FRBSF Economic
Letter
2006-35; December 8, 2006
The Mystery of Falling State Corporate Income Taxes
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The share of corporate profits in the U.S. collected
by state governments via the corporate income tax has
fallen sharply in the past quarter century. Some commentators
have even referred to this as the "disappearance" of
the state corporate income tax (SCIT). Such claims,
of course, are an exaggeration—after all, a longer
perspective reveals that the share of profits collected
by state corporate income taxes was actually lower
in the 1960s than it is now. Nonetheless, state public
finance experts and state policymakers surely are correct
in noting that, since around 1980, corporate income
taxes have become an increasingly smaller share of
total state tax revenues and a smaller share of businesses'
costs.
This Economic Letter attempts to unravel the mystery
of falling state corporate income taxes by analyzing
the primary determinants of these taxes and reviewing
how they have changed in the last 25 years.
The primary factors determining SCIT
Before discussing the possible causes of the decline
in SCIT/profits, it is useful to go over how corporate
business income is taxed by states. First, a corporation
determines its federal taxable income; in general,
states use this as the basis for their own corporate
income tax. The corporation then allocates this income
to any state in which it has a sufficient presence—or "nexus"—according
to each state's allocation formula. Once a business
has allocated income to a state, it then subtracts
any state-specific deductions (for example, federal
tax payments are deductible in a small number of states)
to arrive at state taxable income. Finally, the firm
applies the legislated (or statutory) corporate income
tax rate to its state taxable income and then reduces
that amount by the value of any state-specific tax
credits.
Thus, three factors influence a state's corporate
tax revenues as a share of profit (income)—its apportionment
of federal taxable income, its legislated tax rate
(adjusted for deductions), and its tax credits—and
common trends in these factors among states will
have
similar effects on the aggregate share of profits
captured by state taxes. In addition, this aggregate
share will
be affected by the share of corporate profits that
is considered federally taxable and by the distribution
of income across states.
How have the primary SCIT factors changed?
One area of change has been in the formulas dictating
how businesses allocate federal taxable income to the
states. Although each state has leeway in choosing
its formula (subject to the strictures of Public Law
86-272, which bans states from taxing businesses with
no physical presence in the state), traditionally,
the formulas have required a business to allocate income
to a state in proportion to its share of the business's
nationwide sum of sales, payroll, and property, where
each of the three is equally weighted. However, over
the past 30 years or so, most states have increased
the weight on sales in this formula (some all the way
to 100%) to encourage businesses to invest and create
jobs in their states. As a result of different apportionment
formulas, it is quite possible for more or less than
100% of a business's income to be allocated among states.
For example, a manufacturer located in state A that
sells its product in state B could end up allocating
much less than 100% of its federal taxable income to
states A and B combined if state A's formula were based
only on sales. Some states have "throwback" rules
to tax at least a portion of the income that escapes
state taxation, but these are limited and far from
universal.
The increasing non-uniformity across states in apportionment
formulas over the past 30 years has afforded businesses
increasing latitude to site operations so as to maximize
the share of federal taxable income that escapes
state taxation. It is likely that this increased non-uniformity
has contributed to the declining share of profits
captured
by states. However, it also should be noted that
the non-uniformity trend appears to have reversed itself
somewhat in recent years, with the majority of states
now weighting sales primarily or exclusively, so
the
contribution of this factor has probably waned.
 A closely related factor that many state tax experts
have pointed to for the decline in SCIT is increased
tax planning or avoidance by businesses. As Figure
1 shows, it appears that avoidance of federal corporate
income tax (FCIT) is probably not a significant part
of this explanation, as SCIT has fallen not just relative
to total profits but also relative to FCIT over the
last 25 years. Still, there are other possibilities
to consider. For example, in recent years, a good deal
of attention has focused on the use of so-called passive
investment companies or PICs. Because a handful of "tax
haven" states do not tax specific forms of income,
such as trademark royalties or interest income on loans,
large multistate businesses often set up subsidiaries
in these states to which the rest of the company pays
large royalty fees or interest on loans. This effectively
shifts income out of other states and into the tax
haven states, avoiding state taxation on the income.
