Part II of the Article provides an overview of the classic case against the corporate income tax, at both the federal and state levels. Briefly, the imposition of two “layers” of tax in the corporate tax system is critiqued as a double tax that creates a lack of parity of taxation between corporate investments and investments in pass through entities. The corporate income tax system also results in other “distortions” of behavior, meaning that the existence of the tax causes a taxpayer to change behavior as compared to a world where that tax did not exist (e.g., the use of debt over equity or the retention of earnings). Corporations that operate in multiple jurisdictions also face high costs of complying with the corporate income tax. Complying with state corporate income tax is particularly costly because of the inherent costs incurred with multiple tax filings and because states’ taxing rules differ from the federal rules and from one another. Although all states largely piggyback on the federal tax code to define their tax bases, all states deviate to some degree from federal law. States must also apportion income among them, which results in further complications as states’ rules for tax apportionment also differ from one another. Taxpayers operating in multiple states are therefore required to spend time and money to determine how to comply in each of the jurisdictions in which they operate. It is also the case that large taxpayers increase their own compliance costs by engaging with tax advisors to strategically exploit differences in states’ laws to their own advantage and to implement corporate structures motivated by tax reductions.
These conceptual critiques of the state corporate income tax have been accompanied by a general distaste for income taxes in many circles with the result that the state corporate income tax is on the decline. Recent years have seen many states reduce their corporate income tax rates and look to eliminate the tax entirely.
Part III of the Article provides a different look at the state corporate income tax. Instead of critiquing the tax for its shortcomings, the material in Part III evaluates the faults of a subnational revenue system without the corporate income tax. The Article discusses many features of U.S. federal and state taxing systems that (1) limit the achievement of “pure” single taxation under any optimal tax model, (2) prevent the proper allocation of taxing rights over income earned through the corporate from within the personal income tax, and (3) limit the effectiveness of corporate income tax cuts as a matter of competitiveness for in-state investment. Following the model of The General Theory of Second Best, the Article suggests that those critiquing the corporate income tax must take these complications into account when evaluating the merits of the tax. Ultimately, the reality that states face on the ground suggests that state legislatures should be careful in responding to calls for the reduction or elimination of the state corporate income tax and that they work instead to improve the tax.
Part IV of the Article concludes with thoughts and suggestions for improving the state corporate income tax. The tax may not be a part of our ideal tax system, but it serves a useful role for states given the other restraints on their achievement of that “first-best” ideal world.
II. The Flawed State Corporate Income Tax
State legislatures in the U.S. began implementing state corporate income taxes in the early 1900s after the federal government adopted the precursor to the modern federal corporate income tax in 1909. That new form of taxation allowed states to address revenue shortfalls and inequities created by the failure of their pre-existing tax bases—largely property taxes—to apply to the values that were being created by modern businesses. Currently, forty-four states impose a corporate income tax in some form. Despite the extended and extensive use of corporate income taxes in this country, the tax has no shortage of critics, and recent years have seen many states reduce their reliance on the corporate income tax. The critiques of the state corporate income tax range from those based on inefficiency rationales to more practical concerns about the costs of administration. The following subparts introduce these critiques.
A. The General Inefficiencies of the Corporate Income Tax
The economic and legal literature identify many ways that the corporate income tax distorts behavior or is “inefficient.” The imposition of a corporate-level tax gives taxpayers an incentive (all else being equal) to invest in non-corporate entities. Specifically, under current federal law, an investment in a passthrough entity would face a maximum federal income tax rate of 29.6% whereas an investment in a corporate entity would face a maximum federal income tax rate of 39.8%—a 34% increase in tax. According to the economic literature, that difference distorts behavior, which is considered problematic. More practically, corporate investors do not like “double taxation.”
The corporate income tax also distorts behavior by giving taxpayers an incentive (again, all else being equal) to provide debt financing to corporations rather than equity financing because interest payments are deductible to the corporation whereas dividends are not. The Tax Cuts and Jobs Act of 2017 reduced this difference by reducing the corporate income tax rate and by providing limitations on debt deductions, but the difference still exists. Shareholders evaluating debt or equity may therefore change their behavior based on the tax rules—another inefficiency.
The imposition of the two layers of tax on corporate investments also provides an incentive for corporations to retain earnings or to provide returns for shareholders in ways other than by paying taxable dividends. With no payment of a dividend, shareholders can eliminate or defer the payment of the second layer or of tax. The retention of earnings for tax reasons is another distortion that may limit capital from being utilized in its most effective way.
Efforts to address these inefficiencies include a variety of proposals for corporate “integration,” which means the implementation of a tax system in which the taxation of corporate earnings and of individuals’ returns from investment in corporations are integrated to result in taxation that is equivalent to the total tax imposed on non-corporate investments. Integration could occur through taxation solely at the shareholder level or taxation at the corporate level with a mechanism for shareholders to obtain credit for the taxes paid at the corporate level. The literature on this is extensive, and the government’s attention to this issue is non-trivial. Notwithstanding the extensive attention to this issue, a “solution” remains elusive for many reasons. The most viable approach—as revealed by Congressional action— has been to reduce corporate income tax rates and to maintain lower tax rates on capital gains and on qualified dividends.
In the cross-border context, corporate income taxes can also skew investment decisions locationally. The international tax literature has evaluated whether and how to evaluate efficiency in this context as well. The state-tax dialog has developed differently, largely because the U.S. states utilize formulary apportionment to divide the tax base, but the critiques are often focused on the same point. That is, that the imposition of a tax on capital investments can skew investment choices, with the resulting inefficiencies critiqued in the literature.
Finally, corporate income tax payors often implement sophisticated strategies to reduce their tax obligations in ways that can require significant government resources to audit and potentially challenge. The costs of that government activity reduce the net revenues raised by the tax and thus reduce the immediate financial benefits of implementing that tax instrument.
B. The Particular Challenges of the State Corporate Income Tax
Corporate income taxes levied at the state level raise additional concerns. Primary among those additional concerns are the compliance costs associated with scores of different state corporate income tax systems. As introduced above, states generally piggyback on the federal tax code for purposes of their corporate income taxes, but all states deviate from the federal income tax to some degree. Some deviation is constitutionally required in order to ensure that states only tax income that was earned within their borders, but states also choose to deviate from federal tax choices to reflect their own policy preferences and fiscal restraints. For example, states are much more limited in their borrowing capacity, which limits their abilities to smooth spending though borrowing and makes allowing retroactive tax relief—like unlimited net operating loss carrybacks—particularly problematic. States also have different views on the value of tax items like accelerated depreciation, and states’ different approaches result in taxpayers having to keep different books for state and federal purposes. States also offer a variety of different tax incentives on specific types of investments, which creates even more variability between states. The overall result of these state choices is that multistate corporate taxpayers incur compliance costs that would not be borne in a country with a truly unified national market and state-level corporate income taxes can appear to be problematic from an economic perspective.
Existing data suggest that U.S. corporations spend considerable sums of money complying with the state corporate income tax. Those costs are due to the lack of uniformity noted above, but also due to taxpayers’ own efforts to engage in tax minimization. Differences in state laws allow certain taxpayers to limit their tax costs through strategic operational choices—shifting activities between jurisdictions, using different corporate entity structures, or shifting sales to certain states, for example—or through tax reporting that differs from state to state based on differences in state laws, regulations, or case law. The existence of multiple methods for taxation creates opportunities for well-advised taxpayers to exploit weaknesses in those systems, but those efforts require expenditures that would not be spent in a world without a state corporate income tax.
