Wednesday, June 21, 2006

Why Pennsylvania Has Trouble Making Business Taxes Competitive

Pennsylvania has ranked among the worst 10-15 states in job growth over the past fifteen years. If Pennsylvania had merely grown at the average rate for the U.S. over that period, it would have nearly 600,000 more jobs (10% more) today. If it had grown at the U.S. average over the past 2 years, it would have 57,000 more jobs today.

It's not a coincidence that Pennsylvania also has the second-highest Corporate Net Income (CNI) tax, is one of only two states that caps Net Operating Loss (NOL) carryforwards in the CNI tax, has an increasingly uncompetitive income apportionment formula for the CNI tax, and imposes a Capital Stock and Franchise Tax in addition to the CNI tax.

So why doesn't the state make its Corporate Net Income tax more competitive?

Because Pennsylvania tax policy is based on a series of antiquated and irrational arguments that fail to recognize the overriding importance of being competitive.

Irrational Argument #1: The state can't afford to make business taxes more competitive because it will reduce revenues for other programs.
This is the equivalent of a company saying "even though fewer and fewer people are buying our product because it's too expensive, we can't cut prices because we'll lose revenue. " Instead, if the company cuts prices and gets more customers, its total revenues will go up (or go down less) than if it refuses to change. The same is true of state businesses taxes -- if Pennsylvania reduces the "price" to operate a corporation here (i.e., its uncompetitive taxes), more businesses will "buy the product" (i.e., locate and expand in the state), thereby increasing revenues.

In 2004, the Governor's Business Tax Reform Commission acknowledged that Pennsylvania's business taxes were highly uncompetitive, but the Governor required them to make their recommendations "revenue neutral," which the Commission chose to interpret as meaning that other business taxes would have to be increased to pay for those that were reduced. The net effect was to substitute one uncompetitive tax package for the current one.

In 2005, Governor Rendell vetoed legislation that would have made the NOL carryforward and income apportionment factors in the CNI tax more competitive. Why? Because he claimed Pennsylvania would have "lost more than one billion dollars in revenue over the next five years." Aside from the obvious effort to exaggerate the impact by cumulating the effect over 5 years (for comparison purposes, the state will spend $136 billion over the next five years, so the impact was less than 1% of the budget), the implication was that Pennsylvania would actually have less revenue than it has today. But in fact, if the bill had been signed, Pennsylvania's CNI tax would still have been generating more revenue in 2010-11 than it did in 2004-05, even assuming no increase in the state's growth rate. And if the Governor's estimate had assumed that the state's growth rate would increase from making taxes more competitive, there might well have been a net increase in projected state revenue.

Irrational Argument #2: If there's a budget surplus, it's unfair to "give it to wealthy corporations."
If you think of a state budget surplus as something to be handed out to somebody and a tax cut as a giveaway, then you're likely to think that the state should use its surplus for tax cuts for individual taxpayers (i.e., voters) or for programs that benefit voters, rather than for tax cuts for businesses. On the other hand, if you see a budget surplus as something to be invested in policies that will increase growth (thereby creating more private sector jobs for voters), then the state should use it to make business taxes more competitive, which creates more and better jobs for voters. In the longer run, the latter approach gives you the best of both worlds -- more competitive business taxes mean more business investment and job creation, which means more state revenues (from not only corporate taxes but individual taxes since more people will be employed), which means a greater ability to reduce individual taxes and increase funding of state programs.

Irrational Argument #3: Business taxes are high because most businesses are using loopholes to avoid paying taxes.
Governor Rendell and other state officials often cite a statistic that "73% of all businesses subject to the Corporate Net Income (CNI) tax pay no tax" as evidence that the majority of businesses are using tax loopholes to escape legitimate tax liability. What state officials fail to explain is that most of these businesses have no income at all (e.g., they may have no employees or sales), which means they would not pay taxes no matter how few loopholes there were. In fact, IRS statistics indicate that approximately half of corporations nationally have no income - in other words, most of the 73% of companies that are "non-tax payers" in Pennsylvania likely have no income which would be subject to tax under any circumstances. Moreover, surveys by the Pennsylvania Department of Revenue have shown that the 73% figure is comparable to other states, and is actually lower (better) than in some states that supposedly have fewer tax loopholes.

Because of this fallacious argument, even though Governor Rendell acknowledged in his 2005 budget address that the state's Corporate Net Income Tax is highly uncompetitive and needs to be reduced, he has refused to do so unless the General Assembly also enacts something called "mandatory combined reporting" in order to curb the so-called tax avoidance. However, mandatory combined reporting would cause significant increases in the tax burden for many multi-state firms, and would make Pennsylvania highly uncompetitive for attracting and retaining operations of many current and out-of-state companies with a choice as to where to locate. Currently, none of Pennsylvania’s neighboring states have a mandatory combined reporting system. Corporate site selection consultants have indicated that the competitive disadvantages of establishing a mandatory combined reporting system would outweigh the advantages of reduced CNI tax rates or any of the other tax improvements currently being considered.

Irrational Argument #4: Business tax rates aren't a major factor in business location decisions.
It's true that the differences in tax rates between many states is relatively small, so in a lot of cases, they don't affect the location decision for a business. However, Pennsylvania's CNI tax rate is 25-40% higher than competitor states, which makes it a more significant factor. Moreover, Pennsylvania's problem is not just its rate, but its ranking -- it has the second highest tax rate in the country. On top of that, unlike every major state, it limits the ability of companies to carry forward losses from previous years, and unlike most states, it imposes a high capital stock tax in addition to the corporate net income tax. Pennsylvania is so unusual in having these problematic provisions that it sticks out like a sore thumb on national rankings of state business taxes and business climate, making businesses and site selection consultants cross it off the list before even trying to evaluate the actual tax burden compared to other states or regions.

There is only one rational basis for setting state tax policy in a global economy, and that's to be competitive. The taxes where Pennsylvania is uncompetitive are its state business taxes. So a priority for the state budget should be to make them more competitive.

What specifically should the state do?

1. Reduce the Corporate Net Income tax rate to 8.5% (the rate where it was in 1990 before it was raised) so that the rate is competitive with other states. This reduction can be phased in over four years in order to minimize any negative impacts on the state budget;

2. Raise or eliminate the cap on Net Operating Loss Carryforwards in the CNI tax so that Pennsylvania is competitive with every other major state.

3. Create a single sales factor in the CNI tax income apportionment formula so that Pennsylvania stays competitive with other states; and

4. Continue to phase out the Capital Stock and Franchise Tax so that Pennsylvania becomes competitive with other states.

With a surplus in excess of $700 million this year, the state can afford to make the changes needed to be competitive. And if it hopes to improve its job creation rate, it can't afford not to.


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