On September 17, 2007, the Federal Reserve Bank of Chicago, Ernst & Young, and the Office of Tax Policy Research at the University of Michigan’s Ross School of Business brought together over 120 business people, academics, and public policymakers to examine the changing dynamics of state business taxation.Taxation ; State finance

Richard H. Mattoon

English

Research Papers in Economics

Future State Business Tax Reforms: A conference summary
by Richard H. Mattoon, senior economist and economic advisor
On September 17, 2007, the Federal Reserve Bank of Chicago, Ernst & Young, and the 
Office of Tax Policy Research at the University of Michigan’s Ross School of Business 
brought together over 120 business people, academics, and public policymakers to 
examine the changing dynamics of state business taxation.
Chicag  o Fed Letter
ESSAYS ON ISSUES                                               THE FEDERAL RESERVE BANK                          DECEMBER 2007
                                                                                 OF CHICAGO                                                          NUMBER 245b
Materials presented at the 
conference are available at 
www.chicagofed.org/
news_and_conferences/
conferences_and_events/ 
2007_tax.cfm.
Recent changes to state business tax 
structures in Ohio, Texas, and Michigan 
have reinvigorated interest in how states 
should (and should not) tax business. 
The program held at the Federal Reserve 
Bank of Chicago examined the complete 
range of business taxes, including income, 
sales, and property taxes, as well as value- 
added and gross receipts taxation. 
State taxes and the beneﬁ  ts principle
George Zodrow, Rice University, dis-
cussed the underlying economics (par-
ticularly the increasing mobility of capital 
and high-skilled labor) that policymakers 
should consider when designing tax sys-
tems. Consumption taxes (usually sales 
taxes at the state level) have broad appeal 
to policymakers. However, a primary fault 
of sales taxes is that they fall on business 
input purchases and, therefore, result 
in tax pyramiding, making the effective 
rate of the tax higher than the nominal 
rate. Zodrow argued that the sales tax 
base should be as broad as possible with 
a low rate to limit distortions. Income 
tax adjustments or rebates to the poor, 
he added, should be used as compen-
sating mechanisms. In addition, taxes 
on business inputs should be avoided.
Among general business tax structures, 
Zodrow said he preferred taxes based 
on the “beneﬁ  ts principle,” which are 
designed to reﬂ  ect the value of the 
government services a ﬁ  rm receives. 
Granted, developing appropriate proxies 
for beneﬁ  t taxes can be difﬁ  cult, he said. 
In addition, states are likely to want to 
tax beneﬁ  ts arising from location-speciﬁ  c 
rents that ﬁ  rms receive and, particularly, 
from resource rents such as mineral pro-
duction or natural resource extraction.
Finally, Zodrow questioned the appro-
priateness of the corporate income tax 
when applied to multistate ﬁ  rms. When 
states apply formula apportionment to 
the tax base, the corporate income tax in 
reality becomes a three-factor tax on 
labor, property, and sales. If the intent 
of policymakers is to tax each of these 
factors of production separately, he said, 
they should do this directly.
William Testa, Federal Reserve Bank of   
Chicago, criticized the current labeling 
of taxes as levied on business versus in-
dividuals. For example, many so-called 
business taxes are labeled as such for 
political reasons, even though the bur-
den is shifted to households. Testa ar-
gued that tax and expenditure systems 
would be made more transparent to 
voters under a beneﬁ  ts principle of gen-
eral business taxation. Such an approach 
would conﬁ  ne business taxes to a gen-
eral levy on ﬁ  rms that aligned with the 
costs of public services that are directly 
used in the ﬁ  rms’ production. 
Looking at broad and varied taxes in 
each state that today fall under the rubric One focus of business property tax reform has been to reduce 
or eliminate the personal property tax that places a burden 
on business capital.
of “business taxes,” Testa noted that the 
bulk of taxes fall on capital inputs to 
production and that this should be of 
concern to policymakers hoping to foster 
economic development in their states. 
A general business tax based on the 
beneﬁ  ts principle, he said, would help 
citizens make decisions based on the 
real tax costs of government services 
that are provided to both businesses 
and households. This would also help 
government to plan and deliver those 
services that are valued by ﬁ  rms, there-
by supporting state economic growth 
and development.
