It's Time to Abolish State Corporate Income Taxes

Corporate tax reform is hot in Washington right now. President Obama called in his State of the Union for a revenue-neutral corporate tax reform that would lower tax rates -- since a recent tax cut in Japan, the United States now has the highest corporate income tax rate in the OECD -- while closing loopholes and broadening the tax base. The House Ways and Means Committee held the first of what are likely to be several hearings on the matter last month.

But if discussions of corporate tax reform focus solely on the federal tax code, we will miss an opportunity: the chance to abolish state and local corporate income taxes. Instead of focusing on lowering the federal rate, Congress should broaden the federal corporate income tax base and then forbid states and localities to tax corporate income -- replacing their foregone revenues with an unrestricted federal block grant.

Currently, states and localities collect about 14.7 percent of all corporate income tax in the United States in a typical year. (Local corporate income tax is rare; notably, New York City levies one.) Yet, because of a lack of uniformity in tax law and the complications associated with apportioning corporate income among states, state and local taxes account for about 30 percent of large companies' income tax compliance costs.

But more important than direct compliance costs are the economic distortions caused by state corporate income tax. Multistate corporations have significant leeway to determine the jurisdiction in which their income will be taxed -- whether by actually moving operations or through accounting shifts -- which had led states to enact beggar-thy-neighbor tax policies aimed at luring the most mobile firms to change states. When firms make business decisions designed to maximize tax advantages instead of pre-tax profits, the result is economic loss.

Meanwhile, in the last several decades, state corporate income tax revenue has dropped significantly as a share of the economy. David Brunori, a left-of-center tax law professor at George Washington University, characterizes the state corporate income tax as a "nuisance tax" and favors repeal. He says: "It does not work for a variety of reasons, and the primary reason is... state competition." Essentially, states have competed to sharply narrow their tax bases, and the state corporate tax has become more trouble than it's worth.

Of course, the 44 states that do tax corporate income are reluctant to repeal their taxes, as the taxes still do generate some revenue. Only the federal government has the power to wipe away this patchwork of nuisance taxes with a blanket prohibition on states levying them.

What would a world without state corporate income tax look like? It doesn't have to mean taking a crippling bite out of state revenues. By expanding the federal tax base and offering an unrestricted grant to state governments, the federal government can replace states' revenue loss. Even if structured in a revenue-neutral manner, this reform would improve the economy for two reasons: the combined federal-state corporate income tax rate would be lower, and federal corporate income tax is more economically efficient than state corporate income tax.

Conversion to a federal block grant would also make it possible to address one of the key drawbacks of corporate income tax as a government funding source: volatility. For example, state corporate income tax receipts were 17 percent lower in 2008 than 2007, according to Bureau of Economic Analysis data. While the federal government can run deficits to adjust for the effects of volatile revenues, states are forced to take painful fiscal adjustments when revenues fall sharply.

The federal grant should aim to replace the approximately 14.7 percent share of corporate tax revenue that goes to states under the current system. (That's the average figure from 1999 to 2008). But to avoid volatility, the grant should be smoothed based on a revenue trendline from the previous ten years, instead of equaling 14.7 percent of actual corporate tax revenues in the current year.

As an example, based on performance from 1999 to 2008, expected corporate tax revenues at all levels of government in 2009 were $412 billion, implying a state and local share of $60 billion. But due to the recession, actual revenues were just $232 billion. Under my plan, states would receive that $60 billion payment from the federal government anyway; conversely, when corporate profits are rising sharply, states could expect to receive less than 14.7 percent of actual receipts. Effectively, this would mean the creation of a new (though not especially large) automatic stabilizer.

There are some issues that would arise with a move to federal-only corporate income tax. One is the question of how to apportion grant funds among the states. Simply apportioning the receipts on a per-capita basis would transfer funds from rich states to poor states (as all major federal taxes do now.) Apportioning the funds in proportion to state GDP would reduce these transfers, though not eliminate them, as corporate profits make up a different share of GDP in different states.

It's also important to note that a reform that is revenue neutral nationally would not be revenue neutral for each state. States that currently place little reliance on the corporate income tax (or do not levy one at all) would get a revenue boost, while states with heavy reliance on such taxes would need to close a shortfall. In most cases, these effects would be small, as corporate income tax accounts for less than five percent of state and local government receipts. But some small states (notably, New Hampshire and Alaska) would need to levy significant new taxes to replace the substantial corporate income taxes they levy today.

Some conservatives might object that interstate tax competition is a good thing, and that the federal government would undermine it by effectively levying a uniform state corporate income tax. But in this instance, interstate competition has mostly led to the granting of special favors and the narrowing of tax bases -- not a desirable form of competition. States would continue to compete and differentiate themselves on major taxes, especially those on personal income, sales and property.

Abolishing state and local corporate income tax looks like a bold step, but it is preferable to simply reforming the federal corporate income tax. My proposal would achieve all the same goals as a revenue-neutral federal corporate tax reform, while also reducing compliance costs and doing more to reduce the economic burden of corporate taxation. And with a consensus in Washington that corporate tax reform is needed, abolishing these taxes may be more feasible than ever.