Testimony Archive

Testimony of Johanna Neumann on behalf of the Maryland Public Interest Research Group (Maryland PIRG)

October 31, 2007 

Testimony before a Joint Committee of Senate Budget & Tax and House Ways & Means 

Combined Reporting 

Position: FAVORABLE

Chairman Currie, Chairman Hixson and members of the Committee:

Thank you for the opportunity to offer Maryland PIRG’s views on reforming the tax code by mandating “combined reporting.” Maryland PIRG has long been an advocate for combined reporting as way to make our tax system fairer and more efficient.

My testimony today will not focus on the additional revenues that combined reporting would make available to the budget, or how these revenues could support public structures or broad reductions in tax rates. I will instead focus on the tax-fairness and administrative problems that combined reporting would help to solve. In addition, I will discuss some of the economic impacts of combined reporting and how combined reporting is becoming standard best practice among states. Maryland PIRG believes combined reporting is a basic issue of tax fairness and tax modernization. It should be enacted regardless of the revenue consequences and regardless of the state’s budget situation.

1) The Problem that Combined Reporting Solves:

State tax systems were crafted at a time when few businesses operated across state lines. With the exception of Hawaii and Alaska – both of which have combined reporting – states’ business tax systems come from an era when tax shifting with out-of-state subsidiaries was simply not an issue.

Over the years, Maryland businesses have increasingly found themselves competing against parts of multi-state corporations with operations in multiple tax jurisdictions. That presents a quandary for assessing taxes on profits. Revenue departments face the task of figuring out which costs and revenues should most accurately be assigned to particular corporate entities. Typically, a company’s business executives themselves argue over what operations should properly be considered cost drivers and profit centers, and they often change their assessments year-to-year or quarter-to-quarter. Tax officials could not hope to accurately second-guess these assessments.

Thankfully, states created formula-based assessment. Companies pay taxes based simply on their business activity in a state. These formulas, which differ between states, require businesses to apportion their taxable profits based on the percent of sales, assets and workforce in the state.

But out-of-state subsidiaries challenge this system. Some companies can use creative accounting beween subsidiaries to avoid paying their share of taxes. Four examples:

• Inflated transactions between subsidiaries – Small-scale operations can be created in one of the few states without a general business tax, like Nevada, to avoid taxes in other states. The Nevada subsidiary may consult to its MarylandMaryland entity, for instance. If accountants for the Maryland entity artificially inflate the value of these transactions, they will raise accounting costs and thereby erase the taxable Maryland profits, shifting them to Nevada operations, or it may own the land or equipment used by the where they can not be taxed.
• WorldCom – The telecom giant managed to avoid state taxes by creating what a court later determined was a sham subsidiary in Mississippi whose only asset was the “business foresight” of its WorldCom’s top management. WorldCom then erased – on paper, at least – billions in taxable profits by having its Mississippi subsidiary charge its state operations billions in royalties for use of the foresight. The subsidiary did not pay taxes on these profits because income from intangible property is not taxed in Mississippi. WorldCom was not alone in adopting this tax strategy. It came at the recommendation of a leading accounting firm, KPMG. The facts only came to light because of a leak from some disgruntled WorldCom bond holders.
• Toys ‘R Us – Similar to the WoldCom maneuver, the toy company greatly reduces its taxable profits because operations around the country pay large fees to a DelawareDelaware where the subsidiary is based. Unlike the WorldCom strategy, this practice was declared legal by a judge after being challenged by the state of South Carolina. subsidiary for use of the “Goeffrey Giraffe” character and its logo. This intangible-property income is not taxable in
• Wal-Mart – As documented in a front-page story in the Wall Street Journal, the retail giant largely escapes taxes by creating real estate trusts (REITs) that are then paid large rents by Wal-Mart stores, reducing or erasing the stores reported profits. Real estate trusts are then exempt from paying taxes on this income. Wal-Mart claims to meet the legal requirement that a REIT have at least 100 independent shareholders because the company distributes 1 percent of its nonvoting stock to a group of 100 senior managers.

