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Franchise Tax is Eliminating Jobs in Minnesota

Monday, June 21st, 2010
by Ford Peterson c2010 (1)

The land of 10,000 taxes…

Minnesota is the home to many corporate giants. Honeywell, General Mills, the former Northwest Airlines, Medtronic, US Bank, 3-M, and many more, located their worldwide headquarters right here in our back yard. Many of these are home grown companies, some of which were started in a garage and grown to be multi-national giants of commerce. Many of these companies are staffed by Union workers making excellent wage rates. All companies doing business here pay homage to Minnesota in the form of the corporate franchise tax. It is my belief that this tax is the root cause for the attrition of jobs leaving Minnesota year-after-year. The quickest way to reverse the trend is to eliminate the tax and once again make Minnesota a tax haven for business.

You cannot understand this complex topic without understanding its far-reaching tentacles. What follows is a tutorial on Minnesota’s franchise tax, as implemented through the Unitary method of allocating tax between states.

HISTORY OF THE FRANCHISE TAX(2)
In 1967, the tax rate was raised to 11.33%. In 1971 it was raised to 12%. In 1981 the rate was reduced to 9% on the 1st $25,000 of income but remained at 12% for large corporations. The death blow to MN jobs came the same year when they also enacted the Unitary method of taxation. In 1987 they reduced the Unitary rate to 9.5% and started with federal taxable income. In 1990 the rate increased to 9.8% and a new fee (up to $5,000/year) was introduced.

In 2005 the legislature had the political will to address the hemorrhage of jobs, at least partially induced by the allocation formula, by passing some allocation reform. Beginning in 2007, the inter-state allocation weighting formula changed from 15% property, 15% payroll, and 70% sales, to 0% property, 0% payroll, and 100% sales, during an 8 year transition period ending in 2014.

The Department of Management and Budget estimated in February 2008 that the corporate franchise tax collections would be $1,034 million(2) for FY 2009. The actual collection for FY 2009 was just over $700 million(3) in 9.8% corporate franchise tax—almost 1/3 less than anticipated. That’s still a lot of money in a state whose anticipated deficit is upwards of $8 Billion for 2010-2011. The real question is, how did the corporate franchise tax alter sales tax, income tax, and property tax, after the Unitary method drove tens of thousands of jobs from the state since imposing Unitary back in 1981? We may never know!

Understanding the malicious nature of this tax policy is complex. In this paper, I will attempt to explain the subtle factors leading up to the imposition of the Unitary method. While some steps were taken in 2005 to reduce the job killing effects by 2014, much of the damage has already been done. It is my opinion that the trendy exodus of jobs can only be corrected through the complete elimination of the franchise tax—even then the correction may take as many years to recover as it took for the damage to occur in the first place (possibly 30 years). While some might argue that this gives big business a ‘free ride’ on Minnesota’s highways of commerce, it is clear that the propensity for these same big businesses to hire highly-paid Union workers is greater when disincentives for doing so are removed from the equation.

WHO PAYS THE FRANCHISE TAX?
When it comes to corporate income tax, there are two types of corporations. An election can be made by certain shareholder groups to either be taxed at the corporate level (C-type), or the individual shareholder level (S-type, or pass-through entity).

S-type corporations pay no tax (other than fees). These are closely held pass-through corporations where the shareholders have agreed to add their allocated share of the company income to their personal tax return each year, and pay the tax personally. They pay the tax once whether they actually receive the money as a dividend or not. Dividends are deemed paid on the last day of the year (and effectively deducted from the corporation’s income subject to MN tax) and taxed at the individual shareholder level.

C-type corporations are groups who either a) cannot, because of the number of shareholders, be S-Corps, or b) choose to pay the tax at the corporate level AND at the personal level when dividends are actually paid. Unlike S-Corps, a C-Corp is unable to effectively deduct the dividend payment from income subject to MN tax. So dividends are paid to shareholders out of ‘after-tax’ income. This introduces the notion of “double taxation.” Income earned is therefore taxed once when the company makes the money, and taxed again at the individual level when the company pays out dividends from funds remaining after the franchise tax.

