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The main factors behind the long-term weakness seen in corporate income tax collections are as follows.
Business tax incentive credits. Tax credits introduced or expanded since the mid-1970s now cost the State more than $250 million annually in foregone corporate income tax revenue.
• Investment tax credit. When first offered in 1969, the State investment tax credit gave manufacturers a credit equal to one percent of the value of the amount they invest in plant and equipment. Despite doubts about its efficacy raised in several studies, including an extensive examination by the Legislative Commission on Modernization and Simplification of the Tax Law in the mid-1980s, in subsequent years increases were phased in so that by 1990 it stood at its current five percent for investments under $350 million and four percent for investments of more than $350 million. A special credit for research and development investments, now nine percent, was added in 1982, and an additional Employment Incentive Credit was offered beginning in 1987.
When first enacted, unused ITC credits could be carried forward for up to seven years. In 1994 this was extended to 10 years and in 1997 to 15 years for credits generated on or after 1987. For 1998 to 2003, the investment tax credit was extended to securities brokers and dealers.
In 1998, according to a report by the New York State Department of Taxation and Finance, corporations earned $210 million in investment and employment incentive tax credits, used $120 million, and carried forward $1.5 billion. Credits used by securities brokers and dealers will total $75 million in 2002. Those who believe in a Laffer-curve effect assume that some of the revenue forgone through the investment tax credit may have been offset by additional investment and tax payments.
• Empire Zone credits. The State offers additional tax credits in the 71 Empire Zones located throughout the state but disproportionately located Upstate. Starting in 1986, companies making certain investments in these zones could take a credit for doing business and creating jobs there. Thirty-four million dollars in tax revenue was foregone in 2002. Qualified Empire Zone Enterprise tax credits, offered starting in 2001, will forgo $65.4 million in revenue in 2002. With the State adding another six Empire Zones to be added, it likely that the value of these tax expenditures will continue to grow.
• Miscellaneous credits. Since 2000, the State has offered an Industrial or Manufacturing Business Credit, which will cost $33 million in 2002 and, since 1999, an Emerging Technology Companies Credit that cost $8 million in 2002.
• New York City credits. New York City provides credits against the general corporation tax including a Relocation Employment Assistance Program credit.
Tax rate reductions. The State corporate income tax rate including temporary surcharges was reduced in stages from 12% in 1976 to its current 7.5%, for a total reduction of 37.5%. The reduction from 9% to 7.5% enacted in 1998 was estimated to reduce corporate income tax revenue by $230 million annually when fully effective in 2002. Bank and insurance company tax rates were similarly reduced; the bank tax rate reduction in 1999 was estimated to reduce collections by $100 million when fully effective in 2003.
The State gave up substantial amounts of corporate income tax revenue when it reduced the corporate alternative minimum tax (AMT) rate from 3.5%, the rate in effect when the AMT was enacted in 1987, to 3.0% in 1998 and 2.5% in 2000. The Legislature’s intent in enacting the AMT was to be sure that the investment tax credit and other credits could not be used to reduce tax liability to zero. Because the investment tax credit carry-forward period was extended to 15 years, companies can continue to apply these credits -- as mentioned, $1.5 billion in unused credits had been “banked” by 1998 -- to pay the reduced AMT rate for as long as a decade and a half. The Business Council of New York State continues to advocate repeal of AMT, arguing that it prevents companies from realizing the full benefit of the investment tax credit.
The City has also cut its corporate income tax (the “general corporation tax”) rate. The 10.05% rate on net corporate earnings in effect in 1976 was reduced to 9% in 1978 and, to return a windfall the City would have received through the 1986 Federal Tax Reform Act, the rate was lowered to its current 8.85% in 1987. Further changes implemented in 1988 that conformed the City to the State’s Business Tax Reform and Rate Reduction Act of 1987 included an array of savings provisions, and further changes in 1989 conformed the City to new modifications in the State corporate income tax.
Changes in the formula New York State uses to allocate corporate income to the state. Corporations that do business in more than one state must apportion their taxable income among the states where they have a presence. As in most of the other 43 states with a corporate income tax, New York’s tax code allows corporations to apply an apportionment formula that is based on three factors: the company’s payroll in New York, the value of property owned in New York, and the sales receipts allocated to New York. Starting in 1976 the formula was changed from counting the factors equally to double-weighting the receipts factor. Double-weighting receipts was intended to encourage companies to invest and hire workers in New York, inasmuch as the impact of the property and wage factors in the apportionment formula would be reduced compared to the sales factor. According to Frank Mauro, Executive Director of the Fiscal Policy Institute, double-weighting of sales reduced total corporate income tax revenue by more than ten percent, “with the benefits going overwhelmingly to a small number of multinational corporations.” New York City allows only manufacturers to double-weigh sales receipts.
