NYU Tax Policy Colloquium, week 12: Kim Clausing's "Lessons for International Tax Reform from the U.S. State Experience Under Formulary Apportionment"

This past Tuesday, Kim Clausing presented the above paper.  It examines evidence concerning the U.S. states' experience with formulary apportionment for corporate income.

The background is as follows.  With the source of income being notoriously difficult to pin down, when earned by a multi-jurisdictional company, two main approaches currently prevail.  In the international realm, countries generally use transfer pricing.  For example, in deciding to what extent Apple's worldwide income pertains, say, to the U.S. parent as opposed to an Irish affiliate (and is treated as U.S. source as opposed to foreign source), the key question is what arm's length price we should attribute to the hypothetical transaction between the two affiliates.  By contrast, when the same issue rises within the U.S. under state and local income tax systems, various formulary apportionment (FA) approaches apply.  Under classic FA, the percentage of the national company's income that is treated as arising in-state depends on the extent to which the company's property, payroll, and sales are to be found in-state rather than out-of-state.  (Intangible property usually is kept out of the property computation, given the difficulty of assigning it a meaningful location.)

Charles McLure famously showed, in an article some decades ago, that state and local corporate income taxes, when the taxable share depends on FA, resemble directly taxing the apportionment factors.  Thus, basing the income measure is a bit like having a property tax - if you locate more property in the state, you owe more, although the details also depend on the amount of overall corporate income.  Likewise, using the payroll factor is a bit like taxing in-state employment, and using the sales factor is a bit like having a sales tax.

Recent decades have brought considerable movement at the state level away from using a simple three-factor formula in which all three of the above get equal weight.  For example, a number of states double-weight sales, and others only look at sales.  This shift reflects pressures of tax competition, and/or arguments made to state legislators based on tax competition, with the idea being that you don't want to lose in-state investment or job opportunities, but that sales are relatively immobile.  It also has the effect, albeit crudely and imperfectly, of making states' corporate taxes more destination-based, and possibly also more sales tax-like.

A study of the economic effects of using FA, with or without giving sales pride of place, is of interest given the possibility that a given country, such as the U.S., could revise its international rules to move part or all of the way from transfer pricing to FA.  (The U.S. rules already have some formulary elements, however - for example, pertaining to interest expense - and it's also likely true that in practice putting more factors in a given jurisdiction may influence transfer pricing outcomes.)  Indeed, Clausing has coauthored an article, with Reuven Avi-Yonah and Michael Durst, arguing for the use of sales-based FA in international taxation.

A couple of earlier papers in the field found that states did indeed get some of the positive effects they were seeking (for example, with respect to employment) when they shifted towards giving sales greater weight in the formulas.  Clausing's study, however, finds very little effect apart from revenue loss (which apparently was anticipated).  The why of the revenue loss is itself an interesting question, possibly reflecting who converted when and also the fact that lots of sales escape being allocated anywhere under typical state formulas.

The paper's somewhat negative finding arguably suggests that shifting to FA in international tax would prompt only smaller, rather than larger, real tax planning responses.  On the other hand, as it recognizes, extrapolating from the state to the international level can be risky.  State and local tax rates may be too low to induce much tax planning, especially if it has significant fixed costs, but this clearly need not be true at the international level.  On the other hand, it's presumably easier to shift factors such as property and payroll between states in the U.S., as distinct from between separate countries.

Also, if the paper's finding smaller responses than the earlier literature had reflects a change over time, as more and more states altered their formulas, this might be evidence of early mover advantages.  That might weigh in favor of a given country's deciding to be the first or one of the first to shift from transfer pricing to FA.

I think of the case for FA as based largely on "costly electivity" - that is, on the hope that forcing companies to make real changes in what they do, as the price of getting more favorable results, will have a favorable ratio of revenue raised to deadweight loss incurred. Whether this hope would be realized in practice would depend in good part on the design of the FA rules, and in particular how they countered various new tax planning opportunities that they might create in lieu of the old ones.

In two weeks, we will return to transfer pricing versus FA as an international tax issue, in connection with a paper by my NYU colleague Mitchell Kane that reflects greater sympathy for transfer pricing in the international realm than I personally can summon up, based in good part on claimed advantages from its being already in place.  I've been working ahead as the end of the semester nears, but will wait to address here until that session actually occurs.