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February 15, 2012
Federal Tax Reform: Lessons From the States

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by Robert Cline and Steven Wlodychak

Robert Cline is principal and national director of state and local tax policy economics at Ernst & Young LLP and Steven Wlodychak is principal, indirect tax, and state tax leader for the Ernst & Young Center for Tax Policy.

The views expressed in this article are those of the authors and do not necessarily represent the views of Ernst & Young LLP.

* * * * *


As the federal corporate tax reform debate in Washington intensifies, the recent experiences of states with business tax reform may prove instructive. A number of states have been debating business tax changes -- ranging from corporate tax rate changes to eliminating the corporate income tax. And several states have already adopted major business tax reforms that fundamentally change the way businesses are taxed at the state and local levels.

The federal corporate tax reform debate is being driven by the same forces that have affected the states for the last decade: intensified cross-border business competition, high unemployment, inadequate capital investment, and a need for revenue to fund public infrastructure and services.

The 2001 recession was a catalyst for significant state business tax reforms -- beginning in Ohio in 2005 and followed closely by reforms in Texas (2006) and Michigan (2007). The state fiscal challenges generated by the longer and significantly more severe 2007-2009 recession are expected to trigger another round of state business tax reform debate.

The fiscal situation that pushed states to consider tax reform mirrors federal fiscal challenges in many ways. Both the federal government and the states have large, multiyear structural budget deficits. The states' varied responses to those deficits have been largely driven by a desire to attract and retain companies that bring jobs and expand state and local tax bases, a desire echoed at the federal level.

States have been closing budget gaps through combinations of spending cuts and temporary and permanent tax increases. From the states' experiences, businesses can gain insight into the approaches, challenges, and possible effects of tax reform on a national scale. This article examines the following lessons from the recent state experience:

  • Strong opposition to tax increases is changing the way legislators balance budgets.
  • Business tax reform may involve cutting business taxes to grow jobs and stimulate investment.
  • States impose lower taxes than the federal tax system on business income earned abroad.
  • Corporate income taxes are just one option for taxing business activity.
State Legislators Are Reluctant to
Raise Taxes to Balance Their Budgets

The 2007-2009 recession left states with a combined budget deficit of $477 billion for fiscal 2009-2012.1 Cumulative deficits equaled almost 19 percent of total general fund spending. The 2011 state legislative sessions have been the most challenging since the last recession began in December 2007 because of the expiration of federal emergency funds to the states from the American Recovery and Reinvestment Act of 2009 (ARRA), the slow economic recovery that has reduced tax revenue, and recession-driven expenditure increases.

State legislators have been more reluctant to respond to those budget challenges by increasing taxes, even temporarily, than most analysts expected based on state responses in prior recessions. For example, in response to the shorter and less severe 1990-1991 recession, state legislators adopted cumulative tax increases of 9.4 percent in the three sessions from 1989 to 1991. Cumulative state tax increases in response to the six-month 2001 recession were 2.9 percent over three legislative sessions.2

In contrast, despite facing the largest cumulative budget shortfalls since the 2007-2009 recession began, in 2011 state legislators adopted new tax changes that increased taxes by only 1.4 percent, with almost all of the tax increase attributed to only two states: Illinois and Connecticut.3 In the 2010 legislative session, legislators adopted state tax increases of only 0.4 percent. The largest increase in response to the recent recession occurred in the three sessions from 2008 to 2010, during which state legislatures adopted cumulative tax increases of 5.2 percent (compared with prior-year taxes), according to the National Conference of State Legislatures.4

The relatively small net tax increase in 2011 is partly due to the renewed growth in state tax collections.5 But it may also be the result of the changing political landscape at the state level. In November 2010, Republicans, who ran on a platform of smaller government, picked up control of both legislative chambers in 11 new states, including much of the industrial belt from Minnesota to Pennsylvania. The GOP now controls both houses in half the states and controls both the legislature and governorship in 20 states. (In contrast, Democrats have complete control in only 11 states.) This switch in political alignment appears to have made it more difficult to increase state taxes, even temporarily, in response to short-run state budget deficits. This challenge is also reflected at the federal level, where Republicans control the U.S. House of Representatives, whose new GOP members were elected after campaigning against revenue increases.

