Ready to go on BEPS 2.0?

Ready to go on BEPS 2.0?

Tax Policy – Ready to go on BEPS 2.0?

Yesterday, the Organisation for Economic Co-operation and Development (OECD) released a consultation document in connection with its continuing efforts under the Base Erosion and Profit Shifting (BEPS) project Action 1 to address the challenges of taxation in the digitalizing economy. The document provides an outline of proposals that the Inclusive Framework (IF) on BEPS (a group of 128 countries) is considering for ways to change international tax rules. This consultation document allows interested parties an opportunity to provide feedback on the policies until March 1. A public consultation on these policies will be held in Paris from March 13-14.

The policy options outlined in the document are motivated by multinational business models and their tax practices that can result in low or no tax liability due to the location of business profits in certain jurisdictions that apply either a very low or zero corporate tax rate. The options are grouped into two pillars and answer two separate policy questions.

The first pillar includes policies to allocate more taxable profits to market countries relative to what results from the current system. The policy question for pillar one is, what profits should be taxable in a market country? If a digital services company has no employees, buildings, or equipment in a country, but has lots of sales generated through marketing efforts over the internet, what profits from those sales should be taxed in the market country? Pillar 1 is mainly, then, about reallocating the tax base among countries using different metrics and methods. The consultation document describes three alternatives that the IF is considering.

  • Define the tax base for reallocation by measuring user contributions, then allocate that base to market countries with an allocation metric (potentially revenues).
  • Define the tax base for reallocation by assessing marketing intangibles investment, then allocate that base to market countries with an allocation metric (potentially sales or revenues).
  • Reallocate the tax base among countries based on a definition of significant economic presence and multi-factor formulary apportionment including sales, assets, employees, and (potentially) users.

The second pillar is a global anti-base erosion proposal that would set a minimum effective tax rate in response to a policy concern that profits from intangible assets are often subject to no or very low rates of taxation. The proposal follows the approach of the U.S. Global Intangible Low Tax Income (GILTI) policy that was part of the U.S. tax reform of 2017. Additionally, the proposal would include a tax on base-eroding payments. Together these would set a minimum tax on income of multinationals. Though the consultation document discusses the mechanics and some ramifications of these proposals, the actual minimum rate is not mentioned.

Pillar 1 Policies

User Contribution

The user contribution approach follows an argument made commonly by the UK government that users of digital services contribute significant value to digital firms and that value creation should give rise to taxing rights in the country that the users are located. The specific business models targeted by this approach are social media platforms, search engines, and online marketplaces. As an example, if a digital company has 100 million users located around the world, but with taxable presence in only the country where the firm is headquartered, this proposal would envision a method of allocating a portion of that company’s profits to the countries where the users are located. This calculation would require multiple assumptions about the value created by the users, and the consultation document admits that:

It could be argued that the value created by user contribution and engagement of users does not constitute value created by the business, and instead constitutes value created by third-parties, that are more akin to suppliers than employees, and are remunerated at arm’s length through the provision of a free service.

The document also notes that the proponents of this option dispute this argument.

Marketing Intangibles

The approach to reallocate taxing rights based on marketing intangibles follows a theme that the U.S. Treasury has been arguing recently. Instead of impacting a defined set of business models, this approach would impact a broad range of multinational businesses. Footnote 4 of the consultation document points out that “…marketing intangibles may include, for example, trademarks, trade names, customer lists, customer relationships, and proprietary market and customer data that is used or aids in marketing and selling goods or services to customers.”

The theory behind this approach is that businesses possess brands, customer lists, and customer relationships that are either developed directly in connection with a market or are valuable because of the market. Because of this, the option proposes to allocate some taxable income of multinationals to market countries based on the value derived in the market in the form of marketing intangibles. That tax base would then be divided among countries based on some metric like sales or revenues.

A drawback to this proposal as discussed in the document is that some marketing activities occur outside of market jurisdictions and apply to all sales of a business rather than being designed for specific sales in a specific market. Identifying marketing intangibles directly associated with a market (and resolving disputes over whether an intangible is particular to that market or in general) will likely create difficulties in administering a system that follows this proposal.

Significant Economic Presence

A third approach to allocating taxable income described in the consultation document is to define taxable nexus to include “significant economic presence.” Rather than a physical presence nexus standard where taxing rights might arise due to the presence of physical assets or employees in a jurisdiction, this approach would allocate taxing rights based on a broader set of non-physical items. According to the document, metrics for establishing significant economic presence could include:

  • The existence of a user base and the associated data input
  • The volume of digital content derived from the jurisdiction
  • Billing and collection in local currency or with a local form of payment
  • The maintenance of a website in a local language
  • Responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services such as after-sales service or repairs and maintenance
  • Sustained marketing and sales promotion activities, either online or otherwise, to attract customers

The allocation of profits to an entity with significant economic presence in a jurisdiction would be done in a formulaic manner with attention paid to the global profit rate of the company, and apportionment factors of sales, assets, employees, and (potentially) users.

Each of the Pillar 1 policies would result in a shifting of where and how much taxes are paid by a variety of multinational corporations. However, the details that are left to be worked out could significantly impact how taxing rights are ultimately allocated among countries.

