THE EFFECTS OF STATE TAX STRUCTURE
ON BUSINESS ORGANIZATIONAL FORM
LeAnn Luna and Matthew N. Murray
This study examines business organizational form decisions as a source of tax base mobility. We posit that organizational form responses to state tax policy allow for an indirect means of exploring mobility through business tax planning. Using state-level IRS data for the years 1997–2008, we examine the decision to fi le as a partnership or corporation and how those decisions are affected by a variety of state tax policies. The results suggest that state tax policy, especially corporate and personal income tax rates, affects business entity choice decisions and impacts business planning opportunities within and across states.
Keywords: state corporate income tax, business organizational form, tax base mobility
JEL Codes: H25, H73
I. INTRODUCTION
A
wide body of literature has empirically examined the effects of state and localtaxes on the location of business activity and found that state and local taxes may affect the location of capital investment and employment. This literature investigates one of three types of business mobility motivated by tax policy. First, tax policies may encourage one organizational form over another, and this choice may affect the loca-tion of reported profi ts as well as real economic activity. Second, the structure of tax policies can affect the opportunities for business tax planning, as fi rms strategically shift income to lower-tax states without physical movement of assets and/or employees. Finally, tax policies may change fi rmsʼ decisions regarding locating operating activities in the state — the type of behavior examined most frequently in the academic literature. States have a clear interest in the location of physical assets and workers because they have obvious effects on state output, personal income, the property tax base, and other economic development markers.
LeAnn Luna: Center for Business and Economic Research, The University of Tennessee, Knoxville, TN, USA (leann@utk.edu)
Matthew N. Murray: Center for Business and Economic Research, The University of Tennessee, Knoxville, TN, USA (mmurray1@utk.edu)
We examine the fi rst of these three types of business mobility — business organiza-tional form decisions. We posit that fi rms’ organizational form choices are often made to achieve tax advantages, meaning the selection can be an important aspect of tax base mobility. While tax planning cannot be investigated directly, this study of how taxes affect organizational form allows for an indirect means of exploring mobility through tax planning. A fi nding that taxes affect organizational form strongly suggests that
fi rms structure their business to reduce their taxable base. Furthermore, determining which changes in tax policies generate a change in organizational form decisions, and the relative magnitude of change, provides researchers and policymakers with a better understanding of the expected harm or benefi t of particular tax changes.
Tax base mobility through the choice of organizational form can be illustrated with several examples, which are elaborated in the next section. These decisions might entail shifting from one organizational form to another, such as forming a partnership rather than a C corporation, to avoid corporate income taxes. This behavior directly reduces the corporate tax base, which provides evidence of base mobility. Alternatively, fi rms may choose to form businesses in multiple jurisdictions, some located in high tax-rate jurisdictions and others in low tax-rate jurisdictions, to isolate income in the latter. This involves creating more fi rms under the corporate umbrella than are necessary for productive operations. Then, transfer pricing can be used to shift the tax base to low-rate locales. The shifting of tax base to tax haven countries or low-tax states in this fashion has received considerable attention in recent years. The mobility arising from organizational choice decisions might even affect production choices, as fi rms choose to create or expand production in jurisdictions that were primarily chosen because of the ability to establish business structures that facilitate tax avoidance.
Using data on the tax systems of the 50 states, we examine how tax policy infl u-ences the choice of business organizational form. We apply a weighted least squares estimator to data on the number of corporations as a share of total business fi lings using a panel model that employs both time and state fi xed effects. Our fi ndings are gener-ally consistent across specifi cations and show that some tax policy parameters affect organizational form decisions, though the magnitude of the effects is modest. While we cannot directly capture the intricacies of tax planning, the small elasticities that we estimate suggest that concerns over tax planning on the part of the states may be overstated. The estimates indicate that corporate and individual income tax rates have a consistently negative effect on the share of businesses choosing the corporate form, as does following the Uniform Division of Income for Tax Purposes Act (UDITPA) treatment of non-business income. Imposing an entity level tax on limited liability companies (LLCs) was also consistently associated with a smaller corporate share, perhaps because it results in diminished tax planning opportunities.
Prior research has focused primarily on the effects that various tax policies have on the tax base and revenues. For example, Edmiston (2002) uses a computable general equilibrium model to examine the revenue effects of different corporate income tionment formulas. Goolsbee and Maydew (2000), on the other hand, look at appor-tionment formulas and their effects on economic development. Fox and Luna (2005)
consider the way in which LLCs have infl uenced state corporate income tax revenues. Gupta et al. (2009) consider an array of factors that infl uence corporate revenues.
In the study most closely related to ours, Goolsbee (2004) empirically examines the relation between tax rates and organizational form for the retail sector. We extend this work in several important ways. First, we examine the relative attractiveness of doing business in alternative business forms by looking at detailed features of state corporate and personal income tax systems rather than just tax rates. For example, we consider whether the state has combined reporting and throwback rules for corporations and withholding requirements for nonresident members of LLCs. Second, we examine federal return fi lings across the states for 1998–2008 rather than for a single year. Third, we include fi rms across all sectors of the economy rather than just the retail sector. The sample includes fi rms in sectors like manufacturing, which often require access to national capital markets, as well as small, professional fi rms.
This study sheds light on which state tax provisions change behavior1 and impact business activity as measured by the rate of entity formation. State policymakers should be interested in mobility through organizational form for several reasons. Tax base shifting, which is accomplished using nothing more than accounting entries, directly affects corporate income tax revenues (Fox and Luna, 2002). States must also balance their dual goals of offering businesses a friendly operating environment and raising
suf-fi cient revenues to fund government operations. In addition, the differences in taxation of various entity types increase the excess burden of state income tax systems (Goolsbee, 1998) as well as the costs associated with tax administration, tax compliance, and tax planning (Gupta and Mills, 2003; Hildreth, Murray and Sjoquist, 2005).
The remainder of the paper is organized as follows. The fi rst section frames the empirical inquiry by discussing how tax policies may affect tax planning and organi-zational form. While we are not able to directly capture the nuances of these planning mechanisms in the empirical analysis, we argue that these behaviors are embedded in the observed responses to tax policy parameters. The next section develops the logic that underlies the empirics. We then turn to our empirical strategy and fi ndings. The
fi nal section offers a brief conclusion. II. TAXES AND ORGANIZATIONAL FORM
Why do some fi rms choose the corporate form while other fi rms choose not to incor-porate? The tax literature has focused primarily on the interaction between the federal corporate and personal income taxes. Regular (i.e., C) corporation income is taxed at the entity level and distributed earnings are taxed again as dividends under the
1 We specify our models in such a way as to measure causality from policy to organizational form, but in
practice, causality can be unclear. Businesses adjust their tax strategies in response to policy changes, but states also respond to businesses. For example, states close loopholes that businesses have exploited or raise rates in response to declines in tax revenues. The results reveal statistical correlations, and we infer causality.
sonal income tax.2 Business owners can avoid this double taxation at the federal level by operating as a sole proprietorship or by forming a pass-through entity such as an S corporation, a partnership or a limited liability entity.3 Earnings for these entities fl ow to their owners and are taxed only once on the owners’ personal income tax returns. Only a small number of empirical studies have examined how this federal tax wedge infl uences business behavior (Ayers, Cloyd, and Robinson, 1996; Mackie-Mason and Gordon, 1997; Omer, Plesko, and Shelley, 2000).
