States have taken two different paths in response to falling revenue from corporate tax collections.On the one hand, some states have focused on lowering corporate taxes or at least changing them to make themselves more attractive for investment. At least five states have debated bills to reduce corporate tax rates in 2005, while dozens of others have introduced bills that shift corporate taxes away from the property and employees of corporations, and onto the customers of corporations.

On the other hand, some states are trying to shore up declining corporate tax collections by attempting to tax more companies with only tenuous connections to states, or by requiring combined reporting of income that typically boosts companies' tax liabilities, according to Tax Foundation staff attorney Chris Atkins.

"In many ways, states attempting to shore up corporate tax collections are fighting a losing battle against economic reality," said Atkins.

In a study of state corporate tax systems, Atkins warned members of Congress not to back efforts by states attempting to aggressively tax out-of-state firms, as rising state corporate tax burdens can hurt overall U.S. competitiveness.

"In an age of increasingly mobile labor and capital, companies are more sensitive to tax burdens than ever," said Atkins. "Rather than chasing away employers with overly aggressive corporate tax laws, states should move toward more stable and less economically harmful revenue sources."

Atkins noted that no state has ever eliminated a direct corporate tax without replacing it, but proposals to do so are gaining momentum in many states. Georgia and Utah have both introduced bills to eliminate state corporate income taxes altogether, while Kentucky and Ohio have enacted legislation to eliminate the corporate income tax and replace it with a corporate tax on gross receipts.

"Lawmakers in these states want to make their tax systems more competitive for jobs and investment in the international marketplace," he said.

Even those states that aren't discussing tax repeal are modifying their corporate taxes, according to Atkins. "Fourteen states have, or are steadily moving towards, single-sales apportionment for all or some taxpayers. Six states weight sales at least 50 percent or higher in their apportionment formulas. This year, bills were introduced in five more states and enacted in four states to move to full or modified single-sales apportionment."

"Lawmakers in these states believe that general economic growth from a business-friendly tax code will offset specific corporate tax collections," he said.

On the other hand, a number of states have raised the alarm over declining tax revenues, and are taking aggressive steps to prevent what they consider "leakage" of tax revenue, according to Atkins. As a consequence, bills have been introduced in five different states to bolster corporate tax collections through combined or unitary reporting, he said.

"These measures, however, can have a chilling effect on a state's image as an attractive place to do business, both in the national and international market, and thus, ultimately, harm the state's economy," Atkins stated.

The two groups of state lawmakers have a different worldview when it comes to taxing corporate income, according to Atkins: One sees the corporate income tax or any direct tax on corporations as an impediment to economic growth, while the other is striving to increase corporate income tax revenues.

Commentator Lee Sheppard, a frequent contributor to Tax Notes, agreed.

"We're at a fork in the road on state taxation of business income," she said. "Either the states use the powers available to them to enforce their laws, or plan on serious reductions in business tax revenues."

"The real issue is that states, other than the big ones, do not have a lot of tax administrators and an army of lawyers, and corporate taxes are a very small percentage of state revenue," she said. "So if you're running a state, you have to ask, do I spin my wheels fighting with the big corporations and their lawyers, or do I forget about it?"

However, Sheppard does not believe the corporate income tax should be entirely scrapped. "The states need money, but the corporate income tax may not be the most efficient way to get at it," she said. "If you decide to keep the income tax, combined reporting is the way to go."

Combined reporting requires the reporting of the income of a unitary business group, even though the group may operate through separately incorporated entities.

Atkins and Sheppard disagreed on what remedies states should consider. Although Sheppard argued for combined reporting, she also advocated "other simplifying approaches that do not give businesses obvious tax-planning opportunities. It also may mean ditching the corporate income tax for a value-added tax."

For Atkins, it's not a question about a tax system so much as it's a question about spending. "It depends on the state," he said. "Lawmakers in some states may have a higher appetite for public spending and not want to replace the corporate income tax. In other states, they may discard it completely and find the revenue is more than made up by a more attractive business environment."

Environmental concerns

The importance of the need for a favorable business environment is underscored by a recent Ernst & Young study that shows that only one-third of major investments in the U.S. last year came from companies that were headquartered in-state. Two-thirds of the investments were made by U.S. companies headquartered in other states or in foreign countries. "Our results indicate that nearly one-half of the investments originated from out-of-state U.S. companies and over 15 percent from foreign companies," said Tom Neubig, who directed the study. "State economic development must focus on growing companies headquartered in-state, as well as attracting new investment from foreign and out-of-state companies."

The study, Ernst & Young's first annual U.S. Investment Monitor, tracks and analyzes business capital investment location decisions within the United States.

If the tax is going to be replaced, the Tax Foundation's Atkins believes that it should be replaced by a tax on consumption. "States generally use formulas based on the portion of a corporation's property, payroll and sales that are in the state to determine taxable income attributed to the state," he said. "At each step of this process, conflict and litigation between corporations and state revenue officials is widespread, with businesses seeking to minimize tax payments and states seeking to maximize tax revenues."

"Many states have considered or passed legislation to address problems in each area, some to enhance business investment, and others to recoup 'lost' revenues," he said. "These efforts have usually led to more litigation and confusion."

"There's a widespread conception that when you raise taxes on corporations, you're hitting back at the fat cats in the boardroom," Atkins said. "But what really happens is a cascade effect. If a steel firm pays a tax on coal, that tax gets embedded in steel, which is paid for by the purchaser. It creates a tax on a tax, ending with a levy on the final user."

Those who wish to keep state corporate taxes are fighting a losing battle when stacked up against lawmakers in other states who are willing to forego state corporate income tax revenue to attract business investment, according to Atkins.

"States may one day again view the corporate tax as an important component of state revenue, but for now those who are fighting to keep it are fighting a losing battle, not only against lawmaking trends but against economic reality itself," he said.

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