Pillar 2

The second policy pillar in the consultation document is a global anti-base erosion proposal that would effectively set a minimum effective tax on profits of multinationals. The policy document assesses the current policy environment as risking “un-coordinated, unilateral action, both to attract more tax base and to protect existing tax base, with adverse consequences for all countries, large and small, developed and developing.” This is a glancing reference not only to tax competition as countries work to improve their tax policies and attract more business investment, but also to policies like digital services taxes and other base expansion regimes that tend toward double taxation. Without specifically mentioning a particular policy, the consultation document is direct in saying, “Unilateral measures…can lead to double taxation and may even result in new forms of protectionism.”

In this context, the document describes both an income inclusion rule and a tax on base-eroding payments. This seems to follow the pairing of the U.S. policies of GILTI and Base Erosion and Anti-Abuse Tax (BEAT) which are both worldwide minimum taxes on different types of income. The income inclusion rule would allow a jurisdiction to tax a foreign subsidiary if that subsidiary’s income is subject to a low effective tax rate. The tax on base-eroding payments would separately deny deductions or treaty relief unless those payments were subject to a minimum effective tax rate.

Altogether, these two proposals would set a floor on tax rates applied to the international income of companies. What is left out of the consultation document is what the minimum rate would be.

Conclusion

The OECD IF has a good deal more work to do to come to a clear, detailed proposal for reallocating taxing rights and applying a minimum tax on the income of multinationals. The consultation period will allow businesses and policy groups to analyze the current proposals from a number of angles including the economic and behavioral effects. The policy options described in the consultation document will impact business decisions in a variety of ways while raising the cost of capital and potentially hurting global capital and trade flows. The Tax Foundation will continue to review this document and will be following up with more analysis of the various options.


Source: Tax Policy – Ready to go on BEPS 2.0?

Capital Allowances in Europe

Capital Allowances in Europe

Tax Policy – Capital Allowances in Europe

Although sometimes overlooked in discussions about corporate taxation, capital allowances play an important role in a country’s corporate tax base and can impact investment decisions—with far-reaching economic consequences. And as today’s map shows, the extent to which businesses can deduct their capital investments varies greatly across European countries.

Businesses determine their profits by subtracting costs (such as wages, raw materials, and equipment) from revenue. However, in most jurisdictions, capital investments are not seen as regular costs that can be subtracted from the revenue in the year of acquisition. Instead, depreciation schedules specify the life span of an asset, which determines the number of years over which an asset must be written off. By the end of the depreciation period, the business would have deducted the total initial dollar cost of the asset.

However, in most cases, these depreciation schedules do not consider the time value of money (a normal return plus inflation). For instance, assume a machine costs $1,000 and is subject to a life span of five years. A business can deduct $200 every year for five years. However, due to the time value of money, a deduction of $200 in later years is not as valuable in real terms. As a result, businesses cannot fully deduct the net present value of capital investment. This inflates taxable profits, which, in turn, increases the cost of capital investment. A higher cost of capital can lead to a decline in business investment and reductions in the productivity of capital and lower wages.

Capital Allowances in Europe

The map reflects the weighted average capital allowances of three asset types: machinery, industrial buildings, and intangibles (patents and “know-how”). Capital allowances are expressed as a percentage of the present value cost that businesses can write off over the life of an asset. The average is weighted by the capital stock’s respective share in an economy (machinery: 44 percent, industrial buildings: 41 percent, and intangibles: 15 percent). For instance, a capital allowance rate of 100 percent represents a business’s ability to fully deduct the cost of an asset (e.g., through full immediate expensing or neutral cost recovery).

Latvia (100 percent), Estonia (100 percent), and Slovakia (78.2 percent) allow for the best treatment of capital investment, while businesses in Spain (54.5 percent), the United Kingdom (57.2 percent), and Poland (59.3 percent) can write off lower shares of investment costs. Estonia and Latvia only tax distributed profits and reinvested earnings are untaxed. This allows for 100 percent of the present value of capital investment to be written off.

On average, businesses in Europe can write off 69.4 percent of the present value cost of their investments in machinery, industrial buildings, and intangibles. By asset category, the highest capital allowances are for machinery (84.2 percent), followed by intangibles (79.5 percent), and industrial buildings (49.9 percent).

The United Kingdom recently improved its place on this measure because the government has adopted a capital allowance for new nonresidential structures and buildings. Previously, UK businesses could not deduct any costs associated with buildings, and the UK weighted average for capital allowances was just 45.7 percent. This new policy would allow businesses to recover 27.9 percent of costs from investments in structures and buildings. This is reflected in the UK’s weighted average of 57.2 percent.

Apart from capital allowances, statutory corporate income tax (CIT) rates significantly determine the amount of corporate taxes businesses are required to pay. One of our previous maps provides an insight into European statutory CIT rates.