In 2011 there was intense congressional debate over the $1.3 trillion federal deficit (8.5 percent of U.S. gross domestic product for fiscal 2011) and the $10.2 trillion publicly held federal debt from accumulated deficits (67 percent of GDP).6 That pressure has led to increased calls for fiscal discipline at the federal level. Federal policymakers may want to look to the recent experience of the states for guidance, because nearly all states are subject to constitutional or statutory balanced budget requirements.

States Are Cutting Business Taxes to Stimulate Growth

For many states, the economic objective of stimulating the economy has outweighed fiscal pressures to increase taxes on business to address state budget deficits. In fact, a number of states have reduced business taxes and have offset those increases by raising taxes on households. Examples include California7 and Michigan,8 two states hit hardest by the recession.

Given their concern about longer-run business tax competitiveness, state legislatures have generally avoided substantial increases, temporary or permanent, in business taxes to fund deficit reduction. The NCSL estimates legislators increased corporate income taxes by $2 billion in 2009, followed by a cumulative net reduction of more than $300 million in corporate taxes in 2010 and 2011.9 The cumulative net three-year business tax increase accounted for only 5.7 percent of the total legislated tax increases over this period ($30.1 billion). The NCSL reports that 20 state legislatures cut business taxes by more than $1.9 billion in 2011 through tax rate reductions (five states), reductions in tax bases, and expanded business tax credits.

New York provides the most recent example of state tax policies reducing business taxes. Gov. Andrew Cuomo (D) signed tax reform legislation in early December that provides overall business tax reductions. The new law provides a temporary three-year 50 percent reduction in the corporate income tax rate for selected manufacturers, expanded business tax credits, and a small business exemption for the payroll tax used to fund the Metropolitan Transportation Authority. Also, the governor is establishing a tax reform commission to recommend a comprehensive overhaul of the New York tax system.10

This emphasis on enhancing state business tax competitiveness has fueled a trend toward reducing state business taxes in both the short term and the long term. Even Illinois, which was one of the lone states to increase tax rates in 2011, included future rate reductions in its new business tax legislation. Also, states that are making more fundamental, long-run changes in their business tax systems are generally not requiring revenue neutrality. Instead, they are providing substantial reductions in overall business taxes as part of the tax reform process.

As in the states, job growth and increasing capital investment are concerns at the federal level. Those concerns have been reflected in the debate over the impact of federal corporate income taxes on the United State's tax competitiveness with other countries. However, in contrast to the state experience, the federal corporate income tax reform debate is being framed in terms of a revenue-neutral package, with additional revenue from base broadening used to pay for lowering statutory corporate income tax rates.

The state experience suggests that federal tax policymakers may want to consider combining corporate tax reform with longer-run overall reductions in the level of corporate income tax rates to improve U.S. business tax competitiveness in the global economy. States have also found overall tax cuts to be important in mitigating the redistribution of tax liabilities across industries and types of firms that would result from revenue-neutral corporate income tax reform.

State Tax Systems Are More Favorable to
Foreign-Source Income Than the Federal Corporate Tax

International taxation is another area in which the state experience can offer a path for the federal tax reform debate. As federal policymakers discuss the potential merits of moving the United States from a worldwide to a territorial international tax system, they may benefit from examining the states' approach to taxing foreign-source income. With a few notable exceptions, states generally do not adopt the complex subpart F, controlled foreign corporation, effectively connected income, and foreign tax credit regimes that, in combination with deferral of taxes on foreign-source income, are the hallmarks of the federal system. Instead, the states use a variety of measures, such as apportionment and allocation, as well as combined reporting (with variants on which income of foreign operations is includable in the tax base) to substantially reduce or eliminate state taxation of foreign-source income.

The U.S. Federal Method of Taxing Foreign-Source Income

The federal corporate income tax is often criticized for reducing the global competitiveness of U.S.-based firms operating overseas and the attractiveness of the United States as a business location for foreign-based firms. The federal corporate income tax is structured as a worldwide tax system that imposes taxes on the global net income of U.S. corporations, whether earned in the United States or elsewhere.

However, the U.S. corporate income tax also provides a mechanism for deferring U.S. taxes on the overseas operating income of foreign subsidiaries of U.S. corporations. Federal corporate income taxes are not imposed until the overseas income is returned (repatriated) to the U.S. parent in the form of dividends.11 To avoid double taxation, credits are provided to U.S. corporate taxpayers for foreign taxes paid on the net income included in the U.S. base. In effect, the U.S. corporate income tax imposes an additional tax on foreign-source income of U.S. corporations that equals the excess of the U.S. 35 percent federal corporate income tax rate over tax rates in other countries.