I’m oversimplifying the election by saying that corporations with few investors (‘closely held’ means less than 100 shareholders) made up of individuals and estates are eligible for S-Corporation treatment. Wall Street entities are excluded from electing S-Corp status because their shareholders number over 100 and often include other corporations, who are ineligible for S treatment. Suffice it to say, big companies are C-Corp and pay the double tax, and small companies are S-Corp and pay tax individually.

The franchise tax is imposed only on C-Corps. It is fair to say, large companies, large employers (often unionized employers) pay the franchise tax in MN. Small companies, and S-Corporations, pay only a filing fee between zero and up to $5,000 per year.

MINNESOTA USED TO BE A TAX HAVEN (PRE-UNITARY TAX)
Minnesota used to be an incubator for business. Small business could become large entities without the entanglement and overhead of a high state tax. MN was also the home to large employers. How can this be? Minnesota has taxed business for decades prior to the Unitary tax. Prior to 1981, Minnesota taxed each separate corporation doing business within the state. Only those doing business here were required to pay a tax to Minnesota. Practical application of tax policy encouraged a business to locate high overhead activities within our borders. How did this work? A national or multi-national corporation usually owns many individual corporations. An illustration is in order. For purpose of illustration, let’s use an over-simplified example to understand.

XYZ Corporation of America, Inc. (parent)

XYZ of Minnesota, Inc. (100% owned subsidiary)
XYZ of California, Inc. (100% owned subsidiary)
XYZ of Florida, Inc. (100% owned subsidiary)

Only the parent’s stock appears on the New York Stock Exchange (or comparable). Profits from the subsidiaries roll-up to the parent through inter-company transactions. Often times one subsidiary manufactures a product and sells it to the other wholly-owned subsidiaries located all over the world.

If any of these individual companies had property, payroll, or sales within MN, there would be “Nexus” to Minnesota imposing the franchise tax based on that subsidiary’s income allocated by the property, payroll, and sales factors located within Minnesota. In any business, there is overhead associated with the operation of a facility and the staff to run it. When located in MN, this high overhead had Nexus with Minnesota, whereas the income did not.

In our example, let’s assume the headquarters is located in MN, along with the primary factory. The other subsidiaries purchase product from the factory and conduct their activities in other states. Suppose that subsidiary manufactured thermostats (or food, or air travel, or medical devices, or magnetic media, etc.) and sell their products world-wide.

Pre-Unitary Example

The headquarters and manufacturing facilities, along with related payroll, are located in Minnesota. Clearly the factory has Nexus to MN because they are not only located here, they also sell products to Minnesotans. These two corporations, headquarters and the factory, have Nexus and were always required to file a franchise tax return. However, subsidiaries located outside Minnesota have no Nexus. They buy product from the factory subsidiary and sell it elsewhere, but they have no Nexus (property, payroll, sales) within the state. No Nexus? No tax return necessary—effectively insulating the non-Minnesota subsidiaries from MN tax. MN was a tax haven!

Let’s further assume that each state consumes the same amount of product, for discussion let’s say product gets sold in 4 different states and $30,000,000 per state. The MN factory would receive income from the other states in the form of products sold to the other out-of-state subsidiaries and from products sold to Minnesotans. 100% of the property, 100% of the payroll, and only 33% of the sales are located in MN. Using the standard 15% / 15% / 70% = 100% weighting implied an allocation percentage of 53.3%. The Headquarter facility actually lost money, because its net income was a loss. So the Headquarters paid no tax even though 100% of its operations were within MN (100% of $0 is $0). The factory earned $1,500,000 nationwide. $1.5M x 53.3% x 12% tax rate equaled $96,000 of MN franchise tax.

UNITARY METHOD OF ALLOCATING TAX TO MN (POST-UNITARY TAX)
In 1981, the Unitary method was introduced. Notwithstanding the many technical arguments for and against Unitary policy ‘fairness’ of allocation amongst the states, most companies find ‘fairness’ in paying less tax. The most notable argument for the Unitary method is that a company can easily ‘game’ the system to reduce their state tax burden—such as with favorable inter-company transactions, which have no shareholder consequence other than a reduction in state tax. The notion of gaming the system is perceived to be a good thing for shareholders and a bad thing for states.

