Revised September 1, 2005

A Boon to Economic Development or a Costly Giveaway?
by Michael Mazerov

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In a number of states, business representatives are lobbying aggressively for an arcane change in tax law that could dramatically reduce state taxes on the profits of many multistate corporations.  Corporate interests are seeking a fundamental change in the so-called “apportionment formula” that is embedded in each state’s corporate income tax law and used to determine the share of a multistate corporation’s nationwide profit that an individual state may tax.  This change is being advanced as a way to stimulate job creation and investment.  There is little evidence that would happen.  Rather, the cost in lost tax revenue of changing the apportionment formula may impair the ability of states to provide vital services needed by both citizens and businesses.

How Apportionment Formulas Work

When a corporation produces and/or sells goods and services in more than one state, each state requires the business to pay tax on just a portion of its profit.  The tax laws of the large majority of states determine the portion of the corporation’s profit that is subject to tax in relation to the shares of the corporation’s total property, payroll, and sales located in each state.

Under New Jersey law, for example, a widget manufacturer that had its only factory and all of its employees in Trenton but sold all of the widgets outside the state would have one-half of its total, nationwide profit taxed in New Jersey.  (Like many states, New Jersey gives the same weight to the location of sales as it does to the location of property and payroll combined.)  The remaining half of the corporation’s profit could be subjected to tax by the states in which its products are sold.  This result reflects a broad consensus that states that provide services to a corporation’s property and workers and states that provide a market for the corporation’s output should be empowered to tax roughly equal shares of the corporation’s profit.

Now, however, multistate businesses in some states are advocating that the traditional “three factor formula” (property, payroll, and sales) be abandoned in favor of a “single sales factor” (or “sales-only”) apportionment formula.  Under a single sales factor formula, the share of a corporation’s total profit that a particular state would tax would be based solely on the share of the corporation’s nationwide sales occurring in the state.  Thus, under a sales-only formula:

The unilateral decision of a state to change from a property-payroll-sales formula to a single sales factor formula provides tax cuts to some corporations and imposes tax increases on others.  Corporations with relatively large shares of their nationwide property and payroll in a state adopting a sales-only formula but a relatively small share of their nationwide sales in that state receive tax cuts.  Corporations with relatively little property and payroll in a state adopting a sales-only formula but significant shares of their nationwide sales in that state experience tax increases. 

If all states adopted a sales-only formula, much of the tax savings received by particular multistate corporations in particular states would be offset by higher tax payments by these same corporations in other states.  That is why multistate corporations are pushing adoption of the single sales factor formula in a limited number of states but not on a nationwide basis.  By creating a situation in which apportionment formulas are not uniform among the states, multistate corporations can minimize their aggregate tax liability for all the states in which they do business by ensuring that the tax cuts they receive in some states are not offset by tax increases in other states.  (See the box on the following page.)

The Economic Development Rationale for a Sales-only Formula

Like many proposals to modify state corporate tax codes, the change to a single sales factor apportionment formula is being sold as an economic development incentive that will stimulate the creation of substantial numbers of new, high-paying jobs in any state that adopts it. As previously explained, a change from the traditional three factor formula to a sales-only formula tends to cut the corporate tax payment of any corporation that is producing goods in a state but selling most of them outside the state where the production occurs.  Accordingly, proponents of the change argue that adopting a single sales factor formula will:

These claims are substantially overstated —if they have any validity at all.  For reasons discussed below, states adopting a single sales factor apportionment formula are likely to find it a relatively ineffectual incentive for job creation and investment.

A Weak Economic Development Incentive

The claim that adoption of a single sales factor formula is likely to be a potent economic development incentive is contradicted by a large body of research on the effect of state and local taxes on state economic competitiveness.

Ford, Kraft, AT&T, and the Sales-only Formula: What Goes Around Comes Around

Individual corporations generally refrain from publicly expressing support for or opposition to single sales factor apportionment, preferring to leave the lobbying to the state manufacturers’ association or chamber of commerce.  The Ford Motor Company, Kraft Foods, and AT&T diverged from this practice in recent years; by doing so, the companies exposed the sometimes opportunistic nature of business’ pursuit of single sales factor apportionment and the substantial tax savings businesses can receive when apportionment formulas are not uniform among the states.