In contrast to the U.S. corporate income tax, most other countries, including, most recently, the United Kingdom and Japan, have adopted corporate income taxes that are structured as territorial tax systems. Under a territorial system, corporate taxes generally are imposed only on economic activity occurring within the taxing country. The territorial system avoids double taxation of the income of multinational companies operating in different countries by excluding most, if not all, dividends received from overseas affiliates from the home country's corporate tax base. Under a territorial tax system, there are no foreign tax credits related to the exempt dividends. Proponents of territorial tax systems view them as enhancing the global competitiveness of domestic firms, encouraging the repatriation of earnings from foreign subsidiaries, and strengthening the domestic economy through increased investment and employment.12

The States' Approach to Taxing Foreign-Source Income

State corporate income taxes operate, for the most part, as territorial tax systems. States determine the geographic location of the U.S. income of multistate firms by apportioning the taxpayer's income to a specific state. An apportionment formula is used to determine the share of the taxpayer's U.S. business income generated by economic activity within a state.13 The formula determines the state's share of the total taxpayer activities assumed to generate the firm's taxable income. The formula most often used is a weighted average of in-state to total payroll, property and sales, or sales only. The geographic location of the factors is used to define the territory (state) where the income is produced. If all states used the same apportionment formula and the same measurement of taxable income, in theory, that system would avoid double taxation of the income of multistate taxpayers.14

Most state corporate income tax systems provide a dividends received deduction (for dividends received from both domestic and foreign subsidiaries) that effectively removes dividends paid from income earned by foreign subsidiaries from the state tax base.15 This is similar in operation to a foreign dividend exemption territorial tax system that is being discussed in Congress. States may also subtract other foreign sources of income, including interest and royalties, from the tax base.

However, state corporate income tax systems are not pure territorial tax systems. States may tax some foreign-source income, such as subpart F passive income and a portion of dividends received. Also, states that require mandatory unitary combined reporting may include a portion of income from foreign subsidiaries in the state tax base.16 Most states minimize the inclusion of foreign entities in the combined group by adopting a water's-edge combination. The water's-edge approach excludes from the combined group unitary members that are incorporated in a foreign company or conduct most of their business in foreign countries.17

While U.S. constitutional constraints have played an important role in shaping state corporate income tax treatment of foreign-source income, the exclusion of that income from state corporate tax bases also reflects the influence of intense national and global competition. States perceive that their corporate income tax systems are more competitive because of the reduced level of taxation of foreign-source income, which may be instructive in the federal debate over moving the United States to a territorial system.

Many States Have Adopted Alternative Business
Tax Systems to Increase Competitiveness

While states have been dealing with substantial short-run budget deficits over the last decade, they have also been addressing long-run competitiveness challenges by debating, and in some cases adopting, alternative business tax systems that do not rely on net income.

                                  Table 1.
           State Experiments With Alternative Business Tax Bases

     State             Dates                Description of Tax Base

                    General gross receipts tax (GRT)

 Ohio           2005-present          Commercial activity tax (CAT), a single,
                                      low-rate gross receipts tax with few

 Washington     1935-present          Business and occupation tax (B&O), a GRT
                                      with few deductions with rates that vary
                                      based upon business classification

 Texas          2006-present          One of three elective margin tax bases:
                                      taxes 70 percent of gross receipts at a 1
                                      percent general rate and 0.5 percent rate
                                      for wholesalers and retailers

                              Modified GRT

 Michigan       2008-2011             One of two MBT bases; base is gross
                                      receipts minus purchases of goods from
                                      other firms. This tax has been repealed
                                      and replaced with a corporate income tax
                                      effective January 1, 2012

 Minnesota      1990-present          Factors tax, a minimum tax based on the
                                      amount of in-state sales, property, and


 Michigan       1953-1967             Business activity tax (BAT), a tax on the
                                      sum of payments to labor and capital
                                      (addition method) or gross receipts minus
                                      purchases from other firms (subtraction

 Michigan       1976-2007             Single business tax (SBT)