Instead of considering each separate corporation and allocating the Nexus to MN based on property, payroll, and sales, the state demanded consideration of all the other corporations in the group—e.g. “Unitary.”

Unitary Example

Let’s use the same facts and circumstances, but impose the Unitary methodology. We now find that 87.5% of the property (primarily factory), 87.7% of the payroll (primarily factory and headquarters), and only 16.7% of sales, are located within Minnesota. Apply the 15% / 15% / 70% = 100% weighting and you have 37.9% allocated to MN. While 53% was allocated to the factory only income, 38% is now allocated to the whole company income. Instead of considering just the factory income, the entire national income acquires Nexus. Under the Unitary equation and current rates the same group of companies pays $922,000 of franchise tax to MN. Instead of $96K imposed when the rate was 12%, it is now $922K even though the rate is currently 9.8%. That’s nearly a 10 fold increase in franchise tax! Ouch! I’ll bet this got people’s attention back in 1981 when the rate was even higher (12%)!

MN REVENUES (POST-UNITARY)
Is this to say the corporate collections increased 10X starting in 1981? No! This example is provided as a reasonable illustration to describe the tax imposed under Unitary versus separate accounting methods. In practice, national companies operate in all 50 states and around the world. This example company (for clarity of illustration) only operates in 4 states. National companies have factories in many states. So this is an oversimplification. But it serves to illustrate the following truisms:

1) Factory PROPERTY located in MN has caused a portion of national income to be allocated to MN, even though no income may be arriving from within MN borders. Since 1981, and until 2014, locating property outside of MN has provided (and will continue to provide) relief from MN taxation.
2) Headquarters and factory PAYROLL located in MN has caused a portion of national income to be allocated to MN, even though no income may be arriving from within MN borders. Since 1981, and until 2014, locating payroll outside of MN has provided (and will continue to provide) relief from MN taxation.
3) The factor weighting formula (15% to property; 15% to payroll, and 70% to sales, changing to 100% sales by 2014) has a significant impact on the allocation. A national company has had 27 years to adjust its business practices to legally avoid MN taxation by locating business reorganizations and expansions elsewhere. The legislature didn’t recognize this to be a problem until 24 years of attrition had taken its toll on MN jobs. In 2005 the legislature voted to curtail the unfavorable practice and is changing the formula weighting over the next few years. By 2014 (33 years later) only MN sales will factor into the formula.

MN REVENUES (POST-2014)
So what happens to our fictitious company starting 2014?

Beginning in 2014

Assuming the legislature and the Governor choose to keep the 9.8% tax rate, our little company will find some relief under the new “Sales Only” formula. The $96K at 12% (taxed separately) ballooned to $1,129K at 12% (under Unitary), then dropped to $922K with the current 9.8% rate. The new “Sales Only” formula at 9.8% would induce a tax of $405K. While this is a significant improvement, any company having already reconfigured their operations to a no-tax state(4) like, South Dakota, Washington, Wyoming, Utah, or even to a foreign country, would find no joy in re-locating high-overhead operations back to MN unless we make this a tax haven once again.

THE SOLUTION
So what’s the solution? Economists generally believe apportionment formulas appear to be a tax on the factors(5). Eliminate the franchise tax. Much (perhaps all) the damage has been done through almost 30 years of jobs attrition. If eliminated, future changes in home-grown business operations would not need to consider the tax disincentives associated with the franchise tax when considering the option of locating operations here in Minnesota. If Minnesota was a safe-harbor, more jobs would locate here. More jobs equates to more personal income tax collections, more sales tax, and more property tax. Sounds like a win-win-win situation. A win for business, taxpayers, and the state.

