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Chicago Fed Letter
State and local business taxation: Is there a better way?
by Richard Mattoon, senior economist

Over 80 academics, business leaders, and public policymakers came to the Federal
Reserve Bank of Chicago on September 13, 2004, to explore how state and local
governments tax business. The conference, which was co-sponsored by the National
Tax Association, examined proposals to improve business tax efficiency and equity.

In welcoming remarks, Charlie Evans,

Businesses paid $404 billion
in state and local taxes in
fiscal 2003, accounting for
43% of state and local tax

Chicago Fed senior vice president and
director of research, provided the following description from a mid-twentieth
century article on business taxation: “At
best it is the disordered product of fiscal
expediency and piecemeal legislation—a
more or less accidental conglomeration
of tax laws, enacted at different times
and applied to different businesses or
different attributes of the same business,
according to the exigencies of the moment.”1 Evans noted that although this
article was written in 1940, one could argue that the description still applies today.
Fred Giertz, executive director of the
National Tax Association, noted that
many advocate for the abolition of corporate income taxes. However, it is difficult to see what tax base might replace
this revenue source.
State and local business tax burden

Tom Neubig from Ernst & Young and
president of the National Tax Association
presented joint work identifying the total
state and local tax burden on business.2
His study measures the effects of property
taxes, sales taxes, excise taxes on business
inputs and investments, franchise taxes,
gross receipts taxes, as well as unemployment insurance, workers’ compensation,
and business license taxes. The study finds
that businesses paid $404 billion in state
and local taxes in fiscal 2003, accounting
for 43% of state and local tax receipts.

In terms of (state and local) revenue
raised by type of tax, 39% of business tax
receipts derive from the property tax.
The sales tax on business inputs is responsible for 25% of the total, while the
corporate income tax raises only 9%.
Neubig noted that roughly 67% of state
and local taxes fall principally on capital—at least initially—before the burden
can be shifted into prices or elsewhere.
Neubig also presented estimates of state
and local taxes across industries as a percentage of industry value added. For all
industries, the tax share of value added
was 3.8%, with the bulk falling on capital.
The rates varied widely across industries,
ranging from a high of 8.2% in agriculture and mining to a low of 2.2% for
services. Finally, Neubig argued that
policymakers should consider total
business taxes and determine the economic incidence of business taxes (how
much falls on resident versus non-resident consumers, capital owners, and
workers and landowners) and whether
the tax burden is proportionate to the
public services that businesses consume.
Is there a better way to tax business?

William Oakland, professor emeritus
from Tulane University, suggested that
business taxes should recoup the cost
of providing public services to businesses.
Taxation should also be firm specific—
the business tax burden should vary directly with each firm’s production activity
and government services consumed.

In this way, the tax burden acts as a price
signal for firms, voters, and state–local
governments. Applying the benefits principle would: reduce windfalls to the private sector; promote locational neutrality;
promote production efficiency; and promote better political decisions by revealing the real cost of public services and
any cross subsidy paid by business.
This system would require identifying
and apportioning the public services
provided to businesses. At the top of
the list, Oakland said, unemployment
compensation represents a direct benefit service to the business community
and should be fully paid for by business
taxes. Many public services are designed
to benefit both consumers and businesses,
such as public safety and transportation,
and these costs could be apportioned
between the two sectors. Oakland argued
that safety net expenditures and educational expenditures should not be funded
by business taxes. Because businesses
compensate workers for the cost of their
education with higher wages, taxing
businesses directly to pay for education
would amount to double taxation. In a
1995 study, Oakland and his co-author
William Testa of the Chicago Fed argued
that businesses should be responsible
for funding 16% of tax-financed state
and local combined expenditures.3
However, they estimated that 38% of
state and local expenditures were
actually supported by business taxes.
Oakland recommended the adoption of
two different tax structures. On the state
level, the corporation income tax and the
sales tax on business purchases should be
replaced with an origin-based value added
tax (VAT). This would apply to all forms
of economic enterprise, including service
firms and non-profits (since even nonprofits use public services) and would
create a large, non-distortionary tax base.
At the local level, the reliance on the
property tax should be balanced by a local earnings tax, and business property
taxes should exclude payments to schools.
Oakland concluded that this structure
would promote efficiency and identify
the true cost of public services.
Matt Murray from the University of
Tennessee presented joint work on
restructuring the state corporate income
tax.4 Murray highlighted the following