 New Hampshire  1993-present          Business enterprise tax (BET), operates
                                      as an alternative minimum tax

 Oklahoma       2010-2012             BAT, a modified subtraction VAT, but tax
                                      is limited to former franchise tax

 California     2009 proposal         Business net receipts tax (BNRT)
                                      apportioned, subtraction method VAT
                                      (proposed by California's Commission on
                                      the 21st Century Economy but not enacted)

                            Gross margin tax

 Texas          2006-present          One of three elective margin tax bases:
                                      taxes gross receipts minus cost of goods
                                      sold (COGS)

 New Jersey     2002-2006             Alternative minimum assessment (AMA),
                (for most taxpayers)  the smaller of gross receipts minus COGS
                                      or gross receipts taxed at lower tax

                           Labor-adjusted tax

 Texas          2006-present          One of three elective margin tax bases:
                                      taxes gross receipts minus labor costs

                           Business income tax

 Michigan       2008-2011             One of two bases under the MBT: taxes net
                                      income of almost all business entities

                          Corporate income tax

 Used in                              New corporate income tax, same as
 45 states                            business income tax base but limited to C
                                      corporations; after 56 years, Michigan
                                      reinstates a traditional corporate
                                      income tax effective January 1, 2012

State business tax policy has been shaped for decades by an environment of open-border economies and intense competition for new, mobile capital investment. Increasingly, intensified global competition is forcing the same perspective on the federal corporate tax reform debate. Both state and federal lawmakers recognize that businesses have many location options both within the United States and internationally. Keeping a state's taxing system competitive is necessary to promote growth and encourage new capital investment while generating taxes needed to finance public-sector spending.

In response to the 2001 recession and the dramatic impact that the falloff in income tax-based receipts had on revenue, a handful of states launched business tax reform efforts to increase state competitiveness and attract and retain jobs and capital investment. Table 1 describes those new business tax bases, along with other tax bases, that states have adopted as alternatives to the corporate income tax.

The alternatives include broad-based, low-rate gross receipts taxes (Washington, Ohio, and Texas), business taxes based on different measures of a taxpayer's value added (Michigan, New Jersey, Oklahoma, and a recent California proposal), and business income taxes that vary substantially from the federal corporate income tax (Michigan, before the replacement of the Michigan business tax (MBT) with a corporate income tax beginning in 2012, and Texas). In some cases (New Hampshire, Minnesota, and New Jersey), states have combined business income taxes with alternative bases to impose minimum tax levels on both C corporations and passthrough entities. The taxes in Table 1 are listed roughly in order of the relative size of the tax bases, ranging from the gross receipts tax to the corporate income tax.


Michigan continues its decades-long search for the optimal business tax structure. As shown in Table 1, Michigan has experimented with five different business tax systems since 1954: a subtraction method, VAT base (business activity tax from 1954 to 1966); a C corporate income tax (1967 to 1974); an addition method, VAT base (the single business tax (SBT) from 1975 to 2007); a combination of business income and modified gross receipts tax bases (MBT from 2008 to 2010); and the return to the C corporate income tax (beginning in 2012).

In 2011, at the urging of new Gov. Rick Snyder (R), the Legislature replaced the MBT, a combination of a modified gross receipts tax and a business income tax on all types of taxpayers, with a flat rate 6 percent corporate income tax that is based on federal taxable income.18 The new Michigan tax applies only to C corporations and disallows almost all tax credits provided under the replaced MBT system.19

Battered by one of the highest state unemployment rates and a weak economy, Michigan adopted a major business tax reform package in 2011 while still dealing with substantial short-run budget deficits. Most important from a business tax competitiveness perspective, the Michigan tax reform package reduced business taxes by a projected $1.2 billion annually. This 60 percent business tax cut was paid for with increased individual income taxes and a $500 million cut in annual state spending programs. The individual income tax increases included a permanent tax rate increase, reductions in pension and retirement income deductions, and the elimination or reduction of a number of tax credits.