Source: Tax Policy – Capital Allowances in Europe

Bonus depreciation safe-harbor rules for vehicles issued

Bonus depreciation safe-harbor rules for vehicles issued

IRS Tax News – Bonus depreciation safe-harbor rules for vehicles issued
The IRS issued a safe-harbor procedure that taxpayers may follow for determining the deduction for depreciating passenger vehicles when they are eligible for 100% bonus depreciation but are also subject to the Sec. 280F limits on deductions for luxury automobiles.
Source: IRS Tax News – Bonus depreciation safe-harbor rules for vehicles issued

Wisconsin Tax Options: A Guide to Fair, Simple, Pro-Growth Reform

Wisconsin Tax Options: A Guide to Fair, Simple, Pro-Growth Reform

Tax Policy – Wisconsin Tax Options: A Guide to Fair, Simple, Pro-Growth Reform

Executive Summary

Wisconsin has struggled with its tax system for decades. The state has always been marked by high property tax burdens, but in its effort to “fix” them has leaned on corporate and individual income taxes to a sizable degree as well.

Wisconsinites are often flummoxed by why taxes are so high here—government services have a good reputation, but it isn’t always clear they are worth the price tag. Still other taxpayers feel they should be grateful as at least fiscal matters aren’t in as dire of straits as in Illinois. In recent legislative sessions, the legislature and administration have made strides to improve the roughest edges of the state’s tax system, but comprehensive tax reform has not been at the top of the agenda. We believe it ought to be.

Over the last year, our team of economists and tax experts at the Tax Foundation joined with Wisconsin’s own Badger Institute to investigate what can be done about the state’s tax system. Over the course of 12 months, our team met with over 100 stakeholders from all walks of Wisconsin life, including small business owners, local government officials, trade associations, industry representatives, state legislators, accountants and tax attorneys, and everyday taxpayers. We also reviewed the history of the fiscal system, previous tax reform studies, and historical revenue and economic trends.

The result is this book, which is meant to help Wisconsin achieve the goal of true tax reform—reform that benefits all taxpayers and sets the state on a competitive path in the region and in the nation. It’s meant to start the conversation about what Wisconsin does well, but also what it could do better—by recognizing strengths, diagnosing challenges, and prescribing real, workable solutions.

During our meetings across Wisconsin, several themes emerged:

  • Individual income tax rates are high. At 7.65 percent, Wisconsin’s top individual income tax rate is among the highest nationally and regionally, and taxpayers are aware. This issue is especially acute in Milwaukee, where firms must compete for top professional talent with other states, and taxes can influence relocation decisions.
  • Corporate tax rates are high but are significantly abated by the Manufacturing and Agriculture Credit (MAC). This credit shields manufacturing and agriculture firms from much of the burden of the state’s high tax rates, but many industries do not have access to it, and this unequal treatment discourages diversified investment in the Badger State.
  • For many Wisconsin taxpayers, property tax burdens are a persistent political concern, but attempts at fixes have been costly. While property taxes are a local revenue stream, the state government has tried all sorts of levers to ameliorate the property tax burden, including reimbursing local governments for property tax credits, providing property tax credits on state income tax returns, and offering direct subsidies to local governments in the form of a “shared revenue” program.
  • Wisconsin is a member of the Streamlined Sales Tax Project and adheres to the U.S. Supreme Court’s standards for online sales tax collection. The state began remote sales tax collection in 2018 and now has the opportunity to apply this new revenue stream toward comprehensive tax reform.

Our conversations with Wisconsinites from all walks of life were instrumental in our development of four comprehensive tax reform options tailored to the Badger State’s unique strengths and challenges. Informing every page of this book are the insights and perspectives we gained from those who interact with Wisconsin’s tax system on a daily basis.

With these valuable perspectives at the forefront of our minds, we undertook this project as an independent national organization familiar with tax developments in many states, with the view that tax systems should adhere to sound economic principles, including simplicity, transparency, neutrality, and stability. Positioning Wisconsin for the future means creating a tax code that can grow with the state, not hold it back. A tax code better aligned with growth, opportunity, and job creation is in the interest of all Wisconsinites.

While economic efficiency is only one lens through which to analyze a tax code, it is an important one. After all, there are many ways to generate a dollar of tax revenue, but some taxes are more harmful to the economy than others and should be mitigated wherever possible.

Major tax studies consistently find that taxes have a negative impact on economic growth, and that this impact varies across tax types and structures. Among major tax types, corporate income taxes tend to be the most harmful to economic growth, since they penalize capital investment, followed by individual income taxes, which impact individuals’ labor and savings decisions.[1] Property and consumption taxes are less harmful because ultimately, it is production, innovation, and entrepreneurial risk-taking that drive economic growth.[2] Within each of these taxes, moreover, the decisions states make— to carve out tax bases, incentivize or penalize certain economic decisions, or create or reduce complexity—have an effect as well. For example, Mullen and Williams (1994) found that higher marginal tax rates reduce gross state product growth.[3]

Each of the four comprehensive tax reform options presented in the pages ahead tackles Wisconsin’s tax dilemmas through a slightly different angle, but all four options present bold reforms and prioritize progress in key areas in which the state’s economic wellbeing is most at stake.

We hope that this book and its recommendations will provide useful information and observations for policymakers, journalists, and citizens in the Badger State as they evaluate the state’s fiscal system. We are thankful to the Wisconsinites who spent time with us talking about Wisconsin’s taxes. Without their input, this publication would have been far less rich and meaningful. We are also grateful to the Wisconsin Department of Revenue for providing data to assist in estimating the fiscal impact of our proposed reforms.

