Legislators Let Corporations Dodge State Taxes

Ohio's primary business tax has shriveled significantly over the past three decades. Accounting for 16.45 percent of the general revenue fund in 1972, the corporate franchise tax comprised only 7.27

Ohio's primary business tax has shriveled significantly over the past three decades. Accounting for 16.45 percent of the general revenue fund in 1972, the corporate franchise tax comprised only 7.27 percent of that fund in 1999, a year in which corporate profits were near historic highs.

Relative increases in other taxes accounted for some of this withering, but corporations are forking over a markedly smaller share of their profits to the state, according to William Fox, a University of Tennessee researcher and economics professor. In 1986 businesses paid state taxes equal to 8.8 percent of their income. By 2000 that percentage had dropped to 4.6 percent.

Several explanations for this reduction stand out in expert testimony presented to the Ohio General Assembly's Committee to Study State and Local Taxes, whose final report is due March 1.

One such explanation is the rapid proliferation of S-corporations, limited liability corporations and other "pass-through entities," so called because their income is not subject to corporate taxes but is instead passed through to shareholders and taxed as personal income.

According to data presented to the tax study committee by Dan Bucks, executive director of the Multistate Tax Commission — an agency of state governments that monitors tax implications on interstate commerce — S-corporations now comprise 10 percent of all businesses. For-profit corporations, which accounted for 16 percent of all businesses in 1986, now account for only 10 percent.

This transition from for-profit corporations to pass-through entities does not merely represent a one-to-one re-classification of revenue from corporate franchise taxes to personal income taxes.

The overall tax liability of pass-through entities and their shareholders is less than that of corporations and their shareholders.

In its 2002-2003 Tax Expenditure Report, the Department of Taxation estimated that Ohio would have raised an additional $357.7 million during the four-year period ending June 30, 2003 if S-corporation income had been taxed as corporate profits instead of as personal income. This estimate ramped up during the period, indicating even larger losses in the future, as pass-through entities continue to proliferate.

But even for-profit corporations can sidestep taxes.

Several experts, including Bucks, presented data to the tax study committee showing that, although Ohio has a high statutory corporate tax rate — 10.5 percent on all income over $50,000 when state and local rates are combined — it collects a surprisingly small percentage. In 2000, the effective combined tax rate — the percentage of taxable corporate profits collected after credits and exemptions — was only 5.1 percent.

In the committee's December meeting, Tom Zaino, Ohio's tax commissioner, reluctantly admitted this problem.

"[The corporate franchise] tax may not be as productive compared to other states," Zaino's presentation said.

In a different section of this presentation, Zaino noted "concern with integrity of the [corporate franchise] tax due to aggressive tax planning..." and that "many corporations are paying their fair share while other corporations may not be."

The big gun of the aggressive tax planning mentioned by Zaino is income shifting, one form of which is illustrated in Ohio's Vanishing Corporate Franchise Tax, an October 2002 report by Zach Schiller, a researcher with fiscal watchdog Policy Matters Ohio.

"One tactic that has proliferated is the establishment of companies in other states, such as Delaware ... which tax corporate income at a lower rate," the report says. "The parent next transfers its trademarks or other intangible property to them. Then the operating company pays a fee to the Delaware company for the use of the mark, reducing its income in its own home state and lowering the corporate income tax it would pay."

Ohio law, either purposefully weak or poorly drafted, ineffectively confronts this practice by nullifying such transactions only if the fees are paid to passive income entities, non-operating subsidiaries that merely hold assets. Unhampered by this provision, many Ohio companies shift income by paying such fees and expenses to operating subsidiaries.

Mandatory combined reporting would effectively close this obvious loophole. Under this method, corporations would consolidate all U.S. operations before determining, under an allocation formula, which income is taxable in Ohio. Currently employed by 16 states, such a requirement would eliminate income-shifting schemes.

In an interview with Schiller, Department of Taxation administrators Carol Bessey and Frederick Church estimated that mandatory combined reporting would yield an additional $200 million in annual revenue.

The third factor that has led to the shrinking of the corporate franchise tax is the Ohio General Assembly. In the heady days of 1997, lawmakers capped the net worth component of this tax at $150,000, lopped nearly one-third off the net worth tax rate, trimmed the maximum corporate income tax rate by 4.49 percent and cut the rate applicable to financial institutions by 13.33 percent.

According to the Legislative Budget Office, these cuts will cost Ohio $266.8 million for the five-year period ending June 30, while corporate tax credits will cost another $507.2 million over the same period. Unless the legislature reverses these changes, similar losses can also be expected in future years.

Even prior to these cuts and credits, most of which became effective in 1999, Ohio did not appear to present an anti-competitive burden to corporations.

Examining Ohio's pre-1999 corporate franchise tax and the available credits and exemptions in their entirety, the Wisconsin Department of Revenue considered them to be less burdensome than the business taxes of 10 of the 18 states examined.

Michael Wasylenko, a Syracuse University researcher and economics professor, found that 29 other states had heavier corporate tax burdens than Ohio's pre-1999 system.

Wasylenko and many others, however, found Ohio's net worth tax to be anti-competitive to capital-intensive companies, who generally have a high net worth relative to their income.

Faced by the apparent inequity of this tax component, the legislature should have examined the state's long-term needs and constructed an equitable and adequate corporate tax code. Instead, shortsighted lawmakers slapped a cap on the net worth tax, cut corporate franchise tax rates across the board and allowed obvious, well-documented loopholes to slash those statutory rates even further.

While seriously jeopardizing the state's fiscal health, the General Assembly's corporate tax giveaway has done virtually nothing to improve Ohio's abysmal competitiveness: Only two states rank lower than Ohio in attracting new business.