Interestingly, Michigan's action to remove passthrough business entities (for example, partnerships, LLCs, and S corporations) from the business tax system comes when other states are going in the opposite direction and extending their business taxes to noncorporate entities, and federal policymakers are debating whether to extend the federal corporate income tax to passthrough entities.20

Key lessons from Michigan's ongoing experiments with business taxes include:

  • Many business taxpayers strongly oppose business taxes that have tax bases unrelated to income. Opposition to the VAT and gross receipts tax bases pushed Michigan legislators to add profit-sensitive features to the tax structure that increased complexity and administrative and compliance costs.
  • Combining business tax reform with major reductions in the overall level of business taxes helps reduce the inevitable shifts in tax liabilities across industries and types of taxpayers that result from business tax reform.
  • The long-run objective of strengthening the state economy by adopting a more competitive business structure may be a higher state priority than business tax increases to help reduce short-run deficits.
  • Given the substantial redistributions in tax liabilities that occur in making any major changes in business tax systems, it is critical to have detailed revenue estimates that identify the expected change in tax liabilities by industry and type of business. Knowing the change in the distribution of business tax liabilities under alternative policy proposals will become increasingly important as the congressional debate over federal corporate income tax reform proceeds.21

The elimination of most business tax credits under the new Michigan corporate income tax is also a new direction in Michigan's approach to taxing businesses. Michigan provided a significant number of generous tax credits and specific deductions under both the MBT and its predecessor, the SBT. The revenue loss from those business "tax expenditures" was roughly the same size as the total net (after-credit) collections from the MBT. With the adoption of the corporate income tax, a portion of the revenue dedicated to supporting tax incentives was redirected to direct appropriations for the state's more targeted economic development programs.

In addition to Michigan, a number of other states are evaluating the effectiveness of business tax credits and debating restructuring of the credits. California, Georgia, Hawaii, and Missouri, for example, have been considering changes in business tax credits and incentives to increase their effectiveness and transparency. Proposals being discussed include requiring evaluations of the economic effects of credits; reducing the number of credits; and targeting credits in terms of industries or types of business activities, including new investments, additional jobs, and increased research and development spending. With policymakers at the federal level considering reducing or eliminating business tax expenditures as a way to broaden the corporate income tax base, the experience of the states in this area could prove instructive.22


Growth in Ohio's economy (gross state product) from 1990 to 2000 was the ninth lowest among all of the states. Also, Ohio was hit relatively hard by the 2001 recession. In reaction to the weak economy and a perception that Ohio's business tax environment contributed to it, the Ohio business community teamed with the state legislature to adopt fundamental business tax reform in 2005. Among the changes were phaseouts of the state's corporation franchise tax (based on both net income and net worth) and the state's tax on business personal property.23 As a partial replacement for these revenue streams, the state enacted the commercial activity tax, a gross receipts tax on most businesses regardless of legal form, with a phase-in completed in 2009. Individual income tax rates were also reduced as part of the 2005 tax reform.

Before tax reform, Ohio was ranked the 31st most competitive state and local business tax system for five types of new U.S. business investments. In 2009, after the reform package was fully phased in, Ohio ranked third most competitive.24 The reform reduced state and local business taxes by an estimated 50 percent.

Key lessons from the Ohio experience include:

  • The overriding objective for business tax reform was to increase Ohio's tax competitiveness and strengthen the state's economy. This was achieved through a $1.4 billion net reduction in state and local business taxes, as well as a restructuring of the tax system to reduce taxes on capital-intensive businesses competing in U.S. and global markets.
  • Given the focus on the expected economic benefits from adopting a more competitive state and local business tax system, Ohio legislators benefited from estimates, prepared by the business community and the state economic development agency, of the "dynamic" economic effects of the tax reform package. The dynamic impacts identified included the creation of more jobs, higher incomes, and overall increased economic activity.25 Interestingly, there appears to be growing congressional interest in estimating the dynamic effects on the U.S. national economy expected from corporate income tax reforms that improve U.S. business tax competitiveness. Ohio's experience shows that dynamic impact modeling is both possible and helpful in the business tax reform debate.
  • The balance between business and household taxes was maintained with roughly proportional reductions in total taxes on both households and businesses.
  • The economic and fiscal problems associated with the corporate income tax, including volatility over the economic cycle, a narrow tax base and high statutory tax rate, and the high concentration of taxes paid by large, capital-intensive C corporations, were addressed with an entity-level gross receipts tax imposed at a low tax rate (0.26 percent) on most industries and types of businesses. The tax includes a relatively broad exemption for small businesses through a high threshold of gross receipts before the tax applies.
  • It is important for legislators to pay attention to phase-ins and transition provisions when changing business tax systems. In Ohio the business tax changes were phased in over multiple years to allow taxpayers greater flexibility in adjusting to changes in the tax law. Also, provisions were included that protected some deferred tax assets accumulated under the prior business tax system.

