Much is written about the need to attract and retain businesses in New Jersey. A common practice in New Jersey and most states is to offer business tax incentives to either locate or retain corporations that are “thinking” about or “threatening” to move for a better business climate. Local governments offer subsidies and other incentives to reduce the property tax burden for the corporations. At the state level – which is the focus of this article – corporations are offered incentives to reduce their corporate tax liability.
There is much debate as to the effectiveness of these subsidies. To oversimplify the argument, some suggest that offering these deductions encourages corporations to settle or stay in New Jersey and that in the long run the economy here will expand and new jobs will be brought to or retained in the state that otherwise would not happen; and that, although there might be a tax loss in the short run, the future impact is more than favorable and future corporate revenue and other revenues will increase.
Others argue that these tax incentives are an ineffective tool for economic development because, among other reasons, they so often reward companies for actions they would have taken anyway. And, more importantly, the state is losing valuable tax revenue that will not be recovered. For example, budget reports issued by New Jersey’s Department of Treasury project a loss of an average of $135 million each year for the past seven years of activity or a cumulative impact of almost $ 1 billion.
Furthermore, the argument is made that corporations make decisions about locating or retaining business in New Jersey based not just on the corporate tax climate but on our location, the highly educated workforce, desirable communities, and good schools — recent PARCC scores ranked New Jersey second in the country.
Academic research is also mixed, depending on assumptions and certain variables. In short, there is no clear evidence about the effectiveness of tax incentives. We argue that a better way to incentivize corporations is to eliminate the current corporation tax and related business taxes and replace them with a simple entity tax on all business regardless of business form.
Most corporations pay a nine percent tax based on net income, one of the highest rates in the country. The effective rate that they actually pay is much lower thanks to deductions which minimize income, and many credits which reduce the tax paid. Furthermore, based on the type of deductions, certain businesses reap higher benefits than others – this is certainly not fair.
The tax is the state’s third largest revenue source — $2.3 billion out of a total of $34 billion in fiscal year 2016. Looking at historical trends, the corporation tax has been very static — as contrasted to the income and sales taxes — over the past ten years, averaging $2.6 billion.
The corporation business tax (CBT) was designed as a franchise tax for the “the privilege of doing business” in the state at a time when nearly all business of any size was conducted by corporations. The economic landscape has changed over time and now the CBT is sadly out of date.
Some background about who pays the tax is instructive. Business enterprises in New Jersey are of all forms and sizes and pay anywhere from ZERO dollars to millions. The specifics of corporation tax law are complicated regarding form. There are C corporations — usually the big boys, the Mercks and Campbell Soups of the world – subject to the nine percent rate.
There are S corporations, for example, auto dealers and many small businesses; they pay a flat maximum CBT of between $375 and $1,500. But, many businesses, such as limited liability corporations and partnerships — for example, professional services, accountants and lawyers — are neither C nor S corporations and avoid the CBT entirely, paying a flat fee of $150/partner up to a maximum of $250,000. In all these cases, distributions made to owners or partners are taxed under the individual gross income tax rules.
Based on 2014 data, there are 117,000 C and 101,000 S corporations in the state, the majority of which are small. In fact, less than 13 percent have gross receipts of more than $10 million and almost 60 percent have gross receipts of less than $500,000.
The corporation tax has several problems with its structure. Specifically: + The taxable value of the entity is measured by net income. While net income may be conceptually appealing as a measure of economic value, in the real world of separate entity accounting, pass-through entities, and extensive deductions, it does not adequately measure business activity. Net income is hardly an objective measure. As a result, it has extensive loopholes that allow the tax to be evaded or reduced for certain corporations.
The tax base has been shrinking for many years; businesses of all types and sizes are electing a non-corporate structure — taking advantage of limited liability and partnership forms — as a simple means of avoiding the tax.
The governor and the Legislature are frequently enacting legislation to lessen the impact on certain corporations by implementing a series of incentives. Some corporations receive these credits and deductions; others do not.
