Romancing the smokestack : formula-apportioned corporate income taxes and regional economic development

States have always competed for new investment and business expansion, but the competitiveness of economic development at the state level has greatly intensified over the last several years. This increased use of economic development incentives and intensified levels of state and local tax competition has generated some controversy over the efficacy and efficiency of these policies. This paper is a detailed investigation of one such policy: altering the factor weights in state corporate income tax apportionment formulas.

Formula apportionment, which is used by all U.S. states to allocate the taxable income of multistate corporations, measures the proportion of a multistate firm's income earned in a given state as a weighted average of the state's shares of total firm sales, property, and payroll. Traditionally, states have employed an equally weighted formula, but recently many states have moved towards a greater weight on the sales factor (uniformly lowering the weights on property and payroll factors) in an effort to export more of the corporate income tax burden and to encourage economic development. A two-region, eight-sector computable general equilibrium (CGE) model is developed to evaluate the likely impact of disproportionate sales factor weights on economic development, state government finances, and state and national welfare. The choice of specific policy changes examined is designed to highlight the competitive nature of recent moves towards disproportionate sales factor weighting. Not only is a single state's move to disproportionate weighting considered, but also the impact of potential responses by other states.

The results from the CGE analysis indicate that the efforts of states to stimulate economic development by placing a disproportionate weight on the sales factor are effective in terms of the direction of the effects, but that the magnitude of the effects is very small. Regional characteristics such as size and industrial make-up and situsing rules can significantly influence the efficacy of the policy. Revenue effects, while also small, are significantly larger in magnitude than are the economic development effects. The analysis shows that states may have been overestimating the impact that disproportionate sales factor weighting has on economic development, while at the same time, states may have been paying too little attention to the revenue consequences.