Despite the fiscal problems facing Ohio during the 2007-2009 recession, the business tax components (with the exception of a two-year delay in the phasedown of individual income tax rates) were not changed by the legislature. Although the gross receipts tax base has its own shortcomings, including tax pyramiding, in Ohio it appears to be a politically and fiscally more stable business tax than the corporate income tax.


Texas made major changes in its business tax structure in 2006 when it replaced the net worth (taxable capital) and net income (earned surplus) bases of its corporate franchise tax with an entirely new taxable margin base (the so-called margin tax). As shown in Table 1, the margin tax uses the same base of total income (essentially gross receipts) and allows taxpayers to choose among three different methods that result in the least amount of tax: (1) 70 percent of gross receipts, (2) gross receipts minus cost of goods sold, and (3) gross receipts minus labor compensation. The taxable margin is apportioned to Texas based on a single gross receipts factor and then subject to tax at the relatively low rates of 1 percent (for most taxpayers) or 0.5 percent (wholesalers or retailers).

Key lessons from the Texas experience include:

  • Texas imposed several important constraints on the 2006 business tax reforms, including that they could not result in a net change in the amount of overall business taxes and they should impose only a minimal redistribution of taxes among industries. As a result of these constraints, the margin tax is complex. If the federal corporate income tax reform debate faces similar constraints, the resulting corporate income tax may not be simpler than the current corporate tax.
  • Forecasting the revenue to be raised from a substantially changed business tax system can be a challenge. Current estimates suggest that Texas margin tax receipts are running at least 20 percent lower than estimated at the time of adoption (after adjusting for the impact of the recession).

Other States

Table 1 shows that several other states have adopted or considered major changes in their state corporate income tax system. New Hampshire adopted a business enterprise tax (BET) based on value added of all business types that acts as a minimum tax -- taxpayers pay the larger of the BET or the corporate income tax. New Hampshire has found that the BET, combined with the state's corporate income tax, provides a more stable business tax base during recessions.

Policymakers in a number of states, including California, Georgia, Hawaii, and Missouri, have also been considering changes in business tax credit and incentive programs to increase those programs' effectiveness and transparency. Proposals being discussed include eliminating credits and requiring more detailed analysis of the economic effects of the credits and incentives. With policymakers at the federal level considering reducing or eliminating tax expenditures, the experiences of the states in this area could prove instructive.26

California's Commission on the 21st Century Economy recommended in 2009 that California replace its corporate income tax and general sales tax with a subtraction-method VAT (the business net receipts tax (BNRT)) that would apply to all business enterprises regardless of legal form.27 The proposal also included a recommendation to restructure the personal income tax base and lower the tax rates. The California State Legislature did not afford the measure much debate.

Key lessons from the California BNRT discussion include:28

  • An entity-level tax based on value added is a difficult concept to explain because it is fundamentally different from a business income tax and is different from the credit-invoice transaction VAT used in most other countries.
  • Many businesses will strongly oppose a business entity tax that is not based on profits.
  • The substitution of a business tax based on value added for a corporate income tax will result in a large number of winners and losers, even if it is a revenue-neutral substitute for the corporate income tax. Policymakers and stakeholders will want to consider the industry-by-industry changes in tax distributions, as well as the tax shifts by business form, for any corporate tax reform proposal.
  • Mixing corporate income, sales, and personal income tax changes in a single tax reform package may be too complex a change for Congress (or the electorate) to consume. At a minimum, it intensifies the debate over the equitable distribution of household and business taxes, a matter that involves complex issues of economic tax incidence and strongly held political views.

The idea of a state-level or federal VAT may emerge again as policymakers seek new sources of revenue. For example, an 8.5 percent subtraction-method VAT as a replacement for the federal corporate income tax was included in a proposal by U.S. Rep. Paul Ryan, R-Wis., "Road Map for America's Future," which outlined an overhaul of the federal tax system.29


The different state tax actions taken over the last decade to reduce short-run deficits related to recessions and to improve longer-run business tax competitiveness reflect a similar balancing of conflicting goals and policy challenges to those confronting federal policymakers now. States have experimented with a variety of changes to modify their corporate income taxes or replace them with alternative business tax bases. Those actions have been shaped by growing concern over the national and international competitiveness of state business tax systems.