five key issues: defining the taxable base
(what businesses and types of income
should be taxed); establishing nexus
for taxation, including establishing substantive nexus (the power to tax) and
enforcement nexus (the power to compel collection); making a choice between
separate and combined reporting of
the corporate entity; determining the
distribution of the tax base for multijurisdictional firms—apportionment
and allocation rules; and determining
whether to use a throwback rule where
sales to non-tax states are included in
the sales factor numerator in the state
where the sale originated.
When it comes to defining the taxable
base, Murray said, the key is to be guided
by neutrality. The inclusion or exclusion of certain types of income should
not lead to economic distortions. In the
case of nexus, Murray favored using
an economic presence nexus standard.
This would tax income where it is earned,
which occurs at both origin and destination. Murray also favored the use of
combined reporting, where firms file a
combined tax return for a unitary group
of companies. This would help eliminate some of the distortions that can
occur through transfer pricing, the assignment of royalties, and the sharing
of overhead when separate reporting
is used. Further, in the case of apportioning the tax base of multi-jurisdictional firms, Murray cautioned that allocation
can create distortions by allowing firms
to assign income to low tax states. Finally,
Murray argued that throwback rules
create inconsistencies in the tax base by
assigning income to a state that may not
have had a role in producing the income.
Federal tax reform

Next, Rudolph Penner, senior fellow
at the Urban Institute, discussed federal tax reform. Penner noted that in
the early 1990s proposals ranged
from the adoption of a flat-rate income tax to the creation of a national
sales tax. Some bipartisan interest was
shown in a progressive consumption
tax. Efforts were also made to reduce
the tax burden on capital. However,
the removal of a tax on capital would
cause the after-tax rate of return on
investments to rise and that in turn
would lead to a rise in discount rates.

As the discount rate increases, the value
of existing capital declines. Another transition issue is the potential to have to compensate corporate taxpayers for prepaying
taxes. Corporations can accumulate many
types of tax credits and future tax savings that are often treated as assets on
the balance sheet. Tax reform that wipes
out these assets would require very high
levels of compensation that would
force any new tax structure to initially
carry very high marginal rates, which
would be politically unpalatable.
Penner noted that much of tax reform
is geared toward social engineering rather than business tax improvement. Estimates suggest that social tax expenditures
(foregone tax revenue) in the federal
budget now equal 5.3% of gross domestic product (GDP). In contrast, special
credits for business equal 1.2%. In addition, many tax reform efforts are complicated or temporary. The 1997 tax
reforms added many exemptions and
credits with little clarity, and recent tax
cuts for dividends, capital gains, and
estate taxes have all been passed as
temporary measures.
Further, even apparently clear-cut, targeted measures sometimes fall prey to special interests. For example, in response
to the World Trade Organization’s ruling
that U.S. tax subsidies to exporters are
illegal, lawmakers sought to compensate
U.S. export firms (particularly manufacturers) for losing this subsidy. However,
Penner noted, what originally was geared
as tax relief for manufacturers has broadened to cover a host of industries, including energy, tobacco, sellers of ceiling
fans, and native subsistence whalers. One
of the problems with trying to create a
tax structure that compensates firms for
lost subsidies is that it does not establish
tax incidence. As Penner noted, there is
a difference between the direct portion
of taxation that stays with the seller and
the indirect portion that is shifted forward. Ideally he argued, this would support the adoption of an origin-based VAT.
Looking ahead, Penner said that decisions would have to be made on which
expiring tax benefits will be extended
or made permanent. Second, the alternative minimum tax has never been indexed
for inflation but is now beginning to
grow very large and pervasive.