State tax authorities can not effectively police these forms of creative accounting. These examples come from court cases that have brought the practices to light. But more generally, state tax authorities are at a loss to second-guess the true value of transactions between corporate subsidiaries. Legislatures can pass laws to close particular well-understood loopholes, such as the Goeffrey Giraffe loophole. But the legislative process is slow and tax authorities can not keep up with the booming industry of consulting and banking firms that constantly invent, and sometimes

even patent, new tax-avoidance techniques. State tax authorities do not, and perhaps should not, have the resources and authority it would take to keep up with these accounting shell games. Tax authorities are simply outgunned.

Business taxes that are intended to be broad-based are instead increasingly paid by some companies but not others. As evidence, I submit to you figures on the resulting decline in state corporate income tax collections. Please keep in mind that these declining tax payments are not generally the result of falling tax rates. Also keep in mind that in lieu of receiving these revenues, state governments have had to shift the tax burden to individual households through higher taxes and fees. These charts were prepared by Harley Duncan, Executive Director of the Federation of Tax Administrators, based in Washington DC.[i]

Figure 1 shows that the effective rate of state taxes has trended sharply downward from a peak of about eight percent to a low-point below four percent. The slight upturn since 2003 may be because profits have been so high that it becomes harder to find offsetting exemptions for tax purposes. Some states have also become more aggressive in trying to close individual loopholes. 

Figure 1: Effective State Corporate Tax Rates

 

Figure 2 demonstrates what logically follows. The falling effective rate of state corporate income taxes – largely as a result of growing tax avoidance – leads to a falling share of the tax burden shouldered by corporate profits. Increasing taxes and fees on individuals have been forced to take up this burden. Nationwide, the share of state taxes paid by corporate income taxes has fallen from about 10 percent to about 6 percent. 

Figure 2: State Corporate Taxes as Percent of Total State Taxes

Figure 3 demonstrates that the declining share of corporate profit taxes in total state taxes has nothing to do with flagging profit rates. On the contrary, profits have been very strong, averaging 8 percent annual growth over the period and far more in recent years.

Figure 3: Average Change in Corporate Profits (1980-2006)

One study which looked more specifically at Fortune 500 corporations in 2003, showed that these companies paid only one-third of the statutory state-level tax rates on profits.[ii] They were able to use exemptions, write-offs, or other strategies to avoid the rest. Moreover, 28 percent of these large corporations paid no taxes at all for at least one year between 2001-2003, despite reporting $86 billion in profits to their shareholders during these no-tax-payment years. No wonder that an April 2006 Gallop poll shows 70 percent of Americans agreeing that corporations pay too little in taxes.

In Maryland, the Comptroller’s office reports that nearly half percent of profitable corporations do not pay anything in corporate income taxes. This leaves the remaining companies to shoulder most of the corporate tax burden. Tax secrecy laws make it impossible to know which companies pay tax. But in Wisconsin, the only where with a limited ability to obtain that information, a recent study found that 26 of the largest 35 companies operating in the state paid no corporate income tax.[iii]

In our opinion, these lost revenues and unpaid taxes would not be a problem if they were the result of popularly backed legislative intent. They are instead generally the result of inaction and revenue departments being overwhelmed by tax-avoidance strategies they are unable to monitor.

Moreover, as a result of these shifting tax burdens is a tax burden that places some companies operate at an unfair competitive disadvantage against others. Companies with access to high-powered tax lawyers and, most notably, those that can make use of out-of-state subsidiaries are unfairly favored by the present system at the expense generally smaller in-state businesses. We believe that Maryland will best thrive when businesses prosper based on their productivity and ability to innovate, rather than their superior opportunities for tax avoidance.

2) How Combined Reporting Works

California was the first state to create combined reporting in 1937. The state decided to get out of the business of trying to outfox corporate tax lawyers. They largely took themselves out of the business of rather than sorting through transactions between subsidiaries and trying to establish which might be sham transactions and whether they reflected the true corporate structure of these entities. Companies with subsidiaries were simply asked to file together as a single entity.