Ford spearheaded the victorious campaign for a sales-only formula in Michigan to be applied to that state’s “Single Business Tax.” 1  A report on the campaign in State Tax Notes observed: “Most ardently supporting the change [to a sales-only formula] are large, Michigan-based companies led by Ford and Amway.”  However, just a few years later Ford vigorously opposed Illinois’ adoption of the same policy.  This time, State Tax Notes reported: “Opponents of the [Illinois single sales factor] measure, principally Ford Motor Co.. . . argued that the new rules would be unfair to out-of-state companies. . . .”2  Ford’s inconsistent position on the desirability of single sales factor apportionment in the two states was brought to public attention by Walter Hellerstein, a leading authority on state corporate income tax law and policy.  Hellerstein observed: “What goes around comes around.” 3

Kraft Foods is headquartered in Illinois and, according to the Chicago Tribune, lobbied for that state’s adoption of the single sales factor formula.4   In early 2001, Kraft opposed Maryland’s adoption of the formula.5

AT&T is headquartered in New Jersey, and in June 2001 testified in favor of that state’s adoption of a single sales factor formula.6  Less than a month earlier, AT&T had testified against Oregon’s adoption of single sales factor legislation.7

Ford, Kraft, and AT&T were seeking what any rational multistate corporation would desire: single sales factor treatment in their headquarters and primary production states and three factor treatment in their “market states.”  The fact that corporations can reap tax savings by exploiting inconsistencies between state tax rules suggests, however, that state officials would be wise to adopt a skeptical stance toward arguments that a unilateral change in their state’s corporate tax apportionment policy will lead to more equitable tax treatment of multistate corporations.

1  “Michigan Single Sales Factor Bill Creates Controversy,” State Tax Notes, September 21, 1995.
  “Single Sales Factor Triumphs, but without Throwback Repeal,” State Tax Notes, June 1, 1998.
 “Letter to the Editor,” State Tax Notes, June 8, 1998.
  “Corporation In Line for Big State Tax Break,” Chicago Tribune, May 25, 1998.
  “Taylor Backing Tax Change,” Baltimore Sun, January 6, 2001.
  Statement of Deborah Bierbaum in support of Assembly Bill 3420, June 4, 2001.
  Statement of John McNamara in opposition to House Bill 2281-A, May 10, 2001.

Even if a state’s adoption of a single sales factor formula could potentially attract some in-state investments, the cost-effectiveness of this economic development strategy is likely to be low — much lower than other possible forms of assistance to business that can be conditioned on actual in-state job creation or investment.  Switching to a single sales factor formula automatically provides an immediate tax savings to any in-state business that sells a large share of its goods or services in other states.  A business does not have to create a single new job or make even one dollar’s-worth of new investment to reap the benefits of the tax cut.  Indeed, as Massachusetts discovered soon after enacting single sales factor legislation, companies can be laying-off employees and still obtain tax savings.  (See the text box on the next page.)  If single sales factor apportionment is adopted to promote economic development, much of the corporate income tax revenue forgone by this switch is likely to be captured by companies that are not contemplating expansion because demand for their products does not warrant it.

Former Alcoa CEO and Bush Administration Treasury Secretary Paul O’Neill highlighted this wasteful aspect of corporate tax incentives at his confirmation hearing:

   I never made an investment decision based on the tax code. . . . If you are giving money way I will take it.  If you want to give me inducements for something I am going to do anyway, I will take it.  But good business people do not do things because of inducements, they do it because they can see that they are going to be able to earn [at least] the cost of capital out of their own intelligence and organization of resources.

A Potentially Counterproductive Economic Development Incentive

The switch to a single sales factor formula does cut taxes for businesses that sell a relatively large share of their output outside the states where the goods are produced.  However, the change also automatically increases taxes on predominantly out-of-state corporations.  Even assuming that changes in corporate tax liability resulting from the change to a single sales factor formula could be large enough to influence some corporate location decisions, the fact that the formula imposes tax increases on many corporations renders it a double-edged sword.  A state’s adoption of a sales-only formula could just as easily lead to net job losses as to net job gains.

Massachusetts, Raytheon Company, and the Sales-only Formula: “Payoffs for Layoffs”

Massachusetts’ experience following its 1995 enactment of a single sales factor formula illustrates well the ineffectiveness and wastefulness of the formula as an economic development incentive.  Massachusetts enacted the sales-only formula in response to a threat by the Raytheon Company — a major defense contractor and the state’s largest industrial employer — to close plants in the state unless it were granted substantial tax relief.  A sales-only formula was high on the company’s wish-list as a mechanism for such relief.  The Massachusetts legislature initially attempted to limit the application of a single sales factor formula to defense contractors, but this proved politically impossible.  All non-defense manufacturers were also granted a sales-only formula — albeit on a phased-in schedule.