REFERENCES:
1. Author grants permission to re-print with proper attribution.
2. http://www.house.leg.state.mn.us/hrd/pubs/ss/sscorpft.pdf
3. http://www.taxes.state.mn.us/taxes/legislative/PDFWeb/2010UpdateLegPackPrimerCorporate.pdf
4. http://www.house.leg.state.mn.us/hrd/pubs/ss/ssappss.pdf
5. http://www.house.leg.state.mn.us/hrd/pubs/ss/ssapcft.htm#Q7

Optimum Rate of Tax

Sunday, May 23rd, 2010

By Ford Peterson © 2010

Did you know that there was an optimum amount of tax?  It’s true.  There is a point where too little is being done as a community, and another point where the overhead becomes a drag on the economy.  As a portion of Personal Income, the federal government collects about 21%[1] and MN collects another 16%[2] for a total of 37% of Personal Income.  Is this too much?  Too little?  There is a way to determine the optimum.  The notion of Optimum Tax Rate is inseparably entwined with the population’s ability to Save.

A Call for Bigger Government

The DFL caucus is universally calling for more revenue.  With the economy on the ropes, loading additional burdens on people seems, at a minimum, counter-productive.  More than likely, additional burdens could even be destructive.   Calls to “Tax the Rich” are commonplace today, followed by cheers of hooray from the little people.  Guess what folks.  The “Rich” own Minnesota.  They own the engines of commerce, the banks that hold the mortgages, and the politicians hired to run the place.  Gouge the ‘rich’ and they extract more rent from everybody to compensate.  More than likely an aggressively progressive tax system would incentivize the rich to move away and avoid Minnesota (Oops!  Cook the Golden Goose and she stops laying golden eggs!).  Many argue that government is already too big.  Yet the seemingly endless line of people in need indicates to compassionate people that government is not big enough.  What does this have to do with tax rates and saving rates?  Let me explain…

Balanced Budget Multiplier

A balanced budget happens when revenues are sufficient to offset spending.  On a macroeconomic scale, the population as a whole is roughly indifferent to a balanced budget.  I liken it to scooping water out of one side of the pail and dumping it into the other.  The money circulates around and life is good.  There are two counter-balancing variables in this equation.  Consider the multiplier (over simplified but here goes) to be spending over revenues.  A balanced budget is 1:1 spending to revenue.  There are numerator (spending) effects and denominator (revenue) effects.  Understanding how this relationship is affected under various conditions allows us to answer the question: “Can we afford higher taxes?”  When 20% is extracted, and 20% is spent, we have a balanced budget.  When 60% is extracted, and 60% is spent, we still have a balanced budget.  Obviously the size determines who gets to consume the income.  Is it spent by the individuals that generated the revenue, or by society as a whole?  The overall size of the budget matters.  When is it optimum?  The equation is optimized when the budget includes saving.

Surplus Vs Deficit

Economists have long understood, and politicians have learned to amplify, a budget deficit will accelerate the circulation of money because the government is spending more than it is extracting.  Surplus of course means just the opposite.  When spending increases to exceed the extraction, money circulates quicker.  A budget deficit is therefore analogous to going on a spending spree with your credit card, or fueling consumption by liquidating your savings.  I don’t mean investing it, I mean consuming.  The federal government has the added luxury of being able to print money, which induces inflationary effects well beyond the scope of my thesis.  However, the state does not have the luxury of printing and is therefore limited to either: 1) borrowing; or 2) spending reserves; or 3) taxing.  Whether the government borrows the money or prints the money, as long as they spend more than they extract there is a positive budget multiplier in play (spending over revenue).  A ratio less than 1 is negative on the economy.  A ratio greater than 1 has a positive influence.  Although very difficult to measure accurately, the multiplier effect is universally known to exist.

So why not spin-up the economy by running only deficits?  Eureka!  That’s exactly what has been happening at the federal level for many years.  The natural limit on this multiplier is that we live in a world with limited resources.  The state’s limited cash reserves can quickly be depleted.  Politician’s can only borrow so much before credit ratings deteriorate and cost of borrowing becomes prohibitive or credit disappears.  Since the state cannot print money, it must therefore choose to eventually extract it from the people.  With the state, the Surplus / Deficit issue is all about timing.  Minnesota’s annual cycle arbitrarily runs from July through June.  Over time, consumption must be funded and credit lines must be paid.  Oh yes, silly me.  There is also the often used political trickery referred to as “kicking the can down the road.”  Can this be done forever?  Forever is a long time.  But I digress…