Our Objective

We hope these solutions guide the tax reform conversation in Wisconsin by providing a framework upon which legislators and citizens can make further decisions. Each “option” in the menu of choices we present is designed to ensure the state builds a tax system for a diversified economy and positions itself as a destination for investment, entrepreneurs, and talented individuals in the years ahead.

Menu of Tax Reform Options

Our menu of comprehensive tax reform options is designed to allow legislators and taxpayers to reimagine their tax system to build an economy for the long term. Each of these plans streamlines the tax system, removes or consolidates duplicative provisions, and positions Wisconsin for long-term growth. They are designed with economic growth in mind, consistent with the literature on the economic effects of different tax types and structures.[4] These plans are roughly revenue neutral, but if policymakers desire a net tax reduction or increase, rates can be dialed up or down accordingly.

Option A would transform Wisconsin’s income tax into a streamlined, simplified flat tax, balanced by modernizing and increasing the sales tax. These changes would align the state’s tax rates with competitor states, resembling changes enacted in the past decade in Indiana. It includes:

  • A flat income tax rate of 4.82 percent
  • A standard deduction that conforms with the new federal standard deduction created by the Tax Cuts and Jobs Act (TCJA), including elimination of Wisconsin’s sliding scale so that the standard deduction becomes available to all taxpayers regardless of income
  • A repeal of the personal exemption
  • A moderately broadened sales tax base with a statewide rate of 5.75 percent, slightly higher than it is today
  • A slightly lower corporate income tax of 7 percent
  • Improvement in Wisconsin’s ranking on our State Business Tax Climate Index from 32nd to 12th

Option B would recraft Wisconsin’s tax system in a similar fashion to state-level tax reforms in other states, simplifying and reducing income and business taxes while broadening the sales tax to match today’s economy. It includes:

  • A consolidated income tax structure with rates of 4, 5, and 6.8 percent at thresholds of $0, $10,000, and $40,000
  • Conformity with the generous new federal standard deduction
  • A repeal of the personal exemption
  • Moderate sales tax base broadening at the current sales tax rate of 5 percent
  • A reduction in the corporate income tax rate to 4.6 percent
  • Improvement in Wisconsin’s ranking on our State Business Tax Climate Index from 32nd to 14th

Option C would set Wisconsin apart as the only state in the region with no corporate income tax, making the state stand out as one of the few with no taxes on investment and job creation. Income tax rates are consolidated and reduced while the sales tax is broadened at the current rate. It includes:

  • A full repeal of the corporate income tax, one of the biggest impediments to growth in the Badger State
  • Large sales tax base broadening paired with a slightly higher sales tax rate of 5.2 percent
  • A consolidated income tax structure with rates of 4, 5, and 6.8 percent at thresholds of $0, $10,000, and $40,000
  • Conformity with the generous new federal standard deduction
  • A repeal of the personal exemption
  • Substantial improvement in Wisconsin’s ranking on our State Business Tax Climate Index from 32nd to 6th

Option D simplifies and stabilizes Wisconsin’s existing tax system, broadening bases and adopting growth-friendly reforms while retaining progressivity, reducing business taxes, and keeping the current sales tax rate. It includes:

  • A graduated individual income tax with rates of 4, 5, and 7.5 percent at thresholds of $0, $20,000, and $150,000
  • Elimination of the marriage penalty in the standard deduction but retention of the sliding scale as it exists under current law
  • Retention of the current law personal exemption
  • Moderate sales tax base broadening while maintaining the current 5 percent sales tax rate
  • A reduction in the corporate income tax rate to 4 percent
  • Improvement in Wisconsin’s ranking on our State Business Tax Climate Index from 32nd to 14th

Improvements Included in All Options

In addition to the specific changes listed above, Options A, B, C, and D each include the following structural improvements to Wisconsin’s tax code, designed to move to more neutral treatment of business and individual activities while improving the state’s competitiveness in the region and nation:

Individual Income Tax

  • Repeal the state’s marriage penalty by doubling bracket widths for married couples and repealing the married couple credit
  • Repeal the itemized deductions credit, as a more generous standard deduction available to all taxpayers (in Options A, B, and C) will reduce dependency on this credit

Corporate Income Tax

  • Conform to the TCJA’s new full expensing allowances under Internal Revenue Code (IRC) Sec. 168(k)
  • Repeal the 3 percent surcharge levied on top of the corporate income tax and instead fund the Wisconsin Economic Development Corporation (WEDC) through the General Fund
  • Conform with new federal standards for treatment of net operating losses (NOLs) under the TCJA
  • Eliminate the throwback rule in the corporate income tax Sales Tax

Sales Tax

  • Pursue sales tax base expansion (as detailed above and in Chapter 5)
  • Share revenues from local flow-down of state base expansion between counties and municipalities
  • Use revenue from the new online sales tax Supreme Court ruling to help pay for comprehensive reforms

Each of our reform solutions would improve Wisconsin’s performance on our State Business Tax Climate Index overall and in the corporate tax, individual income tax, and sales tax components.