Testa then described a methodology for 
assigning tax-funded expenditures to 
the business and household sectors to 
estimate what beneﬁ  ts the business sector 
receives through taxation. If the current 
hodgepodge of so-called business taxes 
were to be replaced with a single business 
tax based on beneﬁ  ts received, what would 
be the approximate size of the tax? 
Based on a distribution of state and lo-
cal expenditures across the business and 
household sectors, Testa concluded 
that the business sector is paying a sig-
niﬁ  cantly higher amount in taxes than 
it is receiving in government expendi-
tures. Thus, a single business tax based 
on a beneﬁ  ts principle would likely as-
sign lower tax liabilities to businesses 
than they face today. 
Of course, the basis on which business-
es are assigned tax liability under ben-
eﬁ  ts taxation must be a good proxy for 
government services received. Testa 
concluded that a value-added tax (VAT) 
would be a suitable proxy because it 
would avoid large biases for or against 
the use of capital versus labor across a 
state’s many businesses. Such a tax base 
would be deﬁ  ned by the “origin” of a 
ﬁ  rm’s value added, that is, the location 
where production takes place. This would 
align best with services a ﬁ  rm receives 
from the state government.
Robert Cline, Ernst & Young, discussed 
some recent moves by states to improve 
their tax competitiveness—e.g., by reduc-
ing taxes on capital and shifting from 
origin-based taxes to destination-based 
taxes. In addition, states seem willing 
to shift to a beneﬁ  ts principle and away 
from ability to pay. Other reform ob-
jectives include: reducing business tax 
volatility; ﬁ  nding an effective way to tax 
the service sector; adopting more uni-
form taxes that apply to all forms of 
business; increasing taxes on “out-of-
state” companies; and ﬁ  nding tax sources 
to pay for health care expenditures.
Income, sales, property, and value-
added taxes
William Fox, University of Tennessee, 
noted that corporate income tax accounts 
for only about 9% of the business tax 
total and has been declining. The decline 
is being driven by state and federal policy 
decisions, as well as tax planning by busi-
nesses. States have been trying to shore 
up the business tax base through efforts 
such as requiring combined reporting 
and disallowing certain deductions be-
tween related businesses.
Fox highlighted the tendency to move 
business taxes in the direction of sales 
taxes. For example, when states adopt 
single factor sales apportionment for 
their corporate income tax, the tax es-
sentially becomes a gross receipts tax 
(GRT) with the rate dependent on ﬁ  rm 
proﬁ  tability. The GRT has the advantage 
of capturing a broader tax base and 
making avoidance of the tax more dif-
ﬁ  cult than a corporate income tax. 
However, tax pyramiding in the GRT 
causes a number of distortions and can 
be a particular burden for low-margin/
high-volume ﬁ  rms for which the tax 
paid may have little relationship to the 
ﬁ  rms’ economic presence in the state. 
Additional burdens for states adopting 
GRTs are administrative issues, such as 
deﬁ  ning what is taxable, and nexus 
issues. However, for policymakers, Fox 
explained, the relative revenue stability 
of a GRT and its sizable revenue poten-
tial are likely to be attractive features.
Matthew Murray, University of Tennessee, 
described the decline in the sales tax 
base. Policymakers have been reducing 
sales taxes on business inputs and ex-
empting basic consumer items, such as 
food and drugs, thereby reducing the 
sales tax base. In response, sales tax 
rates have continued to rise and, when 
combined with local tax add-ons, now 
exceed 10% in some jurisdictions across 
the nation. The business sector’s pay-
ments in all states made up 43% of the 
sales tax total in 2003.
Murray noted that, while an expansion 
in scope of business exemptions for the 
sales tax would constitute good policy, 
it faces many political hurdles, including 
perceptions of corporate welfare, dimin-
ished capacity to export the tax base, 
and the practical problem of shifting 
the tax burden to make up for the loss 
of sales tax revenue from business.
Murray said the consumer side of the 
sales tax base could be expanded to in-
clude health services, educational ser-
vices, residential construction services, 
personal services, and amusement and 
recreation. Standing in the way of these 
efforts are concerns about tax fairness 
(particularly for lower-income consum-
ers), administration, and compliance. 
There is also a concern over the appro-
priateness of taxing human capital in-
vestments. Murray concluded that in 
optimal tax theory, if you cannot tax 
the output, it may be appropriate to 
tax the input.
Andrew Phillips, Ernst & Young, dis-
cussed trends in property tax reform. 