Forced Consumption Versus Saving

The government is not the only entity involved with the economy.  Each individual and business can run a deficit or surplus.  On the aggregate, individuals with more revenue than expenses can ‘save’ the money to spend later.   Businesses can build cash reserves (equity) using the very same principle.  And when they save, they are not consuming.  Increased consumption fueled by liquidating savings, or through additional borrowing, creates a positive economic multiplier.  And failing to consume revenue is a negative economic multiplier.  This creates a political paradox.  It is good for my personal economy when I save, but it’s bad for the entire economy when anybody saves.  Yet saving for future need is paramount to the sound management of resources.

The government resolves the paradox by choosing a rate of tax.  By spinning more money through the treasury, the ability to save is limited.  The government can force you to consume by extracting the money and consuming it for you.  Sounds evil doesn’t it?  In large measure, they spend it on each of us in the form of infrastructure and presumably ‘necessary’ services.  Everybody wants roads, bridges, sound banking, personal safety, courts, police, fire, schools, welfare, etc.  If the proxy spending sounds evil, get over it and figure out how you want to pay for the shared consumption, or help figure out what we can do without.

Over time, the winners and losers fine-tune the tax code to conform to the political winds blowing—lobbying to get somebody else to pay.  Eventually it gets tweaked again, loopholes disappear, and inequity gets evened out.  Ultimately, in an otherwise benevolent and democratic society, the rate of tax settles around ‘from each according to his ability, to each according to his need.’  This of course is a quote right out of a text on Marxism[3].  That’s scary!  Please don’t shoot the messenger.  Redistribution is a well understood procedure, promulgated by your government.  But again I digress…

Ability to Save is the Barometer

So the rate of tax is too high when saving becomes too low.  What is too low?  We each view the room from our respective corner.  A biased opinion would suggest that all the money I can save is good for me, and any money you save is bad for me.  Obviously this is the extreme position at the microeconomic level.  In my unbiased opinion, any macroeconomic budget that includes some saving is more reasonable than a budget with zero or negative saving.  Bad things can and do happen to good people, and to the nation, or to the states within.  Saving for that rainy day is imperative to prudent management of money.  The same is true of individuals, business, and government.

What is Saving?

Good question.  Economists consider saving to be the act of setting income aside to conserve it for future consumption.  Investing is something you do after you have saved it.  So don’t confuse investing with saving.  Saving is simply NOT consuming it today.

Why don’t economists consider the family residence in the ‘saving’ equation?  In some respects paying for the family residence is an act of setting money aside, but it’s different because buying a house is not necessarily consumption.  If everybody built a brand new house, and nobody recycled old houses, then building a house would look more like consumption.  Remember, the definition of ‘saving’ is setting income aside to conserve it for future consumption.  The home does not fit this definition.  Increasing home prices would have suggested some windfall saving in addition to the mortgage payment—especially in an environment where people pull the equity every 3-4 years and consume it.  Decreasing values have the opposite effect.  In any event, including a personal residence as saving doesn’t fit the measure we are looking to use as a guidepost to striking a balance regarding: “How high a rate is too high?”

It is interesting to note that the United States used to measure savings in the form of M3, an empirical measurement of the components of savings.  In November 2005 the practice of disclosing it was discontinued.[4] Rest assured the minions in charge of our currency are tracking it.  They simply don’t want the people to be concerned about policy or practice.  Today the people can only estimate the rate of saving.  It is believed that the rate of saving in America is now zero.[5] The implication is that we are officially over-taxed making this a perfect time to cut spending and the rate of tax.

Individual or Shared Responsibility

The implication of saving seems obvious.  To be clear, if you have no savings, your needs will eventually overtake your ability to provide for yourself.  In America we have a complex maze of social safety nets funded by individual responsibility (insurance, saving, etc.), private charity (homeless shelters, etc.), and government institutions (Social Security, Medicare, Medicaid, welfare, etc.).  Pressure from an aging population coupled with abuses imposed by foreign invaders has brought these social structures to the brink of failure.[6]  Individual willingness to consume to the point of zero saving implies a willingness to consider complete reliance on government to provide in a time of need.  People stopped saving after government convinced them that society will provide.  Of course this notion is not correct, or in any event unsustainable.  We need to change the equation.  Lower the tax and increase the expectation that personal responsibility will be rewarded.