Wisconsin’s Rankings on the State Business Tax Climate Index, Current (2019) and Proposed
  Overall Rank Corporate Taxes  Individual Taxes Sales Taxes

Current Law

32 35 39 8

Option A

12 10 15 9

Option B

14 4 30 7

Option C

6 1 30 7

Option D

14 3 33 7

Other Important Considerations

  • Continue toward repeal of taxes on tangible personal property
  • Allow property tax limits to continue working
  • Consider tolling of Wisconsin’s highways
  • Repeal minimum markup law, which drives up gas prices
  • Reform the state’s unemployment insurance tax system
Key Elements of Wisconsin Tax Reform Options
  Current Wisconsin Tax System Option A Option B Option C Option D

Income Tax

Income Tax Rate

Four Rates:
4%
5.84%
6.27%
7.65%
Single rate of 4.82% Three rates:
4%
5%
6.8%
Three rates:
4%
5%
6.8%
Three rates:
4%
5%
7.5%

Tax-Free Income for Couples or Families (tax year 2018)

$19,580 plus $700 per exemption; phases down after $22,000 in income $24,000 $24,000 $24,000 $21,160 plus $700 per exemption; phases down after $22,000 in income

Tax-Free Income for a Single Filer with No Children (tax year 2018)

$10,580; phases down after $15,500 in income $12,000 $12,000 $12,000 $10,580; phases down after $15,500 in income

Itemized Deductions Credit

Yes No No No No

Marriage Penalty

Yes No No No No

Sales Tax (state portion)

State Sales Tax Rate on Sales of Retail Goods to Consumers

5%, with many exemptions 5.75%; prescription drugs and medical devices exempt 5%; prescription drugs and medical devices exempt 5.2% on all items 5%; prescription drugs and medical devices exempt

State Sales Tax Rate on Sales of Retail Services to Consumers

Mostly Exempt 5.75% 5% 5.2% 5%

Corporate Income Tax

Corporate Tax Rate

7.9% plus 3% surcharge 7% 4.6% Repealed 4%

Connection to Federal Full Expensing and Net Operating Loss Rules

Does not conform Conforms Conforms Conforms Conforms

Throwback Rule Partly Taxing Out-of-State Income

Yes No No No No

Overall Estimates

Revenue Estimate (2021)

$16.5b $16.4b $16.4b $16.6b $16.4b

Distributional Effect

Slightly Progressive More Regressive Slightly Progressive Slightly Progressive Slightly Progressive

Rank on State Business Tax Climate Index

32nd 12th 14th 6th 14th

Above is a brief excerpt from Wisconsin Tax Options: A Guide to Fair, Simple, Pro-Growth Reform. To download our full reform guide, click the link below.

Download The Full Book

Notes


[1] Jens Arnold, Bert Brys, Christopher Heady, Åsa Johannsson, Cyrille Schwellnus, and Laura Vartia, “Tax Policy for Economic Recovery and Growth,” The Economic Journal 121, no. 550 (February 2011).

[2] See William McBride, “What is the Evidence on Taxes and Growth?” Tax Foundation, Dec. 18, 2012, https://taxfoundation.org/what-evidence-taxes-and-growth.

[3] John K. Mullen and Martin Williams, “Marginal Tax Rates and State Economic Growth,” Regional Science and Urban Economics 24, no. 6 (December 1994).

[4] Karel Mertens and Morten Ravn, “The Dynamic Effects of Personal and Corporate Income Tax Changes in the United States,” American Economic Review 103:4 (June 2013). 


Source: Tax Policy – Wisconsin Tax Options: A Guide to Fair, Simple, Pro-Growth Reform

Learning from Europe and America’s Shared Gross Receipts Tax Experience

Learning from Europe and America’s Shared Gross Receipts Tax Experience

Tax Policy – Learning from Europe and America’s Shared Gross Receipts Tax Experience

As states in America continue to consider gross receipts taxes (GRTs) as a source of tax revenue, Europe is also evaluating proposals to use GRTs to tax digital firms. Europe’s historical experience, like the experience of its American counterparts, shows that GRTs are bad tax policy with no place in debates over digital taxation and optimal sources of tax revenue.

Prior to 1970, western European countries other than France levied turnover taxes, also known as gross receipts taxes, including Germany, Italy and Belgium. These taxes are levied on total sales when goods “turn over” without any deduction for a firm’s costs. Turnover taxes have a long history in Europe. The first turnover tax, named the alcavala, was established in Spain in 1342. In The Wealth of Nations, Adam Smith in 1776 condemned turnover taxes as having caused “the ruin of the manufactures of Spain.”

Turnover taxes were a major source of revenue for European countries after World War I. By 1967, for example, revenue from turnover taxes made up about 15.4 percent of Germany’s total revenue. They were replaced by national value-added taxes (VAT) as part of a larger tax harmonization effort by the European Economic Community (EEC), a precursor to the European Union (EU).

Turnover and Value-Added Taxes in the European Common Market, Calendar Year 1967

*Note: This rate applied as a rebate for goods exported out of the country and as an equalization tax on goods imported into the country.

Source: Guenter Schindler, “Tax Harmonization in Europe and U.S. Business,” Tax Foundation, Aug. 1, 1968.

