causes suggested for the relative decline in SCIT revenues include: 1) changes in the federal income tax rules and aggressive federal income tax planning, both of which affect federal taxable income (the typical starting point for computing the SCIT); 2) changes in organizational form, especially the increased use of flow-through entities whose income is typically not included in the corporate income tax base and which are widely used in state tax planning strategies; and 3) changes in the economy resulting from a shift away from manufacturing to services and technology for which the extant design of state tax systems is arguably obsolete (Brunori, 2002; Hofmann, 2002; Tannenwald, 2002; Florida Senate Committee on Finance, 2003; Cornia et al., 2005; Bankman, 2007). A concurrent development over the past quarter century has been the increasing use of the SCIT as an instrument of economic development charged with attracting business and jobs into states, and only secondarily as a means of raising revenue to meet state budget needs. With economic development as an objective, state legislators have actively sought to implement policies to differentiate the structure of their state's SCIT from that of other states, adding another candidate to the list of likely explanations for the revenue decline.

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In this study we focus on this development and examine the role of tax policies used by states to measure, allocate/apportion and tax corporate income in explaining the pattern of SCIT collections over the two decades from 1982-2002. During this period, while SCIT revenues relative to overall economic activity measures have generally trended downwards, experiences between states have differed markedly, with some states recording stable revenues as a share of total tax collections, and some even showing revenue increases (Cornia et al., 2005). These differing state experiences suggest that factors likely to affect all states similarly, such as changes in the federal tax base or macroeconomic fluctuations, probably cannot fully explain the SCIT revenue decline. Further, during this period many states changed their tax structures, particularly the factor weights in their apportionment formula and the statutory tax rate.

We believe that focusing on the role of state--level differences in the structure of the SCIT is critical to the policy debate, in part because the extant empirical research on the declining SCIT phenomenon and its potential causes is sparse. The studies that exist focus on the apportionment formula and the effects of changing the weights placed on the factors used in this formula on economic activity, such as employment (e.g., Goolsbee and Maydew, 2000) and investment (e.g., Gupta and Hofmann, 2003), and on firms' incentives to engage in tax planning (e.g., Gupta and Mills, 2002). To be sure, some studies have also examined the effect of apportionment formula differences on state tax revenues (e.g., Klassen and Shackelford, 1998; Edmiston, 2002; Edmiston and Arze, 2006). Although this attention is well deserved given the primacy of formula apportionment in determining the SCIT and the frequency of changes made in the formula's factor weights, state tax codes differ in many other respects as well, notably in the definition of the tax base and in various accounting policies that affect the calculation of taxable income. Recent studies have begun to broaden the enquiry to include factors such as tax incentives (Fisher, 2002) and the increased use of flow-through entities (Fox and Luna, 2005) in explaining the revenue decline. Yet, ambiguities remain because of conflicting results, failure to consider all of the relevant structural differences, and methodological issues, prompting calls for further research (Cornia et al., 2005).

We contribute to this line of research in two ways. First, we address one of the largest methodological challenges facing all studies in this area--endogeneity between SCIT revenues and state tax policies, specifically apportionment formula weights and tax rates. Tax policies are not randomly assigned. Instead, each state's policymakers identify

revenue needs and sources differently depending on a variety of variables, including historical factors, natural resources, economic opportunities, education systems, and political affiliations of elected officials. Over time these variables have combined to shape each SCIT system, while each SCIT system has also likely had an impact on some or all of these variables. More immediately, policymakers consider revenue needs when defining the tax base, the accounting policies used to determine the base, and the tax rates used to compute state corporate income tax liability. Thus, state tax policies are likely endogenous with state corporate tax revenues. Unlike previous studies, we explicitly attempt to mitigate this problem with a two--stage least squares approach to account for the endogeneity of apportionment formula weights and tax rates in SCIT revenue regressions.

Second, we comprehensively examine whether, and to what extent, a broad array of state tax policy choices affects SCIT revenues. Thus, our analysis also considers cross-state differences in the definition of the tax base, such as whether the state utilizes the throwback rule or requires unitary (or combined) reporting, and in various other tax policies, such as net operating loss carryback provisions, definition of business income, deductibility of federal income taxes, imposition of the alternative minimum tax, and state policies relating to passive investment companies.

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