Why “100% sales factor apportionment” is relevant to state policy debates over business tax cuts vs. public investments in early childhood programs

An important issue in state policy debates is the relative effectiveness, in boosting state economic development, of these two alternatives: cuts in state corporate taxes; investments in productive public services such as early childhood programs.

A crucial point is that in at least 20 states (see Mazerov 2010), the critical “export-base” businesses in the state economy are already largely exempt from the main state corporate tax. This exemption is largely due to basing the “apportionment” of corporate income to that state on sales in the state. Because these export-base businesses are already exempt from the main state corporate tax, across the board reductions in the state corporate tax are unlikely to have much effect upon state economic development.

What are “export-base” businesses and why are they important to state economic development? “Export-base” is regional economics jargon for businesses that sell their goods or services to businesses or residents from other states, or at least potentially substitute for imports of goods and services from other states.

The crucial idea is that incentives or other measures to promote the health of a state’s businesses will have a much larger effect on the state economy if directed at export-base businesses. If these businesses expand, new dollars are brought into the state economy from outside the state. This increased economic activity and the accompanying dollars will then recirculate within the state economy, with multiplier effects that further boost state economic activity. The export-base businesses will buy some of their supplies from other state businesses. The additional workers in these export-base businesses and their suppliers will spend some portion of their increased wages on retail businesses located in the state.

In contrast, if we offer an incentive or any other measure to increase economic activity of a non-export base business, this is much less likely to have large effects in expanding the state economy. The non-export base business by definition sells its goods and services to state residents or other state businesses. Therefore, any expansion of this individual business’s sales is likely to reduce sales of other businesses in the same state. The immediate net effect on state economic activity is likely to be small.

In the long-run, improving the business climate or competitiveness for all non-export base businesses may have some indirect effects in boosting state economic output. If all non-export base businesses are more competitive, this will eventually lower the equilibrium prices these businesses will charge. Lower prices at retailers will increase real wages of state workers, which will attract some in-migrants. Lower prices at business suppliers will attract some export-base businesses. However, these indirect effects are long-run and are unlikely to be as large as the state economic development benefits from directly targeting export-base businesses for assistance.

State economic development policymakers are aware of the crucial importance of export-base businesses. One policy many states have adopted to differentially attract such businesses is apportioning a business’s tax base to the state based on sales in that state.

Consider a state corporate income tax levied on business profits.  One issue is how to levy such a tax on businesses with operations in many states. In general, it is difficult to precisely allocate profits across all the states in which a business has operations. Such profit allocation will depend in part on what arbitrary internal prices the business decides to assign to shipments between its various operations.

Therefore, it has been customary for many years for states to levy taxes based on a business’s overall U.S. profits, with a formula to apportion profits to each state in which the business has operations. The traditional formula was a “three-factor” formula: one third each based on the payroll, capital stock, and sales of each state.

But many states in recent years have shifted to a formula that overweights sales, or even only uses sales to apportion a multi-state corporation’s profits across states. A crucial point is that the Supreme Court has ruled that a state cannot tax a corporation’s profits if it simply has sales in the state, with no personnel or capital stock in the state. Therefore, only the states in which the corporation has personnel or capital stock can tax the corporation, even if the corporation has sales in all 50 states.

A practical implication of this 100% sales factor formula, as administered by many states, is that only a fraction of the corporation’s profits are taxed by any state, and even a smaller portion by any particular state.

Consider a corporation that has operations in two states. Suppose that its sales are distributed across all states according to population. Suppose that the two states in which it has operations are of “average size”, meaning that the corporation has 2% of its sales in each of these states.

Then, under the way many states administer 100% sales factor apportionment, the corporation’s total national profits would be multiplied by 2% in each state before being multiplied by the state’s corporate income tax rates. Only 4% of this multistate corporation’s profits would be taxed by any state.

Formula apportionment only applies to multistate businesses. A business with operations in only one state would have 100% of its national profits taxed by that state. Thus, compared to a multi-state corporation, a single state corporation would pay 50 times as much in profits tax to that state.

Although the correlation is not perfect, multi-state corporations are much more likely to be export-base than single-state corporations. Thus, 100% sales factor apportionment acts as a large subsidy to export-base businesses.

For more on sales factor apportionment, see Mazerov (2005).

The point is that if export-base businesses are already largely untaxed by the state’s main corporate tax, then across the board cuts in a state’s main corporate tax will not much affect a state’s export-base businesses.  The tax cuts will help non-export base businesses. This tax cut will in the long-run have some modest effects in boosting a state economy. But these effects will be far lower than for business tax cuts that target the export-base sector, or business tax incentives that target new investment in the export-base sector. Across-the-board business tax cuts are not a particularly effective way to boost state economic development. Cutting educational investments to finance across-the-board business tax cuts does not make sense as an economic development strategy.

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