Country Tax Type Turnover Tax Rate Turnover Tax Rate for Luxury Goods Border Tax Adjustment Rate*
Belgium Turnover tax 7% Up to 23% 5% – 6%
Germany Turnover tax 4% 4% 5%
Italy Turnover tax 4% 6.4% – 23.3% 4% – 5%
Luxembourg Turnover tax 3% 3% 5% – 6%
Netherlands Turnover tax 6% 15% – 25% 5%
France Value-added tax 20% 25% 20%

Europe’s turnover taxes presented a challenge to international trade. Under the Bretton Woods system, which provided rules for the international financial system from 1944 to 1971, countries held their currencies at fixed exchange rates. This meant that currencies would not adjust when the proportion of imports to exports was altered. Domestic turnover taxes encourage imports, as imports are relatively cheaper without the turnover tax applied to them.

The General Agreement on Tariffs and Trade (GATT), an international trade agreement established in 1947, permitted equalization taxes on imports. Exported goods received a rebate to compensate for the turnover tax applied to domestic goods. While policymakers could have allowed prices between countries to adjust, they decided to use this system of rebates and taxes to equalize the tax treatment of imports and exports instead.

This arrangement suffered from a problem: it is difficult to determine the tax burden imposed by a turnover tax, as the tax is applied to the same value of a good’s inputs in each stage of production.  Known as tax pyramiding, this means that industries with supply chains of different lengths will have different effective turnover tax rates. Industries with a high degree of tax pyramiding may not receive the right rebate amount when the good is exported to offset the tax, while importers may be levied the wrong equalization tax rate.

The EEC resolved this problem by implementing a uniform value-added tax regime, as Tax Foundation’s Guenter Schindler documented in 1968. By 1970, EEC members replaced their turnover taxes with VAT, which can be harmonized between countries more easily. Firms can determine the VAT paid at each stage of production and receive a credit exactly offsetting the tax when goods are exported. Imported goods have the VAT applied to them, equalizing the tax treatment across countries.

Turnover taxes have been revived in the 21st century in the debate over how to tax digital firms in the EU. In 2018, the European Commission (EC) proposed a 3 percent turnover tax levied by individual countries on firms with worldwide revenues of €750 million (US $850 million) and total EU revenues of €50 million (US $56.67 million). Like other gross receipts taxes, this proposal threatened to harm firms with low profit margins, raise prices on consumers, and slow economic growth in Europe. While the European Commission failed to gather enough consensus to move forward, several individual countries are moving forward with unilateral proposals to tax certain digital companies on their turnover. A related debate is now going on at the Organisation for Co-operation and Development (OECD).

The comeback of turnover taxes in Europe mirrors the experience of American states, which eliminated gross receipts taxes as a revenue option by the mid-20th century, but these tax proposals have returned over the past decade. European and American policymakers should consider their shared historical experience on both sides of the Atlantic and identify other ways to raise revenue and avoid the negative economic consequences of turnover taxes.


Source: Tax Policy – Learning from Europe and America’s Shared Gross Receipts Tax Experience

The Status of State Personal Exemptions a Year After Federal Tax Reform

The Status of State Personal Exemptions a Year After Federal Tax Reform

Tax Policy – The Status of State Personal Exemptions a Year After Federal Tax Reform

Key Findings

  • Under the Tax Cuts and Jobs Act, the personal exemption is suspended through 2025, balanced by other provisions, including the near-doubling of the standard deduction and an enhanced child tax credit.
  • Some states mirror the federal government’s personal exemption, but many others set their own dollar amounts while using federal eligibility definitions.
  • Conformity to the Tax Cuts and Jobs Act introduced doubts about the status of some states’ personal exemptions, with the federal approach—zeroing out the personal exemption rather than repealing it outright—interacting with state statutes in unexpected ways.
  • Six states saw the repeal of their personal exemptions under TCJA conformity, while legislators in another five states acted to preserve exemptions that might otherwise have been wiped out.
  • Minnesota would lose its personal exemption if the state updated its conformity statute without expressly providing for its retention, and ambiguous language remains on the books in several other states.

Introduction

When federal lawmakers suspended the personal exemption for tax years between 2018 and 2025, that decision had ripple effects in the states, many of which incorporated the provision into their own tax codes. Whereas most other individual income tax changes under the Tax Cuts and Jobs Act of 2017 (TCJA) proved fairly straightforward for states to incorporate, zeroing out the personal exemption created significant uncertainty in some states and, for a few, took much of the year to sort out.

With tax year 2018 in the books, six states which previously offered personal exemptions eliminated them in line with federal law, while a seventh state (Kentucky) eliminated its personal exemption as part of a broader tax reform. Five states took legislative action to restore a personal exemption that would have been eliminated otherwise. Another thirteen states which reference federal law in the calculation of their own personal exemptions already did so in such a way as to preserve the exemption for state filers.

State Personal Exemptions a Year After Federal Tax Reform

Implications of the TCJA

For states which conform to other changed federal income tax provisions, like the higher standard deduction, the ramifications were straightforward. The personal exemption was another matter altogether, largely the result of the procedures under which federal tax reform was adopted.

