As Minnesota legislators consider by making theirs the first state to require combined reporting worldwide, they are relying on an estimate of revenue that is, this may not be the technical term, completely false.
Because Minnesota was unable to generate its own revenue estimate, state revenue estimators turned to a 2019 study by the liberal Institute of Tax and Economic Policy (ITEP). Unfortunately, the ITEP research is fundamentally flawed, because the study neglects the apportionment of corporate tax when estimating revenue. This is not a small mistake; its omission renders the entire analysis useless.
When corporations do business across multiple states (or around the world), the states must determine how much of the company’s activity is properly associated with them and can only tax that part of the company’s profits. There are three traditional apportionment factors: sales, payroll, and property, but today, many states (including Minnesota) use only the sales factor, in what is known as single sales factor apportionment. Basically, what this means is that if 10 percent of a business’s gross sales are in Minnesota, then Minnesota can tax 10 percent of that business’s profits.
But business taxation is never simple, partly because businesses are rarely simple. Few large companies consist of a single entity, but rather a collection of subsidiaries and affiliated entities. Many states adopt what is called combined reporting, which means that the affiliated entities are considered a unitary group for tax purposes. These groups, however, stop at the “water’s edge.” States typically do not tax foreign-based companies if they do not have their own direct contacts with a state. Minnesota is considering becoming the only state to require companies to use worldwide combined reporting.
If adopted, this would mean that Minnesota can tax a lot more activity, including a lot of activity that takes place exclusively abroad. it does No it automatically follows that Minnesota will generate additional tax revenue. To see why not, let’s imagine an incredibly simple stylized example.
Suppose there is a parent company with two subsidiaries, the American Tractor Company and the European Harvester Company. For the sake of simplicity, they both have $1 billion a year in gross sales. The former, as the name implies, sells exclusively in US markets, with 10 percent of those sales being in Minnesota. The second sells exclusively in Europe, which means it has no sales in Minnesota.
Under its current combined (water’s edge) reporting regime, Minnesota taxes 10 percent of profits on $1 billion in gross domestic sales. In a worldwide combined reporting regime, Minnesota would tax 5 percent of profits on $2 billion in gross sales. That is, of course, an equivalence. Whether this generates or loses revenue will depend on whether the US or European entity was more profitable. But the gross sales allocated to the state are the same either way; that’s the whole point. (If a foreign company had sales in Minnesota, it would already have a proportionate tax burden in the state.)
The ITEP analysis that Minnesota legislators rely on misses this vitally important point. In doing so, you misunderstand how corporate income taxes work. Starting with an estimate that US multinationals earn $235 billion in profits abroad, ITEP simply assigns these additional profits to the states for tax purposes, giving each of them a share of the $235 billion based on their share of the national gross domestic product (GDP), and then imposing the highest marginal corporate tax rate in the world. been over that amount.
Because, between 2013 and 2017, Minnesota’s GDP was about 1.8 percent of the national GDP, ITEP simply allocates 1.8 percent of this $235 billion in foreign earnings from multinationals to Minnesota, multiplies it by Minnesota’s top corporate tax rate of 9.8 percent and estimates that Minnesota could gain $418 million by adopting combined reporting worldwide.
This is incorrect, because by adding worldwide activity to the unit group, Minnesota would simultaneously dilute its sales factor. There would be additional income (and potentially additional profits) in the unitary group, but the taxable portion of that group’s profits would be less. The ITEP methodology ignores this fundamental characteristic of corporate income tax.
(Interestingly, the narrative of the ITEP report recognizes apportionment, but the methodology used to generate revenue estimates neglects it).
Minnesota, in generate your own income estimatesused the $235 billion ITEP figure (which itself is the Congressional Budget Office average of two very different outside estimates) but then assumed that Minnesota accounted for 1 percent of the national economy. This yields a lower figure than the one generated by ITEP (based on 1.8 percent), but incorporates the same fundamental error.
Combined information as it currently exists, not worldwide, has its supporters and detractors. Proponents cite concerns about profit shifting, where companies seek to allocate profits to lower-tax jurisdictions in ways that do not reflect where the profits are generated, and situations where there is “no income anywhere” that is not taxed. nowhere. Detractors argue that while these concerns are valid, their impact is greatly exaggerated and that the double taxation and additional complexity associated with combined filing outweigh the benefits.
Detractors also argue, convincingly, that combined reporting often means taxing the wrong income in the wrong jurisdiction at the same rate. Take our tractor and combine example from earlier. If the tractor company were to locate its intellectual property (IP) in a low-tax jurisdiction and then have the selling subsidiary pay royalties that functionally allocate most of the profits to this IP subsidiary, many would think that these revenues should be consolidated to tax effects. (There are a variety of guardrails to limit the degree to which companies can do this.) But if there is a European combine company that sells combine harvesters to Europe, and an American tractor company that sells tractors to American customers, it is not clear why the parent company should pay lower taxes to Minnesota on American tractors by adding tax. about European combines.
These concerns about complexity and double taxation take on added importance with worldwide combined reporting, which is much more complex and would make Minnesota’s extremely high corporate income tax rate that much more relevant to some of its companies. Fortune 500. But both friends and foes of combined reporting acknowledge that the revenue gains (or losses) associated with combined reporting depend on differences in profitability between jurisdictions; all of these foreign earnings cannot be allocated to the states.
Combine profits from entities with sales in Minnesota with profits from affiliated entities without Sales in Minnesota will, by definition, reduce the sales factor. A smaller portion of the pool’s revenue will be allocated to Minnesota. Forgetting this is a fundamental error that renders the estimates Minnesota relies on useless.
If Minnesota lawmakers recognized that the revenue estimates were based on a misunderstanding of how corporate taxes work, and that there is no guarantee that combined reporting around the world will increase revenue at all (let alone), would they still care? ?