Measuring state business tax

Robert Tannenwald of the Federal
Reserve Bank of Boston discussed indicators used to rank the competitiveness, fairness, and adequacy of state business taxes.
However, he argued, many of the indicators used to judge these criteria are
flawed. Those purporting to gauge tax
competitiveness fail to provide a comprehensive assessment of the effect of
taxes on long-run profitability or the marginal return on investment for businesses. In addition, popular tax indicators
fail to account for the degree to which
business tax burdens may be shifted
over time to customers, workers, and
others. For example, one widely cited
indicator of competitiveness ranks states
based on the fees, taxes, and charges
raised per $1,000 of statewide personal
income. This measure provides no insight into the distribution of tax burdens
and public service benefits between
businesses and households. Similarly,
Tannenwald described a Massachusetts
group’s analysis of historical trends in
the revenues from the state’s corporate
excise tax as a share of total state tax
receipts and per $1,000 of personal income. In both cases, Tannenwald noted that these measures could establish
neither whether business was paying its
fair share of the tax burden nor whether
the corporate excise tax was affecting
firm profitability.
Further, Tannenwald noted that another
widely quoted business tax indicator—
the business sector’s share of total
state and local taxes—is a more passive
reflection of the capital intensity of a
state’s economy than an indicator of
Tannenwald offered a new indicator of
business tax competitiveness that compares states in terms of business taxes
paid as a percentage of profits earned
within a state. He also touted the representative-firm approach, whereby the
state and local tax liability is calculated as
a percentage of pre-tax corporate income
for a specific hypothetical firm in an industry group. However, this measure
evaluates the effect of taxes in the absence of other factors, such as relative
property and labor costs, that might
swamp the effect of the reported tax

structure. He concluded that what is
really needed is a comprehensive measure of business climate and not just
tax climate. This can only be achieved
if businesses are more willing to share
information about the effects of policy
on their bottom line.
Michigan, Illinois, and Indiana

Next, Doug Roberts of Michigan State
University (and former state treasurer
for Michigan) spoke about Michigan’s
single business tax (SBT). Adopted in
1975, the SBT was an effort to introduce
an origin-based business value added
tax (based on a benefits received principle) to replace a business tax structure
that tended to produce revenue booms
and busts. The SBT replaced seven existing business taxes with one broad
based/low rate (2.35%) tax, which could
be computed in one of two ways. A firm
could either pay a 2.35% tax against its
tax base (calculated as compensation,
profits, depreciation, and interest paid)
or pay a 1.175% tax on the basis of total gross receipts. In the latter case,
the maximum tax base could not exceed 50% of gross receipts.
Roberts credited the passage of the
SBT to a convergence of strong political leadership with a state fiscal crisis.
However, over time revisions to the
SBT have significantly reduced its revenue raising ability. Currently, the tax
is being phased out; it is scheduled to
expire on December 31, 2009.
Roberts suggested that many misperceptions have made the SBT unpopular. The
first is that it is a small business tax. In
reality one-tenth of 1% of all firms in the
state account for 27% of the revenue
raised, and 2% of all firms pay 60% of
the tax. Conversely, 27% of all firms have
no SBT liability, with 44% of all firms
paying less than $1,000 per year in SBT
taxes. The tax also drew opposition from
special interest groups that may not
have been previously subject to corporate taxation or disliked paying a tax
when their businesses lost money.
Replacing the 27% of general fund revenues the SBT provides will be difficult.
Options include keeping the SBT and
overweighting the profits factor, enacting a small SBT and combining it with
an independent corporate income tax,