Finally, the imposition of a state corporate income tax could distort capital or operational decisions and thus introduce an inefficiency like those mentioned in the material above in the context of international taxation. The fiscal federalism literature generally agrees that subnational governments should avoid taxes on mobile bases, like capital, to avoid those distortions. Instead, the literature might support only the imposition of a federal corporate income tax with federal grants to the states intended to recognize their contributions to corporations’ abilities to profit.
C. The Incidence of the State Corporate Income Tax and Tax Exporting
Some also critique the state corporate tax because the nature of the tax obscures its ultimate economic incidence and exports the state tax burden to “outsiders.” Corporations are legal creations of the state, and corporations’ earnings and expenditures ultimately impact one or more humans—usually considered to include investors, employees, and customers. The literature therefore distinguishes between the legal and economic incidences of the corporate income tax. A corporation might be legally obligated to pay a tax, but the economic result is some combination of (1) shareholders experiencing a loss of return; (2) employees being paid less, and (3) customers paying more. Studies suggest different allocations of those burdens, with some concluding that in-state labor bears the brunt and more modern suggestions that capital might do so given the rise in apparent supernormal returns. Even within the labor pool, there is evidence that laborers at higher income levels are impacted more significantly by corporate income taxes than are low-income laborers. Similar distributional issues may also occur with regard to how the burden on consumers is allocated. Regardless of where the burden ultimately falls, it is the case that the corporate income tax obscures the ultimate economic incidence of the tax burden and thus violates the ideal notion that citizens should be aware of the amount of tax that they are paying. The nature of the tax also means that it is paid, in part, by individuals in remote states and not necessarily by those who directly use state resources.
States’ widespread utilization of single-factor sales factor apportionment also impacts how some view the corporate income tax. Under that apportionment method, the tax may actually operate much like an additional sales tax on corporate sales—and only on corporate sales. This may provide even more reason to abandon the tax. A disguised sales tax not only obscures regressivity, but it also imposes an inconsistent additional level of consumption taxation on top of transactions that are already subject to sales tax, and it does so at greater administrative cost. Implicit in this analysis is that the hidden sales tax does not apply to sales made by noncorporate entities, thus creating more inefficiencies.
D. A Tax Not Worth the Candle
The inefficiencies and complications of the state corporate income tax, along with a general aversion to income taxes, are enough for many to advocate for the elimination of the tax. The relatively small percentage of revenue that it generates is even more evidence that the costs of imposing the corporate income tax are simply not worth it. At the U.S. federal level, the corporate income tax raises under 10% of tax revenues. Corporate income tax revenues as a percent of GDP in the U.S. are well below the country’s OECD peers. For the states, corporate income taxes raise an even smaller percentage of their revenues. For most states, the tax raises less than 5% of their tax revenues and an even lower percentage of total funds. That percentage has been declining for decades. The increased use of limited liability companies and S corporations in the last decades of the twentieth century led to declining amounts of income earned through the corporate form and a concomitant reduction in the amount of state corporate income tax revenue. Sophisticated corporate tax planning has also undermined that revenue. And finally, state reductions in corporate income tax rates have added to the tax’s reduced importance as an element of state finance.
In sum, the state corporate income tax has well-understood flaws: it is inefficient tax instrument with which compliance is costly, it hides and misallocates the state tax burden, and it raises little revenue. From a political economy perspective, the tax also happens to impact the holders of corporate equities, generally powerful interests either alone or in the aggregate, which may help to explain its political unpopularity. It is no wonder, then, that the tax has been disfavored by states and is on the decline, especially in fiscally conservative states. In recent years, over a dozen states have cut their corporate income tax rates. State legislatures clearly perceive corporate income taxes as harmful to some important interest and are responding. One might be left to wonder whether this race to the bottom will end before nearly all states simply forgo the corporate income tax as a source of revenue altogether.
III. Far From Ideal: The Reality of Eliminating the “Bad Tax”
The state corporate income is far from an ideal tax for the reasons noted above. But it is a mistake to proceed directly from that conclusion to an assumption that reducing or eliminating the tax will lead to net improvements for states. The state corporate income tax is but one small part of an entire legal structure imposed by states to provide for the health, safety, and economic wellbeing of their residents. The state corporate income tax is also not the only “inefficient” tax instrument utilized by the states. To say that the corporate income tax is flawed then, is nothing special.
It is also not the case that isolated changes to any one flawed tax instrument will necessarily result in overall improvements for states given the complexity of the tax and spending systems involved. This is a key insight of Lipsey and Lancaster in The General Theory of Second Best. In that paper, the authors identify an issue that often presents itself in analyses of optimal structures—in their paper, the economic concept of Pareto efficiency. The insight of their paper is that, when an optimal solution requires multiple conditions for attainment, the failure to fulfill any of those conditions leaves in doubt whether attainment of the others creates an improvement over the status quo. In fact, it may very well be the case that adopting one condition in isolation actually decreases overall welfare, depending on the circumstances. So, for example, if an optimal state taxing structure requires making reforms A, B, and C, it is not necessarily the case that a state is better off making change A in the absence of B and C. In fact, the state may be worse off than before.
This Article does not take a position on the actual welfare maximizing position for states. That task is well beyond the scope of an article like this or the competency of this author. Drawing from the theory of second best, though, this Article argues that it is important for states and those interested in state-tax policy to recognize that eliminating the corporate income tax does not necessarily mean welfare improvement even if we accept that eliminating the tax would be a part of an ideal taxing system. Stated differently, the state corporate income tax can be flawed but still be a part of a tax system that is better for states than the system that would exist without that tax. Eliminating the tax has costs, and those costs might not offset the gains that accrue from the isolated change. With that framing in mind, this Part of the Article evaluates the major effects on states of eliminating or reducing the corporate income tax as a source of revenue.
Subpart A explains why the state corporate income tax in its current form may (1) not result in double taxation like the classic model assumes, while also (2) ensuring that market states have some ability to tax the value created within their borders. Subpart B then explains why the states that cut their own corporate income taxes might be choosing to bear the burden of seeking optimal national tax policy in a manner contrary to their own interests. Subpart C then explains why reductions in corporate income taxes have limited effect in the competition for in-state investments. Subpart D concludes this part of the Article by looking at state corporate income tax revenues as an absolute matter rather than as a relative matter. Altogether, the materials that follow suggest significant reason to doubt the dominant narrative surrounding the state corporate income tax.
A. The State Corporate Income Tax and Single Taxation
A significant part of the classic critique against the corporate income tax is that it results in “double taxation” of the value derived through corporate investments. That critique is generally accurate, but obviously only to the extent that the value derived in the corporate form is actually taxed at both the corporate and shareholder levels. The reality of how corporations operate, however, is that taxation at both levels is far from assured. To start, corporate value can fail to be taxed at the corporate level—consider “nowhere” income for example. Shareholders can also avoid being taxed on the value derived through corporate investments because not all corporations distribute earnings to their shareholders and not all shareholders will sell their shares in taxable sales. For example, the wealthiest Americans, who hold the vast majority of the stock in U.S. corporations, often hold corporate investments until death, and the taxable gains in that stock are eliminated on death through the stepped-up basis rule of section 1014. Further, even if dividends are paid or corporate stock is sold, not all shareholders are taxable or reside in states with income taxes. Double taxation is thus far from assured in the state tax system as it currently exists. These points merely undercut the notion that a state corporate income tax necessarily results in “double taxation,” though some will surely exist.
