On the Extent, Growth and Efficiency Consequences of State Business Tax Planning

ABSTRACT: Our focus in this essay is on the extent to which tax planning in response to variations in state tax policy has affected state corporate income tax bases and revenues. Tax planning is defined as a broad set of actions undertaken by firms to reduce their tax liability. Financial or accounting tax planning is contrasted with what we refer to as locational distortions, in which firms move physical operations to avoid higher tax liabilities. Results from a fixed effects instrumental variables regression model using a 1985-2001 panel of state-level data provide highly suggestive evidence that tax planning activity significantly diminishes taxable corporate profits in high tax states. Specifically, we find that state corporate income tax bases decline by nearly 7 percent following a one-percentage-point increase in the top marginal corporate income tax rate, controlling for locational distortions. We also find that throwback rules are usually ineffective in restoring corporate income tax bases while combined reporting requirements are often effective. Further analysis indicates that tax planning has not diminished the locational distortions of tax policy