Protecting States and Cities From Themselves

Posted by Bob Lord

Sunday's New York Times included an excellent piece by Louise Story on the devastating effect of tax and other giveaways by state and local government to big business. 

I submitted an op-ed to the Times on how federal tax policy could be used to address this situation. They've passed on my piece, so I'm free to post it here, which I've done below. Interestingly, although they passed on my op-ed, the Times' editors used the same term I did, "Race to the Bottom," in an editorial on the same subject that appeared in yesterday's Times. Since I didn't coin that phrase, it's quite possible they came up with it independently, but, curiously, I didn't see the phrase used in Ms. Story's article.  

Anyhow, here's my idea to address this very serious problem, which, by the way, impacts Arizona in a big way.

In her piece, The Empty Promise of Tax Incentives,
which appeared in Sunday’s Times, Louise Story did a good job of shining a
light on the “race to the bottom” among our nation’s states, towns and cities.
States compete with states and localities compete with localities to give giant
(or sometimes not so giant) corporations the best “deal” in order to entice
that corporation to locate a prized plant, distribution center or other
facility there. In the long run, the state and local governments drain their revenue
bases but accomplish little else, as the tax and other incentives they offer
are matched by their competitors, thereby canceling out the competitive
advantage they sought to achieve. The only winners are the corporations.

This serious problem could be solved, or at least
ameliorated, through reform of the federal tax code. Currently, corporations
can deduct the tax payments they make to state and local governments. The value
of a tax benefit from a deduction bears an inverse relationship to the tax rate,
and therein lies the problem. As the corporate tax rate has fallen, the net
cost to a corporation of paying state tax has increased, as has the value of
state tax incentives. Thus, corporations have much to gain by “shopping” state
and local tax incentives.

This could be addressed by replacing the federal level
deduction for state and local tax payments with a credit. Whereas a federal deduction
causes the federal government to take on part of a corporation’s state and
local tax obligation, a federal credit causes the federal government to tax on
the entire obligation. The credit would have to be capped so that the states
would not use the federal tax credit as a feeding trough. Also, the corporate
tax rate would have to be increased to render the change revenue neutral at the
federal level.

If this change were made corporations would gain little by
pitting states and cities against one another in tax incentive bidding wars, as
the reduction in a corporation’s state and local tax liability would be matched
by an increase in the corporation’s federal tax liability. The benefit of the
reduction would flow to the federal government, not the corporation. The
reformed structure also could address the use of direct subsidies by state and
local governments in their race to the bottom. A subsidy would be treated as a
negative tax, thereby reducing the federal tax credit flowing to that
corporation.

This structure is not unprecedented. Until recently, the
federal estate tax code included a credit for state inheritance taxes. The
maximum available credit was based on the size of the taxable estate and was
progressive in structure. Most states simply adopted the federal credit
schedule as their schedules for their state level inheritance taxes. These
state level taxes were referred to as “pick-up” or “soak-up” taxes. The states
had no incentive to reduce their inheritance tax rates below the level of the
federal credit, because the reduction would benefit the federal government, not
the taxpayers. If the same structure were used to implement a federal credit
for state and local income tax payments by corporations, the states and their
subdivisions likely would enact soak up taxes on corporate income, thereby
restoring the revenue base the states so desperately need.   

By making this modest reform to federal corporate tax code,
we would go a long way towards ending the devastating race to the bottom Ms.
Story describes. Actually, we could go a step farther and extend this reform to
individual taxes as well, thereby ending the competition between states for
wealthy residents and retirees, and the shameful transfer of the state level
tax base from the income tax, which is progressive, to the sales tax, which is
regressive. 

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