Another issue often ignored in the discussions surrounding the state corporate income tax is just how weak and distorted the state taxation of income earned through the corporate form would be without that tax. If states were to eliminate their corporate income taxes as many suggest, states would then need to rely on shareholder-level taxation to collect tax on the value created in their borders. In states’ current systems, that means the imposition of tax on dividends and capital gains. As those familiar with state tax know, dividend and capital gain income is taxed differently than corporate income under the corporate income tax and in ways that ignore accepted norms on the proper allocation of taxing power.
One of the major areas of discussion and policy debate regarding the corporate income tax involves the allocation of taxing power between jurisdictions. Both origin states—the places where a corporation develops, manufactures, and/or ships products—and market states—the places where a corporation’s customers are located—have claims to tax the corporation’s resulting income. Discussions about the proper allocation of taxing power between origin and market states have occurred for a long time and in both the national and international contexts, and at this point, the normative justification for allocating primary jurisdiction to market states is widely accepted. Indeed, this basic premise has driven much of the move toward market-based sourcing within the United States and much of the discussion surrounding the OECD’s Base Erosion and Profit Shifting (BEPS) project, where both Pillar 1 and Pillar 2 recognize market jurisdictions’ taxing rights. In the context of corporate taxation, the principles underlying market-based sourcing support the conclusion that the jurisdiction in which a corporation makes sales or otherwise derives value has a right to tax the income generated from that activity. The U.S. states largely operate under this principle, and the clear movement is toward giving market states even greater power.
Moving away from corporate taxation and toward shareholder level taxation would be abdicating this approach. To start, the dividends and capital gains of individual taxpayers are not apportioned to market states like corporate income is apportioned to those states under the corporate income tax. Instead, dividends and capital gains are generally taxed by the state of a residence of a recipient. That means that the elimination of the corporate income tax would effectively result in a shift of tax revenue from (A) the states in which the corporate income was earned to (B) the states of residence of corporate shareholders. This tax shift not only runs counter to established norms on taxing power, but it also results in different tax results for owners of corporations and of passthrough entities, where nonresident equity holders pay tax to market states. This difference represents a tax distortion, which was an evil identified as a reason to eliminate the corporate income tax in the first place. Eliminating one distortion just creates another.
A brief example demonstrates the issue. Presume a single individual who is a resident of Florida and who earns 100% of her income from operating a house-cleaning business for Georgia residents. If that individual ran her business through an LLC, she would pay tax to Georgia on her business income from sales to Georgia customers. She would pay no income tax to Florida because the state does not impose a personal income tax. If Georgia were to eliminate its corporate income tax, though, she could operate through a corporate entity and avoid Georgia tax on her corporate earnings. As a Florida resident, she would also avoid shareholder level taxation. Georgia would also likely not tax her dividend or capital gain income from that corporation because she is a nonresident of Georgia. The elimination of the state corporate income tax in this situation would not eliminate double taxation, because none existed, but eliminating tax on the corporate investment would create a tax incentive for the individual to operate through the corporate form instead of through a passthrough entity. The move would thus introduce a distortion into state’s tax systems.
To correct for this distortion of tax revenues, market states could theoretically pursue shareholders for personal income tax on their states’ “shares” of the dividends and capital gains. That approach would be theoretically possible, but states would find it practically challenging to collect tax from a large number of remote shareholders, and collecting tax from them may be of questionable constitutional validity in any event. Imagine a market state having to collect tax on a dividend payment from each shareholder of a company like Microsoft or Exxon Mobil, for example. Taxpayers would also certainly complain about the costs and uncertainty of having to apportion their dividend and capital gain income between market states and having to file and pay taxes in those states. The costs of this system would certainly rival or exceed the costs of having a corporate income tax—where the responsibilities are centralized with large economic actors better able to manage those costs. The elimination of a state corporate income tax as an integration technique, without more, would thus most likely result in a shift of tax revenue from market jurisdictions to the jurisdictions of residence of taxable corporate shareholders.
Focusing our analysis specifically on the possibility of relying on dividend taxation reveals additional issues. First, states could respond to the challenge of imposing tax on nonresident shareholders’ dividends by instead imposing a tax-withholding obligation on corporate payors. That approach would address the administrability and constitutional issues that arise for states when thinking about taxing nonresidents on their dividend income. However, a dividend withholding approach would still distort tax payments between states unless the withheld amounts were apportioned between states like the underlying income would have been under a corporate income tax. That approach would thus seem to simply shift the complexity of the corporate income tax to a new system. A more critical issue with relying on a dividend withholding tax is that the tax would only apply when corporations actually paid dividends, which is a far from assured event under current corporate practice. The imposition of such a tax would thus create discrepancies in taxation between investors in dividend paying and non-dividend paying firms and would result in another tax-induced distortion in favor of retained earnings.
Relying on capital gains taxes would be similarly fraught. To start, some states tax capital gains at lower rates than apply to ordinary income, and some provide more targeted preferences. Capital gains are also largely elective under the current realization-based income tax. Among states that impose taxes on capital gains, their tax rules all permit the classic buy-borrow-die strategy for the avoidance of tax on capital income as is present federally. This means that corporate investors can avoid current taxation on their capital gains as they accrue and either hold their stock until death or move their residency to a state that does not tax capital gains before making a taxable disposition of their stock. Capital gains may thus never be generated for states to tax.
State taxation of capital income is also limited by federal statutory and constitutional law. For example, the State Taxation of Pension Income Act of 1995 prohibits states from taxing nonresidents’ distributions from qualified retirement accounts. That means that individuals can avoid current taxation of their wage income by making contributions to qualified retirement accounts, and they can avoid future taxation of the gains in their in-plan capital investments by ensuring that they move to no-tax states before taking distributions. States that conform to the federal tax-deferral rules for contributions to such accounts may thus be ceding their right to ever tax that income. Deferral becomes exemption, and states that eliminate the corporate income tax fully lose the chance to impose tax on that value derived in their borders.
Taxpayers can also utilize trusts to avoid the taxation of their capital income at the state level. The Supreme Court’s 2019 decision in North Carolina Dep’t of Rev. v. Kimberley Rice Kaestner 1992 Family Trust determined that the Due Process Clause limits states’ taxation of trusts as separate taxpayers. The result of Kaestner is that capital owners can now escape state taxation by placing their assets in a properly structured trust that is managed by a trustee located in a state without an income tax. As long as the trust beneficiaries avoid taking direct advantage of that source of funds by taking distributions, or do so while in a tax-advantaged jurisdiction, they can avoid tax as well. This method of avoiding tax is somewhat limited, but represents a real world constraint on capital taxation by the states and should be accounted for in any analysis of the effects of removing tax at the corporate level.
The combination of these rules means that taxing corporate income and value as it accrues may be the only way for states to tax the value that is created in their borders through the corporate form. To do that in an integrated system—a tax system with only one “layer” of tax—means either (1) taxing the corporation on its income and exempting shareholders from tax on their dividends or capital gains or (2) taxing corporate shareholders on corporate income on a passthrough basis. Neither is practically a reality at the state level. The former would be accomplished with some sort of shareholder credit, deduction, or exclusion, but that approach has been preferred federally without political success. At a state level, that approach would also conflict with the desire to cut the corporate income tax in the first place. And if pursued, the approach would require residence states to give up taxing power over their own residents’ dividend and capital gain income, another tough proposition, especially without the assurance that market states are taxing the income at the corporate level. The second option above—taxing corporations like passthrough entities—is similarly a non-starter for political and administrative reasons. The costs and complications of imposing current tax in market states on all shareholders of corporations is implausible given current conditions.