Taxation at the state level is generally consistent with federal law, but important exceptions exist. Some states disregard S corporations and tax them as C corpora-tions.4 States authorize LLCs and limited liability partnerships (LLPs) and other limited liability forms of business according to state law. Because these entities are not formally recognized as a separate entity type under the federal income tax system, LLC/LLP members “check the box” for the organization and elect to be taxed as either a corporation or partnership. At the state level, LLCs and LLPs electing to be taxed at the federal level as partnerships are generally taxed as pass-through entities, but some states now levy an entity level tax on partnerships and/or LLCs and LLPs. Individuals forming single-member LLCs are taxed as a corporation or sole proprietorship at both the state and federal levels.
There are two additional tax considerations that may affect the choice of business organizational form.5 First is the progressivity of the federal corporate income tax and some state corporate income tax systems. A pass-through entity like an LLC may enjoy a lower tax burden if its income is spread among several members and taxed at member rates as opposed to having all income taxed at the entity-level corporate rate. At high levels of profi tability, this advantage of the LLC form vanishes if corporate and personal income top bracket rates are similar. In 2008, 13 states had progressive corporate rate structures. Second, states generally impose higher rates on corporations than they impose on individuals. Of the states with a tax on corporate income and per-sonal income, 24 states had a higher top-bracket rate on corporations while 11 states had a higher top-bracket rate on personal income.6
2 The Jobs and Growth Tax Relief Reconciliation Act of 2003 lowered the maximum tax rate on qualifi ed
dividends to 15 percent, reducing the double-tax penalty for operating in the corporate form.
3 Note that LLCs and other limited liability entities (LLPs, PLLCs, SMLLCs, etc.) can be taxed as
partner-ships, corporations, or sole proprietorships at the federal level, depending on the number of members (one
versus more than one) and the entity’s election. The data refl ect the election, so an LLC electing to be taxed
as a partnership fi les a partnership return.
4 S corporations are domestic corporations that have less than 100 shareholders (only U.S. citizens, resident
aliens, estates, certain trusts and exempt organizations) and one class of stock (Internal Revenue Code Section 1361).
5 Non-tax benefi ts, such as limited liability and access to national and international capital and credit
mar-kets, are also important considerations that we are not able to account for in our empirical analysis. For
more discussion on non-tax benefi ts, see Ayers, Cloyd, and Robinson (1996), Mackie-Mason and Gordon
(1997), and Gravelle and Kotlikoff (1989).
6 These counts omit Rhode Island, which taxes personal income at 25 percent of the federal liability; Rhode
A. New Business Formations Versus Multi-entity Firms
Prior literature has generally examined the formation of unaffi liated new business entities that would be domiciled in a single taxing jurisdiction. While the choice of organizational form for an independent startup would presumably depend on both tax and nontax considerations, tax planning in this instance is minimized in importance and scope because the business owner need only consider the tax policies of a single state and can ignore considerations that might loom large for a multi-entity, multi-state business. Single state fi rms, for example, need not consider transfer-pricing issues and whether there is an advantage to organizing as a pass-through entity to shift profi ts to an entity located in a lower-tax state. This research is useful to lawmakers because most businesses are small and operate in a single state.
However, the assumption of a single jurisdiction fi rm ignores the decision-making factors that exist for large regional and national businesses that conduct a large share of U.S. business activity and are of particular concern to policy makers because of their economic impact. Those businesses operate in many jurisdictions and have proved adept at exploiting their interstate operations to achieve their tax planning goals. For these businesses, whether to form a new entity, and, if so, what type of entity and where to locate it will likely hinge largely on state tax planning considerations.7 In fact, for multi-state businesses, new entities are often formed for the express purpose of achiev-ing state tax plannachiev-ing goals.
B. State Tax Planning Across Borders and Entity Choice Decisions
State tax planning can involve either shifting income to a jurisdiction with a lower (sometimes zero) tax rate on that type of income or creating “nowhere” income that is not subject to tax in any jurisdiction. Firms want to accomplish either of these tasks for two reasons. First, states treat income and expense items differently and tax them at different rates. Second, states generally respect the separate legal existence of a separately formed entity, even if that entity is wholly owned by a related entity (e.g., parent-subsidiary or a brother-sister relation). Therefore, states often tax a newly formed entity without regard to its owners and related entities. Many tax planning strategies take advantage of one or both of these elements of state tax practice. States have attempted to blunt the effectiveness of income shifting strategies that use separate entities, with some success. Several examples illustrate how these schemes work in practice, as well as some of the states’ responses.8
7 The federal taxation of the new entity is often dictated by the taxation of the existing business. For example,
income earned by entities formed under a corporate umbrella will be ultimately taxed on the parent’s corporate return, either through consolidation of corporate entities, or, for pass-through entities such as LLCs, when income is passed through to the corporate owner.
8 We do not intend this to be a comprehensive list of tax avoidance schemes. For more detailed information,
First, for state income tax purposes, the choice of entity can be as simple as deter-mining if the business as a whole wants taxable income to remain in the state where it was earned. In that case, a separately formed corporation doing business in a single state is often suffi cient.9 Alternatively, a fi rm may prefer that the income be shifted to another state with a more favorable tax environment, in which case the business might be formed as an LLC and the income passed out to an out-of-state owner without nexus. For example, Tennessee taxed LLCs as pass-through entities for several years. Many large organizations that wanted to shift Tennessee operating income out of state simply reorganized their operating activities as LLCs with a 99 percent owner organized as a Passive Investment Corporation (PIC) located in Delaware, which does not tax the LLC profi ts of a PIC. This arrangement effectively removed 99 percent of the operating income of the business from Tennessee and likely fueled an increase in LLC formations in the state with a corresponding drop in corporate formations. Tennessee now imposes entity-level taxes on LLCs, which diminishes the incentives to organize as an LLC. However, the same planning opportunity is still available in other states.
Second, nowhere income — or income that is not taxed in any state — can generally be created by doing business in a state without a corporate income tax or by exploit-ing P.L. 86-272 which allows a fi rm to avoid nexus if its only contact with a state is making or soliciting sales of tangible goods.10 In the absence of nexus, there is no apportionable income that might be taxed in states where sales take place. Throwback rules attempt to ensure that this nowhere income is ultimately taxed in the origin state (see the discussion below).
A third popular planning strategy is to use PICs to “park” income and expenses in tax-advantaged states using entities that are not pass through (e.g., corporations). An example of this planning model is a business that transfers intangible assets such as trademarks and trade names to a Delaware PIC. Operational entities in other states then make royalty payments to the Delaware PIC for the right to use the intangible assets. The payments are deductible to the operating entities, but non-taxable to the Delaware PIC. The transaction creates deductible expenses and non-taxed income, but its success is dependent on the ability to locate both the income and the expense in the state with the most favorable income tax treatment. The ability to locate income in low-tax or no-tax states should encourage corporate formations in those states versus corporate formations in high-tax jurisdictions.