A more recent change in the allocation formula will likely lead to the State losing forging additional millions – probably tens of millions -- of dollars in corporate income tax revenue. Starting in 2001, a new State law provides that receipts from financial services transactions are no longer attributable to where the service was performed (“origin basis,” usually New York City) but to where the customers were located (“destination basis,” which could be anywhere). Billions of dollars worth of financial services sales will no longer be counted when the allocation formula is applied .
Tax code loopholes, no requirement for combined reporting. In a recent article in State Tax Notes, Richard D. Pomp, former director of the New York State Legislative Commission on Modernization and Simplification of the Tax Law, attributes the decline in state corporate tax collections being experienced across the United States in part to “corporate chiefs… paying more attention to state tax matters” and to corporations “using increasingly aggressive and sophisticated tax planning strategies.”
The State has not made it very hard for them. A study of state corporate tax systems by the Center on Budget and Policy Priorities (CBPP) in April 2002 identified three loopholes in state tax systems that are causing some of the corporate income tax revenue losses being experienced in nearly every state with a corporate income tax. New York is one of eight other states that have all three of these loopholes. The three loopholes are:
• Lack of a “throwback rule” that ensures that profits earned in a state in which a corporation may not be subjected to an income tax are taxed instead by New York home state. One study found that corporate profits are affected twice as much by a “throwback rule” as by a property tax abatement or investment tax credit .
• Unbridled use of passive investment companies (PICs). Under this loophole, major corporations transfer ownership of trademarks and patents to a subsidiary corporation located in a state such as Delaware or Nevada that does not tax royalties, interest, or similar types of “intangible income.” The subsidiary charges a royalty to the rest of the business for the use of the trademark or patent. The royalty is a deductible business expense. According to the CBPP, data obtained from court cases in which states challenged PIC arrangements indicates that the sums involved “may be enormous.” In cases involving just three companies, a total of $400 million annually was shifted to such subsidiaries. Approximately one-third of the 44 states with corporate income taxes now have laws to prevent this.
Ultimately, the solution to corporate income-shifting is "combined reporting" under which an entire corporate family, including all of its subsidiaries, files a single tax return instead of the separate filing system used today. Only then is the income allocation formula applied to determine state and local corporate income taxes. Sixteen states including California require combined reporting of unitary business in some form. With combined reporting, there is no longer an incentive to transfer income among various subsidiaries to avoid taxation.
• Failure to amend the definition of apportionable “business income” to strengthen the ability to tax “non business income,” e.g., income from capital gains realized on the sale of major assets, reversions from over-funded pension plans, damage awards in lawsuits. Certain irregular transactions are considered to be “non-business income” and are not included in the income to which the state’s corporate income apportionment formula applies. New York is one of 27 states that do not define as apportionable income all the income they are permitted to apportion under U.S. Supreme Court decisions. Corporations have stretched the definition of “non-business” income to include a widening array of transactions. The CBPP says that as a result, many states are being denied their “fair share of tax on billions of dollars worth of corporate profits.”
This summer, New Jersey enacted a Business Tax Reform Act that closed these three loopholes among others. The new law was enacted after Governor McGreevey noted that corporate tax collections had declined from 15% of all state revenues to less than five percent. According to the Governor, corporations were “shifting money from their New Jersey books into out-of-state companies. Or they’re changing the structure of their companies on paper from one legal destination to another.” Richard Pomp, testifying in favor the New Jersey reform measure, said that loopholes have made that state's corporate business tax “voluntary.”
Because of loopholes, Governor McGreevey said, some 30 of the 50 largest employers in the state paid only the minimum tax of $200 a year. A study by former State Senator, Franz Leichter (D-Manhattan) in the early 1990’s made a discovery similar to McGreevey’s: major New York State employers, manufacturers in particular, were utilizing an array of loopholes to pay hardly any New York State taxes at all.
Closing these three loopholes would produce substantial new revenue for New York State and, inasmuch as the City has not closed these loopholes either, for New York City as well. The Legislative Fiscal Estimate for the loophole closing provisions of the New Jersey Business Tax Reform Act of 2002 was an additional $157 million to $220 million in 2003. Northeast Action estimates that Massachusetts would gain $106 million by enacting a “throwback” rule and closing the “passive investment company” loophole. With its much larger corporate sector, New York State and City together would likely raise several hundred million dollars annually by closing the three loopholes identified by the Center for Budget and Policy Priorities.