The sum of this analysis suggests that while eliminating the state corporate income tax might eliminate the double taxation of corporate earnings, doing so would not create a neutral tax system with “single taxation.” In contrast, investments in corporations would often avoid state taxation completely, and even when those investments were taxed, they would be taxed differently than investments in passthrough entities. Removing the state corporate income tax would therefore create other distortions, including a tax incentive for the use of the corporate form over passthrough forms.
The blunt reality is that the real world does not present the conditions necessary for states to eliminate the distortions introduced by the corporate income tax without also creating other distortions. The federal constitution, federal statutes, and administrative practicalities impede the achievement of truly neutral—meaning non-distortionary—taxation. The resulting choice for states may thus be limited double taxation of corporate investments or limited, locationally distorted taxation. States need to understand that choice, especially because the under-taxation option may inure to a great degree to the benefit of nonresidents and other out-of-state interests, as discussed in the next Subpart.
B. A Tax Instrument for the Self-Interested States
The discussion above established that the distortion-based critique of the state corporate income must be supplemented with a discussion of the distortions that would result if states eliminate that tax. The choice facing states is not between double taxation or single taxation, but between something falling short of double taxation and something perhaps closely approximating no taxation. However, even if the current system does result in the “over” taxation of corporate earnings by some metric, states should still grapple with the fact that correcting for that error may not be optimal for them. Much of the argument presented against the state corporate income tax has to do with its effect on overall national economic efficiency, but it might be that individual states would be harmed by reducing or eliminating their corporate income taxes even if the country, as a whole, is benefitted. This subpart thus looks at an individual state’s interest in corporate income tax reductions, rather than at the national interest in overall national economic efficiency.
Before analyzing the claims about who tax cuts benefit, we should first recognize that the metric for analyzing “success” in this area is unclear. Assume, for example, that a state cuts its corporate income tax revenues by some amount with the idea that the cut will “help” the state. How do we evaluate whether that result is obtained? Do we judge success based on the effect on current residents and their earnings, on their life expectancy, or their quality of life? Or do we judge the efficacy of a state tax cut on economic factors like GDP, rates of poverty, or inequality? Maybe instead we evaluate success by looking at the long-term viability of a state and its ability to attract future residents rather than by its effect on current residents or businesses. Or should we instead look only at the psychological or moral benefits that some might feel from reduced taxation? The goals for a state are not always clear and certainly not all people agree on the right way to think about this issue. This inability to precisely articulate what “success” looks like in terms of tax cuts makes it difficult to present a neutral analysis of what states “should” do with respect to their corporate income taxes. If a states’ residents are morally opposed to the taxation of corporations, then cutting that tax may be the right choice regardless of the other consequences. But if such a cut is proposed as a method of encouraging in-state investment or returning funds to local businesses, the analysis would be much different.
With this wide difference and uncertainty in mind, it is useful to set out what we do know about the immediate effects of a corporate income tax cut. The first certainty with a state corporate income tax cut is that much of the immediate economic benefit will go to parties outside of the tax-cutting state—an outflow of funds from the state treasury to non-state interests. To start, the first 21% of a state corporate income tax cut goes immediately to the federal treasury due to the taxpayer’s reduced federal deduction for their state corporate income taxes. Beyond that first 21%, the immediate economic benefit of a tax cut depends on how one evaluates the incidence of the corporate income tax and whether tax cuts replicate that distribution. There is an existing literature suggesting a complicated relationship with respect to how tax cuts are allocated, and it is not clear that the distribution of a tax cut matches how the tax burden was originally allocated. Despite this uncertainly, we know that some portion of a state tax cut will almost certainly go to residents in other states.
This claim starts with the recognition that large corporations report the vast majority of corporate taxable income and pay the vast majority of the resulting corporate income tax. The economic incidence of the tax is therefore largely spread among the employees, customers, and investors in and of those companies in some proportion. For most or all states, the percentage of those employees, customers, and investors within their borders is surely a small amount of the total, which impacts how the benefits of a tax cut are distributed unless firms are able to price or wage discriminate at the state level (i.e., unless a multistate firm prices its products and pays wages differentially in each state to account for the disparate tax liabilities incurred in those states).
The extraterritorial shift of the benefits of a tax cut can be evaluated in all three groups—equity holders, labor, and customers. With respect to equity holders, estimates suggest that up to 40% of the equities in U.S. corporations are held by foreign investors. To the extent that the corporate income tax burden is on equity, then 40% of the amount “returned” to equity holders—after the 21% to the federal government—could go abroad. Among domestic shareholders of a corporation, it is likely that most will be nonresidents of a state enacting a cut as well, so benefits flow to those outside individuals. Of course, smaller in-state corporations may have a high concentration of in-state owners, and the tax cuts that flow to those shareholders could help local economic activity. But, in total, states need to understand the overall shareholder mix of the corporations that pay tax in their state to understand where the benefit of a tax cut would flow with respect to equity.
This point is particularly true given the emerging literature on the allocation of the corporate tax burden in the modern economy. The economic literature has long struggled to determine the incidence of the corporate income tax, with older models starting with an assumption that capital would bear the burden in a closed economy. Later models introduced capital mobility and shifted some or all of the burden to labor. Those models are now being challenged as well given new features of the world economy and the rise of super-normal returns. The difficulty of these estimations is completely understandable. As Professor Kimberly Clausing notes “[t]he theory does not provide a crystalline roadmap for investigation, exogenous changes in tax policy are difficult to identify, and the true consequences of variations in corporate tax policies likely occur over time, with substantial lags from the policy changes.” Professor Michael Devereux similarly comments that the “the incidence of [taxes on business profits] is, typically, hard to fathom” and that, after sixty years of research, “the incidence of typical taxes on business profit is still the subject of dispute.” Evaluating the myriad economic studies, their assumptions, and the relevancy of the results is complicated, to put it mildly. As previously noted, however, the emerging literature gives reason to believe that capital may bear a higher proportion of the corporate income tax in the modern economy than before because of the prevalence of supernormal returns for the large corporations that pay the vast majority of corporate income tax revenues. To the extent that this modern literature is accurate, it suggests both an extraterritorial flow of the burden of the state corporate income tax and a progressive effect as well given the financial makeup of capital owners within the United States and abroad.
Some portion of the state corporate income tax is certainly also borne by labor, but it is again not necessarily the case that in-state labor bears the entire burden or that in-state labor would benefit from a cut. To start, the headquarters for the largest corporations in America are concentrated in large markets in a few states, which means that management-level employees whose wages are impacted by state corporate income taxes would see a benefit from a cut. Recent scholarship suggests that management-level employees do indeed benefit from corporate income tax cuts more than lower-wage employees. Other research complicates our understanding of the relationship between corporate income tax rates and “real” wages by providing evidence that some high-income firm owners respond to state corporate income tax cuts by lowering their wages and increasing their returns through higher resulting capital income. The real world is far too complicated to trace a corporate income tax reduction directly to a return to in-state labor.
In sum, saying that “labor” pays a portion of the corporate income tax is a bit of a blunt observation. Labor almost certainly pays a portion of that tax, but that portion is split between laborers in different states and at different income levels, which means that a tax cut may go to raise wages in other states. Old research may have suggested that in-state labor bore the brunt of the tax, but modern conditions again may significantly change those conclusions—however strong or weak they were in the first place. The result is that more of a state tax cut may benefit other states’ economic systems than thought before.
