State Corporate Tax Evasion

In 2005, Citizens for Tax Justice  released a report  on effective state corporate income tax rates entitled "Corporate Tax Avoidance in the States Even Worse Than Federal."  The most prominent conclusion of the study is that:

A new analysis of the state corporate income taxes paid by 252 of America’s largest and most profitable corporations finds that by 2003, these companies on average failed to include two-thirds of their actual U.S. pretax profits on their state tax returns.

By 2003, these 252 companies had slashed their state income tax payments to an average of only 2.3 percent of their U.S. profits. Since the average statutory state corporate tax rate is about 6.8 percent (weighted by gross state product), that means that in 2003, two-thirds of their profits escaped corporate tax entirely.

This is an important study of corporate income tax rates-- a subject we know little about-- and I don't doubt the finding that two-thirds of corporate profits avoided state tax. I am less certain, however, that this is mostly because companies set out to avoid state corporate income taxes.

For companies that operate in multiple states, corporate income must be apportioned to each state. States do this through a formulary system. In 1957, the formulary was based on an equal weighting of sales, property, and payrolls. As I understand it (please correct me if I'm wrong), this means that if a company had 10% of its sales, 33% of its property, and 60% of its payroll in Alabama ,and 90% of its sales, 67% of its property, and 40% of its payroll in CA, then 36.7%=(.333*.1)+(.333*.4)+(.333*.6) of that corporation's income would be apportioned to Alabama and 63.3%=(333*.9)+(.333*.6)+(.333*.4) of its income to California. Many states have changed the formula, however to overweight sales. In a state like Alabama, this would reduce the corporation's state tax burden. For example, if Alabama placed a two thirds weight on sales, then only 23.3%=(.667*.1)+(.167*.4)+(.167*.6) of that corporation's income would be taxed in Alabama.

If every state followed the same formulary (and doubled the weight on sales), then on a national level there would be no decrease in tax. The company would pay less of its tax in Alabama, and more tax (76.7%) in California where sales are high. Every state doesn't follow the same formulary, however. For some background, see pages 14 and 15 of this article. Indeed, I think that states with high sales typically do not place added weight on sales. If California sticks with the original formula while Alabama deviates, then only 86.6%=63.3%+23.3% of corporate income will be attributed to some state.

Thus, the effective state corporate tax rate will be lower than the average state corporate tax rate, not because comapanies are deliberately avoiding corporate income taxes, but rather because the formulary inconsistencies allow some corporate income to be effectively untaxed. I don't know about the size of this effect, and it may be small, but if the formularies are highly skewed, it is easy to imagine that a lot of corporate income doesn't get taxed in any state without any deliberate avoidance by corporations. Further empirical work on this issue could easily get at the size of this effect.

Comments

[Sarah Lawsky]

Tom Rudibaugh--good point. Pub. L. 86-272 is probably one of the main reasons that having a 100% sales factor is such a boon to corporations (because, as you note, if a corp's only contact with a state is sales into that state, the state can't impose tax on the corp). Thus, pace the original post, a majority of states, including high-sales states, do heavily weight their sales factors (sometimes even providing 100% sales factors). Nonetheless, the original post is exactly right that planning that takes advantage of various states' methods of apportionment can be an important element in reducing a corporation's overall tax.

Note too that the Citizens for Tax Justice report isn't suggesting only that corporations are trying to avoid state-level tax by dishonesty. Rather, the report faults both the states and the corporations. Corporations reduce their state-level taxes in part by successfully lobbying states--lobbying for high sales factors in states in which they do a lot of business (high sales states) but don't have a physical presence, lobbying for laws like Pub. L. 86-272, and lobbying for any number of other special tax breaks.

Anyway, state corporation taxation (and state taxation in general) is a subject that certain deserves more academic study, both empirical and theoretical (though there is already some excellent work in the area, by Kirk Stark, among others).

[Tom Rudibaugh]

This issue is even broader. Many companies have moved their manufacturing operations offshore, and thus have converted their domestic businesses to distribution operations. These operations are then moved to non-taxing states such as Nevada, via distribution facilities. This dilutes the property apportionment factor since the phyiscal assets are now located in a non-taxing jurisdiction. The move offshore, and to Nevada respectively have potentially eliminated nexus in Alabama (California harder to due under unitary principles), so that there would be no tax paid to Alabama. Public Law 86-272 provides relief into Alabama if there are only sales into the state. The discussion is a good discussion that pushed for uniformity amoung the states. Probably will never happen.