What has Massachusetts received for its $50 million annual “investment” in its manufacturing industries?  Although the experience of a single state with a sales-only formula does not prove that it is an ineffective development incentive, the initial experience in Massachusetts has not been encouraging: 

  • Between the end of 1995 and the end of 2004, Massachusetts lost more than 107,000 manufacturing jobs.  This 25 percent decline was moe than 50 percent steeper than the 17 percent decline in manufacturing jobs in the median corporate income tax state in the same period.
  • Only four states had a steeper rate of decline in manufacturing jobs than did Massachusetts over this period.
  • As early as 2000, the Boston Globe concluded “More than four years after Massachusetts enacted a controversial tax break to save manufacturing jobs in the state, there’s scant evidence the policy has worked as advertised.”

The job-creation record has been just as disappointing in the defense industry, which, unlike the rest of the manufacturing sector, was granted single sales factor treatment immediately.  Raytheon’s performance since 1995 includes the closure or sale of several major Massachusetts facilities and an 8000-person reduction in its Massachusetts workforce.  This has stirred up considerable anger on the part of labor organizations that had supported the company’s demand for tax relief.  In order to qualify for single sales factor treatment (through 1999), defense contractors were required to maintain their Massachusetts payrolls at 90 percent of their 1995 levels.  In the face of massive layoffs of its blue-collar workforce in Massachusetts, Raytheon managed to meet this requirement largely by increasing the salaries of engineers and managers.  This sparked legislation to renew the job maintenance requirement and to convert the 90 percent of 1995 payroll requirement to 90 percent of 1995 employment.  The sponsor of this legislation, State Senator Susan C. Fargo, labeled the single sales factor formula granted to defense contractors “payoffs for layoffs.”  Intense lobbying by the Massachusetts business community defeated Senator Fargo’s bill. 

Raytheon’s defenders assert that no matter how many Massachusetts jobs the company has eliminated, even more would have been lost had the state not enacted the sales-only formula.  Raytheon went so far as to release data showing that the reduction-in-force in its Massachusetts facilities has been far lower in both absolute and relative terms than that in other states — suggesting that the state’s adoption of the sales-only formula was a wise investment nonetheless.  There is a problem with this interpretation of the data, however.  The state in which Raytheon reduced its workforce the most was Texas — also a state with a single sales factor formula.  Raytheon did not explain how the single sales factor formula was responsible for the preservation of Massachusetts jobs yet did not have a similar effect in Texas. Moreover, Raytheon shifted at least one major defense contract from Massachusetts to a plant in Arizona — a state without a single sales factor formula at the time.  In recent years, Raytheon has lobbied the Arizona legislature for a sales-only formula in that state, hoping to obtain the same tax windfall there that it received in Massachusetts.

Unarguably, Raytheon suffered a considerable decline in its economic fortunes because of cutbacks in defense contracting after the end of the Cold War; some job reduction in Massachusetts may have been inevitable.  But that really is the point.  Corporations will accept tax breaks gladly if states offer them and will even lobby strongly to obtain such breaks.  In the final analysis, however, corporations almost always will locate their investments and employees where fundamental business considerations demand.  Most tax breaks simply confer wasteful windfalls on corporations, rewarding them for creating jobs they would have created anyway — or, in Raytheon’s case, even for eliminating jobs.

Changing to a single sales factor formula could be counterproductive to economic development in at least one additional respect.  As will be discussed below, the adoption of a sales-only formula can significantly reduce a state’s corporate income tax receipts.  A state experiencing a large decline in revenues either would have to reduce some spending or increase another tax.  Depending on the choice, the loss of corporate tax revenue that results from the formula shift could interfere with the ability of an adopting state to provide high-quality public services sought by businesses when they contemplate locating or expanding in a state.  This possibility must be weighed carefully against the purported positive investment incentive effects of changing to a sales-only formula.

The Single Sales Factor Formula and Manufacturing Job Retention

Proponents of the single sales factor formula generally argue that the formula’s most potent incentive effects are likely to be on the investment and location decisions of manufacturers.  Manufacturers most closely fit the profile of a business that reaps a tax cut from the switch from a three-factor to a sales-only formula, which is a corporation selling into a nationwide or worldwide market from one or two in-state production locations.