We can replicate this analysis for the portion of the state corporate income tax borne by customers. Customers are thought to bear some of the burden of the state corporate income tax because corporations may respond to taxation by increasing prices when market conditions allow. The allocation of that “pricing burden” depends, then, on where a corporations customers reside and whether a corporation changes prices in different states to reflect those states’ particular tax burdens. With respect to corporations’ customer bases, we might expect those individuals to be proportionately allocated among states—certainly more than their management-level employees—such that a corporate income tax cut’s benefits might flow relatively proportionately from market states to customers in those states. This of course only matches to the extent that states tax on a market basis and to the extent that corporate sales are distributed in accordance with population. As those two conditions fail, the flow of funds from a tax cut, to the extent distributed to customers in the form of lower prices, could easily go disproportionately to out-of-state consumers.
Another critical factor in this regard is that state-tax burdens seem to impact national-level pricing—rather than firms adjusting prices between states. For example, Apple does not charge different prices for iPhones or MacBooks between states based on state corporate income tax rates; it charges a price that is consistent between jurisdictions. This national pricing policy suggests a smoothing of the impact of state corporate income taxes—and tax cuts—between markets. To the extent that this practice holds across firms, this means that the portion of states’ corporate income taxes that is borne by customers is spread between all customers rather than simply impacting consumers in the taxing state. As a corollary, a state corporate income tax cut will benefit consumers in all markets rather than just lowering prices in the tax-cutting state. This again suggests an extra-territorial flow of funds that may not appeal to states. This is particularly worth recognizing because consumers in the tax-cutting state will still pay the portion of other state’s corporate income taxes through higher prices.
Of course, this discussion is not intended to suggest that in-state interests do not bear any of the burden of the corporate income tax or that in-state interests do not benefit from a tax reduction. Surely, in-state equity holders pay a portion of the state corporate income tax, in-state laborers pay a portion, and in-state consumers pay a portion. But for most states the portion that those in-state interests pay is very far from a complete amount of the overall tax revenue received by a state. In one relevant study, the Minnesota Department of Revenue Tax Research Division estimated that 44% of its corporate franchise tax burden was paid by non-Minnesota taxpayers, and that analysis assumed that the tax burden borne by labor fell entirely on Minnesota residents.
But what if the corporate tax is borne to a significant degree by out-of-state parties? Wouldn’t this provide an argument against its utilization? The American aversion to “taxation without representation” and an aversion to “tax exporting” could suggest that shifting the corporate tax burden to out-of-state interests violates fundamental notions of tax fairness. Three responses to that general argument are worth noting.
First, those potential objections ignore that out-of-state investors, laborers, and customers all benefit to some degree from a taxing state’s spending. States’ expenditures on public goods like roads, courts, and schools create and improve the markets that contribute to the national economic market from which our citizens benefit as investors, laborers, and customers. Florida imposes high taxes on hotel rentals because non-residents like to access Florida’s climate and entertainment, and those visitors take advantage of the public infrastructure that makes their enjoyment possible. The state thus rationally exports its tax burden to non-voters in exchange for that access. Similarly, one might say that a Montana laborer is in higher demand because its employer can sell goods to a Minnesota customer whose purchasing power is increased by that state’s investments in public goods. Minnesota thus acts rationally if it “exports” a portion of its tax burden to the Montana company and laborer. This is not to say that the corporate income tax is an ideal benefits tax, but it does suggest that the tax might be a tolerable way for states to obtain contribution from the remote parties who benefit from in-state market exploitation done through the corporate form.
Second, even if the connection between an in-state market and the value derived by a distant individual is unclear, it is even less clear that state legislators should, or even can, legislate with the intent of preferencing those individuals or the national market to the detriment of their residents. To the extent that a state legislator can obtain contributions from outsiders, they probably should do so. A state legislator’s duty is to her state, not to the national economic market. To be clear, this self-interested stance may not be ideal from a national perspective, but it is wholly rational at the state level and in a state legislative body. If state legislators want to legislate in the name of the national economy or national efficiency, they should probably serve in Congress rather than in the state house.
Finally, states and their taxpayers should recognize that, regardless of what they do in their own legislative bodies, in-state taxpayers will continue to pay a portion of other states’ corporate income taxes—through reduced returns to investment, lower wages, or higher prices. The result of a state like Missouri reducing or eliminating its tax is that, maybe, the price of Corn Flakes goes down a bit for customers across the country in some small amount, but Missourians will still continue to pay for the portion of the price attributable to California’s corporate income tax. Missouri residents suffer from lower public services or higher taxes while California collects their money. It’s a double whammy. The result is a prisoner’s dilemma of sorts where maybe everyone would be better off if no state imposed a corporate income tax, but every state is better off if it imposes a corporate income tax than if it does not. This situation is again likely not ideal at the national level, but it is hardly clear that states should act in isolation to pursue a national goal while their residents pay for other states not following suit.
C. The Limited Utility of Tax Cuts for Encouraging In-State Expansion
We saw above that a state corporate income tax cut likely results in something much less than the total amount of that cut being retained by in-state economic interests. This reduction in funds does not necessarily strike everyone as irrational though. Some hold the view that the value of those dollars in the government’s hands was much less than its value in private hands in the first place, so any return of money to the market is beneficial. For others, state tax dollars have greater value in the public’s hands than in private hands because of the types of projects that government can accomplish for the greater good. For these individuals, that a tax cut results in less than a full amount of those funds going to in-state interests only adds to the problems associated with state corporate income tax cuts.
Taxpayers obviously have very different views on these matters, and there is not much that one can do in the confines of a piece like this to discuss which view should prevail as a matter of public policy. We can look at a variation of this factor, though, with a little more utility. Much of the rhetoric surrounding corporate income tax cuts goes beyond mere pessimism about taxation in general but focuses on the potential for immediate tax losses to act as an investment of sorts in future growth by encouraging outsiders to move to or invest further in the state and ultimately “grow the pie.” Under state’s current tax systems though, multiple factors complicate the ability of state corporate income tax cuts to spur future growth.
1. Existing Structural Preferences for In-State Investment
One claim often encountered in the state-tax space is that state corporate income tax cuts will act to encourage in-state investments. On first blush, that argument seems perfectly rational. Lower taxes translate to higher post-tax returns, which should provide greater ability and incentive to invest in a state. One significant problem with this reasoning in the state-tax space, though, is that most states currently impose corporate income taxes based only on where a firm’s sales occur, so a multistate firm’s investment choices may have nothing to do with their corporate tax responsibilities.
Those familiar with state-tax apportionment methods should understand this point as stemming from states’ use of single sales factor apportionment methods. Under those methods, states apportion corporate taxpayers’ incomes by multiplying that income by a fraction, the numerator of which is their in-state sales and the denominator of which is their total sales. Notably omitted from this method are the traditional property and payroll factors. The use of an apportionment method that looks only to sales was blessed by the Supreme Court in 1978 in Moorman Manufacturing Co. v. Bair and is utilized precisely to eliminate any corporate-tax disincentive for firms to locate property or payroll in a state. Currently, thirty states have adopted this approach to taxing corporate income. The consequence of that choice, though, is that those states cannot further drive in-state investments through rate cuts because the rate of tax on those investments is already zero. Further, out-of-state firms get the benefit of the rate cuts on their in-state income regardless of whether they move into the tax-cutting state or not. Given this reality, the bigger impact on a firm’s choice of where to expand would be the other costs of those investments (i.e., property prices, property taxes, wage rates, wage taxes, local labor pools, energy costs, etc.). Notwithstanding the limited utility of corporate tax reductions to stimulate growth under these conditions, of the thirteen states that have implemented corporate income tax rate cuts since 2021, nine use a sales-only method of apportionment, three double weight the sales factor, and one uses the standard three-factor formula. These numbers are, of course, inverted from what they should be if those cuts were intended to drive in-state investment.
