Blue Green Line in Header

The Worst of Both Worlds: Understanding Why Prop 39 Is The Right Way To Go


This November, as usual, California voters will face a slew of state propositions at the ballot box. One deserves a closer look and, we believe, should be passed. Prop. 39 would change the current system that allows inter-state corporations a choice in how they calculate their liability for California corporate taxes. If passed into law, Prop 39 would enact a system where a company's income tax liability would be based solely on its sales in California. And then for the first five years, about half of the estimated $1 billion in additional annual revenue would be dedicated to energy-efficient projects at schools and other public buildings.

To understand why this is an important change for the state – and one that levels the playing field – take a brief look at the history of corporate taxes in the state and how recent changes have left the state in the worst of all worlds.

In 1957 a group of states came together to create a uniform set of state tax systems with the goal of simplifying the system and helping to level the playing field. At the time it was decided that the best way to apportion corporate profits for large national firms was to determine the share based on three factors, property, employment and sales. The firm would calculate its in-state share of each and then take the average. The factor multiplied by total corporate profit would constitute the local taxable income for the company.

On its surface this approach seems reasonable. However, it creates perverse incentives driven by the firm’s natural inclination to minimize tax liabilities—a perfectly reasonable pursuit when working to maximize shareholder wealth. If the company lowers the share on any one factor, it can similarly reduce its tax liability in that state. Of course, of the three, to reduce the sales share would be pointless since sales are what create profit. But if a corporation is able to reduce its in-state employment or property share—that is to disinvest in the local economy—it can reduce its tax liability while still earning profits. It’s never a good idea to tax inputs, which this system essentially does.

In the 1960’s when California adopted the tax system it may not have mattered that much. The cost of communication and transport was high enough that the tax savings would likely have been swamped by the increased cost of supplying products from an out-of-state provider. And since most states had adopted the same system, a decline in the ‘production’ share in one state would necessarily be offset by an increase somewhere else—hence only state differences in the corporate tax rates would matter for tax planning purposes.

But times have changed. The cost of transport and communication has fallen sharply, making cross state sales cheaper. And more importantly, many states began to abandon the system, moving to a single sales factor system—where only the share of in-state sales matters for tax liability calculations. Texas was one of the first to move to this system.

To see how this benefits Texas to be one of the first (and hurts California), take a simple example of a single company that operates in just two states—California and Texas. For simplicity sake, assume that the company keeps half its operations in each state, and half its sales as well. Also assume that the total corporate profits are $100. If both states have the same 3-factor tax system, things work out as expected. Each factor is 50% (half of sales, half of property and half of employment in each place). As such, their multiplier is also 50%, the average of the three inputs. This means the tax liability will be $50 in each state. If both states had the same corporate tax rate, the taxes paid would also be equivalent.

When both states have the system there is no advantage for the firm to move resources from one state to another. If they moved all their employment and property from California to Texas, they would reduce their California tax liability percentage to 17%. But this would not reduce their total tax liability, it would simply shift it from one location to the other because the tax share in Texas would rise to 83%. While corporate tax rates might be lower in Texas, the cost of moving and the increased cost of operating in California would likely offset any tax advantage.

Now assume that Texas moves to a single factor sales tax system. At first, the corporation continues to divide its employment, property, and sales between both states and nothing changes. The average 3-factor tax liability for California, 50%, is the same as in the sales-only system in Texas. The taxable liability in both places remains $50.

Then the incentives become clear. The firm’s management quickly realizes that if they move all production from California to Texas, they can substantially reduce their overall tax bill. This is because the liability share in Texas would stay at 50% despite employment and property going up to 100%, while in California, the liability would drop to 17%, because two-thirds of the weights fall to 0%.

In short, the company now gets one-third of its profits tax-free at the local level—a strong incentive indeed. And California gets hurt twice—both by the reduction in local taxes paid, and in terms of job losses and reduced property investment even though the firm is still profiting at the equivalent level through its sales in the state. As for Texas, it receives the same level of taxes, but benefits additionally from the movement of employment and property into the state.

This shouldn’t suggest that every firm will pack up and leave—there are many reasons why a corporation chooses to locate a portion of its employees and production facilities in one place rather than another, and many of these reasons may be greater in value than the potential local tax benefits of moving elsewhere. But nevertheless, the incentives are clear, and over time, they will have a detrimental impact on the economy’s ability to grow.

