State Corporate Rates Still Matter Under Single Sales Factor Apportionment
Officials in New York and elsewhere appear to have convinced themselves that state corporate income tax rates are irrelevant under single sales factor apportionment. Their misapprehension has real consequences for state economies.
SALT News and Updates
Hawaii Gov. Josh Green has floated the possibility of partially reversing the state’s recent income tax cuts, retaining cuts to lower rates but restoring higher rates for the top brackets, in response to the state’s budget challenges.
Illinois has decoupled from full expensing for machinery and equipment and updated its statutes to transition from taxing GILTI to the much more expansive NCTI.
Worth Reading
Significant tax changes will go into effect in many states on January 1st. My Tax Foundation colleagues Nicole Fox and Jacob Macumber-Rosin have a round-up.
State Tax Competition Under Single Sales Factor Apportionment
New York policymakers appear to believe that, in an era of single sales factor (SSF) apportionment, corporate rates don’t matter. They’re mistaken—and understanding why is important for lawmakers everywhere.
New York Gov. Kathy Hochul has been guarded in her comments on the possibility of raising the state’s corporate income tax, but in private conversations with NYC Mayor-Elect Zohran Mamdani, her office reportedly takes the idea of raising the state’s corporate income tax rate to 11.5 percent seriously.
Mandani characterizes this as matching New Jersey’s top corporate rate, currently the highest in the country, but the comparison is misleading. The New York City metropolitan area has three layers of corporate taxation: the standard state corporate income tax rate (currently 7.25%), a 30 percent MTA surcharge (which functionally adds 2.175% to the rate), and New York City’s 8.85% corporate tax, for a combined rate of 18.275%. If the state’s rate increased to 11.5%, the MTA surcharge would be worth 3.45% for a combined increase of 5.525% and an all-in rate of 23.8% on corporate income apportioned to New York City.
To put this in context, just the proposed increase is about in line with the total rate in many states. At 23.8%, state and city corporate taxes would exceed the federal burden (21%) and roughly match the average burden of OECD countries.
Lawmakers sometimes convince themselves that corporate rates don’t matter since, under single sales factor apportionment (where the taxable share of a multistate corporation’s profits is assigned based on the share of sales into that state), companies can only avoid burdens by restricting their markets. Moving payroll or property doesn’t make a difference.
There is truth to this, but it ignores two important points: one, the tax discourages businesses from expanding physical operations to increase their sales footprint in local markets, and two, it has the potential to drive up prices for local consumers. These effects are largely hidden from residents, who won’t connect higher prices or reduced consumer choice to high corporate rates, but that doesn’t make them any less real.
Corporate tax incidence and its economic consequences is hotly disputed. A popular public finance textbook observes that “[t]he incidence and long-run economic effects of corporate income taxes is one of the most unresolved and controversial topics of public finance. The special aspects of state government use of corporate income taxes, especially formula allocation of the tax base, complicate matters still further.”1 Even while acknowledging competing estimates, however, we’re not left entirely in the dark. There are some things we can say with considerable confidence.
The first is that corporate income taxes are uniquely harmful to the economy. Studies routinely report employment, wage, and establishment elasticities of -0.4 or more, meaning that jobs, wages, and the number of corporate establishments each decline by more than 0.4% for each one percentage point increase in the corporate tax rate.2 These are economists’ results even with the prevalence of sales factor apportionment, which should attenuate some of the localized effects of corporate income taxation.
The second is that the burden of corporate income taxes falls on three groups of people: owners/investors, in the form of lower return on their capital investment; workers, in the form of lower wages; and consumers, in the form of higher prices. Estimates of incidence vary and can differ based on industry, state tax structures, how highly capitalized a market is, and more. But the incidence on owners and investors is far lower than most people likely believe.3
And the third is that apportionment matters—though not always in the ways policymakers anticipate.
Under formulary apportionment, the corporate income tax is essentially a factor tax: while its base is net income (profits), its channels are payroll, property, and (increasingly) sales. The economist Charles McLure long called the corporate income tax a set of three taxes on sales, wages, and property. Now, in most states, it is primarily a tax on sales. The upshot is that a substantial share of the tax’s incidence will come in the form of an implicit sales tax, raising prices.
Research bears this out. One study finds that every percentage point increase in a state’s corporate tax rate leads to a 0.24 percentage point increase in retail product prices. The researchers find that, when effects on prices are taken into account, 52% of the corporate income tax’s incidence falls on consumers, 28% falls on workers, and only 20% falls on shareholders.4
If anything, the 0.24 percentage-point increase in retail prices is a lower bound estimate, given the study’s design. The researchers employ an identification strategy that relies on comparing the prices of products sold in one state that are produced by firms with significant operations in different states, exploiting rate increases in the production states (which are exogenous to demand conditions in the destination state) and ascertaining whether prices rose in the destination states.