By the end of 1995, five states had enacted a single sales factor formula for manufacturers — Iowa, Massachusetts, Missouri, Nebraska, and Texas.  (Massachusetts implemented a sales-only formula immediately for defense contractors and phased it in between 1996 and 2000 for other manufacturers.)  By the end of 2001, Connecticut, Illinois, and Maryland had also put a sales-only formula into effect.  Virtually every state has suffered a net loss of manufacturing jobs since 1995, but the single sales factor states have not fared appreciably better in this regard than the other states levying corporate income taxes:

Finally, it may also be instructive to take a longer-term view of the experience of Iowa and Missouri, both of which have had a sales-only formula in place for decades.  A reasonable starting point for such an examination might be 1979, when manufacturing employment in the U.S. as a whole reached its post-War peak.  (The ending point of this analysis must be 2000 due to a change in the government’s method of classifying manufacturing employment after that year.)  Manufacturing employment in Iowa did rise between 1979 and 2000, but only by a modest amount.  Iowa generated on net only 1,100 manufacturing jobs in that 21-year period — an increase of 0.4 percent.  That was the lowest growth rate among the 18 corporate income tax states that experienced net growth in manufacturing employment between 1979 and 2000.  Missouri, on the other hand, was one of the 27 corporate income tax states that lost manufacturing jobs from 1979 to 2000.  It lost 63,000 manufacturing positions, a decline of 13.7 percent.

Missouri’s long-term loss of manufacturing jobs is particularly noteworthy because it allows corporations an election between the traditional, equally-weighted property-payroll-sales formula and the sales-only formula.  This means that no out-of-state corporation has faced any of the kinds of disincentives for Missouri investment that a mandatory sales-only formula can create.  The fact that neither of the states with long-term experience with a sales-only formula had a particularly impressive long-term record for attracting or creating manufacturing jobs is a further indication that the formula is unlikely to live up to its billing as a potent economic development incentive.

The Single Sales Factor Formula and Major Plant Location Decisions

Recent data on major plant location and expansion decisions similarly do not lend much support to the argument that adoption of a single sales factor formula has a major positive impact on a state’s economic competitiveness: 

According to Site Selection Magazine, 71 facilities valued at $700 million or more were placed in states with corporate income taxes from 1995 through 2004.  Three of the five states that had a single sales factor formula in effect (or phasing in) during this period — Iowa, Missouri, and Nebraska — did not capture a single one of these major plant locations/expansions.  In four others — Connecticut, Maryland, Oregon, and Wisconsin — the facilities that made the Site Selection list were announced before the enactment of the sales-only formula.  The eighth state, Illinois, captured two major plants, actually somewhat less than what would be expected given Illinois’ share of the national economy.

In sum, just as there is little evidence that a single sales factor formula has significantly helped the states adopting it to retain manufacturing jobs, recent state-by-state data on the location of major new facilities suggests that the presence or absence of the formula is not a significant factor in plant siting decisions.

A Single Sales Factor Formula Is Unfair to Out-of-State Businesses and Small Businesses

A single sales factor apportionment formula undercuts one of the fundamental rationales for a corporate income tax, which is that a corporation should pay taxes to a state as compensation for the benefits it receives from state services.  Corporations benefit from a wide range of governmental services that specifically relate to the extent of property and payroll in a state.  States often underwrite local government police and fire protection for the corporation’s property and employees.  States provide roads and other transportation services to allow access to factories by suppliers and employees and the shipment of goods to markets.  States also fund K-12 and higher education services that enable many businesses to find workers with adequate skills.  The change from a property-payroll-sales formula to a sales-only formula substantially reduces the corporate tax burden of businesses that arguably are benefiting the most from public services in a state and unfairly shifts the tax burden to out-of-state businesses that benefit from state services to a lesser extent. 

It certainly is legitimate for a state in which a business’ customers are located to tax a share of its profit even if the business does not engage in production in that state.  After all, “market states” also provide services that benefit out-of-state companies —  such as the roads they use to transport their goods to their customers and a judicial system that ensures that customers pay their debts.  But a single sales factor formula goes too far in imposing corporate income tax liability solely on the basis of customer location rather than in proportion to both customer and production location.