One complicating factor to this point is the use of throwback rules by many states. A “throwback rule” is a rule that “sources” income based on an origin basis instead of a destination basis when the state of destination does not have the power to impose tax on the sale—for example, because the federal constitution or P.L. 86-272 protects the firm from taxation in that state. So, for example, if a firm from State A makes a sale to a customer in a state that cannot impose its tax on the firm, State A would consider that sale a “State A sale” rather than a sale in that other state, even if the state would normally source the sale to that other state on a market basis. The practical effect of that rule is to potentially increase a firm’s corporate income tax in a state where it does locate property, even if that state generally uses only a sales factor. Concomitant with that reality is that a reduction of the state’s corporate tax rate could encourage in-state investment in contrast with the discussion above. The impact of the throwback rule on a particular taxpayer will depend on their operations and largely on whether they have sales that are protected from taxation by P.L. 86-272, but the impact should not be ignored in this accounting. Notwithstanding this potential counter-consideration, it still seems likely that corporate tax cuts as an incentive for in-state investment is unlikely to be particularly effective even in states with throwback rules for three reasons. First, only a limited percentage of corporate taxpayers are protected from taxation by the constitution or by Public Law 86-272 given the evolution of the economy and the constitutional law related to taxable “nexus” between a taxpayer and a state Second, tax cuts implemented to attract “protected” companies inure to the benefit of all corporate taxpayers, so the tax cuts are overinclusive of the firms that might be responsive. Third, states likely have better ways to specifically target those protected companies. Under these conditions, the likelihood that rate cuts are worthwhile in order to attract firms who might be negatively impacted by a throwback rule seems slim.
When thinking about the impact of state corporate income taxes on firms’ investment choices, it is also worth considering how the modern economy has changed many markets and firms’ investment choices. Corporate expansion traditionally required increased investments in goods, property, and sales personnel to exploit new markets. An Ohio firm operating a furniture business and wanting to create a market for its products in Illinois might require an investment in an Illinois showroom, inventory, and salespeople, for example. The corporation’s resource choices might also be rivalrous in that it could not easily expand in Illinois and in Kentucky at the same time, so we could assume that the business would take into account the tax-burden differentials between potential expansion states when choosing where to locate. In a digital market, though, firms can often expand their sales footprint with near-zero marginal capital investments, and their exploitation of one market does not necessarily impact expansion in another market in the way that the production and distribution of a physical good might. Compare our furniture store with a software company for example. The software company may be able to expand in both Illinois and Kentucky at very little marginal cost. In fact, if it offers its software online, the company likely does not even make a choice about the states in which it operates. It can make sales everywhere. Under those conditions, the only real marginal cost of “operating” in a new jurisdiction would be taxation in the new state. So as long as the costs of taxation do not reduce the corporation’s returns to an amount less than its costs of capital, the firm will be inclined to expand. It may even be the case that corporations cannot meaningfully avoid selling to consumers in a particular state, so they will sell in states regardless of the corporate income tax burden. Under these conditions, the impact of any one state corporate income tax on firms’ actions is likely negligible.
Professor Dan Shaviro has taken this observation and its implications to the extreme and noted that if a firm “can earn profits that are nonrival to its operations elsewhere from interacting with a given country’s residents, it should not be expected to adjust its activity and investment choices in response to even a 99 percent tax on those profits.” Others in the tax and economic literature recognize the distinctive features of the modern economy that create location-specific rents that make possible tax choices that previously seemed unsound. Firms that can exploit markets at low marginal cost may be unaffected by the imposition of a corporate tax on their earnings in particular markets. It makes little sense to go through the hassle of closing off one market from the distribution of such a product when marginal after-tax proceeds are positive. Even very high state taxes may be supported for these new economy actors.
In all then, the argument that corporate income tax cuts will spur in-state investment are fairly weak and outdated for most states. There may be long-term increases to in-state activity as capital owners invest their greater post-tax resources, but that trickle-down effect takes time. It is also the case that government spending or other tax cuts that directly impact lower-income earners might similarly increase local economic activity without the distributional consequences of corporate income tax cuts. Again, corporate income tax cuts do not occur in isolation. They occur instead of other choices. This concept is further explored below.
This section concludes with one final point. The discussion and analysis to this point has largely focused on the potential for corporate income tax cuts to spur in-state investment by the large national and multinational corporate taxpayers that pay most corporate income tax revenues. However, there exists a smaller set of businesses formed as C corporations that operate on a local scale, despite the overwhelming use of passthrough entities for this type of business endeavor. Each state likely has some significant historic businesses of this nature, those businesses likely have some level of political power, and those firms undoubtedly benefit from a local corporate income tax cut. Local lobbying and advocacy can be very powerful for this group. Nevertheless, the question for a state wanting to “help” those firms with lower tax burdens is whether a broadly applicable corporate tax cut is the best way of accomplishing that goal. Those broad tax cuts are expensive ways of directing money to those more local firms, and necessarily have broader consequences, as discussed in the next section.
2. Tax Cuts Instead of What?
The materials in the prior sections focused principally on the direct effects of state corporate income tax cuts. As indicated above, though, it is not advisable to focus solely on those cuts and their immediate effects. No legal change occurs in isolation, and a corporate income tax cut is no different. A cut to that source of tax revenue necessarily has collateral effects that must be considered. To an extent, we can get a bit numb to this idea of tradeoffs because federal tax cuts have generally been accompanied with increases to the national debt. But state finances and state tax choices are fundamentally different because states are limited in their ability to borrow due to balanced budget requirements. One result of those restraints is that states that reduce their corporate income tax revenues must balance that choice by either (1) cutting spending and public services or (2) increasing other sources of revenue—primarily personal income taxes, sales taxes, or property taxes. Either choice effects everyone involved with the state, including both in-state and out-of-state parties.
To start, if a state legislature cuts services in response to a reduction in corporate income tax revenues, in-state taxpayers will likely suffer directly. States may provide less funding for education, public safety, road maintenance, or mental health services in the community, each of which could hurt local business conditions and residents’ quality of life.
Corporate income tax cuts also negatively affect local businesses and residents even if one is of the opinion that lower taxation is always beneficial. For any given level of spending, a state must collect revenue from some source, which means that a choice to reduce the proportion of that funding contributed by the corporate income tax is simultaneously a choice to increase the proportion contributed by other taxes—like personal income taxes, sales taxes, or property taxes. It may be useful in this regard to think of state taxes in terms of percentages of revenue rather than in terms of rates or dollars collected. If a state corporate income tax currently raises 5% of state revenues, then any reduction in that amount must increase the percent of state tax revenue raised from other taxes. If those other taxes are paid by in-state businesses and residents at a higher proportion than the corporate income tax, in-state residents again suffer the burden of providing corporate income tax relief to outsiders. Those in-state residents could have had tax cuts of their own.
