States without an income tax - good idea?

California's largest tax revenue source by far is its personal income tax. This tax generated 67% of total tax revenues for FY 2012-2013's General Fund. As shown in the pie chart from the California State Controller's Office, the corporate income tax only provided 8% of state tax revenues.


Source: California State Controller

Seven states do not impose an income tax and two states impose it on only a portion of one's income. How can they do that? A recent article in Cleveland.com answers that question. See "No-income-tax states use other taxes to pay the bills: Axing Ohio's Income Tax," by Robert Higgs, 10/2/14.

The seven states without an income tax are:

• Alaska (relies on significant oil taxes)
• Florida
• Nevada
• South Dakota
• Texas
• Washington
• Wyoming (also relies on significant oil severance tax)

See the article for details on how the other states manage.

Is it good to not have a state income tax? I say no regarding the personal income tax and maybe regarding the corporate income tax. For states that don't have few people and lots of oil, lack of a personal income tax means greater reliance on the state sales tax, which is a regressive tax. While Nevada and Florida are able to get tourists to pay a good amount of the sales tax, that is not true in all states and Florida have a greater population than Nevada (for 2013, 19.5 million for Florida and 2.78 million for Nevada, per US Census Bureau).

The problem with the sales tax is that it results in lower income individuals using a larger portion of their income to pay it relative to higher income individual (making it regressive). In contrast, the income tax is progressive and even more progressive if tax rates increase with income. High income individuals get a significant tax break if their income is all earned in a state without an income tax. They likely only spend a small portion of their income, so do not pay much in sales tax (again, relative to their income).

Another benefit of having an income tax is that a balance of taxes can help improve revenue stability. For example, an economic downturn might hurt income tax revenues quickly, but not so quickly with respect to sales and property taxes.

So far as the corporate income tax, I think states should consider eliminating it. Already, most states have significant tax benefits to lower corporate taxes and entice corporations to do business in their state. The state will still make revenues from the spending and the wages paid to employees. The tax incentives include single sales factor apportionment (so state income taxes don't go up when you put more property and employees in the state), film credits, R&D credits and various energy and equipment purchase credits. These special rules also add more complexity to the law.

But, elimination of the corporate income tax is not as easy as it might sound. Many businesses operate as LLCs, partnerships or S corporations. The taxes paid by these entities mostly shows up in the personal income tax piece of the revenue pie. It doesn't seem fair to continue to tax these businesses, but not ones that operate in the corporate form. What happens if these businesses convert to the corporate form?  They still have federal income taxes. It could turn into a tax shelter as well if people place investment assets in corporations. Then you need rules to prevent that. So, we end up with a complex corporate income tax that produces a small amount of revenues. Oh well.

What do you think? (about a state having no income tax and elimination of the corporate income tax)

Uniformity of State Tax Laws - Possible? Desired?

When businesses operate in more than one state, the question arises as to how to determine how much of its income should be subject to tax in each state in which it is subject to tax. This is a matter that has been argued at the Supreme Court level numerous times and states have modified their approaches over the years.

Decades ago (1957), the National Conference of Commissioners on Uniform State Laws (NCCUSL) drafted the Uniform Division of Income for Tax Purposes Act (UDITPA). It was last amended in 1966. UDITPA provides rules on apportionment and allocation of multistate business income among states.

In 2007, NCCUSL decided to form a committee to look at changes to update UDITPA. Section 17 of UDITPA which deals with sourcing of sales that are not of tangible property was to be a focal point, but other areas could be looked at as well. Section 17 was clearly outdated. UDITPA provides that sales of tangible personal property are sourced to the destination state. Section 17 uses a costs of performance sourcing rule meaning that typically, sales of services and intangibles are sourced to the origin state. Several states including California have modified their laws to source services to the market (destination) state.

The Committee held its first meeting in late May 2008. There were protests by some businesses urging NCCUSL to terminate the project (see letter submitted by COST and a business coalition). Yet, others supported the project (see, for example, letter from Utah).

Uniformity among states cannot be guaranteed through a UDITPA revision though because states are not required to adopt the Act.

Well, on June 30, the committee voted to recommend termination of the project. Basically, it doesn't meet the goals for a uniform law if it is unlikely that any state is going to adopt the model law.

So, does this mean that Congress might step in?

I doubt it. If Congress took on how to source and apportion income among the states, there would be long debate among members of Congress, the business community and state governments (and some academics, of course) as to what the uniform rule should be. I think Congress is well aware that the states are struggling with how much to tax businesses versus how much to incentivize them to locate or stay in their state. While there has been some concern expressed in the press (Business Week, 7/1/09) as to whether federal stimulus dollars are being spent on state corporate tax breaks, I don't think Congress is going to step in.

Congress already has multistate issues on its plate that it has not be able to resolve in the past 6+ years - (1) updating PL 86-272 and (2) legislation to allow states to collect sales tax from remote vendors.

Perhaps states will move to uniformity given that more are moving to a single sales factor and sourcing sales of services to the market state (which makes sense to do along with a single sales factor if the state is trying to encourage businesses to locate property and payroll in the state). But, when (if) all states have these rules, the economic development aspect of it will be diminished - because all states are then offering the same incentive. So states will then have to find some other incentive to keep and attract businesses. It could be lower rates, more tax credits (such as hiring credits and R&D credits) or even repeal of the corporate income tax.

So, let's see what happens next. What do you think?

Public Law 86-272 - Upcoming 50th Anniversary of Stopgap Legislation

In reaction to a US Supreme Court decision - Northwestern Cement v. Minn., 358 US 450 (1959), which many members of Congress thought would lead states to tax businesses beyond what they should under the commerce clause, Congress enacted Public Law 86-272 on September 14, 1959. Despite the lack of an expiration date in this legislation, it was described as a temporary measure while Congress further studied state taxation (a study established by PL 86-272). The report was completed in the mid-1960s (referred to as the Willis Commission report after the Congressman who chaired the subcommittee). However, PL 86-272 was not revised.

PL 86-272 explains when a state may impose income taxes on multistate businesses selling tangible personal property. Businesses selling services or intangibles, get no protection (or guidance) from the federal law. With more businesses selling services and intangibles today than in 1959, PL 86-272 is in need of updating. There have been various congressional proposals in the past few years, but no changes have been enacted and there are differences of opinion between state governments and businesses on what the reforms should be. Also, recent court decisions have held that "economic presence" is sufficient for a state to be able to impose income tax obligations on a business (businesses believe that "physical presence" should be the standard). The US Supreme Court has declined to hear any of these cases. Meanwhile, the 50th anniversary of this stopgap legislation is approaching.

For background on PL 86-272 and the case that led to its enactment, click here.

For links and related information on PL 86-272 and the current controversies in attempts to modernize this nexus rule - see this website.

Do you think temporary law PL 86-272 will be updated before its 50th anniversary on 9/14/09? If no, why not? If yes, what will the new version look like?