By Andrew Crutchfield, California Common Sense, Analyst
Proposition 39 makes changes to California’s corporate tax apportionment formulas. Separate from rates, corporate tax apportionment formulas allow a state to determine what share of a corporation’s profit is subject to state tax.
The Rise of a Patchwork System
Each state needs a way to compute what portion of a multi-state business’ profit is located within its borders and only tax that share. Problems arise if multiple states tax the same portion of a businesses's profits, thereby subjecting the business to over taxation.
The need for state corporate tax apportionment rules arose in the 1930s when states had “tax methods… almost as numerous as the taxing jurisdictions.”[i] States lacked a common standard until 1957 when the Uniform Law Commission, a nonpartisan body made up of representatives from each states, created the Uniform Division of Income for Tax Purposes Act (UDITPA).[ii]
UDITPA required states to use an equally weighted three-factor formula that considers the ratio of a corporation’s sales, property, and payroll in a state to determine what part of the corporation’s income is subject to the state’s income tax. States considered this formula desirable because it splits taxed corporate income between marketing and manufacturing states.[iii] The property and payroll components ensure a share of profit is apportioned to the states where the corporation operates and manufactures good, while the sales portion ensures a share of profit is apportioned to the states where the goods are actually sold.
In 1959, Congress passed Public Law 86-272 to clarify the minimum presence necessary for a corporation to pay income tax in a given state. The law allows corporations to solicit sales in a state without paying corporate tax, provided that the orders are filled outside the state. Congress designed the measure to limit expanding reach of state corporate tax policy until it could devise a better solution. Congress’s “temporary” law has now been in place for over 50 years.[iv]
In the modern era, the once consistent UDITPA-created corporate tax apportionment system across states has eroded. There has been a trend towards states increasing the weight of the sales factor in their corporate income tax apportionment formulas. Some states have even gone so far as to adopt a single sales factor formula, meaning that those states do not tax payroll and property, only sales. A single sales factor formula uses a ratio that divides a corporation’s sales in a state by its overall sales to determine the portion of profit the state will tax.
States justify this change in tax policy by suggesting that a single sales factor formula will lead to job retention and growth in the manufacturing sector because corporations would be more willing to locate their manufacturing in a state that does not consider manufacturing or payroll in its tax burden. A single sales factor allows businesses to invest in more property or hire more workers in a state without increasing its tax burden; this particularly reduces the tax burden for manufacturing-heavy corporations, whose costs are labor and property intensive.
Businesses take advantage of differences between state apportionment formulas to minimize their tax burdens. Corporations try to base their investments in property and payroll in states that do not consider property and payroll in corporate tax apportionment. Corporations especially desire a single sales factor formula in the state in which they are headquartered. In states in which they sell most of their products, they lobby for the three-factor formula created by UDITPA because the formula gives relatively less weight to sales. Under the UDITPA three-factor formula, these businesses are more likely to pay taxes on their less prominent payroll and property burdens.
For example, Ford lobbied for a single sales factor formula in its headquarters state, Michigan, but against the same formula in Illinois. Kraft fought for the single sales factor formula in Illinois but against it in Maryland. AT&T supported a single sales factor in New Jersey but opposed the formula in Oregon.[v]
As long as a patchwork regime of state tax apportionment formulas exist, corporations will strategically locate their business activity in states with different tax formulas to pay corporate tax on less than 100% of their profits. Corporations aren’t uniformly in favor of one tax formula or the other; instead, their lobbying approaches indicate that they want to continue using the patchwork state tax system.
Creating Uniform Tax Standards?
Opponents of states determining their own tax apportionment methods argue the practice harms both businesses and states. Because different state tax formulas could tax part of their profit twice, corporations run the risk of over taxation. The states lose revenue when some businesses are under taxed due to a portion of their income not being taxed by any state.[vi]
The lack of uniform tax standards also limits fair competition between businesses. A corporation that has the same portion of its profit taxed by multiple states finds itself disadvantaged. Competitors that, through luck or planning to reduce tax liability, don’t pay any state tax on a portion of their profit have a significant advantage.
Finally, the necessity of apportioning corporate profit based on fifty different state formulas is a costly burden on corporations. Every dollar spent on tax preparation is a dollar that is not reinvested into economic activity that helps the business grow and profit. A unified formula for state tax apportionment would substantially decrease the cost and complexity of preparing state corporate taxes. A single unified standard would also reduce tax uncertainty, which can cause corporations to avoid making investments that they would otherwise make.[vii]
State governments recognize the difficulties that arise from maintaining different interstate tax apportionment formulas, but oppose a unified federal standard. State governments argue that they should be free to change their corporate tax apportionment formula based on their particular revenue needs and changes to their economy. They view corporate tax apportionment formula changes as an important tool to drive economic development that they are hesitant to give up.[viii]
Even with a unified apportionment formula, states would have plenty of tax policy options available to support development. States would keep their freedom to set corporate income tax rates or have no corporate tax at all. To encourage specific business activity, states could continue to offer a variety of tax credits and would still be able to compete for businesses and jobs. A unified corporate tax apportionment formula would only end one form of competition that harms both states and businesses.
Only uniform state tax apportionment formulas can resolve the problems a patchwork system causes for states and businesses. Congress considered providing uniform corporate tax apportionment standards after the Willis Committee found in 1965 that differing state tax standards “defies reason.”[ix] However, states’ widespread adoption of UDITPA alleviated the issue.
Now that many states have ceased adhereing to UDITPA, Congress should consider passing uniform standards for state corporate tax apportionment. Uniform corporate tax standards would reduce tax avoidance and simplify corporate tax compliance. Though tax burdens are important factors for businesses, uniform corporate tax standards would also encourage states in the future to compete for businesses based on other meaningful factors, such as an education levels and infrastructure.
[i] Mudge, F.W., 1934. “The Taxation of Business Corporations.” In Elmer D. Fagan and C. Ward Macy (eds), Public Finance: Selected Readings. London: Longmans, Green and Co.
[iii] Mazerov, Michael. The "Single Sales Factor" Formula for State Corporate Taxes: A Boon to Economic Development or a Costly Giveaway? Rep. Washington DC: Center on Budget and Policy Priorities, 2005. Print.
[v] Mazerov, Michael. The "Single Sales Factor" Formula for State Corporate Taxes: A Boon to Economic Development or a Costly Giveaway? Rep. Washington DC: Center on Budget and Policy Priorities, 2005. Print.