Closing Corporate Tax Loopholes Testimony: HB 1186

By Phineas Baxandall
Senior Analyst for Tax and Budget Policy

General Assembly of Pennsylvania House Committee on Finance


Chairman Levdansky and members of the Committee:

Thank you for the opportunity to offer PennPIRG’s views on reforming the tax code by mandating “combined reporting.” We commend you for convening this timely hearing. As you know, PennPIRG has long been an advocate for combined reporting as way to make our tax system fairer and more efficient. PennPIRG, the Pennsylvania Public Interest Research Group, has been an advocate for the Commonwealth’s consumers since it’s founding in 1986.

My name is Phineas Baxandall, Ph.D., Senior Analyst for Tax and Budget policy for PennPIRG. Previous to working for Public Interest Research Groups around the country, I served as a lecturer at Harvard University and on staff of the Taubman Center for State and Local Government at Harvard’s Kennedy School of Government.

My testimony today will not focus on the additional revenues that combined reporting would make available to the budget, or how these revenues could support public structure or broad reductions in tax rates. I will instead focus on the tax-fairness and administrative problems for which combined reporting would help to solve, as well as the extent to which combined reporting has become standard best practice among states. I focus my discussion this way because PennPIRG combined reporting is a basic issue of tax fairness and tax modernization that should be enacted regardless of the revenue consequences and regardless of whether the Commonwealth faces persistent budget deficits or surpluses.


1) The Problem that Combined Reporting Solves:

State tax systems were crafted at a time when few businesses operated across state lines. With the exception of Hawaii and Alaska – both of which have combined reporting – the inherited architecture of state business taxes comes from a time when tax shifting with out-of-state subsidiaries was simply not an issue.

Over the years Pennsylvania businesses increasingly find themselves competing against or part of multi-state corporations with operations in multiple tax jurisdictions. That presents a quandary for assessing taxes on profits. Imagine yourselves some business with far-flung operations and subsidiaries. Revenue departments face the potential task of figuring out which costs and revenues should most accurately be assigned to particular corporate entities. Businesses executives argue among themselves over what operations should be considered cost drivers and profit centers, and they often change assessments year to year or quarter to quarter. Tax officials could not hope to accurately second-guess these assessments.

Thankfully, states created formula-based assessment. Companies pay taxes based simply on their in-state business activity. These formulas, which differ between states, require businesses to apportion their profits based on the percent of sales, assets and workforce in the state.

But out of state subsidiaries challenge this system by allowing some companies to use creative accounting to avoid paying their share of taxes. Four examples:

  • Inflated transactions – Small-scale operations can be created in one of the few states without an income tax, like Nevada. The subsidiary may consult to it’s Pennsylvania operations, or it may own the land or equipment used by the Pennsylvania operation, for instance. If accountants for the Pennsylvania artificially inflated the value of these transactions, they will erase the taxable Pennsylvania profits and shift them to a jurisdiction where they can not be taxed.
  • WorldCom – The telecom giant managed to avoid state taxes by creating what a court later determined was a sham subsidiary in Mississippi whose only asset was the “business foresight” of its WorldCom’s top management. WorldCom then erased – on paper, at least – billions in taxable profits by having its Mississippi subsidiary charge its state operations billions in royalties for use of the foresight. The subsidiary did not pay taxes on these profits because income from intangible property is not taxed in Mississippi. WorldCom was not alone in adopting this tax strategy. It came at the recommendation of a leading accounting firm, KPMG. The facts only came to light because of a leak from some disgruntled WorldCom bond holders.
  • Toys ‘R Us – Similar to the WoldCom maneuver, the toy company greatly reduces its taxable profits because operations around the country large fees to pay a Delaware subsidiary for use of the “Baby Jeffrey” character and its logo. This intangible-property income is not taxable in Delaware where the subsidiary is based. Unlike the WorldCom strategy, this practice was declared legal by a judge after being challenged by the state of South Carolina.
  • Wal-Mart – As documented recently in a front-page story in the Wall Street Journal, the retail giant largely escapes taxes by creating real estate trusts (REITs) that Wal-Mart stores use to erase their reported profits by paying it large rents. Real estate trusts are then exempt from paying taxes on this income. Wal-Mart claims to meet the legal requirement that a REIT have at least 100 independent shareholders because the company distributes 1 percent of its nonvoting stock to a group of 100 senior managers.