The states have amended their tax rules in a variety of ways to try to limit the effective-ness of strategies intended to create nowhere income or to shift income from high-tax to
9 Note that combined reporting requirements limit the effectiveness of using separate entities to shift income
among states; see Fox, Luna, and Murray (2005) and the discussion below.
10 P.L. 86-272 was a Congressional response to the U.S. Supreme Court case Northwestern Portland Cement
v. Minnesota, which was decided in 1959. The question before the court was whether the solicitation of
sales of tangible property was suffi cient to establish nexus as asserted by Minnesota; the court concurred
with Minnesota. The business community subsequently convinced Congress to pass P.L. 86-272 to over-ride the court’s decision. Pomp and Oldman (2001) provide additional detail.
low-tax states. Required combined reporting is the most comprehensive and effective tool against these potentially abusive strategies because the rules effectively ignore the presence of separate legal entities. Entities engaged in a unitary business are combined as one, and the combined income is apportioned to the various states. With combined reporting, for example, the impact of the PIC is mitigated and has the same practical effect of a tiny Delaware offi ce with few employees and/or little property.11 Addback provisions are piecemeal remedies and disallow deductibility of a targeted list of pay-ments such as royalties paid to related parties. Barnwell (2008) notes that 18 states have adopted an addback provision since 2000, though the provisions are inconsistent across states and include loopholes. In practice, states adopt addback provisions to address specifi c rather than general tax planning problems.
Throwback rules seek to tax nowhere income by requiring that sales not taxed in the destination state be “thrown back” and taxed in the origin state. The presence or absence of these rules might affect organizational decisions in both the destination and home state. For example, if sales that would otherwise be protected by PL 86-272 are shipped to a low-tax state but are made by a company located in a throwback state with higher rates, a business could establish nexus in the low-tax destination state to subject the income to tax at the lower rate. Alternatively, a business might avoid incorporating or housing a shipping facility in a throwback state because the throwback rules will guarantee all shipments are subject to state income taxes. If shipping facilities are located in a state without a throwback rule, sales to any state in which the seller does not have nexus will often constitute “nowhere income” that is not subject to income tax in any state. III. EMPIRICAL FRAMEWORK
Businesses have a variety of tax planning options that allow them to shift income into desirable locations without moving factors of production. The tax planning process is diffi cult to measure directly, but the background discussion presented above helps motivate how the detailed characteristics of state income tax systems may affect tax base mobility through the choice of organizational form. We capture this mobility in the context of reduced form estimation of business tax return fi lings by organizational form type. The empirical framework allows examination of a range of state tax policy parameters, like throwback rules and corporate tax rates, and their effect on the choice of incorporating as a corporation versus a pass-through entity.
The empirical analysis begins with estimation of two-way fi xed-effects models that control for states and time and take the form
(1) C orpSharei,t = ß0 + CIT
⋅
ß1 + PASS⋅
ß2 + OTH⋅
ß3 + αi + ηt + μi,t.11 Combined reporting can also lower tax burdens for members of an affi liated group. For example, for
companies reporting in two or more states that use separate reporting, losses in one entity cannot offset the taxable income of a related entity. Under combined reporting, losses are immediately available to offset the income of related corporations included in the combined report.
The dependent variable CorpShare is defi ned as the corporate share of total federal business tax returns for state i in time period t. State and time fi xed effects are captured by αi and ηt. This share model assumes that total business activity in a state could be supported by any mix of businesses with different organizational forms. CIT represents a vector of state corporate tax structure parameters, while PASS is a vector that includes characteristics of personal income taxes that fall on entrepreneurs and limited liability business entities. OTH includes only a small number of control variables because most economic factors will affect corporations and pass-through entities in a similar fashion.
In general, policy adoption by a state legislature in year t would mean implementa-tion in year t + 1. Thus, in the year new policy becomes effective, businesses can make organizational form decisions fully informed of policy changes affecting that choice. However, it will take some time for existing businesses to react to tax law changes by transferring operations to newly formed entities, winding down the previous legal entity, and completing reorganization efforts. Because our dependent variable is the share of businesses fi ling as a corporation, rather than new business fi lings, our baseline model lags all policy variables by one period to allow businesses to complete any tax-motivated transition. This approach also controls for potential endogeneity. As a robustness check, we also present results without lagging the policy variables.
The share models will capture potential changes in both corporations and partnerships. For policy parameters that infl uence these business forms in different directions, the share models will yield clear implications of the effects of policy. But in some instances policy might have a positive or negative effect on both corporations and partnerships, in which case the share models do not provide clear insights on the effects of policy. To address this issue, we complement the share models using levels equations that focus on the number of corporate returns and partnership returns using analogous explana-tory variables:12
(2) Corporationi,t = α0 + CIT
⋅
α1 + PASS⋅
α2 + OTH⋅
α3 + αi + ηt + νi,t (3) Partnershipi,t = π0 + CIT⋅
π1 + PASS⋅
π2 + OTH⋅
π3 + αi + ηt+ νi,tThese level equations allow us to clarify our understanding of how tax policy affects the respective forms of business organizations.
The following discussion describes the explanatory variables in greater detail, while Table 1 offers a summary of variable defi nitions and data sources. We use the top state corporate income tax rate (Corp_rate) to refl ect the tax burden borne by regular corporations. Controlling for the rate on pass-through income (Ind_rate), a higher
Corp_rate should reduce the share and count of businesses taking the corporate form. The corporate tax rate measure is complemented by a number of other tax structure
12 As alternative specifi cations, we also employ a changes-levels model and a changes-changes model. These
Table 1
Variable Defi nitions and Data Sources
Dependent
Variables Variable Defi nition Data Source
Corporation The number of corporate returns
fi led for a state in a given year for
1998–2008
Internal Revenue Service (IRS) Statistics of Income (SOI), avail-able online at www.irs.gov/taxstats Partnership The number of partnership returns
fi led for a state in a given year for
1998–2008
IRS SOI data at www.irs.gov/ taxstats
CorpShare The number of corporate returns
fi led for a particular state divided
by the total number of returns
fi led for a particular state for
1998–2008
Calculated using the IRS SOI data
Policy Variables Variable Defi nition Data Source Corp_rate Highest corporate income tax rate CCH State Tax Handbook,
1997–2008
Ind_rate Highest individual income tax rate CCH State Tax Handbook, 1997–2008
Nonbusinc Dummy variable taking a value of 1 if state follows the UDITPA
defi nition of non-business income,
0 otherwise
CCH State Tax Handbook, 2000–2008
IRC_Conform Dummy variable taking a value of 1 if state conforms with the federal Internal Revenue Code, 0 otherwise
CCH State Tax Handbook, 1997–2008
Comb_Rep Dummy variable taking a value of 1 if state has combined reporting, 0 otherwise
CCH State Tax Handbook, 1997–2008
Salesappor Continuous variable for the weight of sales in the apportionment formula
CCH State Tax Handbook, 1997–2008
Throwback Dummy variable taking the value of 1 if the state imposes a throw-back rule, 0 otherwise
CCH State Tax Handbook, 1997–2008
Addbacks Dummy variable taking a value of 1 if state has addback provi-sions for related party interest and dividend, 0 otherwise
“State Tax Treatment of Limited Liability Companies and Part-nerships” by Eli, Grissom, and
Thistle, published by State Tax
characteristics that may infl uence the formation of corporations and partnerships, per-haps in the same direction.