Noting that property taxes account for 
the largest share of business taxes, 
Phillips explained that property tax re-
ductions have been crucial elements of 
state business tax reform efforts in Ohio, 
Texas, and Michigan. Increasingly, home-
owners are also voicing their dissatisfac-
tion with the property tax. Property taxes 
play a central role in funding local gov-
ernment, so the push for reductions is 
putting policymakers under pressure to 
ﬁ  nd alternative revenue sources.Charles L. Evans, President; Daniel G. Sullivan, 
Senior Vice President and Director of Research; Douglas 
Evanoff, Vice President, ﬁ  nancial studies; Jonas Fisher, 
Economic Advisor and Team Leader, macroeconomic 
policy research; Richard Porter, Vice President, payment 
studies; Daniel Aaronson, Economic Advisor and 
Team Leader, microeconomic policy research; William 
Testa, Vice President, regional programs, and Economics 
Editor; Helen O’D. Koshy, Kathryn Moran, and 
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One focus of business property tax re-
form has been to reduce or eliminate the 
personal property tax that places a bur-
den on business capital. For example, 
Ohio’s tax reform includes a ﬁ  ve-year 
phase out of the personal property tax in 
the state. The ﬁ  scal impact of this change 
is estimated at over $1.2 billion and re-
quires that the state’s new Commercial 
Activities Tax raise sufﬁ  cient revenue 
to reimburse local governments for the 
lost personal property tax income. In 
Michigan, the new Michigan Business 
Tax (MBT) provides for a 23% cut in 
the personal property taxes of commer-
cial taxpayers and a 46% cut in those 
of industrial taxpayers. 
Laura Kalambokidis, University of 
Minnesota, discussed prospects for a 
state-level value-added tax. The VAT is 
appealing because it is a broad-based 
tax on consumption. In theory, a VAT 
on both labor and capital does not dis-
tort business decisions. It also is neutral 
with regard to business type because it is 
levied on all businesses. It also might ap-
ply to a broader range of out-of-state 
ﬁ  rms than the corporate income tax. 
Further, if the VAT is based on origin, 
the tax is perceived as more closely re-
lating to the beneﬁ  ts a business receives 
through public services. Because state-
level VATs are relatively new, more work 
needs to be done to understand their 
effects on business tax structure.
Recent state tax reforms
Scott Schrager, Michigan Department of 
Treasury, described the new Michigan 
Business Tax. The MBT replaces Michi-
gan’s Single Business Tax that was a 
VAT-style tax instituted in the late 1970s. 
The MBT is in fact two taxes. The ﬁ  rst is 
a business income tax of 4.95% that in-
cludes noncorporate entities. The second 
is a modiﬁ  ed gross receipts tax of 0.8%. 
In addition, the new tax structure allows 
for signiﬁ  cant reductions in business per-
sonal property taxes. The new tax raises 
$1.9 billion, with one-third of the revenue 
from the business income tax and two-
thirds from the modiﬁ  ed gross receipts tax.
Businesses that will pay less under this 
new system will include manufacturers, 
ﬁ  rms with $10 million to $20 million in 
gross receipts, construction ﬁ  rms, ﬁ  rms 
with less than $10 million in gross receipts 
and more than $115,000 in owners’ in-
come, and Michigan-based multistate 
ﬁ  rms. Some businesses will see their 
taxes increase. These businesses include 
ﬁ  nance, insurance, and real estate ﬁ  rms; 
ﬁ  rms with little personal property; and 
ﬁ  rms that operate in Michigan but have 
little payroll or property in state. Finally, 
Schrager noted that the new MBT has a 
clearly deﬁ  ned revenue limit to ensure 
that it does not produce a signiﬁ  cant 
revenue increase.
Tom Zaino, currently with McDonald 
Hopkins and former tax commissioner 
of Ohio, described the evolution of 
Ohio’s gross-receipts-style Commercial 
Activities Tax (CAT), which was prompted 
by the state’s declining economic per-
formance. A guiding principle was that 
it would be better to collect the same 
level of tax revenue by taxing consump-
tion rather than investment. 
The CAT base is taxable gross receipts at 
a rate of 0.26%. Taxable entities include 
virtually every type of business (regard-
less of form), as well as trusts, associations, 
societies, and clubs. The only entities 
not subject to the CAT are those with 
less than $150,000 in gross receipts, cer-
tain public utilities, banks and ﬁ  nancial 
institutions, insurance companies, and 
nonproﬁ  ts. Many of these are covered 
by separate tax structures.
