Testimony in favor of Combined Reporting Legislation

Testimony in favor of Combined Reporting Legislation
Corporate Tax Code Commission

Thank you for the opportunity to address the Commission. My name is Phineas Baxandall, Senior Analyst for Tax and Budget Policy for MASSPIRG and other affiliated Public Interest Research Groups across the United States. Previously, I served as a Lecturer at Harvard University and on staff of the Rappaport Institute for Greater Boston at Harvard’s Kennedy School of Government.

MASSPIRG is a non-profit, non – partisan public interest advocacy organization with 40,000 members across the state. I am here today to urge you to support the closing of the tax loopholes which Governor Patrick filed earlier this year.

In-state businesses are playing on an uneven field, competing against multi-state companies that use high-priced, sophisticated accountants and complex transactions with subsidiaries to avoid paying Massachusetts taxes. While currently legal, some multi-state businesses can shift their Massachusetts profits to out-of-state subsidiaries to avoid paying taxes here; while businesses located only in Massachusetts cannot take advantage of these loopholes or other tax shell games.

Businesses should thrive based on their efficiency and innovation, not their opportunities for ‘creative’ tax accounting and tax avoidance.

The existing tax loopholes, totaling over $500 million a year, allow mostly out-of-state businesses to avoid their fair share of taxes. That leaves the vast majority of businesses at a competitive disadvantage. It also leaves taxpayers – both businesses and individuals – to foot the bill for vital services including transportation, education, and public safety.

My testimony today will focus on one of the specific tax reforms that is most significant because it would effectively close a thousand loopholes at once: combined reporting. As I will explain, combined reporting is a common-sense modernization of the tax code that has become best practice across the United States and ought to be adopted in Massachusetts.

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.

So long as revenue departments need not stay ahead of the private tax-accountant industry, formula-based assessment works well enough with separate reporting. Companies that operate in multiple states pay taxes based simply on their business activity in each state. Businesses have long apportioned their taxable profits between jurisdictions based on the percent of sales, assets and workforce in each state.

But out-of-state subsidiaries challenge this system. Companies with subsidiaries in other states can use creative accounting to shift taxable income to avoid paying their taxes. They can engineer paper transactions between subsidiaries for goods, services, royalties, consulting, rent, or whatever their accountants think of.

State tax authorities can not effectively monitor these internal transactions or make rules for them individually. Lawmakers 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.

As a result, some companies operate at an unfair competitive disadvantage over 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 of smaller in-state businesses.

2) Adoption of Combined Reporting as Logical Next Step

California was the first state to create combined reporting in 1937. The state effectively got out of the business of trying to outfox corporate tax lawyers. They stopped trying to second guess which transactions between subsidiaries might be a sham that didn’t reflect 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. The combined entity’s profits will still be apportioned as taxable to states based on its in-state business activity. Companies can use more or less the same spread sheet in each combined-reporting state. They must prepare a one-time breakdown of their business activity; but multi-state companies should know the breakdown of their sales, assets, and workforce by state anyway.

The process works essentially the same in Texas and Ohio that have enacted combined reporting on their broad business taxes, the margins tax and gross receipts tax.1 The effect is to bypass any potential accounting fictions created through the use of out-of-state subsidiaries.

Given the merits of combined reporting and the growing complexity of accounting strategies to avoid taxes, it should not be surprising that this budget year six governors and legislatures in at least four other states have proposed combined reporting.

With ten states enacting or considering enactment, combined reporting is emerging as standard practice for a modernized state tax system. The extent of this trend is made clearer by examining the sheer economic size of the states that have recently passed or proposed combined reporting. Businesses don’t care about the number of states except as a proxy for the extent of the U.S. economy. After all, the ten states with economies larger than Massachusetts together comprise 55 percent of the total US economy. The extent of combined reporting is best measured by combined-reporting states’ gross state products as a share of the US economy.

Back in 2004, states with combined reporting represented less than 29 percent of the nation’s total gross domestic product.2 New York and West Virginia have since joined Texas, Ohio and Vermont in adopting combined reporting for their business taxes over the last two years. These are mostly large states with big economies. And if present gubernatorial proposals for combined reporting in Michigan, North Carolina, Pennsylvania, Iowa, and Massachusetts follow suit, combined reporting will become law in more than 61 percent of the economy by 2009. Combined reporting would cover almost two-thirds of the nation’s economy if bills also pending in Maryland, Missouri and New Mexico also become law.

As the figure below makes clear, as states realize that their tax systems don’t otherwise work fairly and efficiently, combined reporting is becoming the norm.

In conclusion, combined reporting makes sense as a tax simplification that modernizes the tax system and levels the playing field between businesses. We believe that Massachusetts will best thrive when businesses prosper based on their productivity and ability to innovate, rather than their superior opportunities for tax avoidance. I urge the members of the Commission to recommend combined reporting for Massachusetts.

1. Ohio does not technically mandate combined reporting but effectively does so by disallowing companies can not count transactions between entities

2. States using combined reporting for corporate income taxes in 2004 were as follows with percent of GDP listed: Alaska (0.3), Arizona (1.7), California (13.1), Colorado (1.7), Hawaii (0.4), Idaho (0.4), Illinois (4.5), Kansas (0.9), Maine (0.4), Minnesota (1.9), Montana (0.2), North Dakota (0.2), Nebraska (0.6), New Hampshire (0.4), Oregon (1.2), and Utah (0.7). New York (7.7), Ohio (3.6), Texas (8.0), West Virginia (0.4) and Vermont (0.2) issued combined reporting laws in the last three years. Massachusetts’ gross state product is 2.6 percent of the national state total. Data is from the U.S. Bureau of Economic Analysis measures of 2005 gross domestic product by state calculated as a percentage of the entire state-based gross domestic product, including Washington DC and four states with no corporate income tax. Raw data available at http://www.bea.gov/bea/newsrelarchive/2006/gsp1006.htm table 3A.