Sales-weighted apportionment (Salesappor) above the traditional one-third factor weight makes the formation of an in-state business more attractive when the fi rm exports a large share of its output out of state. Typically, these exporters are manufacturing and mining operations that are traditionally organized as corporations. A state may have common or different policies for corporations versus pass-through entities, but we are only able to account for policy toward corporations. A continuous measure with a top value of 1.0 indicating 100 percent sales apportionment is used in the baseline models presented below. While pass-through fi rms and regular corporations may both benefi t from heavily-weighted sales factors, we would expect a positive effect on CorpShare
to the extent manufacturers are typically organized as corporations and are expected to export more of their output than most pass-through entities.
State corporate income tax conformity with the Internal Revenue Code (IRC_
Conform) is an indicator of the relative ease of the state tax compliance process and Table 1 (Continued)
Variable Defi nitions and Data Sources
Policy Variables Variable Defi nition Data Source LLC_WH_Tax Dummy variable taking a value of
1 if state requires LLCs to with-hold tax on non-resident members, 0 otherwise
“State Tax Treatment of Limited Liability Companies and Part-nerships” by Eli, Grissom, and
Thistle, published by State Tax
Notes, 1997–2008 LLC_Corp_Tax Dummy variable taking a value of
1 if state imposes a corporate tax on LLCs, 0 otherwise
“State Tax Treatment of Limited Liability Companies and Part-nerships” by Eli, Grissom, and
Thistle, published by State Tax
Notes, 1997–2008 Control Variables Variable Defi nition Data Source
Pop Population for the state, in
mil-lions
U.S. Census Bureau, Population Estimates Program, 1997–2008 BAdeg Percent of the population with at
least a bachelor’s degree
U.S. Census Bureau, Current Population Survey, Annual So-cial and Economic Supplement, 1997–2008
Manuf_Share Share of non-farm employment in the manufacturing sector
Bureau of Labor Statistics, Current Employment Statistics, 1997–2008
should encourage business formations. Decoupling from specifi c provisions of the IRC could be favorable or unfavorable to taxpayers depending on the circumstances. However, during the study period, taxes were lowered on business activity through two major federal tax acts and several states specifi cally decoupled from federal changes that would have reduced state income taxes. Because the major federal changes such as bonus depreciation affected all business activity, and were not specifi c to business form,
the effect on corporate share is ambiguous. The net impact of IRC_Conform should
be to increase overall business attractiveness because decoupling adds administrative costs and in most cases refl ected an effort to block federal tax cut provisions from tak-ing effect at the state level.
Conformity with the UDITPA treatment of non-business income (Nonbusinc) will
have an ambiguous effect on CorpShare. UDITPA explicitly defi nes apportionable busi-ness income, and income that is not busibusi-ness income is accordingly non-busibusi-ness and allocable to a specifi c state. Businesses typically prefer the ability to allocate income. Some states such as Delaware expand the defi nition of non-business and therefore allo-cable income, a position that should encourage business formation. Other states have expanded the defi nition of business income to all income that is allowed to be treated as apportionable by the Supreme Court. These expansive defi nitions reduce taxpayer planning opportunities because allocating income to a low tax jurisdiction is made more diffi cult. We were unable to compile non-business income data for 1998–2000, so we can only test for the infl uence of this variable during the eight years covered by our data.
A state’s policy toward corporate tax planning opportunities on apportionable income is measured by three variables. The fi rst is the presence or absence of combined reporting (Comb_Rep) for fi rms that have nexus in the state.13 In practice combined reporting may raise or lower a corporation’s tax burden depending on the nature of interfi rm activities. Alternatively, if viewed as a signal regarding the aggressiveness of state tax policy toward business, or if LLCs are not included in the combined report, combined reporting should discourage incorporation. The second is the presence of addback provisions (Addbacks) for fi rms that do not have nexus in the state. Like combined reporting, these provisions (which vary in substance across states) should dampen corporate activity relative to all business activity. Finally, a dummy variable is used to indicate whether the state has a throwback rule (Throwback) for sales that have not been fully apportioned to or taxed in other states. Throwback rules should diminish the likelihood of corporate formation and the creation of in-state nexus.
The fi rst element of PASS is the top personal income tax rate (Ind_rate). The effect of the personal income tax rate on partnerships is ambiguous and depends on the degree of taxpayer risk aversion and the scope of loss sharing with the government (Schuetze and Bruce, 2004). If relatively high individual tax rates discourage partnerships, we would expect an increase in corporate entity formation. This expectation is tempered
13 Some states require partnerships owned by corporate interests to be included in the corporation’s combined
by the fact that an in-state tax rate does not apply to non-residents who receive pass-through income, although some states require withholding for out-of-state members of LLCs. The remaining elements are features of the state tax system that apply to limited liability entities. A dummy variable (LLC_WH_Tax) controls for whether or not the state imposes withholding tax on out-of-state members of LLCs. This measure may directly dampen pass-through formation, but may also discourage corporate locations by diminishing in-state tax planning opportunities, even for out-of-state taxpayers. Together the net effect on CorpShare is ambiguous because the LLC withholding tax may affect both corporations and partnerships, and we do not know which effect will be larger ex ante. A dummy variable that indicates whether an LLC is subject to an entity-level tax (LLC_Corp_Tax), usually at the corporate rate, is also included. The presence of this tax should decrease the attractiveness of the LLC and lead to an increase in the formation of regular corporations. However, to the extent this provision dampens tax
planning opportunities for corporations, the impact of LLC_Corp_Tax on CorpShare
is also ambiguous.
Although many non-tax variables affect entity choice decisions, the aggregated nature of our data does not allow us to control for these factors. Most state-level non-tax fac-tors will be accounted for through the state fi xed effects that are included in all of our specifi cations. However, we do include a small set of additional controls (OTH). The
fi rst is a sector control for the share of employment in manufacturing (Manuf_Share). We expect a larger manufacturing sector to be associated with more corporations because of the greater need to access national capital markets. Moreover, Gupta et al. (2009), among others, have pointed to a declining manufacturing sector14 as one of the explana-tions for the declining role of the corporate income tax in state fi nances.15 The second is population (Pop), which serves as a scale control with uncertain implications for the mix of business activity. The third is the share of the adult population with a Bachelor of Arts degree (BAdeg), a measure that refl ects the quality of the labor force. The effect of education on CorpShare is unclear. On the one hand, a better educated population may lead to more entrepreneurship and therefore more pass-through businesses. But corporations may also choose to establish a presence in places where there is a more highly educated workforce.