State tax authorities can not effectively police these forms of creative accounting. These examples come from court cases that have brought the practices to light. But more generally, state tax authorities are at a loss to second-guess the true value of transactions between corporate subsidiaries. Legislatures can pass laws to close particular well-understood loopholes, such as the Baby Jeffrey loophole. But the legislative process is slow and tax authorities can not keep up with the booming industry of consulting and banking firms that constantly invent – and sometimes even patent – new tax avoidance techniques. State tax authorities do not, and perhaps should not, have the resources and authority it would take to keep up with these accounting shell games. Tax authorities are simply outgunned.

As evidence, I submit to you figures on the resulting decline in state corporate income tax collections. Please keep in mind that these declining tax payments are not generally the result of falling tax rates. Also keep in mind that in lieu of these revenues, governments have had to shift the tax burden to individual households through higher taxes and fees. These charts were prepared by Harley Duncan, Executive Director of the Federation of Tax Administrators, based in Washington DC.

The first figure documents how state and local taxes across the country capture a smaller and smaller portion of corporate taxes around the nation. It tracks the trends in corporate profits since 1979 compared to total taxes and those at the state and local level.

The next three figures clarify and underscore the meaning of the first. Figure 2 shows that the effective rate of state taxes has trended sharply downward from a peak of about 8 percent to a low-point below four percent. The slight upturn in recent years may be because profits have been so high that they are harder to conceal, or it may also result from some states becoming more aggressive in trying to close individual loopholes.

Figure 3 demonstrates that the declining share of corporate profit taxes in total state taxes has nothing to do with flagging profit rates. On the contrary, profits have been strong in past decades, averaging 8 percent annual growth over the period and far more in recent years.

Figure 4 demonstrates what logically follows. The falling effective rate of state income taxes – largely as a result of growing tax avoidance – leads to a falling share of the tax burden shouldered by corporate profits, and thus increasingly from higher taxes and fees on individuals. Nationwide, the share of state taxes paid by corporate income taxes has fallen from about 10 percent to about 6 percent. In Pennsylvania, this decline has been even more pronounced, falling from 12.6 percent in 1979 to 6.2 percent in 2005.

One study which looked more specifically at Fortune 500 corporations in 2003, showed that these companies paid only one-third of the statutory state-level tax rates on profits.1 They were able to use exemptions, write-offs, or other strategies to avoid the rest. Moreover, 28 percent of these large corporations paid no taxes at all for at least one year between 2001-2003, despite reporting $86 billion in profits to their shareholders during these no-tax-payment years. No wonder that an April 2006 Gallop poll shows 70 percent of Americans agreeing that corporations pay too little in taxes.

In our opinion, these lost revenues would not be such a problem if they were the result of popularly backed legislative intent. They are instead generally the result of inaction and revenue departments being overwhelmed by tax-avoidance strategies they are unable to police.

Moreover, the result of these shifting tax burdens is a tax burden that places some companies at an unfair competitive disadvantage against others. Companies with access to high-powered tax lawyers and, most notably, those that can make use of out-of-state subsidiaries are unfairly favored by the present system. We believe that Pennsylvania will best thrive when businesses prosper based on their productivity and ability to innovate, rather than their opportunities for tax avoidance.


2) How Combined Reporting Works

California was the first state to create combined reporting in 1937. California decided to get out of the business of outfoxing corporate tax lawyers, rather than sorting through transactions between subsidiaries and trying to establish which might be sham transactions and whether they reflected the true corporate structure of these entities. Companies with subsidiaries were simply asked to file together as a single entity.

With combined reporting the question of which subsidiary should be assigned particular profits or losses becomes moot. Transactions between corporate subsidiaries similarly need no longer be scrutinized. The combined entity’s profits will still be apportioned to the state and taxed based on its in-state business activity. Some states such as Texas and Ohio have enacted combined reporting on gross receipts taxes instead of corporate income taxes because these are their alternative form of broad business tax. The effect is the same: to bypass the effects of any accounting fictions created through the use of out-of-state subsidiaries.

