It is well known that states use their tax systems as an economic development tool for attracting and retaining businesses. Competition among the states to attract businesses is sometimes called a "race to the bottom." States are frequently reminded of their status in popularity as a business locale by various reports that rate and compare each state on their business climate. Tax incentives result in lower tax bills for businesses making the provisions vulnerable when states desperately seek revenues. In tough budget times, it is a fairly simple strategy to find some dollars by postponing the use of business loss and credit carryovers and suspending the use of credits for a year or more.
Some states are making further changes by implementing plans to examine tax preferences, such as credits and exemptions. This article notes some of the common tax incentives states offer to businesses, describes some of the recent attention placed on them, the tax policy considerations and possible outcomes of the examination.
Types of Incentives
A variety of exemptions, tax credits and special deductions are offered in state tax systems. Examples include sales tax exemptions for manufacturing equipment, income tax credits for hiring certain individuals or hiring them to work in an enterprise zone, income tax credits and sales tax exemptions for certain energy efficient equipment and various types of credits and rebates for film production costs. The National Conference on State Legislatures reports that 45 states offer some types of film production incentives (see list, April 19, 2010). In addition, states may implement the use of a single sales factor for income-tax apportionment purposes as an incentive to encourage companies to locate employees and property in the state.
Selected State Actions
Sometimes a state will enact an accountability measure along with a special tax credit, exemption or deduction. Accountability measures can include temporary enactment of the preference so it will have to be reviewed. Clawback provisions might be used to require repayment of all or a portion of a tax benefit if some requirement is not satisfied, such as, for example, new employees are not employed for the requisite time period. Some tax preferences are structured such as to require the taxpayer to apply and be pre-approved in order to claim the special tax credit or exemption. (For additional information on types and uses of accountability measures, see Nellen, "Calls for Accountability: Will It Help the Overall Incentives Process?," Journal of Multistate Taxation and Incentives, June 2009.)
Recently, some states have added accountability measures to existing tax preferences or authorized or completed reviews of them. These actions may stem from concern over how to address chronic budget shortfalls or unfavorable press coverage of certain tax provisions. For example, in August 2009 Oregon enacted HB 2067 (PDF) to impose a sunset (termination) date for many of its tax preferences, such as business tax credits. In explaining the rationale for the legislation, the House Majority Office noted that there were 380 tax expenditures and that a "regular review of tax breaks and giveaways" was warranted to make sure taxpayers "are getting what we pay for." They also noted that the "cost" of the expenditures — over $30 billion per biennium, was greater than the spending for education, healthcare and public safety combined. (Press release of March 26, 2009.)
Following reports of problems with the use of film project promotion credits in Iowa, the governor suspended the program (Governor Culver press release of September 21, 2009 and Jason Hancock, "Attorney General, Auditor to Investigate Abuse of Film Tax Credits," The Iowa Independent, September 21, 2009). In November 2009, Governor Chet Culver (D-IA) created a Tax Credit Review Panel to review and make recommendations on the state's 30 tax credits (press release of November 19, 2009). The governor also noted the need to conduct a review for fiscal reasons: "In preparation for submitting my budget to the general assembly in January, we are reviewing all areas of state spending, including annual state investments in the form of tax credits."
The Iowa Review Panel issued its report (PDF) in January 2010. Recommendations included:
- Increase transparency of tax credits by having the Revenue Estimating Conference include a list of credits and amounts claimed in the Tax Receipts calculation it prepares. The goal is to enable policymakers to see the effect of the credits on the General Fund budget.
- Do not allow taxpayers to sell their tax credit to another taxpayer. The panel suggested that transferability does not improve the effectiveness of the credit programs and can lead to abuse.
- Create an "effective" return on investment calculation for each credit to help lawmakers know the cost-benefit of the programs and whether changes are warranted.
- Have all credits sunset after five years to ensure review and re-approval (or termination) of the credit and to let people know whether the credits are meeting their intended goal.
- Establish a cap for all credits to improve management of the General Fund budget.
- Eliminate eight specific credits the Panel found were not being fully utilized, were no longer needed, were improperly managed or for which resources had been depleted. The list included the film project promotion credits.
- Change the Research Activities Tax Credit so that it is not refundable for companies with gross receipts above $20 million annually and instead allow these companies to carry the credit forward for five years. This proposal was made to reduce the cost of this credit and make it more equitable.
In 2007, legislation was enacted in Maryland to create the Business Tax Reform Commission to make recommendations regarding the state's taxation of businesses. The review is to include combined reporting, other types of taxes such as a gross receipts tax or value added tax and "improved methods for evaluating the effectiveness of tax policies intended as economic development incentives." The Commission's report is due in December 2010. A subcommittee of the Commission is looking at business incentives in the tax law.
Tax Policy Perspectives
The state actions summarized above focus on the pros and cons of tax preferences to encourage some type of business activity. While tough budget situations and unfavorable press coverage can start such a review, tax system design considerations also drive the questions being raised. Principles of good tax policy, such as simplicity, equity and neutrality are often challenged by special tax provisions. For example, a credit available to certain types of businesses or expenditures complicates the tax law because special rules are needed to define the eligible activity, explain how to claim the credit and provide carryover rules and often dollar or income limitations of some sort. Equity issues arise as to why one category of taxpayers receives a lower tax bill than others, despite similar amounts of income. Neutrality and economic efficiency issues arise because the tax law is encouraging one type of investment over another.
Some would argue that preferences can be replaced with a lower tax rate that might itself be attractive to businesses and help serve a state's economic development goals. In its "State Business Tax Climate Index," the Tax Foundation ranking system favors states with simple systems with low tax rates and broad bases (see introduction to 2010 State Business Tax Climate Index (7th Edition)).
Based on the range of business-tax incentives offered by states, state lawmakers arguably tend to find that specific incentives are needed to entice certain investments or that competitive pressures are needed to attract and retain businesses that warrant the need for such provisions. In testimony before the Maryland Business Incentives in the Tax Code Subcommittee in December 2009, county economic development directors, noted various reasons why tax and other incentives are necessary. These reasons included to help ensure that the tax structure is not viewed as discouraging investment and expansion, to encourage investment in distressed communities or former Brownfield sites, to improve a company's return on investment in selecting a particular location and to be able to be considered in a company's site selection process. Commentators also noted the need to address the reality that "competition among the states is fierce" (statement (PDF) of David S. Iannucci, December 3, 2009) and that these state actions will continue unless federal action is taken (statement (PDF) of Vernon Thompson, December 3, 2009).
With tight state budgets continuing, it is likely that more attention will be given to business tax incentives. While principles of good tax policy generally discourage special incentives, the reality of state competition for businesses and long-term use likely mean that most incentives will stay, but may have new accountability measures attached to them.
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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.