Following Greene (2000), we apply a weighted least squares estimator to the grouped proportion data represented by CorpSharei. Weighted least squares and Huber/White robust standard errors address the heteroskadasticity problem that is commonly associ-ated with grouped proportions data.16 These standard errors are adjusted for clustering
14 During our sample period, the share of employment in manufacturing declined from 13.4 percent in 1998
to 9.7 percent in 2008 (Table 2).
15 Declining corporate tax revenues are a problem only if not offset by increased individual income taxes.
The loss of a manufacturing plant is a net loss of economic activity in the state.
16 While the range of CorpShare falls in the 0–1 interval, neither censored nor truncated regression methods
are applied to the data. The distribution has not been truncated; it is instead a refl ection of aggregation.
Censoring does not apply because the underlying choice is to form a business as a pass-through entity or a corporation.
around individual states. As discussed more fully below, we also estimate level models for corporations and pass-through entities using panel methods. Statistical tests show that state fi xed effects are appropriate for the empirical models. We also include time
fi xed effects in the share and levels equations.
The models are estimated using 1998–2008 federal IRS tax return fi lings aggregated at the state level as reported by the IRS Statistics of Income (hereafter called “SOI data”).17 Using a fi ling address on a federal return generally implies that the business entity has nexus in that state through physical presence at a minimum, so our empiri-cal analysis attributes the location of the business to the state listed on the return. The aggregate SOI data do not distinguish between C-corporations and S-corporations for the years 2000–2003. As a result CorpShare is defi ned as the ratio of S plus C corporate returns divided by the sum of corporate and partnership returns fi led; level models on corporations include both S and C corporations. In some states, the number of S corpora-tions exceeds the number of C corporacorpora-tions. The ratio will depend on whether the state recognizes the federal S corporation election.18 S Corporations also have shareholder restrictions (i.e., corporations cannot be shareholders), and therefore, S corporations are not commonly used for the state planning efforts described in this paper.
For IRS purposes, entities formed as general or limited partnerships, as well as the limited liability entities (LLCs and LLPs, etc.) electing partnership treatment,19 will fi le partnership returns using Form 1065. The SOI data do not distinguish between the various types of entities fi ling Form 1065.
IV. DESCRIPTIVE STATISTICS AND EMPIRICAL FINDINGS A. Descriptive statistics
We present descriptive statistics in Table 2. The share of businesses fi ling federal returns as corporations decreased for most states during the sample period and in some states by signifi cant amounts. The corporate percentage of total federal business returns
fi led averaged 69.2 percent for all states for the years 1998–2008 but varied tremen-dously from state to state. The lowest corporate share was 47.6 percent for Connecticut in 2008. While scale has a large infl uence on the number of business entities, with the most populous states fi ling the most corporate returns (Figure 1), it has much less infl uence on the entity choice between the corporate and partnership forms (Figure 2).
17 We have explanatory data for 1997–2008, but the IRS data are only available for 1998–2008.
18 Currently, fi ve states do not recognize the S corporation election. There is no variation in the treatment
during our time period.
19 As discussed elsewhere, LLCs can choose to be taxed as corporations or partnerships. For discussion
pur-poses, we assume that limited liability entities elect partnership taxation. We cannot identify LLCs taxed as corporations versus partnerships, but for state tax planning purposes, LLCs are effective only when the income can be shifted to out-of-state owners, which requires an election to be taxed as a partnership (Fox and Luna, 2005). We have focused the discussion on the emergence of the LLC because this entity creates a very attractive option for businesses that desire pass through tax treatment.
Table 2 Descriptiv e Statistics M ean M in M ax 1997– 2008 1998 2008 1997– 2008 1998 2008 1997– 2008 1998 2008 Dependent V ariables Corporation 117,907 105,639 138,378 10,032 10,044 12,419 827,342 506,854 827,342 Partnership 48,828 36,453 65,747 3,938 3,938 6,036 359,582 242,524 359,582 CorpShar e 0.692 0.732 0.655 0.476 0.597 0.476 0.890 0.885 0.822 Policy V ariables Corp_rate 6.774 6.864 6.713 0 0 0 12 12 12 Ind_rate 5.505 5.629 5.335 0 0 0 11 11 9.5 IRC_Conform 0.753 0.840 0.680 0 0 0 1 1 1 Nonbusinc 1 0.468 0.440 0 1 1 1 Comb_Rep 0.333 0.320 0.400 0 0 0 1 1 1 Salesappor 0.478 0.450 0.552 0 0 0 1 1 1 Thr owback 0.482 0.500 0.480 0 0 0 1 1 1 Addbacks 0.180 0.020 0.420 0 0 0 1 1 1 LLC_WH_T ax 0.418 0.200 0.660 0 0 0 1 1 1 LLC_Corp_T ax 0.147 0.140 0.160 0 0 0 1 1 1 Control V ariables Pop 5,737,187 5,394,532 6,069,358 479,602 480,045 532,668 36,800,000 32,700,000 36,800,000 BAdeg 25.871 23.768 28.502 14.600 16.200 15.584 44.408 34.000 43.222 Manuf_Shar e 11.068 13.443 9.742 3.000 2.955 2.406 22.566 22.566 17.653 Notes: 1Data for Nonbusinc
are not available for 1998, 1999, and 2000. See
Table 1 for variable de
fi
F igur e 1 SOI Data: 2000–2008 (A v e rage Number of C o
F igur e 2 SOI Data: 2000–2008 (A v e rage Number of C o
For example, the highest corporate share was recorded in Florida in 1999 when 89.0 percent of all businesses fi led as a corporation. But Maine and Vermont also recorded high shares of corporate returns during the sample period.
The number of both corporation and partnership returns fi led increased during the sample period. The average number of corporation returns fi led annually increased by about 33,000 to 138,378. The number of partnership returns fi led annually increased by approximately 29,000 to 65,747.20 Although the LLC taxed as a partnership is an attractive choice for those looking for fl exible ownership rules, limited liability, and avoidance of double taxation of dividends, more corporations were formed overall. However, because corporations represented approximately 70 percent of all business returns fi led, the change in partnership returns over the ten-year period is approaching the change in corporate returns, indicating that new businesses seem to be leaning more towards partnerships or, more likely, the set of limited liability forms of doing business.
