Background
Apportionment Rules Dictate the Tax Liability of Multistate and Multinational Firms. Many corporations earn income in multiple states and/or countries. However, these firms report profits at the national level, therefore each state must determine how much of a corporation’s U.S. profits are subject to corporation taxes in that state. States that tax corporate income use a formula-based approach that incorporates the percentage of a firm’s national property, payroll, and/or sales in that state. There are three commonly used formulas:
- Three-Factor Method: Separately calculates the state’s share of national property, payroll, and sales, then equally weights each of the three factors by summing their shares and dividing by three.
- Double-Weighted Sales: Similar to the three-factor method, but doubles the sales share and divides by four.
- Single Sales Factor (SSF): The percentage of national sales that occur in the state is the percentage of profit subject to corporation tax.
California Has Gradually Shifted Towards a Focus on Sales. A number of past policy changes have slowly shifted California towards SSF:
- 1966: California adopts the three-factor method, along with a majority of other states following the development of the method by the Uniform Division of Income for Tax Purposes Act (UDITPA) in 1957.
- 1993: Double-weighted sales replaces the three-factor model, with the intent to provide a favorable tax environment for firms who produce in California but make sales outside the state, thus incentivizing these firms to locate facilities and employees in California.
- 2011: For a brief period, businesses were given the choice to use the existing double-weighted sales formula or elect to use SSF instead. The rationale for giving firms this option was similar to the one given in favor of introducing double-weighted sales in 1993.
- 2013: Following the approval of Proposition 39 (2012), the use of SSF was changed from being optional to mandatory for the majority of multistate businesses.
Exemptions for Corporations in Specific Industries. A firm’s business income in California is currently apportioned via the SSF. The only exception to this rule is if at least 50 percent of a firm’s gross receipts come from “qualified business activities” (QBAs). There are currently four categories of QBAs: agriculture, extractive industries, savings and loan, and banking or financial., the latter two of which were added to the list of QBAs in 1994. Firms with this exemption use the three-factor method instead.
Majority of States Use SSF. Similar to the trend in California, the majority of states have shifted towards an SSF approach in recent decades. The figure below shows the current primary apportionment formula for each U.S. state. There are 44 states that levy taxes on corporate income. Thirty-eight of those place a disproportionate weight on sales compared to property and payroll, 34 of which primarily use SSF.
Throwback Rule Increases Sales Attributed to California. Businesses often make sales in states where they are not subject to corporation taxes, either because the state does not levy a corporation tax at all or because the business does not have sufficient connection to the state to be taxed. When a business makes a sale in one of these states, the profit on this income is not taxed. California utilizes what is known as a throwback rule, where profits from sales originating in California but going to a state with no tax are attributed to California. This rule has the effect of increasing the sales factor of business in California.
Governor’s Proposal
Switch Financial Institutions to SSF. The Governor’s budget proposes to remove both (1) savings and loans, and (2) banking or financial business from the list of QBAs starting in tax year 2025. As a result, businesses in these sectors must switch to using the SSF method of apportionment.
Analysis
Some Firms Would Pay More and Some Pay Less, but Net Revenue Increase Expected. The Governor’s proposal would generate winners and losers among affected firms. Increasing the weight placed on sales (thereby reducing the weight on property and payroll) would reduce the tax burden for firms with a significant physical presence in the state while increasing the tax burden for firms located outside the state but who have a high concentration of California sales. The administration anticipates the latter effect is larger and, therefore, estimates that shifting financial institutions to SSF will increase revenues by $330 million in the budget year, declining slightly to $270 million by 2028-29.
Firms May Make Strategic Decisions in Response to Change. Businesses impacted by the Governor’s proposal could make different location and sales choices that impact economic growth in California. On one hand, SSF may incentivize financial institutions to increase their physical presence in the state, thereby generating new jobs and spending. On the other hand, an increased weight on sales made in California could discourage firms located elsewhere from providing financial services—such as loans—in California, which could negatively affect economic growth.
Empirical Evidence Provides Weak Support for Economic Development Effects. The existing literature does not provide strong support for the claim that shifting to SSF has a meaningful effect on economic development. One reason for this result is that a lot of the benefit of a reduced tax burden on property and payroll accrues to firms already located in-state and do not expand in response to the change. This is also known as a windfall benefit. Another issue in California is the interaction between apportionment and other tax rules. Specifically, when the base corporation tax rate is higher, the incentive provided by SSF to relocate employees and property is smaller. Since California has both a high tax rate for financial institutions and a throwback rule that increases the share of sales attributed to California, the economic development effect of SSF for these firms is reduced.
Rationale for Industry-Specific Exemptions Does Not Apply to Financial Institutions. There are two primary justifications for allowing exemptions from an apportionment formula. First, an exemption may result in fairer apportionment: Businesses in agricultural and extractive industries typically have a fixed production location but may make a relatively small fraction of their sales in California, and thus have a disproportionately low tax liability under SSF even though they benefit from the state’s natural resources and public infrastructure. Therefore, apportioning their income via the three-factor method may be more appropriate. Financial institutions do not have the same location dependence and can make sales in California regardless of where they are physically located, so SSF is appropriate from a fairness perspective. Second, some states provide exemptions to apportionment as a tax incentive to specific industries. However, given that financial institutions already have a higher corporate income tax rate (10.84 percent) than the base rate (8.84 percent), it seems unlikely that these businesses would fall into this category.
Recommendations
Approve Proposal to Move Financial Institutions to SSF. We recommend the Legislature approve the Governor’s proposal as there is no clear argument for financial institutions to have an exemption from the SSF. Given the broad trend towards states adopting the SSF in recent years, California broadly following suit at a minimum keeps the playing field level with its competitors.
References
Bartik, Timothy J. (2017). "A New Panel Database on Business Incentives for Economic Development Offered by State and Local Governments in the United States." Prepared for the Pew Charitable Trusts.
Giroud, Xavier and Joshua Rauh (2019). State Taxation and the Reallocation of Business Activity: Evidence from Establishment-Level Data. Journal of Political Economy 2019 127:3, 1262-1316.
Goolsbee, Austan and Edward L. Maydew (2000). Coveting thy neighbor’s manufacturing: the dilemma of state income apportionment. Journal of Public Economics 75(1), 125-143.
Mazerov, Michael. 2005. “The ‘Single Sales Factor’ Formula for State Corporate Taxes: A Boon
to Economic Development or a Costly Giveaway?” Washington, DC: Center on Budget
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Merriman, David (2015). A Replication of “Coveting Thy Neighbor’s Manufacturing: The Dilemma of State Income Apportionment” (Journal of Public Economics 2000). Public Finance Review, 43(2), 185-205.
Serrato, Juan Carlos Suárez & Owen Zidar, (2018). The structure of state corporate taxation and its impact on state tax revenues and economic activity. Journal of Public Economics 167, 158-176.
Swenson, Charles W. (2015). The Cash Flow and Behavioral Effects of Switching to a Single Sales Factor on State Taxation. Journal of the American Taxation Association 1 December 2015; 37 (2): 75–107.