The situation darkens further when we think about the forces of competition. Tweaking our example a bit, consider two firms, one based in California and the other in Texas, each with half their sales in both states. Assume both earn $100 total profit, so the potential tax base in both states should more or less double. Begin this example with California continuing to use the 3-factor system, and Texas using the single sales factor.

The result of this simple model is an amazing degree of inequality across the firms, even if not across states. In Texas, both firms end up paying a roughly equivalent tax, since they both have half their sales there. But in California, the relative tax payments are entirely different. In California the local firm is assessed a whopping 83% because it has its operations based there, whereby the Texas-based company pays only 17% – a nice perk for an out-of-state firm that does not contribute to the local economic base.

In this scenario both states end up with roughly the same tax base, but the California based firm ends up paying local corporate taxes (on an aggregate cross-state profit amount) that are greater than what it actually earned, $133, while the Texas based firm paid less than what it earned, $67. Good luck competing with the Texas based firm in the long run. The California company is almost forced to move out of state in order to stay cost competitive.

In an era when competition to attract investment and jobs into local economies is more ferocious than ever, and given the perverse incentives created by this system, it is hardly surprising to find most regions moving towards a sales factor only system. Many states stated by increasing the weight on sales—including California in the early 1990s when it began to weight sales by a factor of 2.

Illinois and Nebraska followed by turning to a single factor only system in the 1990’s, and a wave of other states have done the same in the past decade including Colorado, Georgia, Indiana, Maine, Michigan, New York, Oregon, South Carolina, Wisconsin, and soon Minnesota, Utah, and Pennsylvania. Connecticut and Louisiana use single factor systems for manufacturing firms.

Then in 2009, during a late night budget session, California’s legislative bodies decided to go ahead and change the state’s tax system. But instead of just moving toward the single sales system, they surprisingly, perhaps even shockingly, established a hybrid system whereby firms could choose which system they would use for apportioning taxes.

The following tables shows how the numbers shake out. In California companies, can choose whether to go with a single factor or multi-factor system. Given that they are always looking to reduce tax liabilities, the in-state firm will logically choose the single factor, whereas the Texas company will stay with the old system. This helps the local firm reduce its tax liability, although in aggregate it still has a significantly larger liability than the Texas based firm. In other words it does not solve the problem that incentivizes firms to leave California and take their jobs and investments with them.

And it comes at a cost to California. In the previous example that compared a California and a Texas based firm, each with half their sales in both states, at least California received the same taxes as Texas. Now California actually receives less taxes than its competitor. And this could occur even if it has a higher tax rate because the tax base is smaller.

Add it up and it’s pretty clear that giving firms a choice is the worst of both worlds. It doesn’t end the incentive to move jobs and investment out of California, but it does put the state in a worse fiscal situation. Who would want such a system? Firms that are based out of state who want to maintain a nice competitive advantage over California based firms, and maybe even the Texas government who enjoy touting their lower tax rate without having to acknowledge the broader tax base.

One thing is clear… no one in California should want such a system, not even those who are universally opposed to tax increases because the current system creates an uneven playing field for local firms.

It gets even more disreputable when considering that firms can change how they calculate their taxes on a year-to-year basis. Remember, if a business posts a loss in their tax year, the loss can be written off against future taxes. While California’s system has not been in place long enough to see how this might pan out in practice, theoretically, the Texas based firm could shift to the single factor system in a year they lose money. This would increase their losses in California—and give them more of a tax write-off in future years when they return to profitability. This further erodes the tax base of California relative to Texas over time.

The in-state firm can also take advantage of the flexibility—shifting back to the 3-Factor System during periods of profit losses in order to reduce tax liability. When this happens, the system ends up punishing smaller in-state firms. These companies have to pay taxes on 100% of their profits in California whether they record a profit or a loss. This shifts the tax burden away from larger firms—regardless of whether they are in or out of state—to smaller firms that represent the future of the state.

Getting rid of California’s current system, as Prop 39 proposes to do, is not a tax increase. It levels the tax playing field. And whatever your personal views are on taxes, at the end of the day, whatever we decide is the appropriate amount of taxation, that burden should be spread out as fairly as possible.

Previous article  |  Next article