About Growth & Justice

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February 14, 2009

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Charlie Quimby

A reader sent this comment to me and asked not to have her name attached...

As a small business owner I have a few comments to make regarding the taxation in Minnesota. Many years ago I began renting out 1/4 of our house in South Dakota. The first income tax season I realized that the income derived from the rental of this portion of our home was largely untaxed income, due to depreciation and other deductible expenses related to the rental. Prior to that our income was based on taxable wages and this was fully taxed. In Minnesota a few years later I began to purchase single family homes for the purpose of renting them out. Our tax accountant used the IRS and Minnesota Department of Revenue guidelines to determine the appropriate depreciation and other deductible expenses. This reduced the taxes on my husbands wages since we file jointly. SMALL BUSINESSES AND LARGE BUSINESSES HAVE HAD A LARGE TAX ADVANTAGE FOR YEARS. The typical wage earners have not the deductions that are available to businesses. Ask any accountant who handles income taxes for people to get verification on the discrepancy between the taxes on a wage earner and the business owner. Sure, the business owner takes risks but so does the wage earner.

Also, regarding sales tax. Several years ago my brother was a wage earner at a factory in Minneapolis. He became aware that our 6% sales tax managed to make the bids from this factory less attractive than the bids from states which had no sales tax or less sales tax. For example: on a $100,000.00 order in Minnesota one must add an additional 6% to the cost, or $6,000.00 to the $100,000.00 order. All things being equal or nearly so, it would be prudent to purchase from the factory which had no sales tax or a less sales tax. It seems that a reduction of sales tax would be more prudent than reducing the corporate income tax.

Thank you for keeping me and the rest of the e mail recipients current on the programs which are in consideration in Minnesota.

Carl Draper

I must take exception to you reaction to the commission's report, specifically with regard to the Minnesota Corporation Franchise Tax, as it is properly called.

You seem to buy the commission's argument that corporations don't really pay taxes because:
1.Income, and therefore the effect of the tax on income, ultimately passes down to shareholders.
2.The burden of the corporate tax falls on employees in lower wages, and consumers in higher prices.
These two arguments seem kind of mutually exclusive, but as it happens, neither is very true.
First, corporate income "ultimately" passes to shareholders, but consider the case of Microsoft, which did not declare a dividend for 28 years. No income passed to shareholders because it was all retained. Had there been no corporate tax, all the profits of the Microsoft empire would have gone untaxed for a generation.

So we see that corporate income passes through to the owners slowly and incompletely because a regular C-corporation is not a pass-through entity; if you want income to pass through to owners without being taxed at the company level, you can incorporate as an LLC, a Partnership, an S-corp, a REIT, or some other pass-through structure. The C-corporation is designed to retain earnings, so it is a fair point of taxation.

Where does the "burden" of the corporate income tax fall? If my personal income taxes go up, I might not stop at Starbuck’s for coffee. Does this mean Starbuck’s will bear the burden of my income taxes for me? No. My burden is undivided: For every dollar my taxes go up, I forego exactly one dollar in consumption or savings. Starbuck’s may experience a (tiny) decline in sales, but that is a secondary or indirect effect. It is incorrect to say that the coffee shop “bears the burden.” Though effects do ripple through the economy, the assertion that the burden of a corporate tax falls on employees and customers is simply false.

Money circulates throughout an economy. The art of wise taxation involves applying taxes at many points in the flow, and at rates low enough to avoid distorting the economic activity at each point too badly. While the federal tax on corporate income is large enough to effect corporate planning, there is little evidence that corporate taxes at the state level, and particularly the variations among states, are not large enough to have much effect on corporate planning. Note how few examples one hears of. The Governor is still using an apocryphal story about Marvin Windows from twelve years ago.

Charlie Quimby

Sorry, I don't see how your Starbuck's example supports "the assertion that the burden of a corporate tax falls on employees and customers is simply false."

There are really several questions involved here. The first is whether businesses can pass on the taxes levied against them. It's not just businesses saying yes. The state tax incidence study calculates how much of an effect this transfer has on people at different income levels.

In cases where taxation has been stable for some time, taxes are already a planned part of the company's cost structure; they are built into the prices they charge and the pay and benefits for their workers. Only as a last resort will they pass on the cost of the tax to owners. You may call that an indirect effect if you want, but the cost is passed on in one of those ways — higher prices, lower wages or reduced earnings.

When taxes go up, businesses have to decide which of those will absorb the increase.

Retained earnings is really a separate issue. Under some circumstances, that might delay taxation of shareowner income, but it eventually flows to someone or is spent in a future year. Federal tax laws discourage excess retained earnings.

The second question is whether taxes influence business behavior. I'd agree with you that many business decisions are made net of taxes, and take into consideration a range of non-tax factors. We've made those arguments here. It's very, very difficult to find businesses that have pulled out of a state or shut a plant based on its taxes.

But new investment and growth decisions are more likely to be affected when there is a tax differential between states. The corporate franchise/income tax is certainly not the only state tax businesses pay, but it tends to get the most attention when alternatives are being considered. We can argue whether this is justified, but a higher tax rate may be enough to keep a state off a short list and a percentage point or two might be enough to sway an investment decision.

Despite unfavorable Tax Foundation rankings, a case can be made using the Ernst and Young tax studies that Minnesota's total tax burden on businesses is about average among the states. There are dueling studies on the economic impacts, but none of the studies I know of were done in an economy like the one we're seeing now.

Finally, we should not give up a corporate tax without some kind of swap that brings in equivalent revenue and does not make the overall system more regressive.

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