The tax is highly inefficient to administer by the state, and likewise for corporations to compute legal liability.
The last two points are illustrative of taxation at its worst — it is neither equitable nor easy to enforce or collect. Currently, there is an army of state government tax examiners, auditors, and lawyers trying to understand how each corporation is attempting to limit its payments; and a like army of corporation financial wizards trying to understand the extensive and very complicated New Jersey tax code and how they can limit their liability. The state and corporations could use these valuable resources in a more effective manner.
The CBT is a broken tax that does not meet the needs of business or the state. We suggest going back to square one and starting over; in short, the system cannot be fixed. It should be replaced with a much simpler business tax that has low costs in compliance and administration, is not dependent on corporate form, and raises revenue from the broadest number of entities conducting business in the state.
We would argue for a true “franchise” tax on all business entities, with the activity measured not by net income but by gross profits — New Jersey receipts less deductions for cost of goods sold and normal employment costs. No credits, no other deductions for expenses, no loopholes, just a simple computation based upon an acceptable, recognizable and logical base.
Such an entity tax could, for example, effectively exempt small businesses with gross profits under some level, say $500,000, and instead subject them to a small minimum $500 fee. Businesses with higher levels of gross profits would pay specific amounts dependent upon the gross profits of the entity.
The table below shows how this could operate. We rank the 218,000 C and S corporations into 10 deciles by gross profits. Assume the most profitable 21,800 businesses — the top 10 percent — pay an average of $70,000. The next most profitable 10 percent of businesses pay an average of $50,000. Each decile is assigned a declining average tax. Note the bottom 50 percent of the average businesses pay an average of $1,000 or less. But the total raised is $4.1 billion, or 50 percent more than the FY 2015 CBT yield.
There is a wide range of fee or rate schedules that can be designed to generate as much as the current CBT generates — or more or less — depending on overall state tax policy. This table only includes C and S corporations but should include all business entities, for example, partnerships and LLCs; such data was not readily available to us.
This proposal would replace both the CBT and the partnership tax with one simple and very efficient business tax structure which is independent of business form.
This is not a radical approach and in fact it is virtually the same as the insurance premium tax which has been in operation since its inception and generated over $643 million in FY 2015.
As with any proposal that dramatically changes the base for taxation, some will oppose it. It will be called unfair because it imposes a tax on all businesses regardless of profitability, or is alleged to hurt small businesses. Critics will argue “pass-through entities” should not be taxed since the state captures that income at the individual shareholder level, but these entities already face an entity tax in some form.
The real question: Is there an easier, more equitable way to tax business than our current complex and unfair and highly inefficient current mix of laws? These and other arguments could go on and on, and frankly are examples of why the present system is so complicated and why we are constantly legislating deductions and credits and other loopholes for certain corporations.
The goal of tax policy should be to treat all businesses, regardless of form, fairly. The current tax policy is riddled with loopholes, is easy to manipulate, and allows businesses that are not incorporated to avoid entity-level tax altogether. A reliance on net income to measure profitability or activity, while theoretically attractive to the purist, is fatally flawed in practical application.
In our opinion, the conclusion is clear: The corporate income tax is broken and should be eliminated and replaced with a simple low tax on all business activity regardless of corporate form, levied on a logical and recognizable base not subject to easy manipulation.
More importantly, think what incentive it would present to businesses thinking of coming to or staying in our state if New Jersey eliminated the complicated corporation tax and replaced it with an equitable, understandable tax that did not require an army of high-priced staff. Unlike the CBT based on net income, this tax is simple and does not distort business decisions, does not discriminate between business types, and need not impose an undue burden on any business entity. That’s truly business-friendly.
It has been over 30 years since the State and Local Expenditure and Revenue Policy Commission (SLERP) addressed the issues of the New Jersey tax structure. Given the current debate about taxes and budgetary needs and the overall need to expand the economy, we believe that a serious discussion among business, executive, and legislative leaders is overdue. Our proposal could be a first step in that direction.