Those same concerns are likely to be weighed at the federal level as policymakers seek to simplify the tax code, increase U.S. tax competitiveness, and change the structure of federal business taxes. Although no state has found the "ideal" business tax system that can serve as a model for federal business tax reform, the state experience provides a number of lessons for the federal debate. Companies can help policymakers sort through these complex issues by educating them about possible winners and losers, economic effects, and possible unintended consequences of tax policy changes.


1 "State Budget and Tax Update," National Conference of State Legislatures, July 2011, presentation by Corina Eckl.

2 Cumulative state tax increase figures are from the NCSL's State Tax Update: August 2011 (preliminary report), p. 8.

3 The cumulative legislated state tax increases of $9 billion in 2011 were more than offset by net tax reductions from expiring temporary personal income and sales tax increases in a handful of states, including California, New York, and North Carolina. As a result, the NCSL estimates the net change in total state taxes, including expiring temporary increases, was a reduction of 0.4 percent.

4 Ernst & Young LLP's calculations based on the NCSL's State Tax Update: August 2011 (preliminary report), p. 8.

5 The Nelson A. Rockefeller Institute of Government estimates that state personal income, corporate income, and sales taxes grew at a combined rate of 11.4 percent (year over year) in the second quarter of 2011, following a 9.4 percent growth rate in the first quarter. The preliminary second quarter 2011 tax collection estimates are from "Data Alert: Strong, Broad Growth in State Tax Revenues Continued in Second Quarter of 2011," Nelson A. Rockefeller Institute of Government, Sept. 1, 2011.

6 Federal deficit and debt figures are from "Budget and Economic Outlook: An Update," Congressional Budget Office, Aug. 24, 2011.

7 The 2009 California State Legislature passed an elective single sales factor apportionment formula (effective for tax year 2011) that will reduce corporate income taxes by up to $800 million a year. This change was passed as part of the 2009 Budget Act, which addressed a projected budget deficit of $42 billion over a two-year period. A 2011 proposal by Gov. Jerry Brown (D) to make the single-sales-factor formula mandatory did not pass the Legislature.

8 The Michigan Legislature adopted a new business tax system in 2011, returning to a traditional corporate income tax at a 6 percent rate and reducing business taxes by an estimated $1 billion annually.

9 Estimated legislated tax changes are from the NCSL's State Tax Actions, various years. The business tax figures are for "corporate income and business taxes" that include alternative business entity taxes, such as modified gross receipts taxes. They do not include changes in other state business taxes, such as sales taxes on business input purchases, healthcare provider taxes, unemployment taxes, and net worth taxes. Business tax cuts include rate reductions, changes in tax bases, and expansions in tax credits. The relatively small net tax change figures can include some very large increases and decreases for individual states. For example, in 2011 Michigan reduced business taxes by $1 billion in switching from the Michigan business tax (which was based on a combination of a gross receipts tax and a net income tax applied to all legal entities) to a more traditional corporate net income tax based on federal taxable income. In sharp contrast, Illinois increased business taxes by $1 billion by temporarily increasing corporate tax rates by 30 percent and suspending net operating loss deductions. In response to threats from local businesses to leave the state, on December 16, 2011, Gov. Pat Quinn (D) signed tax relief legislation providing an estimated $371 million in tax credits and incentives to keep Sears and the CME Group (operator of the Chicago Mercantile Exchange) from leaving the state. (See "Quinn signs Sears-CME tax breaks into law," Chicago Tribune, Dec. 16, 2011.)

10 See Ernst & Young LLP's State and Local Tax Weekly Alert, "New York enacts law raising personal income tax rates, reducing corporate manufacturing rate, creating targeted tax incentives," Dec. 12, 2011, for more details on the New York tax law changes.

11 There is no deferral for passive income (subpart F income).

12 Territorial corporate income tax systems can also include restrictions on exclusions of passive foreign income or income earned in low tax rate countries.

13 States generally divide a corporation's income into business and nonbusiness income. Nonbusiness income, which includes income that is unrelated to the corporation's regular trade or business operations, is generally assigned to a particular state instead of being apportioned to more than one state.