The secondary impacts of a corporate-income-tax cut impact out-of-state parties as well. To start, non-resident individuals and businesses may suffer from reduced public investments just like in-state parties. State markets are better when in-state residents are healthy, educated, safe, and employed. Out-of-state firms are also impacted by the tax shift discussed above, specifically as it relates to the effect of increased personal income taxes, sales taxes, or property taxes on the incentive to invest in the tax-cutting state.
For the reasons discussed above, out-of-state firms are unlikely to get a tax benefit from making in-state investments in states that cut corporate-income-tax rates . At the same time, however, those firms would face correspondingly higher rates of other taxes than they could have had absent those cuts. Their property taxes might be higher, sales taxes on their products might be higher, or their employees might face higher personal income taxes on their wages. Locating in the tax-cutting state may mean subjecting their owners and employees to higher taxes than if the corporation had not invested more heavily in the tax-cutting state or if that state had directed tax relief at the types of taxes that do apply to local property and payroll. The corporation might therefore be better off staying out of the state, enjoying the income-tax cut on its in-state sales, and locating its operations in other states that have lower rates on the types of taxes paid by local businesses. This is a delicate balancing game, without many certainties other than that there is no free lunch. The costs of cuts must be borne somewhere.
How this balancing works out for every state and for every taxpayer is highly dependent on the facts involved in each situation, but these are costs that analyses of states’ tax systems should take into account. There is a reason that corporate incentive packages contain a wide mixture of tax relief and not just corporate income tax relief. Corporate income tax cuts are great for a corporation, but corporations get those regardless of whether they invest more in a state. It is the entire state and local taxes and benefits mix that is important to a firm choosing where to locate or expand. The biggest winners from a state corporate income tax cut may thus be the remote investors looking only for short-term gains and with no personal investment in the long-term economic viability or livability of state. Anyone with a long-term interest in a state must account for the more complete picture of how states fund themselves and of what they fund with tax revenues.
D. Corporate Income Tax Revenue and the States
This Article has thus far largely avoided the issue of the value of state spending to states and to their residents. An article of this nature cannot begin to take on the task of valuing state spending or addressing how people should think about tax revenues and state spending. As introduced above, people obviously have very different views on the value and morality of state taxation and spending. For some, any dollar collected and spent on a person below the poverty level is a net benefit to society, desirable as a matter of policy, and maybe even morally compelled. Others morally oppose any tax and spending system that goes beyond what is minimally necessary to maintain an ordered society. It is probably safe to venture a guess that most fall in between those extremes, but that they have not developed precise views on how to judge each marginal dollar of tax revenue that is collected and spent. It also seems safe to guess that most of those who generally favor cuts also put a low “value” on government spending and that those who are in favor of current or higher levels of tax place a high value on that spending, at least as it relates to the alternative use of funds.
Regardless of where one falls in these debates, it is important to ensure that we properly understand just what is at stake when we talk about reduced state-tax collections. As introduced above, the state corporate income tax raises a relatively small percentage of state funds. The tax is also relatively expensive in terms of compliance and administrative costs. For some, the combination of these factors suggests that the tax just isn’t worth the candle. I’d like to offer a contrary view and suggest that corporate income tax revenues should be looked at in absolute terms rather than in relative terms. A million dollars is a million dollars, even if it is a small percentage of some larger pie. And the $130 billion of corporate income taxes collected by state and local jurisdictions in 2023 was $130 billion. That is a large number and has grown significantly in recent years. The Census Bureau reported total state and location collections from corporate net income taxes as just over $90 billion in 2021 and just over $50 billion in 2020.
To start in the process of understanding what that revenue means, we know that state spending is largely focused in a few areas—public welfare, education, health, roads, and public safety. These are the most critical areas of human need and provide the foundation for economic prosperity and individual self-actualization. Income, food, and health security at young ages is especially critical in helping human development. Research has even shown that children who grow up in poverty develop less grey matter in their brains than their more well-off peers. Those differences obviously have life-long effects. A focus on these types of concerns is important even if one is focused on overall public economic health rather than on individual health or economic outcomes. A secure, educated population creates economic value through the development of skills and of businesses that add to commerce. State spending on police and fire protection allows individuals and businesses to thrive and to invest in the future. Robust public education, including institutions of higher learning, aid in the development of technology and other economic drivers.
The corporate income tax may play a small role in funding these programs, but it raises a significant amount of actual revenue. To put the $130 billion of 2023 revenue in context, the cost of universal free school lunch during the pandemic was about $30 billion a year. Total spending on school busing in the United States is roughly $30 billion a year as well. And a recent study estimated that the cost of universal pre-K programming across the United States would be $351 billion over ten years. These numbers are provided only to provide context. Of course, state corporate income tax funds are not, and will not be, earmarked to those programs nor I am suggesting that they should be. But a tax that provides less than 5% of state funding can start to sound not very meaningful. A tax that provides nearly enough funds to ensure that every American school child can get to school and eat at least one meal a day may sound much different.
Where states actually spend their corporate income tax revenues is of course impossible to track given that they go into general funds. However, we can gain some insights into what states would cut if they further reduce or eliminate their corporate income taxes. In the Great Recession, states dipped into their rainy-day funds, but also cut spending on education, health, and social services. Elementary and secondary education accounted for nearly half of the lost public jobs during that period. Law enforcement jobs and highways jobs were the next biggest losers. Funding for education was still below its pre-recession amounts nationally prior to the pandemic, and state general fund spending had just recovered to its pre-recession levels.
The onset of the COVID-19 pandemic saw further cuts to public spending and in particular education. Losses in employment in state and local education accounted for 72% of 2021 public sector job losses. Researchers note that “[s]tate funding for public higher education is especially volatile during recessions, as it is one of the few portions of the state budget that is not determined by constitutional or legal spending requirements and has the ability to raise its own revenue.” Consistent with this recognition, colleges and universities reported a 13-percent drop in employment numbers between early 2020 and 2021. Lower-income wage earners, who likely relied more on public assistance and thus increased state and local needs, were also laid off disproportionately during that downturn.
The purpose of this discussion is not to make a normative point about spending, but to simply note that we have evidence of where states cut when funding drops. If states plan to cut their corporate income taxes without supplementing that revenue from other sources, we have a good sense for which industries will bear the brunt of the resulting lost revenue. States should consider the long-term impact on their residents and their economic viability if those industries suffer.
E. Summary
The materials above provide a bit of a counter-narrative to much of the existing discussion about the state corporate income tax. The tax serves an important role in ensuring that market states obtain contributions from those out-of-state taxpayers who exploit their markets through corporate investments. As a corollary to that point, cuts in that source of tax revenue will inure to the benefit of those out-of-state interests and may make little sense from the perspective of any individual state. The residents of that state will suffer from reduced public services and higher rates of local taxes, while they continue to pay a portion of the state corporate income taxes imposed by other states. At the same time, corporate income tax cuts may offer little to no incentive for out-of-state firms to invest in a state given other tax policies already in effect. To the contrary, cuts to the corporate income tax may make a state fare worse in the market for in-state investments given the burden shift to local taxes. Finally, state corporate income tax revenue may seem of low value because of states’ low reliance on that tax compared to other revenue sources, but the tax raises a significant amount of money as an absolute matter. Cuts to that source of revenue may result in spending cuts with very high impact on a state’s residents and should be carefully weighed against other options.