Without adopting combined reporting or reforms such as New Jersey’s, State and City corporate tax collections are likely to continue their long-term decline. Michael Mazerov, Senior Policy Analyst at the Center for Budget and Policy Priorities State Fiscal Project, observes that recent court decisions give New York State “no recourse” to companies shifting income and cautions that the state can not rely on the courts to stop income shifting. “The state is wide-open,” he noted in a recent interview. Other experts the author interviewed state that largely because of corporate income allocation issues, the City’s corporate income taxes are likely to continue to decline as a share of all City tax revenue.
A lower federal tax base. States and cities that have corporate income taxes like New York use federal adjusted gross income as a starting point for computing tax liability. The increasing utilization of offshore corporate tax havens and the tax treatment of stock options are among the significant factors behind declining federal corporate taxes. Because the states apply federal adjusted gross income in one variation or another, the indirect effect is the long-term decline corporate income taxes seen in states across the U.S. According to Business Week, “To avoid taxes, U.S. companies are shifting increasing amounts of assets to low-tax countries.” Tactics range from transfer pricing to moving the corporate domicile to the low-tax haven, as Stanley Works proposed to do this year. Not surprisingly, Business Week reports, U.S. corporate taxes fell from 6% of gross domestic product in 1952 to around one percent today.
In a paper prepared for a National Tax Association symposium this May, Professors William F. Fox of the University of Tennessee and LeAnn Luna of the University of North Carolina-Wilmington suggested that some of the decline in state corporate tax revenues can be attributed to “reductions in the federal corporate tax base.” As they explain, “[during the 1990s] the federal base actually has fallen about 10 percent relative to profits” and conclude, “Additional tax sheltering is one possible explanation for this decline.”
Business income “pass-throughs.” Limited liability corporations are a relatively new creation authorized in New York in 1994. Subchapter S corporations are a special type of small business that pay no federal corporate tax and are eligible for certain state tax benefits. Through mechanisms such as Subchapter S corporations, limited liability corporations, and limited liability partnerships, business profits are taxed through the personal income taxes of their owners -- that is, business earnings are “passed through” to owners and members. New York City taxes LLC income through members’ unincorporated business tax.
During the debate on the New Jersey Business Tax Reform Act, business interests argued that much of the decline seen in business tax collections could be attributed to the increased use of pass-throughs – changes in tax laws led to an increase in the numbers of Subchapter S corporations filing State corporate income tax returns since the mid-1980s -- and that most of the income lost to the corporate income tax this way was being taxed through the personal income tax.
A number of factors have either limited the impact of pass-throughs on State and City corporate income tax collections or have reduced the amount of personal income taxes collected on what was formerly taxed as business income. Among these are:
• A large share of the corporate income tax is still being paid by larger corporations, which have retained their legal structures.
• Mostly just newly established corporations organize as LLCs. Established corporations can incur substantial federal tax liabilities and administrative expenses by reorganizing as an LLC. According to an analysis by William F. Fox and LeAnn Luna, the number of LLCs increased “from a negligible amount in 1990 to about 2 percent of businesses in the mid-1990s and to over 5 percent of businesses in 2000. LLCs represented up to 10 percent of businesses in some states by 2000.”
• New York City taxes Subchapter S corporations the same as other corporations. Proposals by the Giuliani Administration to provide a Subchapter S credit against the personal income tax were not enacted.
• The City collects less when it taxes LLC income through the unincorporated business tax rather than through the general corporation tax. New York City estimates that the shift of LLC filers from the corporate income tax base to the unincorporated business tax base will reduce general corporation tax collections by an estimated $135 million in 2003 but that the unincorporated business tax will realize only an additional $70 million, resulting in a net revenue loss to the City of approximately $65 million.
• Although LLCs reduce corporate income tax collections, there is not necessarily a proportionate increase in State personal income tax revenue. Profits and losses pass directly through to LLC members. Members who are not New York residents are taxed in their home states where New York may have no nexus. As explained by Professors William F. Fox and LeAnn Luna in their recent analysis of the role of LLCs in the nationwide decline in state corporate tax revenue, even where a nexus exists tax revenue might still not be collected.
Indeed, as Fox and Luna explain, LLCs can be structured so that residents are minority owners, owning as little as one percent, with the rest owned by a corporation in Delaware or another states where the ownership interest is not taxed. The lost income might not be taxed by New York through its personal income tax inasmuch as “ownership of LLCs by large corporations, which is probably the largest source of the loss, does not result in additional individual income tax receipts.” They point out that several states have taken steps to mitigate the revenue losses such as through “increased annual fees on LLCs, imposed withholding taxes, or [they] imposed the corporate tax structure on LLCs.”
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