Timing of Save Versus Tax

In an effort to de-politicize currency issues, the United States has delegated the responsibility of managing our currency to the Federal Reserve, the Chairman of which is appointed by the President.  Artificially establishing the rate of interest has been used as the lever to suppress an over-cooked economy, or stimulate an economy in need of vitality.  The lever has been effective at securing a relatively constant rate of inflation.  But the mechanism is broken.  Interest rates are at zero.  Being in possession of savings has been rendered valueless!  This traditional method imposes a significant burden on those accumulating savings to provide for retirement, etc.  We are also watching in dumbfounded amazement as Billions are being paid as bonuses to bankers standing in the money stream of access to free money.  A more fair method would impose a variable tax on the people, accumulating reserves during the good times and providing stimulus during bad.  We all watched in horror as the price of oil skyrocketed, and witnessed the negative implication of this added “tax” on the people.  doubly offensive was the realization that the additional tax burden was being paid as profit to nations who hate our very existence.  Perhaps a high but variable rate of tax on oil is the answer?  It would work, but how do you de-politicize this function?

Conclusion

In this age of hyper-capitalism[7], a tax is imposed based on needs.  Those with more income and means are taxed higher than those without.  Don’t shoot the messenger; let’s deal with the dilemma of balancing needs and surplus.  Increasing community supported infrastructure may be warranted when the population is in an economic surplus, measured by its ability to save.  In an absence of surplus, extracting less revenue will stimulate the economy.  In the current zero saving environment, spending must first be reduced to equal the extraction.  The tax must then be reduced even further to bring the economy back into equilibrium without adding to the already skyrocketing debt.  The only reasonable answer is to reduce the size of the government budgets, reduce the burden we have asked government to impose on society.  And do so by reducing the Treasury’s public consumption. 

The Chinese people have been saving at record rates and are fortunately buying our national debt[8].  Eventually, the foreign governments structured with policies that encourage saving may realize they too will need to force consumption on their people and raise the tax to do so.  When they raise the rate of tax in those countries, the saving rate in those countries will correspondingly slow, just as it has for those of us in the United States.

Be an informed voter in this November’s elections.  The size of government will be determined by those you elect to represent you.  Be informed.  Demand position papers.  Hold their feet to the fire when they deviate from their elected path.  Don’t be misled by disingenuous rhetoric like “Tax the Rich.”[9]

The opinions expressed are those of the author.  No politicians were injured in the delivery of this message.  You are free to copy and quote giving proper attribution to the author.

References:


[1] http://www.gpoaccess.gov/usbudget/fy09/pdf/spec.pdf  Table 17-1 on pp 245.  18% of GDP equates to approximately 21% based on personal income, a more meaningful measure of available spending.

[2] http://www.mmb.state.mn.us/doc/budget/report-pog/july09.pdf  See the graph on page 1.  The average of years 2006 through 2011 is 16.05%.  It varies up and down between 15.5% and 16.5%.

[3] http://en.wikipedia.org/wiki/From_each_according_to_his_ability,_to_each_according_to_his_need

[4] http://www.federalreserve.gov/Releases/h6/discm3.htm

[5] http://articles.moneycentral.msn.com/Investing/Extra/USSavingsRateFallsToZero.aspx

[6] http://www.cis.org/articles/1998/IR32/impact.html

   http://www.cis.org/Illegal

   http://www.pbs.org/itvs/beyondtheborder/immigration.html

[7] Hyper-capitalism is defined here to describe where one party to a transaction is indifferent to the social consequences.  Sale of tobacco, abusive banking practices, legal gaming, etc., are good examples.

[8] http://www.guardian.co.uk/news/datablog/2010/mar/09/china-federal-deficit-us-america-debt

[9] http://www.forbes.com/2010/04/15/dont-tax-rich-opinions-columnists-john-tamny.html