Permitted exclusions from the gross re-
ceipts base include interest (except on 
credit sales), dividends, and wages. Zaino 
added that the proof of success for the 
CAT will be whether the state realizes 
improvements in jobs, gross state prod-
uct, and personal income.
The new Texas Margin Tax was discussed 
by Billy Hamilton, former deputy comp-
troller of Texas. Motivating the creation 
of the margin tax was a desire to reduce 
property taxes. Texas had signiﬁ  cantly 
reduced its support for local education 
(from 50% in the late 1990s to just 39% 
in 2007), putting a strain on the local 
property tax base. In addition, the state 
wanted to reduce the tax planning op-
portunities available under the franchise 
tax and to provide taxpayers with a 
choice of tax bases.
The new tax is a broad-based, low-rate 
tax based on the net margin of a ﬁ  rm. 
The rate is 0.5% for retailers and whole-
salers and 1% for everyone else. Firms 
not required to pay the tax include sole 
proprietorships, general partnerships, 
insurance companies, nonproﬁ  ts, cer-
tain passive entities, grantor trusts and 
estates, passive investment partnerships, 
and real estate and mortgage investment 
conduits. The tax base is the lesser of 
the following three bases: 70% of total 
revenue, total revenue minus cost of 
goods sold, or total revenue minus 
wages and beneﬁ  ts.
The tax is projected to raise $6 billion 
in the ﬁ  rst year—more than double the 
state’s current business tax collections. 
However, the new tax does not raise 
enough revenue to fully ﬁ  nance the 
state’s property tax cut. 
Conclusion: Key perspectives on the 
new tax systems
A panel of experts from business, aca-
demia, and government concluded the 
conference with a discussion of emerg-
ing state business tax structures. 
Gary LeDonne, Ernst & Young, said that 
states would continue to pursue combined 
reporting. He added that federal ac-
tions might affect the options available to the states. The need to raise revenues 
to fund Medicare and Social Security 
at the national level might even lead to 
a federal VAT.
Lorna Turner, Hyatt Corporation, said 
that policymakers should be realistic 
about who actually ends up paying for 
a business tax. In the case of Hyatt (and 
any other hotel), local sales taxes and fees 
will be passed on to the guest if at all 
possible. Thus, what was intended to be 
a business tax ends up as a consumer tax. 
Joel Slemrod, University of Michigan, 
suggested that academics need to do a 
better job explaining tax principles and 
the consequences of tax policy changes. 
For example, many policymakers have 
misunderstood the academic principles 
of favoring a broad-based, low-rate tax 
and have used this to support adoption 
of the gross receipts tax. Slemrod sug-
gested that the key is having a sensible 
broad base.
Slemrod offered the following ideas for 
states pursuing tax reform: First, offer 
low origin-based taxes on mobile factors 
of production, and second, have a level 
playing ﬁ  eld for all types of business. 
Increasing the top rate on personal in-
come would prove beneﬁ  cial, Slemrod 
argued, as well as taxing services. Sector-
speciﬁ  c tax incentives should be avoided, 
he said, particularly because governments 
have shown little ability to pick which 
ﬁ  rms offer the greatest growth potential 
to their local economy. Finally, Slemrod 
argued that part of why we tax business 
is simply for convenience. It is much 
easier for governments to collect taxes 
from businesses than from individuals.
What might happen in the next ﬁ  ve to 
ten years? George Zodrow said that, while 
it might be wishful thinking, he hoped 
states would move toward a VAT. Richard 
Levin, tax commissioner of Ohio, argued 
that the business sector wants predict-
ability and that his charge was to ensure 
that the rate for the CAT remains stable 
and that the tax base is not gradually 
whittled away. Fred Giertz, University of 
Illinois at Champaign–Urbana, and Doug 
Lindholm, Council n State Taxation, 
said they expected states to continue to 
look at GRTs, although they suggested 
that the distortions in the GRT base and 
the tendency to slowly raise the rate made 
this an inappropriate tax. In contrast, 
Harley Duncan, Federation of Tax 
Administrators, said he expected states 
to try to preserve the corporate income 
tax, particularly through expanded use 
of combined reporting.
Slemrod concluded that there is a need 
to carefully examine the outcomes from 
the reform efforts in Ohio, Michigan, and 
Texas. Measuring the economic effects 
will provide guidance to other states. 

Future state business tax reforms: a conference summary

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