or enacting both a gross receipts tax and
a corporate income tax. The greatest
challenge will be political, Roberts concluded, because any change will likely
affect a large number of firms currently
paying little or no tax.
Then, Fred Giertz of the University of
Illinois and the National Tax Association described recent developments in
Illinois, which he characterized as a
low state tax/high local property tax
state. Illinois has a moderate corporate
tax rate of 4.8% plus a 2.5% local personal property replacement tax for local
government with a sales tax on many
business inputs. The corporate tax rate
is limited by the state constitution to a
ratio of 8:5 to the personal income tax
rate. The property tax is particularly problematic for business. Not only does the
state have generally high property tax
rates, the state’s largest county (Cook)
has a classification scheme that taxes
business property more than residential
property. Giertz concluded that Illinois
has a reasonably good business tax
structure, with the exception of the property tax burden and the tendency to
offer too many types of tax credits.
Recent economic conditions have
placed greater stress on Illinois’s revenue
sources. The state had an outright decline in total revenues for three fiscal
years and current revenue growth
Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; David
Marshall, Vice President, macroeconomic policy research;
Richard Porter, Senior Policy Advisor, payment
studies; Daniel Sullivan, Vice President, microeconomic
policy research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2004 Federal Reserve Bank of Chicago
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The second part of the proposal was designed to improve economic development
and promote tax fairness. These measures
eliminated the corporate gross income
tax, increased the research and development credit, expanded the earned income tax credit, and increased the renter’s
deduction to $3,000. To pay for these measures, a business franchise tax was instituted and the rate for the corporate net
income tax was raised to 8.5%.
Sheldrake noted that the business sector
benefited from the repeal of the unpopular inventory tax, as well as the corporate
gross income tax. In addition, the property
tax burden on business assets was reduced. The major countervailing action
was an increase in the corporate net income tax rate by 0.75%. For individuals, the
reform reduced the impact of property tax
reassessments based on market value and

improved equity for low-income individuals. However, individuals faced
higher sales tax rates and cigarette taxes.

The conference discussions suggested
that state and local business taxation
still lacks clear direction. Immediate
revenue needs and political expediency
are often primary considerations in
developing tax structures. Ideally, business taxes should be restructured to
more closely reflect the benefits that
businesses receive from government.
This could improve tax efficiency and
reduce the distortions often associated
with current tax structures.

Paul Studenski, 1940, “Toward a theory
of business taxation,” Journal of Political
Economy, October.


Robert Cline, William Fox, Tom Neubig,
and Andrew Phillips, 2004, “Total state
and local business taxes: A 50-state study
of the taxes paid by business in FY 2003,”
Ernst & Young, report, January.


William Oakland and William Testa,
1996, “State and local taxation and the
benefits principle,” Economic Perspectives,
Federal Reserve Bank of Chicago, January/February.


William Fox, Leann Luna, and Matthew
Murray, 2004, “Structuring a state corporate income tax,” presentation at Federal
Reserve Bank of Chicago, September,
available at:

Chicago Fed Letter

A proposal to reform the state tax system
was initiated by then Lt. Governor Kernan,
with a goal of improving the business
climate. The proposal eliminated or reduced seven major taxes, reducing state
revenue in FY 2003 by slightly more than
$2 billion. These cuts were designed to
reduce the state reliance on the property
tax. To make up for the revenue loss, two
taxes were increased (the sales tax rate
would rise by 1% and a graduated income
tax rate was introduced) and the property tax replacement credit was eliminated.

Address service requested

Finally, William Sheldrake of Policy Analytics described Indiana’s tax restructuring experience from 2001 and 2002.
The state adopted a market value assessment property tax system in response to
a State Supreme Court order in 1998.
On average, this was expected to boost
residential assessments by nearly 33%,
representing a huge increase in residential property taxes. Changes in the
property tax system provided the state
with an opportunity to consider other
tax reform measures. Sheldrake noted
that Indiana’s tax burden was lower than
many midwestern states’ but that the
structure was relatively regressive, imposing a higher burden on lower-income
groups. In addition, Indiana’s statutory
corporate income tax rate is relatively
high for the region, and the local

property tax burden is particularly difficult for manufacturing firms with high
investments in plant and equipment.

Public Information Center
P.O. Box 834
Chicago, Illinois 60690-0834
(312) 322-5111

remains sluggish. In addition, Governor
Blagojevich has maintained his campaign
pledge of avoiding increases in the sales
or income tax base, while maintaining
service levels in K–12 education and
health and welfare. This has led to a reliance on creative solutions to fund the
budget, including borrowing, tax amnesties, fund transfers, sale of state assets,
and the use of one-time federal aid. Recently, the focus has turned to higher
taxes and fees on business. Businesses
have faced a range of fee increases, as
well as taxes on out of state gas purchases, and trucking and gambling tax and
fee increases. Giertz predicted that efforts will continue to shift the property tax burden toward business.


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