The use of PICs has become increasingly common since
the mid-1980s. Intracompany income transfers are not
publicly reported, so the extent to which this could
explain the decline in SCIT's share of profits is unknown,
but it seems likely that it is of at least some significance.
 A third factor that would lower the share of profits
captured by state corporate taxes could be a trend
toward lower state tax rates, especially if it occurred
disproportionately among states with large shares
of national income. In fact, however, corporate tax
rates
have been roughly constant, on average, since 1980.
This is shown in Figure 2, which plots the average
top marginal corporate income tax rate among states
from 1980 to 2004. (These rates have been adjusted
for the deductibility of federal taxes from state
income for those few states that allow such deductibility).
The figure provides both an unweighted average and
an average weighting states by their 2004 gross state
products (as a proxy for corporate income). While
both
measures have fallen since 1992, they are at or above
where they were in 1980. Thus, the decline in state
corporate taxes' share of profits since 1980 cannot
be attributed to changes in legislated tax rates.
Another possible factor behind the decline in state
corporate taxes' share of profits could be shifts
in economic activity toward states with lower tax rates.
Fisher (2002) analyzed this possibility in detail
and
found that states with higher legislated tax rates
actually have experienced faster economic growth
than other states, at least since the late 1980s. Moreover,
there is a zero, or a slightly negative, correlation
between legislated tax rates and the sales-weight
in
apportionment formulas, so it does not appear that
high tax rates are offset by more favorable apportionment
rules.
A final important determinant of state corporate
taxes is credits. Many states offer businesses various
tax
credits to encourage particular activities. The two
most common types are investment tax credits (ITCs)
and research and development (R&D) tax credits
(RDTCs). The value of a credit is determined by multiplying
the credit rate by some measure of the targeted activity,
such as capital expenditures. A trend toward higher
credit rates, even if the level of targeted activity
remains the same, would have a negative effect on state
corporate tax revenues. To the extent that these credits
have shifted economic activity, and, hence, corporate
income, toward states offering these credits, the negative
effect is even greater.
 Figure 3 shows that average credit rates for ITCs
and RDTCs have indeed risen dramatically since 1980.
The
average ITC rate rose from 0.2% in 1980 to 1.4% by
2004, while the average RDTC rate rose from 0 to
3.5%. The increase in each of these average credit
rates
is due to a combination of an increase in the number
of states with credits and an increase in the credit
rates for those states with a credit. In 1980, just
six states had an ITC and no state had an RDTC. By
2004, 20 states had an ITC and 31 had an RDTC.
A simple back-of-the-envelope calculation provides
a rough sense of the extent to which these tax credits
could explain the declining SCIT share of profits.
Based on national data on business investment in equipment
and structures and R&D, combined with the average
credit rates, I compute that the amount of these credits
(combined) grew by $22.4 billion between 1980 and 2004.
If average credit rates had not changed, the credit
amount instead would have grown by just $1.7 billion;
hence, about $21 billion can be attributed to the change
in credit rates. If this $21 billion were added to
2004 state tax revenues, I calculate that the SCIT
share of profits would have fallen by about 25% rather
than the 50% fall that actually occurred.
Conclusion
This Economic Letter has
discussed a number of possible factors behind the steep
drop in state corporate
tax revenues as a share of profits since 1980. The
average
credit rate for the two most common types of credits
has risen considerably since 1980, while there has
been no decline in corporate tax rates and no apparent
shift in economic activity toward states with lower
tax rates. I find the increase in average credit
rates could explain around half of the decline in SCIT's
share of profits. The increasing non-uniformity of
taxation across states and the increasing exploitation
of this non-uniformity also likely has played a role.
Specifically, the non-uniformity in apportionment
formulas
and the use of passive investment companies likely
have increased the share of federal taxable income
that escapes state taxation altogether. Daniel Wilson
Economist
Reference
Fisher, Peter. 2002. "Tax Incentives and the
Disappearing State Corporate Income Tax." State
Tax Notes (March 4) pp. 767-774.
Opinions expressed in this newsletter do not necessarily
reflect the views of the management of the Federal
Reserve Bank of San Francisco or of the Board of
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