Average state tax rates dropped during the window of our panel. The corporate rate declined slightly from an average of 6.9 percent to 6.7 percent, while the average indi-vidual income tax rate declined from 5.6 percent to 5.3 percent. Approximately 47 percent of the state observations conform to the UDITPA defi nition of non-business income and impose throwback rules. One-third of the states require combined reporting and about 75 percent conform to the Internal Revenue Code. The mean share of states requiring addbacks of certain related-party expenses averaged 18 percent during the sample period, but the change during the panel window was signifi cant. At the beginning of the sample period, only 2 percent imposed such requirements, but by the end of the period, a full 42 percent did. The average sales apportionment factor was 0.48, though it grew by 10 percentage points between 1997 and 2008 from 0.45 to 0.55. Approximately 42 percent of the observations had an LLC withholding tax, with many states implementing the with-holding requirement during the sample period (from 10 states to 33 states). However, only 15 percent of the observations indicated an entity level tax on LLCs. Simple correlations show that these various provisions are not closely linked to one another within given states.
Figure 1 shows the average number of corporate returns fi led, and Figure 2 shows the number of returns fi led as a share of the population for each state. The states with the highest absolute number of corporations follow population sizes, with California, Florida, Texas and New York topping the list. The data that are scaled by population show a signifi cantly different pattern, with both California and Texas losing their dominant status. Florida and New York, on the other hand, also have high per-capita corporate totals along with Nevada, Montana, Utah and Colorado.
B. Empirical Findings
The models used in this analysis take the overall trend towards pass-through entities as a given because many of the key federal policy changes, such as check-the- box rules
20 Check-the-box regulations were issued in 1997. Time fi xed effects should account for the infl uence of
for LLCs, apply equally to all states. Time fi xed effects capture these overall infl uences on business formation. The variables of interest in this analysis are state-level tax policy variables that show variation across both time and space. The goal is to identify the way state tax structure infl uences the variation in the overall mix and levels of corporate and non-corporate business entities.
State tax policies that affect the mix of entity type may not refl ect changes in a state’s level of business activity. Changes in business preference for partnerships ver-sus corporations can occur while the overall number of entities is either increasing or decreasing. CorpShare will refl ect changes in the mix, but the variable does not tell us whether the overall number of business fi lings has changed. However, tax policies that affect (increase or decrease) the number of both partnerships and corporations are more accurately interpreted as affecting overall business activity than shifts between avail-able forms. We use the levels variavail-ables Corporation and Partnership to capture these outcomes in the nominal number of fi rms fi ling as corporations and/or partnerships.
We test our baseline model with CorpShare as the dependent variable and present the results in Table 3. CorpShare for the sample as a whole decreased during the period, from a mean of 73 percent to 66 percent. As such, a negative fi nding for a particular variable indicates a relatively larger decline in CorpShare. Similarly, a positive sign could mean that the decline in that state was smaller than average, but still a nominal decline. The fi rst two columns of Table 3 show the results when the independent vari-ables are lagged by one year; columns 3 and 4 show the same varivari-ables without lags. We could not compile the data for non-business income for the earliest three years, so we test the models for the shorter period with non-business income and for the full sample period without non-business income.
Note that these models, along with those discussed below, include all states, regardless of whether the state has a personal or corporate income tax. We believe that all states should be included because those without corporate or personal income taxes still repre-sent viable locations for doing business. Eliminating states without a corporate income tax, for example, would eliminate a handful of states that might represent tax haven states or simply states with a good tax climate. We estimate a model excluding states that do not tax corporate income and fi nd substantially similar but weaker results than those presented below. This is expected because we have narrowed the possible effects of state tax policy to only those states with a corporate income tax, reducing the varia-tion in the explanatory variables and the set of locavaria-tion opvaria-tions available to the fi rm.21 The results are generally consistent across specifi cations. As shown in Table 3, an increase in Corp_rate reduces the corporate share of total returns fi led, and therefore increases the percentage of fi rms choosing to fi le as a partnership, as expected.22 (The
21 Delaware’s legal and regulatory environment has made it a favorite locale for new corporate formations.
We ran our baseline models excluding Delaware and results are very similar to those presented below.
22 As an alternative to including both the corporate and individual tax rates, we also calculated the difference
between the top corporate and individual rates. This variable was not signifi cant in any model specifi cation,
indicating the top corporate rate was more important than the difference between corporate and individual top rates. We also substituted taxes as a share of personal income for maximum corporate and individual
Table 3
Regression Results: Share Models (Dependent Variable: CorpShare)
Lagged W/ Nonbusinc Lagged W/O Nonbusinc Non-Lagged W/ Nonbusinc Non-Lagged W/O Nonbusinc Variable Coeffi cient (Std. Error) Coeffi cient (Std. Error) Coeffi cient (Std. Error) Coeffi cient (Std. Error) Corp_rate –0.0051*** –0.0040** –0.0028* –0.0033* (0.0013) (0.0018) (0.0016) (0.0018) Ind_rate –0.0044*** –0.0051*** –0.0042*** –0.0051*** (0.0017) (0.0011) (0.0014) (0.0011) IRC_Conform 0.0014 0.0032 0.0055 0.0044 (0.0029) (0.0029) (0.0036) (0.0030) Nonbusinc –0.0149*** –0.0059 (0.0041) (0.0105) Comb_Rep –0.0034 –0.0053 –0.0007 –0.0020 (0.0036) (0.0073) (0.0058) (0.0065) Salesappor –0.0077 0.0015 –0.0062 0.0002 (0.0049) (0.0078) (0.0048) (0.0069) Throwback –0.0172 0.0074* –0.0048 –0.0081* (0.0114) (0.0041) (0.0071) (0.0044) Addbacks 0.0023 –0.0054** 0.0055** –0.0016 (0.0029) (0.0027) (0.0026) (0.0027) LLC_WH_Tax 0.0012 –0.0028 0.0022 –0.0008 (0.0019) (0.0023) (0.0020) (0.0023) LLC_Corp_Tax –0.0194*** –0.0084* –0.0219*** –0.0128*** (0.0048) (0.0044) (0.0048) (0.0047) Manuf_Share 0.0038** 0.0017* 0.0037** 0.0023*** (0.0015) (0.0010) (0.0015) (0.0011)
Pop 1.72e–8*** 9.97e–9*** 1.01e–8* 9.80e–9**
(0.0000) (0.0000) (0.0000) (0.0000) BAdeg 0.0002 0.0000 0.0003 0.0000 (0.0004) (0.0003) (0.0003) (0.0003) Intercept 0.5866*** 0.7071*** 0.5959*** 0.6934*** (0.0407) (0.0270) (0.0557) (0.0552) Number of observations 350 550 400 550
Notes: Asterisks designate statistical signifi cance at the p<0.01 (***), 0.05 (**), and 0.1 (*) levels. All
models include state and year fi xed effects. Robust clustered standard errors presented in parentheses.
independent effects on corporate fi lings and partnership fi lings are confi rmed in the level regressions reported in Table 4.) In general, this is one of the most consistent fi ndings across the models we estimate. For column 1 of Table 3, the elasticity of the corporate tax rate (using panel means) with respect to CorpShare is –0.05, while column 2 produces an elasticity of –0.04. These elasticities indicate small behavioral responses to the corporate income tax rate. Even a 10 percent increase in the corporate income tax rate would only produce a 0.5 percent reduction in the share of returns fi led by corporations.