The TCJA was enacted as a reconciliation bill, under Senate rules which limit debate and amendments for budget reconciliation measures. The reconciliation process made it easier to enact tax reform, but it came at a cost of legislative flexibility. Many individual income tax provisions, in particular, are temporary, yielding provisions that are zeroed out rather than repealed out. The personal exemption statute is still necessary, as it might be restored in 2026. Hence, Congress reduced its value to $0 but retained it in law.

For the handful of states which conformed to the federal personal exemption without any modifications, the consequence was straightforward: elimination. Many states, however, substituted different dollar values for the personal exemption, but used federal definitions to determine eligibility of those exemptions. After enactment of TCJA, seemingly inconsequential differences in the wording of those provisions could mean the difference between offering or denying an exemption at the state level.

In some states, a deduction or exemption is provided for each filer, spouse, and dependent, in an amount set by the state. More frequently, states establish a personal exemption amount that might differ from what the federal government offered—$2,250 in Kansas, for instance, or $1,000 in Michigan—and then provide a state exemption, in that amount, for each exemption allowed the taxpayer under the Internal Revenue Code (IRC). In other cases, states incorporate all federal exemptions claimed.

Using definitions of dependents preserves state exemptions, as does tying the state exemption to the number of exemptions allowable under federal law. Here, California is typical, offering exemptions for filers and “for each dependent … for whom an exemption is allowable under Section 151(c) of the Internal Revenue Code.”[1] Under federal law, exemptions are still allowable, though they are worth $0 for federal tax purposes. California’s personal exemptions, therefore, remain in place.

“Allowable,” however, is just one of many ways that states reference the IRC’s treatment of personal exemptions. Other states key in on the number of exemptions an individual can lawfully claim (Delaware), dependents as defined in IRC § 152 (Maryland), the number of exemptions for which a taxpayer is entitled to a deduction (New York), the number of deductions allowed for personal exemptions (Maine, formerly), or the number of exemptions allowable on the filer’s income tax return (Michigan, formerly), to name a few variations.

Each has a slightly different meaning, and potentially a different outcome. Unsurprisingly, the initial result was uncertainty, with lawmakers, administrators, and tax professionals sometimes unsure, and occasionally at odds on, whether a given state’s personal exemption could be claimed for tax year 2018. As tax season approaches, though, states have clarified the status of their personal exemptions.

Table 1. State Conformity to Federal Personal Exemption Provisions

Notes: Minnesota conforms to federal policy, but still uses the IRC as it existed in 2016 and thus retains the personal exemption. Three states (KY, NC, PA) impose wage income taxes but lack a personal exemption. Nine states forgo a tax on wage income.

Sources: State statutes; Bloomberg Tax; Tax Foundation research

State-Defined Exemption Linked to Exemptions Allowed Conforms to Federal (Eliminated)
Alabama
Arizona
Connecticut
Georgia
Louisiana
Maine
Massachusetts
Michigan
Mississippi
Montana
Ohio
Rhode Island
South Carolina
Vermont
District of Columbia
California
Delaware
Hawaii
Illinois
Indiana
Kansas
Maryland
Nebraska
New York
Oklahoma
Oregon
Virginia
West Virginia
Wisconsin
Colorado
Idaho
Missouri
New Mexico
North Dakota
Utah

Lawmakers in Maine, Michigan, South Carolina, Vermont, and West Virginia amended their tax codes to retain personal exemptions that might otherwise have been eliminated. In Michigan, for instance, state law previously provided that the state’s personal exemption amount was to be “multiplied by the number of personal or dependency exemptions allowable on the taxpayer’s federal income tax return pursuant to the Internal Revenue Code.” Given that such exemptions, while allowable under the IRC, no longer appear on federal income tax returns, lawmakers took action. Specifically, they took federal definitions out of the equation: “A taxpayer may claim a dependency exemption for each individual who is a dependent of the taxpayer for the tax year.”[2]

In Missouri, legislators took the opposite course, resolving an ambiguity (“if he or she is entitled to a deduction for such personal exemptions for federal income tax purposes”) in favor of the clear elimination of the personal exemption, albeit as part of a larger tax package which reduced income tax rates and provided other tax relief.[3]

Two other states, West Virginia and Kansas, illustrate just how unclear the ramifications of such legislative language can be. Both states, like Missouri, referenced being entitled to a deduction for personal exemptions. West Virginia’s code provided a deduction for “each exemption for which he or she is entitled to a deduction for the taxable year for federal income tax purposes,” and policymakers, fearful that it was insufficient to retain the personal exemption, adopted new legislation stipulating that the phrase means “the exemption the person would have been allowed to claim for the taxable year had the federal income tax law not been amended to eliminate the personal exemption for federal tax years beginning on or after January 1, 2018.”[4] In Kansas, by contrast, similar language (“for each exemption for which such individual is entitled to a deduction for the taxable year for federal income tax purposes”[5]) has been understood to preserve the state’s personal exemption.

Thus, while states have settled on their interpretations for tax year 2018, the language of these statutes could continue to matter in the coming years—and, in particular, the choices states make now will have implications in 2026, should the new federal law be allowed to expire.

The following table delineates the statutory language used by states which rely on federal definitions of eligibility but have nonetheless been understood to retain their own personal exemptions.  Of these, two states—California and Virginia—have yet to conform to the new federal law, though their personal exemptions should be unaffected when they do.

