A System Out of Balance Update -- Rhode Island's Corporate Income Tax Apportionment Formula

RIPEC’s award-winning report, A System Out of Balance – Rhode Island’s State and Local Tax System, urged the Governor and General Assembly to consider changing the corporate income tax apportionment formula to encourage business investments in people and property. This recommendation was based on studies and analyses indicating that Rhode Island employers may be at a competitive disadvantage in relation to firms in other states due to the manner by which the Ocean State taxes corporate income.

Arguments supporting a change in the corporate income tax system include:

•Spurring in-state investment in employment and capital;
•Taxing in-state and out-of-state businesses the same; and
•Improving Rhode Island’s economic competitiveness.

Since A System Out of Balance was published in May, additional studies have concluded that changing the method of apportioning corporate income for state tax purposes may be a cost-effective way for a state to retain and expand employment and stimulate capital investments. This RIPEC Comments summarizes some of the more recent studies that analyze the relationship between corporate income tax reform and economic development, explains the differences in the way corporate income is taxed in Massachusetts and Rhode Island, and presents updated information on state apportionment formulas.

What is the Corporate Income Tax Apportionment Formula?

In today’s global economy, taxing business income is a complicated task because many corporations generate income in a number of states and foreign nations. Given the complexity of separate state-by-state accounting for multi-state corporations, formulas are used to apportion business income to individual states.

In the 1950’s, the complexity of apportioning business income among the various states led to the development of a national standard, and in 1957, the National Commission on Uniform State Tax laws developed the Uniform Distribution of Income for Tax Purposes Act (UDITPA). The apportionment formula developed by the Commission used three equally weighted factors to apportion corporate income to an individual state – sales, property and payroll. This formula was developed to allow states to tax corporations based on the percentage of income-producing activity attributed to each state by measuring the extent to which each of these factors was located in the state.

This is how the equal weight apportionment formula works. Payroll and property are considered measures of the two main business inputs (capital and labor). These two inputs represent the supply side of the equation, while sales represent the demand side. A multi-state firm's corporate income tax liability is determined by summing the percentages of in-state payroll divided by total payroll, in-state property divided by total property and in-state sales divided by total sales. As shown in Exhibit A, these three percentages are then added together and divided by three to determine the percentage of taxable corporate income subject to tax by the state.

What is the Corporate Income Tax Apportionment Formula?

In today’s global economy, taxing business income is a complicated task because many corporations generate income in a number of states and foreign nations. Given the complexity of separate state-by-state accounting for multi-state corporations, formulas are used to apportion business income to individual states.

In the 1950’s, the complexity of apportioning business income among the various states led to the development of a national standard, and in 1957, the National Commission on Uniform State Tax laws developed the Uniform Distribution of Income for Tax Purposes Act (UDITPA). The apportionment formula developed by the Commission used three equally weighted factors to apportion corporate income to an individual state – sales, property and payroll. This formula was developed to allow states to tax corporations based on the percentage of income-producing activity attributed to each state by measuring the extent to which each of these factors was located in the state.

This is how the equal weight apportionment formula works. Payroll and property are considered measures of the two main business inputs (capital and labor). These two inputs represent the supply side of the equation, while sales represent the demand side. A multi-state firm's corporate income tax liability is determined by summing the percentages of in-state payroll divided by total payroll, in-state property divided by total property and in-state sales divided by total sales. As shown in Exhibit A, these three percentages are then added together and divided by three to determine the percentage of taxable corporate income subject to tax by the state.

While most states originally used the equal weight formula, a 1979 Supreme Court ruling allowed states to alter their apportionment formula. In an effort to encourage business to expand in-state payroll and property, the apportionment formula now used by the majority of states gives greater weight to sales. This alteration of the formula rewards firms that invest in people and property (see Exhibit D on page 4 for summary of state corporate income tax apportionment formulas).

Increasing the weight of sales and reducing the weight of property and payroll would likely lessen the tax liability of multi-state firms with significant investments in Rhode Island people and property and considerable out-of-state sales. Doubling the weight of the sales factor, as is done in the majority of states, is explained in Exhibit B below.

By way of example, suppose a multi-state firm has 70% of its property, 60% of its payroll, and 10% of its sales in Rhode Island. Also assume that this firm has taxable income of $10.0 million. As shown in Exhibit C, under the three-factor equal weight apportionment formula, the manufacturer’s corporate income tax would be approximately $420,000. Using a double-weighted sales apportionment formula, the same firm's corporate income tax would be $337,500 - a reduction of $82,500 or 20.0%.

Given the assumption that the majority of Rhode Island firms subject to the corporate income tax sell most of their products out-of-state, increasing the sales factor may serve as an incentive for multi-state firms to increase employment, encourage capital investment and expand property holdings in Rhode Island. These investments may then result in increased personal income tax collections and increased property tax revenues for state and local governments.

How does Rhode Island's Apportionment Formula Compare?

As of January 2000, 22 states double weight sales, 10 states use a hybrid formula that gives greater weight to sales, and three states (Iowa, Nebraska and Texas) use a single-sales factor when apportioning corporate income. Only 12 states, including Rhode Island, utilize a three-factor equal-weight formula in apportioning corporate income. In addition, several states treat manufacturers differently than other types of firms, further increasing the weight given to sales in order to stimulate payroll and property investments by manufacturers.