14 The European Union is evaluating a proposal to replace current separate-country corporate income tax systems with a Common Consolidated Corporate Tax Base (CCCTB) system. The new system would consolidate income for affiliated companies opting into the system and allocate the income to the Member States using a three-factor apportionment formula, similar to many state apportionment formulae. For a detailed analysis of the CCCTB proposal and its expected effects, see Robert Cline, Tom Neubig, Andrew Phillips, Christopher Sanger, and Aidan Walsh, "Study on the Economic and Budgetary Impact of the introduction of a Common Consolidated Corporate Income Tax Base in the European Union," a study prepared by Ernst & Young LLP for the Irish Department of Finance, Jan. 2011.

15 The U.S. Supreme Court has determined that under the U.S. Constitution, state corporate income taxes must treat domestic and foreign dividends equally in terms of dividends received deductions. See Kraft Gen. Foods v. Iowa Dep't of Revenue & Finance, 505 U.S. 71 (1992).

16 The unitary principle is a unique state tax concept (upheld by the U.S. Supreme Court) that allows states to tax the combined income of related companies as though they were operating as a single business. The combined income is then apportioned to a state using the apportionment and allocation principles described above. Unitary combined reporting is required in almost half of the states that impose a corporate income tax.

17 Several unitary combined states provide taxpayers with the option of filing on a worldwide combined basis that includes all unitary affiliates, both domestic and foreign, in the tax bases. The combined income is then apportioned using the factors of all members of the combined group.

18 See Ernst & Young LLP's State and Local Tax Weekly Alert, "Michigan legislature approves repeal of MBT and adoption of corporate income tax, provides mechanism for claiming credits," Tax Alert 2011-888, May 22, 2011.

19 The transition to the new C corporate tax system may, in fact, take a number of years. Taxpayers can elect to remain under the MBT until they exhaust unused credits (certificated credits) from the MBT system.

20 Michigan taxed passthrough entities under the first VAT in 1954 and continued to do so under the subsequent SBT and MBT. For a discussion of the federal debate on the taxation of passthrough entities, see "Charting a Course on Tax Reform -- How the Focus on Pass-through Entities Could Shape the Debate," Ernst & Young LLP Center for Tax Policy, July 2011.

21 See Gerald Prante, Robert Carroll, and Tom Neubig, "Lowering Business Tax Rates by Repealing Tax Expenditures: An Industry Analysis," Feb. 11, 2011, for an analysis of the redistribution of tax liabilities by industry and taxpayer type from a revenue-neutral package of federal corporate income tax base broadening and rate reduction.

22 For an example of a study of the effectiveness of the federal research and development credit, see Robert Carroll, Gerald Prante, and Robin Quek, "The R&D Credit: An Effective Policy for Promoting Research Spending," Ernst & Young LLP, Sept. 2011.

23 See Ernst & Young LLP's State and Local Tax Weekly Alert, "Ohio enacts tax reform bill that phases out tangible personal property and franchise taxes, phases in a commercial activity tax," Tax Alert 2005-526, June 30, 2005.

24 See "Analysis of Changes in Ohio's Business Tax Competitiveness: 2004 vs. 2009," report prepared for the Ohio Business Roundtable by Ernst & Young LLP's Quantitative Economics and Statistics practice, Aug. 2011.

25 Ernst & Young LLP's Quantitative Economics and Statistics practice prepared estimates of the dynamic impact of all of the tax components of the Ohio reform package. Ernst & Young LLP used estimates of changes in business tax liabilities by industry to determine how the business tax changes affected the competitive rate of return on new investments in the state. The changes in after-tax rates of return were used as inputs in an Ohio economic and policy model to determine the effect of the tax changes on state jobs, income, and investments.

26 For an example of an analysis of the effectiveness of the federal research and development credit, see Carroll, Prante, and Quek, supra note 22.

27 "Commission on the 21st Century Economy Report" (Sept. 2009), available at

28 These lessons are discussed in more detail by Ernst & Young LLP's Robert Cline and Tom Neubig in "Five Federal Lessons From California's Near-VAT Experience," State Tax Notes, June 7, 2010, p. 821, Doc 2010-10973, or 2010 STT 108-3

29 For more information about the policy implications of a federal VAT, see "Value-added Tax Primer: What US Companies Should Know About Value-added Tax," Ernst & Young LLP, May 16, 2011.


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