California’s budget: Fixing a harebrained tax system

Budget talks in Sacramento are intensifying as Gov. Jerry Brown presses lawmakers to approve a spending plan in time to put four proposed tax increases on the ballot in June. The plan on the table, however, includes a major change in tax law that would not be put before the voters: a new approach to calculating the bills owed by multi-state businesses. The change would bring in an additional $1 billion a year, narrowing the cavernous gap in the state’s budget. The best argument for it, though, is that the current approach is harebrained and counterproductive.

To spare companies that operate in multiple states from paying taxes repeatedly on the same profits, officials developed a standard formula in the 1950s for calculating how to divide a firm’s profits among the states where it had a physical presence. That formula called for a company’s taxable income to be adjusted by the percentage of its national sales, payroll and property in that state, with each receiving equal weight.

States have drifted away from that standard, however, in their efforts to raise revenue or create jobs. California and numerous other states tweaked the formula in the 1980s and ‘90s to give more weight to in-state sales. More recently, two dozen states, including Texas and New York, decided to tax companies on their in-state sales only. The goal was to attract more jobs and investment than states that continued to factor payroll and property into their business income taxes.

California’s Legislative Analyst’s Office found that the disparity in tax formulas does, in fact, favor states that tilt theirs toward in-state sales. “When states use different formulas (all else equal), firms have an incentive to locate their facilities in states that put more weight on sales and sell into states that put more weight on property and payroll,” its report says.

Two years ago, however, lawmakers in Sacramento chose an approach that’s even less favorable to California and its taxpayers. As part of the budget deal struck in February 2009, lawmakers gave multi-state businesses (other than mines, drilling operations, farms and banks) the option to calculate their taxes based solely on their in-state sales. Businesses could shift between the old three-part formula and the sales-only approach every year, picking whichever led to the lowest tax payments.

That new approach, which went into effect in January, enables companies with large payrolls and investments in California to cut their tax burden by switching to the sales-only formula. Other businesses, however, are better off sticking with the three-part formula and confining their expansions to states like Texas and New York.

Opponents of the optional formula backed a ballot measure (Proposition 24) last year to repeal it and two other corporate tax breaks that had been adopted in the 2008 and 2009 budget deals. But by keeping the three-part test instead of making the sales-only formula mandatory, the ill-conceived proposal would have maintained the perverse incentive for California businesses to expand outside the state. Thankfully, voters rejected it.

Now lawmakers have a chance to undo the mistake they made in the rush to seal the budget deal two years ago. They should seize the opportunity to adopt a new tax formula that considers only in-state sales, putting California’s tax policy back on a competitive footing.