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A Noose for Big Firms


A Noose for Big Firms

February 28, 2007
Urban PolicyNYC

While Tuesday's stock market slide was a timely reminder of New York's fiscal vulnerability to external shocks, Eliot Spitzer was already voicing concern about the state's economic prospects during his campaign for governor last fall.

In a September speech to business leaders, the then attorney general pledged to "think about New York State's business climate as though I were the chairman of a site select ion committee."

"Our state has the highest combined state and local tax burden in the nation," he observed. "So let me be clear. I have been guarded in my spending proposals because I know that we simply cannot raise taxes and keep New York compel itive. We will not raise taxes".

Despite that promise, Mr. Spitzer 's first budget calls for more than 5500 million in state corporate and bank tax changes that the new governor insists on describing as 'loophole closers," not tax Increases.

The term "loophole implies a tax provision that can be exploited to produce results the law never intended. That might fit a few of Mr.Spitzer's proposals—such as eliminating Heal Estate Investment Trusts as tax shelters. But it's a real stretch for Mr. Spitzer to apply the loophole designation to a provision of tax law that was specifically designed to encourage economic growth by limiting taxes on New York headquartered companies. That's the case with the biggest of the governor's proposed changes, which would raise $215 million a year from large, multistate firms.

The tax provision in question concerns the treatment of income generated by dealings between New York companies and their out-of-state subsidiaries and related companies. Current state law allows parent firms to avoid being taxed on the income of their subsidiaries if they can demonstrate that their "intercorporate" transactions are conducted strictly at arms-length while paying the subsidiaries fair prices for their products and services.

Corporate tax planners—whose job is to legally minimize what their employers pay—have tried to stretch this combined reporting exception by using subsidiary transactions to move profits front New York to less heavily taxed jum risdictions. But New York State has blocked or outlawed flagrant tax avoidance schemes, such as those attributing income earned here to trademarks owned by Delaware holding companies.

At least 17 states, including California, take a different approach. They have adopted "unitary" taxes, which apply to all domestic income, including subsidiary profits, generated by companies doing business within their borders.

Tax policy purists would argue that a unitary tax is a more equitable approach to corporate taxation. After all, a corporation's true ability to pay reflects the combined profits and losses of its related businesses. If you're going to tax IBM at all, why get bogged down in endless diso pules over the nature of its myriad subsidiary dealings? Why not treat IBM the same as many smaller firms—by taxing a portion of all the income it earns from all domestic sources?

Mr. Spitzer would, move New York a big step closer to unitary taxation by requiring corporations to file combined reports of income from all out-of-state subsidiaries with which they have "substantial transactions, arms-length or not. But while broadening the base, he is not lowering the tax rate. As a result, a relatively small number of large employers will get socked with significantly higher taxes. In this way, a change Mr. Spitzer portrays as "promoting tax equity" would be a setback for economic development.

The governor could have made a more credible case for his corporate tax change—and kept his no-tax-increase promise—if he had proposed an offsetting tax rate cut. Unfortunately, Mr. Spitzer's primary objective is not to reform the tax code but to raise revenue. He needs the money to help finance a $121 billion budget whose state-funded component is rising at three times the rate of inflation, despite his commendable effort to control and redirect health care expenditures.

The impact of Mr. Spitzer's corporate tax increase will be compounded by his proposal to extend the same changes to New York City, which imposes its own business income tax of 8.85%, on top of the state rate of 8.75%.

New York City's combined marginal tax rate of 17.6% on corporate net income is the highest in the nation, more than double the rate in most states. The city gets away with this only because of tax law provisions like the existing combined reporting exception, which narrow the base of taxable income for the largest taxpayers. Broadening this base without a rate cut is tantamount to a huge tax increase for some of New York's largest and most valued employers—which is why Mayor Bloomberg opposes it.

According to a newly released Ernst & Young study, New York State's overall tax burden on business was 15% above the national average last year. In trying to squeeze another half-billion dollars out of New York firms without any hint of a tax cut in the offing. Mr. Spitzer has sent an unmistakably negative signal to any corporation weighing its future in the high tax Empire State. If the governor pauses to think like a site selection committee chairman, he'll take Ins tax proposals off the table.