Arnold Schwarzenegger's first priority is clearly to get the California budget under control. But looking ahead he shouldn't forget about his other big campaign promise: to jumpstart the economy and halt the outflow of business investment to lower-cost states. Why not push for repeal of the state corporate income tax? It's just the sort of bold stroke the new governor needs to show that the Golden State shines with economic opportunity once again.
State corporate income taxes might be the most inefficient taxes in the nation because they create large burdens on businesses but raise little revenue. Corporate income taxes generate just 3 percent of state revenues but "consume an inordinate amount of intellectual firepower and economic resources in terms of planning, compliance, and administration," argues David Brunori, an editor of State Tax Notes.
Repealing corporate taxes makes more sense all the time because they account for a declining share of state revenues. Liberals complain that this decline is caused by aggressive corporate tax avoidance. They are partly right -- corporate profits are increasingly mobile and getting more difficult to tax. But the liberal solution -- high-profile crack-downs on corporate tax avoidance in California and elsewhere -- is just political theatre that provides no economic benefit.
More rules and greater enforcement would increase state tax compliance costs that are already excessive. Indeed, a survey by the Tax Foundation found that compliance costs for the state corporate tax were about twice as high as for the federal corporate tax, measured relative to tax collected. Aside from these costs, the state corporate tax damages the economy by distorting business decisions. For example, firms are encouraged to move labor-intensive production to states that don't count payroll in their "apportionment formulas." These formulas determine how much of a firm's profits are taxed in a state. Businesses must also plan carefully because of the different state rules for intangible assets. For example, Delaware does not tax the earnings from intangibles, thus many firms move trademarks to subsidiaries in that state. A holding company in Nevada--one of the few states with no corporate tax--is also a useful tax planning structure.
More generally, corporations must wade through arbitrary and different tax rules, definitions, and formulas in every state:
- States generally require that firms separate "business income" from "nonbusiness income." This opens the door to strategies that convert business income to more mobile nonbusiness income in order to move it to low-tax states;
- Some states allow separate reporting for each company in a corporate group, while others require combined reporting for the whole corporate group. These rules create tax planning issues such as whether transfer pricing can be used to shift paper profits between states;
- The rules for "nexus" are unclear and heavily litigated. These rules determine how much in-state presence a company must have before it is subject to tax.
Complex and different rules in each state generate endless cat-and-mouse games between taxpayers and state tax enforcers. As Brunori observes: "The only people who really make money from the state corporate income tax system are the major law firms and big accounting firms."
States have made the complexity problem worse by turning their corporate taxes into Swiss cheeses of narrow loopholes. "Incentive packages" for favored companies and fancy credits for job creation, job training, and other activities have proliferated. Aside from being complex, these narrow breaks are unfair to businesses that pay the full tax load and they open up government officials to corruption.
A reformer might call for simpler and more neutral corporate taxes, but that's not the type of business tax that politicians seem capable of actually enacting. Thus, the best solution is full repeal of state corporate income taxes. That would be a "pro-business" policy, but the ultimate winners would be individuals because they currently pay the corporate tax through reduced wages, higher prices, and lower investment returns.
Is repeal likely to happen? I'm hoping that a few smart states will "pull an Ireland" by attracting large investment inflows with a big corporate tax cut. That would spur state competition to drive tax rates down, just as corporate tax rates have tumbled across Europe in recent years. So here is Schwarzenegger's chance to not only "rebuild California's economic engine," but to launch a nationwide drive to get rid of these notoriously wasteful taxes.