Table 2. Statutory Linkages to the Federal Personal Exemption

Sources: State statutes; Tax Foundation research

State Statutory Provision Conformity

California

Taxpayer, spouse, and “for each dependent (as defined in Section 17056) for whom an exemption is allowable under Section 151(c) of the Internal Revenue Code.”[6]

X

Delaware

“for each personal exemption to which such individual is entitled for the taxable year for federal income tax purposes”[7]

Hawaii

“the number of exemptions which the individual can lawfully claim under the Internal Revenue Code”[8]

Illinois

Taxpayer, spouse, and “an additional exemption equal to the basic amount for each exemption in excess of one allowable to such individual taxpayer for the taxable year under Section 151 of the Internal Revenue Code”[9]

Indiana

“each of the exemptions provided by Section 151(c) of the Internal Revenue Code (as effective January 1, 2017)”[10]

Kansas

“for each exemption for which such individual is entitled to a deduction for the taxable year for federal income tax purposes”[11]

Maryland

Taxpayer, spouse, and “for each dependent, as defined in § 152 of the Internal Revenue Code”[12]

New York

“for each exemption for which he is entitled to a deduction for the taxable year under section one hundred fifty-one(c) of the Internal Revenue Code”[13]

Oklahoma

“personal exemptions allowed by the Internal Revenue Code”[14]

Oregon

“the number of personal exemptions allowed under section 151 of the Internal Revenue Code”[15]

Virginia

“for each personal exemption allowable to the taxpayer for federal income tax purposes”[16]

X

West Virginia

“the exemption the person would have been allowed to claim for the taxable year had the federal income tax law not been amended to eliminate the personal exemption for federal tax years beginning on or after January 1, 2018”[17]

Wisconsin

Taxpayer, spouse, and “for each dependent, as defined under section 152 of the Internal Revenue Code, of the taxpayer”[18]

Minnesota is the only state in which the retention of the personal exemption is indisputably contingent on the state’s conformity date. The state’s tax starting point is federal taxable income, which includes the federal standard deduction and (zeroed-out) personal exemption.[19] However, legislators punted in 2018, with the state’s tax code still tied to the IRC as it existed prior to federal tax reform. As such, the personal exemption is retained—for now.

Virginia also offers a degree of uncertainty. Although lawmakers updated the state’s conformity date during the last legislative session, they expressly excluded most of the provisions of the TCJA, leaving those for later consideration. The statute on the books is ambiguous, providing a state exemption for each personal exemption allowable for federal income tax purposes. There is no question that these exemptions are still allowable, though they no longer have an income tax purpose and do not appear on federal tax forms. Nevertheless, tax officials in Virginia have signaled that the personal exemption will be retained.

In most states, conformity to federal tax changes results in additional revenue, since many of the base-broadening provisions are incorporated into state tax codes, while corresponding rate reductions are not. The elimination of the personal exemption is part of that puzzle, and is particularly significant in states like New Mexico, which is expected to finish the current fiscal year with $1.4 billion in excess revenue, largely due to the growth of the state’s oil sector, but with a substantial assist by tax base broadening.[20]

Conclusion

When these state tax provisions were written, there was no reason to anticipate a $0 federal personal exemption; variations in statutory text which loom large now were insignificant when adopted. States which have eliminated the personal exemption should consider offsetting reductions, to the extent that they have not already done so. States which currently diverge from federal treatment might consider aligning with the new federal law as a pay-for to facilitate reforms. And where any ambiguity remains, legislators should seek to address it. Federal tax reform creates many opportunities for states to reform their tax codes. It also, at times, requires efforts to enhance clarity.

Notes


[1] Cal. Rev. & Tax. Code § 17054(d)(1)(A).

[2] M.C.L.A. 206.30(2).

[3] Jared Walczak, “Missouri Governor Set to Sign Income Tax Cuts,” Tax Foundation, July 11, 2018, https://taxfoundation.org/missouri-governor-set-sign-income-tax-cuts/.

[4] WV Sec. 11-21-9(f).

[5] KS Sec. 79-32,121.

[6] Cal. Rev. & Tax. Code § 17054(d)(1)(A).

[7] 30 Del.C. § 1110(b).

[8] HRS § 235-54.

[9] 35 ILCS 5/204(c).

[10] IC 6-3-1-3.5.

[11] K.S.A. 79-32,121.

[12] MD Code, Tax – General, § 10-211(1)(a).

[13] McKinney’s Tax Law § 616(a).

[14] 68 Okl.St.Ann. § 2358(E).

[15] O.R.S. § 316.085(1)(a).

[16] VA Code Ann. § 58.1-322.03(2).

[17] W. Va. Code, § 11-21-9(f).

[18] W.S.A. 71.05(23)(b).

[19] M.S.A. § 290.01(19).

[20] Morgan Lee, “Oil Sector Boosts State Government Fortunes in New Mexico,” Associated Press, Dec. 11, 2018, https://www.lcsun-news.com/story/news/local/new-mexico/2018/12/11/new-mexico-oil-gas-boom-state-government-funding-budget-surplus-revenue-economy-education/2272929002/.


Source: Tax Policy – The Status of State Personal Exemptions a Year After Federal Tax Reform