The coeffi cient of the individual income tax rate is also negative and highly signifi -cant across all model specifi cations of CorpShare. Elasticities vary from –0.03 to –0.04 depending on the model and are of an order of magnitude that is similar to that of the corporate income tax rate. While counter to our expectations, a corporation and its own-ers will pay corporate tax on earnings and an individual tax on distributions to ownown-ers in the form of salary and/or dividends. A higher tax on dividends increases the double taxation of doing business in the corporate form. This fi nding could also be driven by the broad, anti-business perception of relatively high taxes. Since during our sample period about 70 percent of entities were organized as corporations, policies that have a broadly anti-business impact on existing businesses would disproportionately affect corporations. Finally, the individual rate is higher than the corporate rate in only 14 states in both 1997 and 2007, so an increase in the individual rate still left individual rates lower than corporate rates in a majority of states.
The coeffi cient on Nonbusinc, which captures UDITPA’s treatment of allocable (i.e. non-business) income, is negative and highly signifi cant in the lagged model. Unfortu-nately, only two states changed their defi nitions of business income during the sample period, 23 and the implied elasticity is only –0.01. The effect of Throwback depends on the model specifi cation. In the models with the shorter time window that include the variable non-business income, Throwback is insignifi cant. For the complete sample where the non-business income variable is excluded from the specifi cation, imposing a throwback rule is associated with an increase in the share of corporate fi lings. This might refl ect states in the late 1990s with a large corporate presence choosing to imple-ment a throwback rule to generate new revenue or prevent losses in their relatively large corporate revenue base.
The coeffi cient for the weight of the sales apportionment factor (Salesappor) is not signifi cant across the specifi cations we report here. The predicted effect of increasing the sales weight is to attract or retain net exporting in-state businesses, typically capital and labor intensive operations such as manufacturing fi rms. Indeed, the share of manu-facturing in the state (Manuf_Share) is positively associated with a higher corporate share in all the models of CorpShare.24 The manufacturing variable may be capturing some of the infl uence of the apportionment factor.
23 Illinois (2004) and North Carolina (2002) both adopted the broadest possible defi nition of apportionable
business income.
24 We also test the model by including a fourth control variable, Union, that represents the percentage of the
workforce that is in a union. The results are very similar to those presented below; however, Manf_Share
is no longer signifi cant in the models. We do not include Union in our baseline model because data are
Table 4
Regression Results: Levels Model
(Dependent Variables: Corporation and Partnership)
Corporation Partnership Variable Coeffi cient (Std. Error) Coeffi cient (Std. Error) Corp_ratet–1 –6,828.15*** 1,134.44* (2,162.08) (593.89) Ind_ratet–1 137.54 832.60* (783.63) (486.46) IRC_Conformt–1 8,075.94** –1,708.48 (3,630.65) (1,397.25) Comb_Rept–1 –10,539.78 11,094.47 (15,267.84) (8,262.87) Salesapport–1 7,723.93 409.98 (7,855.66) (3,462.85) Throwbackt–1 15,441.40** 344.09 (6,971.26) (2,406.75) Addbackst–1 –3,126.67 4,390.79*** (2,373.26) (1,182.74) LLC_WH_Taxt–1 (2,277.42) 879.40 (1,859.35) (977.06) LLC_Corp_Taxt–1 –12,691.98* 4,388.34 (6,636.03) (3,108.79) Popt 0.05*** 0.03*** (0.01) (0.00) BAdegt 264.77 143.63 (306.70) (147.69) Manuf_Sharet –56.25 593.55 (940.06) (441.32) Intercept –142,309 –125,817.8*** (9,0769.57) (22,223.77) Number of observations 550 550
Notes: Asterisks designate statistical signifi cance at the p<0.01 (***), 0.05 (**), and 0.1 (*) levels.
Models include state and year fi xed effects. Robust clustered standard errors presented in parentheses.
Combined reporting requirements (Comb_Rep), which are often criticized by the business community, do not have a signifi cant effect in the models tested. This could refl ect the fact that not all businesses lose under such a reporting regime. Some fi rms may be encouraged to locate in a state with combined reporting (e.g., those businesses wishing to consolidate loss entities with profi table entities, or to accomplish some transfer pricing tax planning schemes), while some other fi rms (e.g., those with high profi t entities that are located in non-combined reporting, low tax rate states) might be discouraged, together yielding no net effect on corporate formation. We offer no evidence that combined reporting hurts a state’s business climate in terms of the mix of business activity.
During the sample period, the number of states with an addback provision (Addbacks) increased from one state to 21 states. Despite this variation, the effect on CorpShare
is mixed, indicating factors other than addback provisions dictated entity choice deci-sions. Addback provisions that target a narrow slice of intercompany transactions and combined reporting represent a tax policy continuum, with combined reporting being the most comprehensive means of combating tax planning. We experimented with alternative formulations of the combined reporting and addback variables, including a variable that accounted for the absence of either policy, the presence of either policy and the presence of both policies. In general these alternative specifi cations also have mixed results.
Two variables in our model examine the effect of levying a tax on limited liability entities. LLC_WH_Tax, a tax on out-of-state owners, is not signifi cant in any of the
models.25 However, an entity level tax on LLCs, LLC_Corp_Tax, is negative and
highly signifi cant across all four specifi cations in Table 3, indicating that an entity level tax on LLCs reduced the share of entities fi ling as corporations. The coeffi cients indicate that the tax leads to a small decline in the corporate share of returns ranging from about 0.01 to 0.02. States often impose entity level taxes on LLCs to close what lawmakers contend to be abusive tax planning techniques that take advantage of the pass-through nature of the LLC. In Tennessee, for example, the LLC tax was enacted in response to LLCs forming with owners located in a tax haven such as Delaware. Because we fi nd no impact of LLC_Corp_Tax on partnerships (Table 4), it is possible that this is a business climate or tax burden fi nding. Another explanation is that we are capturing a policy choice in reaction to the shift towards the LLC form instead of a cause of that shift. As states have seen LLCs rise in importance, they have responded by implementing an entity level tax on pass-through fi rms to avoid a reduction in the business tax base.
Finally, we fi nd the coeffi cient for Pop to be positive and signifi cant in all models, suggesting that state size is an important factor infl uencing the formation of corpora-tions relative to partnerships. The size effect may refl ect the importance of a range of
25 Because the LLC withholding tax is often a tax on out-of-state owners, we include a dummy variable
that indicates the presence of a withholding tax and/or entity level tax. This variable is insignifi cant in all
non-tax factors associated with larger states that make these states more attractive to corporations. The percentage of the population with a bachelor’s degree (BAdeg) does not have any effect on the share of corporations in the state.
