HOW DOES STATE BUSINESS TAXATION AFFECT BUSINESS?

Responsible researcher: Bruno Benevit

Authors: Xavier Giroud and Joshua Rauh

Original title: State Taxation and the Relocation of Business Activity: Evidence from Establishment-Level Data

Intervention Location: United States

Sample Size: 27.6 million firm-years

Sector: Business

Variable of Main Interest: Opening of firms

Type of Intervention: Tax rate

Methodology: OLS, Poisson, DID

Summary

Tax policies can significantly shape the business landscape, affecting not only job creation but also capital formation and economic growth more broadly. With the objective of analyzing the impact of corporate taxation, this study verified the impact of state taxes on the business activity of multistate firms in the United States. Corporate taxation has had a substantial impact on the labor market, with notable variations in employment in response to changes in tax policies. The influence of taxation on companies' capital proves to be a determining factor in economic dynamics, highlighting the sensitivity of investments to changes in tax policies.

1. Policy Problem

Corporate taxation plays a crucial role in shaping employment, with tax policies having a direct impact on labor market dynamics. The relationship between taxation and capital proves to be a key element in making business financial decisions, influencing investments and resource allocation.

Thus, the impact of corporate taxation on these factors is commonly addressed in public finance literature. These impacts can occur both in marginal incentives through effective marginal tax rates and the cost of capital and in the choice of firm location through the average tax rate. However, the mobility of firms to more favorable business environments can mitigate the incidence of negative effects of this nature (GIROUD; RAUH, 2019). In this sense, multistate companies may present different behaviors when faced with the establishment of state taxes.

2. Policy Implementation Context

In the United States, the structure of state taxation on companies is similar to federal tax legislation, where companies that decide to incorporate have the option of taxation at the entity level according to the corporate tax code at the federal level (GIROUD; RAUH, 2019). Among the federative entities, however, there is great heterogeneity in relation to state tax regimes.

This context further complicates the analysis of the effects of tax policy on corporate activity, as state laws vary regarding the way in which taxable income should be distributed for multinational companies. Unlike federal tax treatment for multinational companies, states use apportionment formulas that eliminate the need to track domestic prices, involving three different measures of economic activity: sales, payroll and ownership. A company must first determine which states have the power to tax the business, considering physical presence, and then apply the apportionment formula in each state with "nexus."

Firms incorporated under subchapter C of the federal tax code (C Corporations) are required to pay taxes at the corporate rates. Under this regime, the owners of these companies paid individual taxes when they received dividends from C Corporations or when they realized capital gains. On the other hand, like unincorporated corporations such as partnerships and sole proprietors, corporations incorporated under subchapter S of the federal tax code (S Corporations) are considered pass-through entities. Pass-through entities pay no taxes at the company level, passing all profits back to their owners, who needed to pay taxes immediately on their profits. Finally, U.S. companies can also organize as Limited Liability Corporations (LLCs), providing some of the benefits of corporate organization, such as full liability protection, while avoiding firm-level taxation under the federal corporate tax code.

3. Assessment Details

This study used establishment-level data through the Census Bureau's Longitudinal Business Database (LBD) to examine the impact of state taxation on employment and capital. Establishments were defined as “unique physical locations where business is conducted,” from which the LBD provides data on employment, payroll, industry sector, location, and firm identifier. Furthermore, the sample considered was supplemented with data from the Census of Manufactures (CMF) and the Annual Survey of Manufactures (ASM). Both samples provide detailed data on establishment-level information such as capital expenditures, total assets, and the value of remittances from a narrower set of establishments. These two bases provide a richer set of establishment-level variables, although less comprehensive.

The study's main sample consisted of all U.S. establishments from 1977 to 2011 belonging to companies with operations in at least two states and with at least 100 employees present at the LBD. This sample consisted of 27.6 million establishment-year observations, equivalent to 647,000 firm-year observations. Additionally, a secondary sample was established considering establishments based on CMF and ASM data, resulting in a new sample of 854,700 establishments-years (104,400 firms-years).

Standard Statistical Establishment List data . SSEL provides a legal form of tax-based organization for all businesses through the LBD firm identifier. Companies can be listed with one of seven possible legal forms. This study only considered the categories of (i) individual entrepreneurs, (ii) partnerships and (iii) corporations. While categories (i) and (ii) are always considered pass-through entities for tax purposes, firms organized as corporations have the possibility of C or S Corporations. Naturally, the regime and tax rates in many states have changed over this period, other data sources are used to compile tax characteristics: the University of Michigan Tax Database , the Tax Foundation, the Book of States, the Commerce Clearing House's State Tax Handbooks, the Census of Government State & Local Finances , among others data sources .