Changing from a three factor apportionment formula to a sales-only formula heightens tax inequities among other groups of corporations as well.  For example, large corporations are much more likely to reap tax savings from a sales-only formula than are smaller corporations, many of which may be family-owned.  If corporations are not taxable outside their home states, they typically are not permitted to apportion any of their profits to other states for tax purposes.  Small corporations are less likely than large corporations to be taxable in more than one state; either all of their customers are in their home state or their out-of-state customers are served without setting up the out-of-state physical facilities that would obligate the business to pay corporate taxes to other states.  If a corporation is not permitted to apportion some of its profit to other states, then by definition it pays tax on 100 percent of its profit to its home state and is not affected by changes in the apportionment formula.  Since small corporations are more likely than large ones to fall into this category, large corporations are likely to obtain a disproportionate share of the tax savings that flow from the switch to a single sales factor formula.

High and Uncertain Costs

The change to a single sales factor formula is likely to reduce corporate income tax revenue substantially in any state where the economic base includes a significant number of corporations that export their wares to national or international markets. 

Moreover, switching from a three-factor formula to a sales-only formula could reduce corporate income tax revenue more than most states project when they are contemplating such a change.  As explained above, some corporations receive tax cuts when a state switches to a sales-only formula and some are hit with tax increases.  The revenue loss that results from the change to a single sales factor formula in many states is the net effect of large tax cuts for some businesses with major in-state facilities partially offset by tax increases on businesses that do most of their production out of state.  However, state fiscal impact estimates rarely take into account the possibility that some of the out-of-state businesses that are expected to pay higher taxes after a switch to a sales-only formula may in fact pay less tax — or no tax at all:

In sum, to the extent that some corporations that would be expected to pay higher taxes under a sales-only formula are able to counteract this impact, the net loss of corporate income tax revenues resulting from the change in formulas will be higher than forecasted.

States generally do not have access to sufficient information about the internal operations of their corporate taxpayers to determine which corporations are likely to seek to avoid tax increases resulting from adoption of the sales-only formula.  As a result, substantial uncertainty surrounds the estimated revenue impact of the shift from a property-payroll-sales formula to a sales-only formula.

Strategic vs. Scattershot Economic Development

These are just some of the reasons that switching from the traditional three factor apportionment formula to a sales-only formula is likely to be a relatively ineffectual economic development tool for a state and a potential threat to the revenue-raising capacity and fairness of its corporate tax as well.  Beyond its specific shortcomings, the single sales factor formula is an example of the scattershot approach to economic development that most states abandoned long ago.  Most states have learned that their best economic development strategy is to focus on providing the high-quality public services that underpin business growth in as cost-effective a manner as possible.  To the extent that specific interventions in the marketplace are warranted to eliminate shortages or reduce the costs of capital, labor, or other key business inputs or to direct investment to particularly disadvantaged population groups or geographic areas, states also have at their disposal a wide array of carefully-targeted tools that have been honed by economic development professionals through decades of trial and error.  State officials should not find it difficult to identify and implement much more cost-effective economic development strategies than the enactment of a single sales factor formula, which provides tax breaks to corporations without regard to their in-state job creation and investment decisions.

Renewing the States’ Commitment to a Uniform Apportionment Formula

The widespread discussion of the sales-only formula that is taking place at the present time may have one positive benefit, however.  It affords the states an opportunity to revisit fundamental principles regarding income taxation of multistate corporations. 

Not motivated in any way by a desire to confer economic advantages on particular states, the public officials and corporate representatives who developed the basic property-payroll-sales formula in the late 1950s arrived at a carefully-considered approach to corporate tax apportionment that sought to implement fairly the “benefits-received” principle that underlies the corporate tax.  In the ensuing years, the double-weighted sales variant of the three factor formula was adopted by a large plurality of states and became the new de facto standard.   Despite the recent adoption of the single sales factor formula in a significant number of states, nearly twice as many states still give a 50 percent or smaller weight to sales in their apportionment formulas.

Rather than pursue what is likely to be — at best — a meager, temporary, and zero-sum economic advantage through the unilateral adoption of a single sales factor formula, states could recommit themselves to a uniform apportionment policy based on the 50 percent sales factor standard.  States that have adopted greater than 50 percent weighting of their sales factors could phase back down to that level; the few states that retain the equally-weighted three factor formula could begin a transition to the double-weighted sales variant.  Given the compelling evidence of its inability to grant economic development wishes, it is still not too late to put the single sales factor genie back in the bottle.