Table 4 presents levels regression results for total corporate and partnership returns with the independent policy variables lagged by one year. As one would expect, the results are largely similar to the corporate share specifi cation. The coeffi cient of the corporate income tax rate is negative and highly signifi cant, with the elasticity of the corporate rate with respect to the number of corporations estimated to be only –0.04. These regressions also help refi ne the results reported in Table 3. For example, high corporate income tax rates not only reduce the share and number of corporations, but they also have a direct effect that increases the number of partnerships. On the other hand, higher top individual rates, which were found to reduce CorpShare, are only linked to the formation of more partnerships. This positive coeffi cient in the partnership model is consistent with much of the empirical literature on entrepreneurship where positive relationships are found between individual income tax rates and various measures of entrepreneurship.26
Throwback rules have a positive effect on the number of corporate returns fi led, consistent with one of the specifi cations for CorpShare, but have no effect on the num-ber of partnership returns fi led. Despite the fact that Throwback is lagged, this result may simply refl ect the choice of states with a large corporate presence to implement a throwback rule to satisfy political pressures or to generate revenue as noted above. Addback provisions do not have a statistically signifi cant effect on corporations, but they do encourage the formation of partnerships. An entity level tax on LLCs has a negative effect on the number of corporations. This could demonstrate a state’s effort to avoid revenue erosion in the face of a declining role played by corporations. Alternatively, there may be a direct negative effect on corporations by limiting tax planning opportunities.
Together our results show that some factors — particularly state corporate income and personal income tax rates — affect the mix of business structures across states, as well as the number of both corporations and partnerships. These effects on business form likely yield real effects as well, as refl ected in the literature. For example, Light-ner (1999) and Gupta and Hoffman (2003) show that higher corporate income taxes adversely impact manufacturing employment and capital investment. On the other hand, Gupta et al. (2009) fi nd that higher corporate tax rates lead to more corporate tax revenue. Coupled with our fi ndings and other empirical results in the literature, this latter result suggests that the higher corporate tax rate more than offsets any decline in corporate business activity.
There is little empirical evidence from the literature on many of the other tax policy parameters included in our models. Prior studies have looked at the effect of combined
26 See Schuetze and Bruce (2004) for a survey of the literature. It also is possible that the positive result
refl ects a tax-induced evasion response and the exploitation of evasion opportunities that may be more
prevalent in partnerships relative to regular corporations due to relatively more non-matched transactions
reporting on corporate tax revenues and have found that this policy has little net effect on such revenues (Bruce, Deskins and Fox, 2007; Fox and Luna, 2005; and Gupta et al., 2009). We do fi nd some evidence of a positive correlation between throwback rules and the corporate form. On the other hand, neither Bruce, Deskins and Fox (2007) or Lightner (1999) fi nd an association between throwback rules and real business activity. As we speculated above, our fi ndings may refl ect states with a large volume of exist-ing corporate activity choosexist-ing a throwback rule to generate additional tax revenue. Edmiston (2002) shows that the effect of apportionment formulas on revenue depends on the scope of in-state sales relative to property and payroll. Lightner (1999) fi nds that the traditional three-factor formula has no impact on employment growth relative to heavily sales-weighted formulas; Goolsbee and Maydew (2000), on the other hand,
fi nd that a diminished weight on the payroll factor increases employment. C. Sensitivity Tests
The SOI data used to estimate the models reported in Tables 3 and 4 did not permit us to isolate the number of new business returns fi led each year. The data include repeat
fi lers plus new entities fi ling initial returns but omit those businesses that failed to fi le that year because of dissolution or other reasons such as insuffi cient business activity. However, we estimated a changes-changes model with the changes in the number of corporate and partnership returns as dependent variables and year-to-year changes in the tax policies as independent variables. We specify these models in analogous fashion to those presented above. Unfortunately, the results are inconclusive due primarily to the large number of dummy variables and the modest variation across individual years. Also estimated were changes-levels models for both corporations and partnerships. These models also produced mixed results. However, there is limited evidence that some policies — Nonbusinc and LLC_Corp_Tax — retard the change in corporate returns, consistent with the fi ndings reported above.
As an alternative to the models that have been estimated above, we test a second dataset taken from the International Association of Commercial Administrators.27 These data (“registration data”), which span 2001–2007, are voluntarily reported by states and include the number of state-level business registrations by organizational form, including regular corporations, limited liability corporations, limited liability partner-ships and partnerpartner-ships. Unlike the SOI data, which track only total returns fi led per year, the registration dataset includes total registrations and new registration fi lings by year.
We construct our core dependent variable as corporate registrations divided by total business registrations and include independent variables consistent with our baseline lagged model reported in Table 3. The trends noted with the SOI data towards
27 These data are publicly available from the International Association of Commercial Administrators,
partnerships and LLCs are confi rmed by the pace of registrations of each entity type. In 2001, for example, corporations represented 56 percent of all registrations. By 2007, the share had declined to 35 percent. Despite the potential of this alternative database, we cannot draw meaningful conclusions from our analysis because the panel is missing a signifi cant number of observations for a variety of different state-year pairs. We have complete sets of data for only 28 states, another nine states failed to report data for a single year, and the remaining states each had more than one missing value.
V. CONCLUSION
The choice of business entity is infl uenced by both state and federal policy factors, along with market forces. The trend toward more pass-through entities and fewer corporations is perhaps attributable to both federal check-the-box rules and state-level developments that provide businesses limited liability, organizational fl exibility, and pass-through income tax treatment in the limited liability organizational forms. How-ever, the large variation in corporation versus partnership fi lings across the states, even when controlling for scale (i.e., population), suggests that state tax policy may have an important effect on organizational form and nexus decisions.
The results of this analysis suggest that state tax policy, especially corporate and personal income tax rates, affects business decision making regarding entity choice. Our fi ndings are consistent with Goolsbee (2004), who fi nds that tax rates infl uence the mix of activity undertaken by corporate versus noncorporate fi rms. Our fi ndings indicate that state tax policy impacts the mix of returns and business planning opportunities within and across states. For example, high corporate tax rates reduce the share and number of fi rms conducting business as corporations. High individual tax rates also reduce the corporate share of returns. High tax rates encourage income shifting out of a state and likely deter real business activity as well. Taxing LLCs at the corporate tax rate rather than personal income tax rates is consistently associated with a smaller corporate share and fewer corporate entities. We fi nd no evidence that combined report-ing discourages business formations of any type. This suggests that the business com-munity’s expressed concerns about combined reporting requirements may have been overstated. In general, while we fi nd that some measures of tax policy do infl uence organizational form and the rate of business fi lings, the implied behavioral responses are small.
The traditional view of the mobility response to tax policy parameters has focused on the movement of mobile factors of production and consumers who seek low-tax jurisdictions. The empirical work presented here provides evidence that some tax policy factors infl uence mobility in an extended fashion by affecting the choice of business organizational form. Further empirical work is needed to understand how tax policy affects business organizational form, especially within complex multi-state entities that utilize sophisticated tax planning tools. Additional work also is needed to translate these impacts on organizational form into real effects on economic activity and state tax revenue and measures of the excess burden of the tax system.
ACKNOWLEDGMENTS
This work has benefi ted from helpful comments from Therese McGuire, Jonathan
Rork, two anonymous reviewers, and conference participants at the The University of Tennessee’s Conference on Mobility and Tax Policy, held in Knoxville, Tennessee in October 2008.
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