4. Method

The study analyzed the impact of taxes on business activity using the distinction between S corporations and C corporations. This empirical strategy was established to explore the fact that the corporate tax code directly affects only companies organized as C Corporations, as opposed to companies organized as S Corporations, partnerships, or sole proprietors, which are affected only by the individual tax code and other business taxes. The analysis only took place in companies with establishments in several states according to their organizational forms at the federal level.

To this end, Ordinary Least Squares (OLS) and Poisson regression models were initially established to estimate the interaction between the two types of taxes (corporate and personal) and the two types of corporations (C and pass-through entities). The dependent variables related to business activity analyzed comprised the number of establishments, at the firm-state-year level, and the number of employees and capital, at the establishment-year level. To measure what effects result from relocation to other states, new models were considered with the inclusion of terms that controlled the average tax rate of all other states (excluding the one from observation). As covariates, non-tax factors and year and firm-state fixed effects were controlled.

Additionally, several strategies were carried out to verify the robustness of the results. First, the authors performed estimates focusing on companies with a presence in multiple states in order to minimize possible effects of organizational change in response to state taxes. Second, the impact of 161 major state tax changes (at least 100 basis points) on the number of establishments was estimated using a difference-in-differences (DID) model. Third, the motivation for the changes in the federal personal tax rate was verified as established by Romer and Romer (2010), in which the changes are classified as “exogenous” or “endogenous”, depending on the motivation. To this end, news coverage regarding tax changes was analyzed to verify the classification of changes, as well as the impact of two federal reforms ( Economic Recovery Tax Act of 1981 and Tax Reform Act of 1986).

5. Main Results

Estimates from the main analysis revealed that a 1 percentage point change in the state corporate tax rate corresponds to an average 0.5% change in the number of establishments per C Corporation. Similarly, a 1 percentage point change in the state corporate tax rate State personal tax affects the number of establishments per pass-through entity by 0.4%. No significant correlations were identified between the activity of pass-through entities and corporate tax rates, nor between corporate activity and personal tax rates.

In the analysis regarding the number of employees per establishment, the results were similar. The marginal effective rate has a more significant impact than the nominal rate, especially on the intensive margin. When focusing on manufacturing companies, similar patterns were found for capital, although with 31%-35% lower elasticities for capital.

Regarding analyzes in response to tax changes in other states where companies operate, the results indicated that approximately half of the effects of changes in taxes are offset by the relocation of activity between states. These results indicate that tax competition between states is economically relevant.

Regarding robustness analyses, the analysis to verify organizational changes in firms in the face of tax changes indicates that companies' response is more significant when the physical location of employees and properties has a greater weight in attributing the tax burden to a given state. The effects remain significant even in cases with greater weight given to taxation linked to the location of sales. The analysis considering large fiscal changes demonstrated that these changes have impacts similar to those found in the full sample, where approximately half of the effects were felt in the fiscal year of the change and the full force in the following year. By analyzing changes in response to the federal tax reforms of 1981 and 1986, effects of comparable magnitude to other major changes in corporate and personal tax rates were identified.

6. Public Policy Lessons

In this article, we explored the impacts of regime changes in state taxation on multistate corporations in the United States, examining both the extent and intensity of their economic responses. When analyzing firms organized as C Corporations and pass-through entities, we observe that variations in corporate and personal tax rates across states result in significant adjustments in the number of establishments, employees, and capital. It has been observed that even when companies have non-tax reasons for locating in different states, state tax rates have been shown to play a crucial role in location decisions. Notably, about half of the responses identified are attributable to the relocation of business activities to states with more favorable taxation. The study's evidence highlights the economic relevance of state fiscal policies and their significant implications for business behavior.

References

GIROUD, X.; RAUH, J. State Taxation and the Relocation of Business Activity: Evidence from Establishment-Level Data. Journal of Political Economy , vol. 127, no. 3, p. 1262–1316, 2019.

ROMER, CD; ROMER, DH The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks. American Economic Review , vol. 100, no. 3, p. 763–801, 2010.