By Jackson Brainerd
When it comes to how states raise tax dollars, they tend to rely on three primary sources (which all of the coolest tax experts call “The Big Three”): personal income, sales and corporate income.
While each state’s reliance varies, the personal income tax accounts for an average of 37.1 percent of state revenue, the sales tax makes up 31.7 percent of revenue and the corporate income tax (CIT) represents 4.8 percent of total collections.
Given its relatively small slice of the state tax collection pie, it’s hard to see why the CIT would be included with sales and personal income as a major revenue source, but it used to be a more substantial generator. In fact, one of the most noteworthy trends regarding state CITs is that it has been steadily declining as a state revenue source.
According to Census Bureau data, the corporate income tax was 9.4 percent of total tax collections in 1981. Over the years, it has tended to fall as a percentage of total collections during economic recessions, as CITs are highly sensitive to business cycle fluctuations, more so than other major taxes. The chart below shows how it fell and partially rebounded after downturns in 1990-91, 2001. Collections dropped after the Great Recession in 2008, but unlike in previous recoveries, the corporate income tax did not grow as a percentage of state tax collections; instead, it has continued to decline.
Experts have cited many reasons for the gradual erosion of corporate income tax revenue.
Changes in Apportionment: The rise of single sales factor apportionment or weighted sales factors is one common culprit. For corporations with taxable income in multiple states, “apportionment” determines how much of a business’s income can be taxed by requiring a corporation to divide its profits among states using a formula that incorporates various factors that measure business activity. The “factors” are fractions that represent the percentage of a company’s activity in-state compared to its total activities. Historically, they have been based on each state’s share of a corporation’s payroll, property and sales, with equal weight given to each factor in determining tax liability.
Over the years, however, states have gradually moved towards giving extra weight to the sales factor, or only using the sales factor to determine the tax base, which is known as single sales factor apportionment. This has the effect of increasing tax burdens on out-of-state businesses with many sales into a state, but reduces burdens on businesses with operations located in-state and more sales out-of-state. State fiscal estimates generally conclude that single sales factor reduces revenues overall.
Base Narrowing: States frequently provide subsidies such as tax credits and abatements to specific companies that agree to create new jobs or make new investments. Every state offers at least some sort of incentive. And while I’ll leave the question of their fairness and effectiveness for another time, there are estimates that incentive programs cost state and local governments $40-$50 billion a year.
Business vs. Nonbusiness Income: When reporting taxable income, businesses divide their profits into “business income” and “non-business” income. Business income is taxed based on apportionment formulas described above, but non-business income is allocated to one state in which the income-generating asset is located. Business income is frequently (perhaps, “loosely”) defined as income that arises from “regular transactions” the company engages in, which has allowed businesses to argue that income arising from “irregular transactions” is non-business income, and then allocate that income to a lower tax state.
Tax Planning: Corporations have developed other creative strategies for reducing their overall tax liability. Some businesses have created Passive Investment Companies and headquartered them in states that don’t tax income from intangible assets (e.g., copyrights, trademarks), a strategy known as the Delaware loophole. The Passive Investment Companies license these intangible assets to related operating companies. The Passive Investment Companies do not have to pay tax on the payments received, and the operating companies can deduct them in the states where they are located, reducing their overall liability. In a related vein, multinational corporations also avoid state taxes by shifting domestically earned income to low tax, foreign countries (e.g., Cayman Islands, Bermuda), and frequently report material operations in at least one tax haven jurisdiction. Corporate income shifting is estimated to cost states roughly $20 billion a year.
Increasing Popularity of S-Corporations: The size of the corporate sector has been diminishing gradually over the years. In the early 1980s, C-Corporations produced most of the country’s business income. By 2013, C-Corps only produced 44 percent of business income. According to a Tax Foundation analysis of IRS data, the number of C Corporations has been reduced by about 40,000 in every year since 1986. The number of S Corporations has gone in the opposite direction. Part of this shift has likely been due to the fact that corporate income is taxed twice (once at the entity level and again when profits are distributed to shareholders) and the effective tax rate on corporate income has been higher than effective rates on pass-throughs. It’s unknown how the recent cut to the federal corporate income tax rate will affect this trend.
Given all of the challenges associated with administering the corporate income tax, some tax experts have questioned whether it is even worth the effort. While the prospect repealing this relatively small but still significant revenue source in the near future seems unlikely, the CIT does appear to be experiencing a very gradual phase-out.
Jackson Brainerd is a policy specialist with NCSL’s Fiscal Affairs Program.