Moreover, as an increasing number of states enact combined reporting, companies can use more or less the same spread sheet for each state. Any multi-state company should know the breakdown of its sales, assets, and workforce by state anyway. Combined reporting is a form of tax simplification.


3) Combined Reporting is Become Standard Best Practice

States across the nation have begun fighting back against corporate tax shelters and loopholes. This budget year six governors and legislatures in at least four other states have proposed combined reporting as a way to stop some companies from avoid taxes by shifting reported profits out of state. Our neighbors in New York and West Virginia enacted combined reporting over the last two months.

Several factors are driving this year’s reform efforts. First, high-profile court cases have publicized corporate tax-avoidance strategies that highlight the weakness of existing laws. Exposure of practices at prominent corporations such as MCI/WorldCom, Toys R’ Us, and Wal-Mart have raised public awareness of aggressive corporate accounting strategies that shift the tax burden away from large corporations through creative use of the tax code.

Second, there is a growing awareness that these loopholes are not necessarily good for business. Arnold Hiatt, former CEO of Stride Rite shoes in Massachusetts, wrote to the Boston Globe that tax reforms including combined reporting, “would benefit our state’s business community by leveling the playing field among businesses.” Although most tax-avoidance strategies are perfectly legal, they disproportionately benefit larger companies that work across multiple states. As a result, smaller in-state businesses find themselves at a competitive disadvantage.

A third factor driving reform has been support from elected officials who face additional revenue needs and understand that closing tax loopholes will make it possible to avoid levying new taxes. As you are I’m sure well familiar, rising health care and energy costs demand more revenues for schools, roads, and other public structures. Unfunded federal mandates for state spending on things like homeland security have further dilutes scarce state resources. In this context, the failure of multi-state companies to pay taxes have put elected officials in a double bind. They have fewer dollars available to meet public needs, while smaller companies and the citizens who elected them have been forced to pick up the tab.

With ten states enacting or considering enactment, combined reporting is emerging as standard practice for a modernized state tax system. This trend is especially clear if we examine the sheer economic size of the states that have recently passed or proposed combined reporting. Back in 2004, states with combined reporting represented less than 29 percent of the nation’s total gross domestic product.2 New York and West Virginia have since joined Texas, Ohio and Vermont in adopting combined reporting for their business taxes over the last two years. These are mostly large states with big economies. If Gubernatorial proposals for combined reporting in Michigan, Massachusetts, North Carolina, Pennsylvania, and Iowa follow suit, combined reporting will become law in more than 61 percent of the economy by 2009. Combined reporting would cover almost two-thirds of the nation’s economy if bills pending in Maryland, Missouri and New Mexico also become law.



In conclusion, combined reporting makes sense as a tax simplification that modernizes the tax system and levels the playing field between businesses. I urge the members of the Committee support future legislation for combined reporting.

  1. This analysis can be found at
  2. See The state tax rate is a weighted average based on gross state product. The sample represents the 252 corporations that reported net profits each year between 2001-2003 and which reported sufficient SEC information that it was possible to calculate aggregate tax rates.
  3. States using combined reporting for corporate income taxes in 2004 were as follows with percent of GDP listed: Alaska (0.3), Arizona (1.7), California (13.1), Colorado (1.7), Hawaii (0.4), Idaho (0.4), Illinois (4.5), Kansas (0.9), Maine (0.4), Minnesota (1.9), Montana (0.2), North Dakota (0.2), Nebraska (0.6), New Hampshire (0.4), Oregon (1.2), and Utah (0.7). New York (7.7), Ohio (3.6), Texas (8.0), West Virginia (0.4) and Vermont (0.2) issued combined reporting laws in the last three years. Data is from the U.S. Bureau of Economic Analysis measures of 2005 gross domestic product by state calculated as a percentage of the entire state-based gross domestic product, including Washington DC and four states with no corporate income tax. Raw data available at table 3A.

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