With combined reporting the question of which subsidiary should be assigned particular profits or losses becomes moot. Transactions between corporate subsidiaries similarly need no longer be scrutinized. The combined entity’s profits will still be apportioned as taxable to states based on its in-state business activity. This assures also that a combined entity can not be taxed on its same profits by multiple states.

The process works essentially the same in states such as TexasOhio that have enacted combined reporting on other kinds of broad business taxes not based strictly on income.[iv] The effect is the same: to bypass any potential accounting fictions created through the use of out-of-state subsidiaries. and

Combined reporting is also a form of tax simplification because companies can use more or less the same spread sheet in each state as an increasing number of states enact combined reporting. They must prepare a one-time breakdown of their business activity; but any multi-state company should know the breakdown of its sales, assets, and workforce by state anyway.

3) Economic Effects of Combined Reporting

There is no evidence that combined reporting has a negative impact on economic growth.

The truth is that a fair and level playing field on taxes is good for Maryland’s job growth. Since American manufacturing employment peaked in 1979, nine of the ten states with the manufacturing growth were states with combined reporting. The tenth state is currently considering adopting the practice. California, which first pioneered combined reporting in 1937, went on to grow Silicon Valley and become a national leader in high-tech industry.

A recent report commissioned by Ernst & Young purportedly showed that 18.3 jobs would be lost for every $1 million dollars of revenue gained by combined reporting. What the study doesn’t say is that removing an existing subsidy for any particular group of businesses will create employment losses, but that many more jobs may be created by alternative uses of those revenues – including lower taxes across the board.

In other words, by not adopting combined reporting MarylandMaryland taxpayers $54,645 annually per job created, while making our tax system less fair and our economic system less efficient. That’s a bad deal considering that than Maryland’s average annual wage is $44,460. By contrast, Federal Highway Administration studies show that spending on public transportation yields 47.5 jobs for every million dollars, or $21,052 per job. would continue subsidizing tax shifting companies that costs

4) Combined Reporting is Becoming Standard Best Practice

States across the nation have begun fighting back against corporate tax shelters and loopholes. New York, West VirginiaMichigan enacted combined reporting in 2007, and Governors in Iowa, Massachusetts, North Carolina and Pennsylvania all recommended that their states implement combined reporting. To date 21 states have adopted the practice and more than 50 percent of the US economy is covered by combined reporting laws.

Several factors are driving this year’s reform efforts.  First, high-profile court cases have publicized corporate tax-avoidance strategies that highlight the weakness of existing laws. Exposure of practices at prominent corporations mentioned earlier such as MCI/WorldCom, Toys R’ Us, and Wal-Mart have raised public awareness of aggressive corporate accounting strategies that shift the tax burden away from large corporations through creative use of the tax code.

Second, there is a growing awareness that these loopholes are not necessarily good for business. Arnold Hiatt, former CEO of Stride Rite shoes in Massachusetts, wrote to the Boston Globe that tax reforms including combined reporting, “would benefit our state’s business community by leveling the playing field among businesses.” Although most tax-avoidance strategies are perfectly legal, they disproportionately benefit larger companies that work across multiple states. As a result, smaller in-state businesses find themselves at a competitive disadvantage.

A third factor driving reform has been support from elected officials who face additional revenue needs and understand that closing tax loopholes will make it possible to avoid levying new taxes. As you are I’m sure well familiar, rising health care and energy costs demand more revenues for schools, roads, and other public structures. Unfunded federal mandates for state spending on things like homeland security have further dilutes scarce state resources. In this context, the failure of multi-state companies to pay taxes have put elected officials in a double bind. As legislators, you often have fewer dollars available to meet public needs, and end up asking smaller companies and the citizens who elected you to pick up the tab.

Conclusion:

In conclusion, combined reporting makes sense as a tax simplification that modernizes the tax system and levels the playing field between businesses. I urge the members of the Committees to support combined reporting.