Given how many of the states in which production took place have single sales factor apportionment, and given that the study measures a rate increase in the production rather than sales market, an elasticity of 0.24 is notable. It’s indicative of a highly robust sales effect for corporate income tax increases, if it would show up even under these circumstances. In more concentrated markets (where there’s less competition), the researchers find an even higher price pass-through, with an elasticity of 0.31.
The study could not explore the impact of destination-state SSF corporate income tax increases due to its design. But if tax increases in other states raise prices, we should expect an even greater effect within the state that raised taxes.
Not everyone expects this, however. The economic development argument for single sales factor apportionment is that it diffuses costs and concentrates benefits. Because the tax falls on sales rather than in-state payroll or property, the tax falls on capital investment nationwide, but the taxing state gets the full benefit of the revenue.
There’s something to this. Sales factor apportionment doesn’t have the same disincentives for locating payroll and property in a given state that traditional three-factor apportionment did. But consistent economic findings that higher corporate rates hurt state economies, even under SSF apportionment, should tell us it’s far from the whole story. McClure and others provide a clue to what’s going on.
Even in today’s global economy, many C corporations are regional, and they experience the full brunt of a state’s high corporate income tax. And even many national and multinational corporations have business models that require them to enter specific geographic markets. Large brick-and-mortar retailers are an obvious example, though far from the only one. Many service businesses also need a meaningful local presence to operate in a given market. If selling into New York City yields a 23.8% tax on net income sourced to the city, that may well deter a large company from opening new stores there. The additional sales generate diminishing after-tax returns.
This is especially true due to how apportionment works. New York City is wealthy, but it’s also expensive. Some businesses might enjoy uniquely high profit margins in the City, but for many, margins will be lower there even if they remain profitable (and at high volume). Imagine a company has $1 billion in sales nationwide with a 5% profit margin ($50 million), and that 10% of its sales are in New York City ($100 million), but its profit margin there is only 3% ($3 million). Apportionment would expose $5 million in profits to the City, not $3 million, and tax them at high city and state rates.
That will affect businesses’ decisions to expand their footprint in a high-tax jurisdiction, as investments elsewhere could yield a far higher after-tax return. High corporate income taxes deter local investment even under single sales factor apportionment, because they reduce the after-tax gains from new sales in that market.
But what about online retailers and other remote sellers? Are they fonts of free cash for states with high CIT rates, since they are hardly likely to redline their markets, and the economic effects of the tax will be diffused nationwide? Not really.
Again, it’s important to remember here that online retailers and online service providers—however prominent when we think of big business—are a far cry from being “the economy.” More to the point, however, high state-level corporate taxes on online retailers affect that state’s economy, in the form of higher consumer prices.
We’ve known for decades that online retailers use variable pricing for many products, based on user location, interests, income, and a host of other factors. The precise details of algorithmic pricing are typically opaque. Still, given what we know about how corporate income taxes raise prices, algorithmic price discrimination is an obvious channel for adjusting prices to account for higher corporate taxes in some destination markets. When states and cities raise corporate income taxes under single sales factor apportionment, they are, to a substantial degree, taxing their own consumers.
Elected officials in New York and elsewhere might think that higher corporate taxes diffuse their adverse impact across the entire country, while concentrating the benefits of the revenue raised from those taxes. Research, however, aligns with theory: even with most states adopting single sales factor apportionment, high corporate rates hurt the taxing state’s economy, reducing gross state product, personal income, innovation, and purchasing power.
Obligatory Marketing Note
My new consultancy provides tax policy research, writing, and other services. If you are in the market for tax policy research or know someone who is, please let me know.
Please Share this Substack
If you find this Substack valuable, please do me a favor and share it with colleagues and others who may be interested. And if you haven’t yet subscribed (it’s free), please consider doing so!
Ronald Fisher, State and Local Public Finance, 5th ed. (London: Routledge, 2022), 368.
See, e.g., Xavier Giroud and Joshua Rauh, “State Taxation and the Reallocation of Business Activity: Evidence from Establishment-Level Data,” Journal of Political Economy 127:3 (June 2019). [Ungated working paper.] Many studies coalesce around similar elasticities.
See, e.g., Suárez Serrato, Juan Carlos, and Owen Zidar, “Who Benefits from State Corporate Tax Cuts? A Local Labor Markets Approach with Heterogeneous Firms,” American Economic Review 106:9 (2016). [Ungated working paper.]
Scott R. Baker, Stephen Teng Sun, and Constantine Yannelis, “Corporate Taxes and Retail Prices,” NBER Working Paper 27058 (March 2023).