In Rhode Island, three types of firms may use a single-sales factor apportionment formula when calculating corporate income tax – regulated investment companies and brokerage firms, pension fund service firms and credit card banks. The single-sales factor apportions the corporate income tax by utilizing the ratio of in-state sales to out-of-state sales while disregarding payroll and property. All other firms subject to the Rhode Island corporate income tax must use the aforementioned three-factor equal weight formula.

Both Massachusetts and Connecticut double-weight sales in determining corporate income tax liability, and both states allow manufacturers to utilize a single-sales factor in determining tax liability.

By way of example, consider the company with an option to locate a manufacturing plant in Massachusetts or Rhode Island. For those manufacturers with significant in-state payroll and property, the corporate income tax liability for firms located in Massachusetts would be significantly less than the tax liability for Rhode Island firms. This is true despite the fact that the Massachusetts tax rate on corporate income is 9.5% and the Rhode Island rate is 9.0%.

In the example below, Manufacturer E, with minimal in-state payroll and property and a greater percentage of in-state sales, would face a higher tax liability as the sales factor is increased than would Manufacturers A, B, C and D, all of which have a greater percentage of in-state payroll and property in relation to their in-state sales.

As set forth in Exhibit D, the current Rhode Island corporate income tax system places manufacturers with a significant physical presence in the Ocean State at a competitive disadvantage vis-à-vis manufacturers located in Massachusetts. A change to a single sales factor for manufacturers in Rhode Island would eliminate the corporate income tax differential between Rhode Island and Massachusetts.

It should be noted that the lack of a "throwback rule" in Rhode Island and the presence of one in Massachusetts may be a competitive advantage for certain Rhode Island manufacturers. A throwback rule provides that sales shipped from a company in state A to a customer in state B will be assigned (or "thrown back") to state A for the purposes of apportioning corporate income tax if state B does not tax the company making the sale. In addition, many states use a throwback rule for sales made to the U.S. government. As of January 1999, 26 states had a throwback rule for non-government transactions and 29 states used a throwback rule for sales made to the Federal government. Rhode Island has neither while Massachusetts uses a throwback rule in both cases.

Does the Apportionment Formula Effect Business Investments?

Would double weighting the sales factor or shifting to a single sales factor for manufacturers have a positive effect on the location or expansion decisions of manufacturers? Does evidence suggest that changing the apportionment formula to give greater emphasis to sales is an effective and efficient way to protect and grow jobs? Recent studies suggest that the answer to both of these questions appears to be YES.

For example, a 1999 study, Coveting Thy Neighbors Manufacturing: The Dilemma of State Income Apportionment, presents evidence that the apportionment formula has an impact on a state’s manufacturing sector. The results suggest that the payroll weight is a determinant of state employment. "…For the average state, reducing the payroll weight from one-third to one-quarter increases manufacturing employment by approximately 1.1%."

Obviously, a change in the apportionment formula could result in a reduction in a state’s corporate income tax revenues. However, recent empirical studies suggest that:

…although increasing the sales weight in a state may lead to corporate income tax revenue losses, the increased employment generates an indirect source of additional personal income tax revenue. The results suggest that this additional revenue reduces and may even exceed the corporate revenue loss for some recently proposed formula changes.

One way to measure the net cost of all business tax incentives is to divide the revenue cost of the tax incentive by the number of jobs created. This dollar-per-job measure is one approach to evaluate the costs and benefits of tax incentives. Depending on the type of tax expenditure, several studies indicate that the dollar-per-job costs range from $4,500 to $60,000, but average approximately $10,000.

An evaluation of tax expenditures associated with reforming the corporate income tax apportionment formula indicates that the dollar-per-job costs are considerably less than the $10,000 average mentioned above.

For example, the costs estimated by the Departments of Revenue in New Jersey and Pennsylvania in 1995 for moves to double weighted sales were $33 million and $41 million, respectively. Assuming 1.1% growth in manufacturing employment, for New Jersey this represents an increase of between 11,000 and 17,500 jobs at a cost of approximately $6,000 per job. In Pennsylvania, whose manufacturing sector is larger than most states, the cost was estimated to be between $1,200 and $2,000 per job.

Researchers have found that "As a means of stimulating job creation, apportionment changes may be a relatively cost effective way to increase employment when compared with other economic development policies."

Revise the Apportionment Formula

Depending on sales and investment patterns, changes in the method of apportioning the corporate income tax for manufacturers will likely result in winners and losers, as well as have a fiscal impact on the state budget. However, manufacturers with a significant physical presence in Rhode Island may improve their competitive position.

Experience in other states suggests that doubling the sales factor or moving to a single-sales factor in apportioning the corporate income tax for Rhode Island manufacturers may strengthen their competitive position and create an incentive for businesses to make investments in facilities and increase employment. This is particularly relevant given the fact that both Connecticut and Massachusetts already allow manufacturers to use a single sales factor.

Because of the potential economic benefits that may accrue from modernizing Rhode Island’s corporate income tax, RIPEC urges the Governor and General Assembly to estimate the costs and benefits associated with modifying Rhode Island's corporate income tax apportionment formula.