None of this analysis suggests that the state corporate income tax is a great tax or that it does not bring with it costs. The standard critique of the corporate income tax stands, but it stands incomplete. Unless one is simply interested in cutting state-tax revenue by any means, discussions of corporate income tax cuts should account for this fuller range of impacts and interests.
IV. Working Toward A Better State Corporate Income Tax
The foregoing material suggests reason to doubt the dominant narrative about the state corporate income tax and the recent efforts to reduce and eliminate that tax. None of that discussion, however, changes or disputes the reality that the tax still has significant flaws—like every other tax instrument. States and those interested in state-tax design should therefore work to improve on the corporate income tax’s weaknesses while still maintaining that important source of revenue. The materials that follow provide some general ideas that should help in starting those efforts outside of the long-standing focus on minimizing gamesmanship through reforms like mandatory combined reporting.
A. Strategic Conformity and Disconformity
One of the primary complaints against the corporate income tax at the state level is that compliance for multijurisdictional taxpayers is too costly. Some of those costs occur because of taxpayer attempts to strategically leverage differences in state laws or to minimize their tax burdens. The costs that corporate taxpayers incurred in the 1990s and 2000s to implement intangible holding company structures for example, should not be attributed to the states in a way that makes the corporate income tax look problematic. The costs that stem from states’ lack of uniformity in their laws, though, is something that states should consider.
States deviate from the federal tax code for many reasons, including fiscal protection and lack of local policy fit. It is well recognized that Congress is using the tax code for a wide variety of goals unrelated the imposition of tax on a results-neutral accounting of economic income. As a result of those choices, it makes little sense for states to piggyback on all federal policy choices. States should be very aware of the costs that they can bear if they blindly conform to every federal tax change. Professor Darien Shanske has particularly noted the possibilities for states in this regard with respect to the taxation of corporations’ international operations. States could work towards worldwide combined reporting and strategically conform to the Global Intangible Low-Taxed Income (GILTI) rules, for example, to more effectively tax profits that firms have (inappropriately) shifted to foreign jurisdictions using available tax planning techniques. At the same time, states should remain aware that every deviation creates some incremental cost for corporate taxpayers. Greater levels of uniformity in the law between the states should therefore be on the minds of state legislatures as they evaluate their own laws.
Attention to uniformity is also important when thinking about when states make tax law changes. States that conform to the federal corporate income tax do so on either a dynamic or static basis. Dynamic conformity states automatically incorporate federal tax changes into their laws and must affirmatively decouple. Static conformity states operate in the inverse; those states must affirmatively change their laws to incorporate federal tax changes. States can best protect their own fiscal stability and ensure that their laws reflect local preferences if they conform on a static basis, but states should be aware that delays in their conformity choices can put taxpayers in a difficult position of not knowing what laws will ultimately apply for a given taxable year. This issue is also present in states that conform on a rolling basis to the extent that states consider decoupling from changes, so this is not necessarily an issue that only applies to one type of state or another. The ultimate point is that states need to be aware of the impact of their conformity choices on taxpayers and decide and communicate as early and as effectively as they can regarding these issues.
As I have written elsewhere, more states should consider the model used by Maryland. That state conforms to federal changes on a rolling basis, but the state does not automatically incorporate changes that are projected to result in significant revenue losses. Conformity with those changes is delayed by a year to give the state time to determine whether it wants to decouple or not. This approach helps taxpayers to better understand the potential impact of federal changes while still protecting the state from large revenue swings without time to adequately consider them.
B. Easing Compliance
States should also endeavor to reduce compliance costs as much as they can in other ways. As someone who just completed a series of 50-state surveys on state tax changes, I can attest to the difficulty of finding reliable, up-to-date information on state tax choices in all cases. Some of that trouble is due to the very nature of state legislative activity. State legislatures operate on different schedules and provide different levels of information about proceedings. Some of the difficulty of learning states’ tax choices is also due to poor communications policies and website design. Those familiar with state research have surely encountered a range of experiences in this regard.
As a means of facilitating taxpayer compliance, states should clearly and regularly communicate with taxpayers regarding legislative changes and related administrative or judicial developments. Responses to surveys by third-party organizations are helpful, but direct public communication is integral as well. Not every taxpayer can access surveys provided by commercial organizations, and the law often changes more quickly than commercial actors can update their products. States should endeavor to provide this information timely and in locations and formats that are easily accessible to the public.
Good communications and easily available guidance are the responsibility both of state revenue administrators and state legislatures. Good taxpayer service, whether in person or online, requires a commitment of effort and funding to ensure that best practices can be followed. State legislatures should ensure that their revenue departments are funded well enough to provide the communications that taxpayers need to ease compliance. This is especially true for states that want to retain and exercise their autonomy to have tax codes that deviate significantly from the federal tax code.
C. State Cooperation
One way for states to reduce compliance costs in the ways mentioned above is to cooperate with one another more fully in ways that help taxpayer compliance. States obviously already cooperate to a degree at an administrative level through organizations like the Federation of Tax Administrators and the Multistate Tax Commission, but they should look for ways to increase cooperation related to uniformity and compliance specifically. States could likely better coordinate on when and how to decouple from federal tax changes, for example. State practices in that regard differ widely, and multistate research is more complicated as a result. State revenue authorities or other relevant offices could also consider whether they could do more to educate their legislatures on the impact of federal tax changes on their states and on the actions taken or being considered by other states in response.
States could also work together to provide taxpayer guidance on their tax choices outside of their responses to surveys from commercial entities. States obviously have a lot of tasks on their plates, but it may be possible for them to engage in coordinated communications to help taxpayers better understand their responses to major federal tax changes. This could again be done through one of the existing multistate organizations or through some new coordinated action. Like the other proposals herein, those within state revenue agencies and taxpayers themselves will likely have more, and better, ideas on what actions are possible and most helpful.
D. Leveraging Technology
Another category of improvements that is relevant to each of the prior suggestions is that states think about ways to leverage technology to reduce the costs of tax compliance and administration. This is an obvious suggestion in 2024, but states have a lot of room to catch up and to innovate in the realm of web design. State websites are incredibly inconsistent in ease of use and depth of coverage. Basic investments in website infrastructure could yield significant improvements for some taxpayers and likely for state revenue departments, as well.
States should also pay attention to developments in the world of artificial intelligence and large language models. Taxpayers and tax advisors are turning to AI-powered applications to help assist their compliance efforts, and states should do the same. States could use AI powered applications to assist with tax administration and perhaps litigation. Many states are already using AI-powered chatbots to communicate with taxpayers, and those tools could be improved and expanded. These advancements could reduce the costs of administration with the corporate income tax and improve its position as a tax instrument. States should also consider whether and how they could use that technology to help taxpayers more easily determine how state law applies to their particular situations or to simply identify relevant applicable laws.
E. Concluding Thoughts
This symposium contribution has focused on the role of the state corporate income tax in the state tax mix of the future. The tax is certainly not perfect, and the tax is fairly subject to significant critique. That said, this Article has tried to encourage a more complete assessment of the tax. Every tax has its faults. But society has costs, and taxes play a role in addressing existing inequities in the application of tax and non-tax laws to the participants in that society. The goal for a state should be to collect revenue in ways that are as unobtrusive as possible while still paying attention to other state goals. That balance is difficult, and state tax systems will necessarily have to adapt for the future world. States should not accept that corporate income taxes play no role in that future. The state corporate income tax serves important roles in today’s society, and states should work to ensure both its ongoing viability and that taxpayer compliance costs are reduced to the extent possible.
