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Blake Christian
Blake Christian

Relative State Income Tax Burdens and Federal Tax Reform

Ten reasons why the U.S. should adopt a territorial system of taxing foreign earnings.

May 26, 2011
by Blake Christian, CPA, MBT

With the relative national debt at its highest level since World War II, state deficits looking just as grim and the economy still struggling to pull out of a two year tail-spin that taxpayers have faced, business owners and their employees have been working longer hours to stay afloat in the current economic environment. Now they can also anticipate working more in the near future to pay off the likely increases in federal, state and local taxes that are still looming in future federal and state/local budgets.

The Tax Foundation has produced two recent studies, which provide some interesting perspective for analysis and potential federal, state and local tax reform.

How Is Your Tax Clock Working for You?

Based on a study done by Kail Padgitt and Alicia Hansen, the average American devotes over a quarter of their standard eight-hour work day to paying various taxes — federal, state and local income tax, social security tax and Medicare, sales and excise tax and even property tax. If we add in payments required to pay down the federal deficit, the average American would need to use up their entire morning income to cover their share of the various government tax burdens.
According to the study, Connecticut, New Jersey and New York are the states with the highest tax burden, which requires the average worker to work until 11:13 (assuming a 9:00 a.m. start time) to pay-off their daily tax burden — only then do these taxpayers begin banking money for "extras" such as food, housing, cars and other creature comforts. Maryland, Washington and California represent the next batch of the bottom rung of tax unfriendly states. The states with the lowest relative tax burdens (which can burn-off the tax bite before 11:00 a.m.) include: Mississippi, Tennessee, South Carolina and Louisiana. or a full listing of all states and their relative tax burdens, please refer to the full study.

The morning tax burden is broken out by tax type in the report as follows:

  • Individual income taxes require the most work. All but seven states and some localities, levy an income tax. When these are added to the federal income tax burden, income taxes are projected to amount to an average of 46 minutes of work in an eight-hour workday.
  • Social insurance taxes (such as Social Security and Medicare) require 29 minutes of work.
  • Sales and excise taxes require 20 minutes of work.
  • Property taxes require 16 minutes of work.
  • Corporate income taxes also require 16 minutes of daily work.

While tracking your minute-by-minute tax burden may be a depressing thought, the report does give us all a unique perspective on how we fund our taxes. This may also be useful information to pass along to your federal, state and local representatives since the report personalizes the tax bites better than other analyses.

Potential Federal Tax Reform

With the country just beginning to see some positive indicators since the beginning of the year, both businesses and individuals are still semi-reluctant to hire and/or to spend. Business owners are still focused on the future tax structure as they develop their hiring, capital investment and overall business plans.

Therefore, there is no better time than the present for our federal and state legislators to fully assess our current federal, state and local tax policies and structure and begin working towards true, long-term tax reform. The House Ways and Means Committee understands that the immediate focus should be on how comprehensive tax reform can help spur job creation in the U.S. and make American businesses more competitive in the global economy.

President Obama even addressed this issue in his January 25, 2011 State of the Union Address, saying that Washington's goal is to make the U.S. a competitive place to do business in and do business from. Unfortunately, due to the extreme complexities of the U.S. Tax Code and lack of a coordinated and comprehensive restructuring of the often unintelligible patchwork of statutes developed since the 1900s, a simple fix is just not in the cards.

One school of thought being discussed by some Beltway legislators, scholars and lobbyists is to:

  • Lower the current corporate tax rates, which begin at 15 percent and top out at 35 percent for C Corporations. Our top federal rate is already significantly above the average for the industrialized world and
  • Move toward a territorial system in which foreign profits are taxed only once.

The Tax Foundation released two new studies earlier this month:

  1. Ten Benefits of Cutting the U.S. Corporate Tax Rate (PDF) and
  2. Ten Reasons the U.S. Should Move to a Territorial System of Taxing Foreign Earnings (PDF).

The current U.S. tax rate is 35 percent. Along with an average 6.56 percent state tax rate, this puts the average combined tax rate at 39 percent, net of state taxes. The weighted average of the Organization for Economic Cooperation and Development (OECD) nations is 30 percent and the simple average of OECD nations is 25 percent (which would match China's rate). Therefore, those pushing for a reduced federal rate believe that legislators should seriously consider lowering the federal tax rate so companies can stay competitive and foster economic growth in all areas.

In addition, the current worldwide tax system generally allows all business income — earned at home or abroad — to be taxed at the U.S. rate. Companies may defer paying U.S. tax on active foreign income until it is brought "home" (in other words, received by the U.S. taxpayer). Even though companies and individuals may claim a credit for foreign taxes paid, they must pay the difference between the amount of tax paid to the foreign government and what would be owed under the generally higher U.S. tax rate. This means that at the end of the day, the taxpayer still pays the higher U.S. taxes unless they keep their earnings offshore. This tax system calls for reform as outlined below.

U.S. Should Move to a Territorial System of Taxing Foreign Earnings

According to the study (PDF), below are the 10 reasons why U.S. should adopt a territorial system of taxing foreign earnings:

  1. Parity. The U.S. system must be aligned with our global trading partners.
  2. The Experiences of Japan and Great Britain are lessons for the U.S.
    1. The Japanese experience: A worldwide system combined with a high corporate tax rate was a disincentive to repatriating profits.
    2. The British experience: A worldwide system and a high-by-European-standards tax rate forced companies with large global sales to relocate to lower-taxed countries.
  3. The premise of the worldwide tax system — capital export neutrality (CEN) — is obsolete when subsidiaries have access to global capital markets and can self-fund their expansion with retained earnings.
  4. The worldwide tax system violates the benefit principle of taxation.
  5. The U.S. maintains a territorial tax system for foreign-owned companies but a worldwide system for U.S. companies. Mov-ing to a full territorial system will level the playing field.
  6. The compliance cost of the current system is excessively high relative to companies' foreign activities and the revenues raised from taxing foreign-source income.
  7. Our current system traps capital abroad — the "lockout" effect.
  8. Our high corporate tax rate and worldwide system makes it cheaper for companies to take on debt rather than use their own profits to fund their growth.
  9. The current system dissuades global companies from headquartering in the U.S.
  10. Eliminating deferral nearly killed the U.S. shipping industry.

Conclusion

Therefore, with respect to reform of cross-border taxation, U.S. legislators have three distinct choices:

  • Maintain the current deferral system and international tax rules for taxing the foreign earnings of U.S. multinationals;
  • Eliminate deferral and move toward a pure worldwide system of taxation; or
  • Move toward a territorial system and tax only those profits earned within the U.S. borders.
The third option is generally preferred and it is in everyone's best interests to promote strong long-term economic growth within the U.S. borders.

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Blake Christian, CPA, MBT is a tax partner in the Long Beach office of Holthouse Carlin & Van Trigt LLP and is co-founder of National Tax Credit Group, LLC. He can be reached at (562) 216-1800.