Dr. Winslow Sargeant is the sixth Chief Counsel for Advocacy of the U.S. Small Business Administration’s Office of Advocacy, appointed by President Obama August 19, 2010. The Office of...
Cross Firm Size Variation in Subnational Taxation Under Federal Consumption-Based Taxation: Impact and Implications
United States Small Business Administration
Office of Advocacy
Cross Firm Size Variation
in Subnational Taxation
Under Federal Consumption-Based Taxation:
Impact and Implications
by Dr. James A. Papke
(Under contract no. SBAHQ-94-C-8138, an addendum to: The Differential Impact of State-Local Tax Incentives on Small Versus Large Firms, Dr. James A. Papke, contract no. SBA-8138-0A-94)
The aim of this research is to use the empirical model developed in The Differential Impact of State-Local Tax Incentives in Small Versus Large Firms to examine the comparative impact of a federal consumption-based tax on the distribution of state and local business taxes across firm size. SBA's Region V is the geographical area covered in the analysis, but the region is a reasonable proxy for the differential impacts for the entire nation.
Scope and Methodology
The comparative tax impact is measured by the effective marginal tax rate (EMTR) on an incremental investment in the corporate sector. The EMTR is the percentage by which a tax or tax system reduces the rate of return on capital investment. The EMTR calculations contained in this paper correspond to two distinct business tax systems: the current federal, state, and local system and the federal, state, and local system containing a replacement federal consumption-based tax.
Taxes, it should be remembered, have two primary effects: they transfer resources from the private to the public sector and they alter the relative prices of goods and services and factors of production.
Under the several federal proposals for replacing the current set of federal income taxes with consumption-based taxation, state and local business taxes are not allowable
deductions from the federal tax base and all capital investment expenditures are treated as current outlays. The consequences of these provisions on comparative interjurisdictional tax burdens and on the distribution of these burdens by firm size and industry type are what is being investigated.
- The current intraregional variations in EMTRs by firm size and
- industry type are relatively small, reflecting the leveling effects of the federal deduction for state and local taxes and competition-induced tax harmonization. Federal tax liabilities vary inversely with the amount of state-local taxes paid; the federal tax offset reduces the absolute burden of state and local taxes and narrows the difference in burdens within and among the states. Competition for capital investment also keeps subnational business taxes in line.
- The current system provides differential benefits to small business enterprises (firms with less than $25 million in capital assets) primarily from reduced federal corporate tax rates on the first $100,000 of taxable income and expensing of the first $17,500 of equipment purchases.
- The adoption of a replacement consumption-based tax (whether on retail sales, value added, or consumed income) means the elimination of the federal tax offset for state and local business taxes paid. Further, and more quantitatively important, full expensing of all capital investment outlays results in the imposition of a zero tax rate on the income from new capital investment.
- The heterogeneity of subnational business tax structures and the elimination of the leveling effect of the tax offset provision and the federal tax on investment returns result in significant increases in interstate variations in EMTRs.
- In some instances, the differentials are increased fivefold. Given the present intensity of tax-induced competition for new investment in economic development strategies, the higher differentials would likely heat up the tax-bidding war between the states and drive subnational business taxation to its lowest common level. The location of capital resources in response to tax-cost differentials instead of to real differences in profitability could generate general welfare losses.
- Although firms of all sizes and industries show reductions in EMTRs under federal tax restructuring, small business enterprises gain less relatively (i.e., lose more) because they are differentially benefited under the current tax law.
- The competitive relationship between small and large firms would be altered significantly.
- A comparative analysis of a value-added tax (VAT) versus a
- corporate net income tax indicates that small businesses would be disadvantaged under the VAT. The VAT would bear more heavily on low-profit and marginal operations, on businesses with comparatively low capital expenditures, on labor-intensive enterprises, and on firms that rely on debt versus equity for raising capital.
If capital income is freed from taxation, some other source or use of income must be exploited to maintain revenue neutrality.
Fundamental federal tax restructuring cannot take place in a vacuum; the starting point is the existing federal, state, and local tax system and the economic, political, and fiscal interrelationships and institutions that have developed over time. Subnational governments' reactions must be taken into account in any realistic assessment of the current reform proposals.
Long-term commitments are made on the assumption that the present tax system will continue. Any change in tax rules will impose windfall gains and losses on different segments of the economy. It is the responsibility of policymakers to balance these gains and losses at the margin based on the best information available.
The addendum is available from:
National Technical Information Service
U.S. Department of Commerce
5285 Port Royal Road
Springfield, VA 22161
(703) 4874639 (TDD)
Order Number: PB96-131321
Cost: A09; A02 Microf.
Also available from NTIS: The Differential Impact of State-Local Tax Incentives on Small Versus Large Firms, Dr. James A. Papke, 167 p., contract no. SBA-8138-0A-94. Refer to Order No. PB96-131321.
*Last Modified 6-11-01