There are portions of the recent state audit report on economic incentives that would warm the hearts of retired Soviet planned economy apparatchiks, sitting around their dachas dreaming of the good old days.  Case in point:  The analysis concluding Virginia’s use of a single sales factor method to tax manufacturers is “moderately effective.” 

The report in question is from the Joint Legislative Audit and Review Commission, and it previously generated mainstream stories about the data center industry and a Bacon’s Rebellion post about grants in the sputtering semi-conductor manufacturing industry.  Only ten of the 127 pages (39 to 49) deal with the use of a single sales factor in determining the state income tax owed by a manufacturer.

The current optional apportionment method, in place since 2014, is burdened by major preconditions.  The taxpayer must make and keep three-year promises on employment and wages, or pay back taxes with interest if its predictions fail and the company falters.  The authors of the report then point to how few companies are taking this option and risking the tax penalties as a sign that the tax policy is not effective.

They might be equally surprised by the number of people who don’t enter a race if told they must tie ten-pound weights to their ankles.

Quick boring explanatory note:  At issue here is how a company with operations in more than one state apportions its taxable income between those states, for state-level income taxes.  Virginia’s main approach is to count percent of total property, payroll and then double-count percent of sales.  But in recent years it has offered manufacturers, with major preconditions, the option to count only sales.  If you are major exporter, with a tiny portion of your sales in-state, that approach really drops the tax bill.  Altria may use this method, for example.

Businesses make rational choices based on facts and risks, and any company from outside the state examining this tax provision gets a clear message:  Virginia is only pretending to offer this option, for brochure purposes, and you can only get it when there is no risk to Virginia.  This is why out of 6,000 eligible manufacturers in 2016 only 70 used this method, and the number has been dropping since.

The report’s appendices include summaries of the situations in other states, Appendix D in this case.  Quite a few states apportion taxes based on sales inside the state, ignoring the other factors often used in the formula:  the percentage of the taxpayer’s property and payroll with the state.

Many other states use the sales-only method, including some states considered high-tax.  Right now, Virginia is offering manufacturers either methods, at their election, as are two other states.  What is missing from the survey of other states is any discussion of what if any pre-conditions and penalty clawbacks they apply.  Virginia’s grudging “try it if you dare” approach may be unique.

So, we get this in the report: “The elective single sales factor apportionment has been somewhat effective. Manufacturers using it have experienced substantially higher rates of employment growth than manufacturers using standard apportionment.”  That’s no surprise, because the restrictions deter all but companies who are 100 percent certain of growth.  Does that mean we should open it up more?

Here is a passage lifted from the text with some added commentary:

“Most existing Virginia manufacturers that are likely to use the single sales formula are probably already taking advantage of it, according to stakeholders and several companies using it. (Note:  That’s because of the risk and restrictions). Manufacturers may have difficulty maintaining employment because of technology changes, difficulties recruiting skilled workers in tight labor markets, the fading appeal of manufacturing jobs to younger workers, and retirements. Some manufacturers in rural regions may face difficulty meeting the wage requirement, which is based on industry average wages, even if they pay substantially more than the average wage for the region.”  (Note:  Exactly, which is why those restrictions add risk and discourage companies from considering this approach.)

And this:

“It may be difficult to improve the effectiveness of single sales apportionment without reducing its economic benefit to the state (Note: That means lower tax revenues), therefore any changes should be part of a broader decision about the state’s apportionment policy.

As an economic development incentive, this idea was doomed from the start by design.   Believe it or not, an earlier approach pre-2014 was even more onerous.

Irony alert:  At the same time JLARC questions the value of tinkering with tax apportionment as a means to spur investment, the Department of Taxation is implementing a 2018 bill based on the premise that it’s a great idea after all.  House Bill 222 was the tax-break measure touted as a way to boost struggling localities, which created the interesting coalition between a Southwest Virginia Republican and a Petersburg Democrat.

If you think that earlier explanation of the three-factor formula or single-factor approach was complicated, wade through this proposed guidance document from the Department of Taxation.  The prize here is better, a potential apportionment factor of zero, with no income tax for several years despite the level of sales, payroll or property in the favored locations.  However, it is short term, expiring in 2025.

The special apportionment rules will only be available in certain distressed localities, only to companies entirely new to Virginia (no expansions) and only if the Virginia Economic Development Partnership annually certifies it has “a positive fiscal impact.”  If this does take off, VEDP may need new staff just for that set of annual reviews.

This is the same game as with the single sales factor – we’ll give you a tax treatment that rewards investment but only if you always succeed, using our definitions of success, and locate where we want you to locate.   The same company making the same product may be taxed differently in different locations.  Two companies making the same product in the same county will be taxed differently if one of them has been in place for a decade.

One difference with the single sales rule is a company that stumbles under these rules simply loses the special tax treatment but faces no penalty.  And this is not limited to manufacturing.  Are the rules on taxing manufacturers clear, simple and fair across the board? No. 

Was the opening comparison to Soviet economic apparatchiks unfair?  The heavy hand of government is seeking to first define winning and losing and then move companies in and out of the boxes.  Perhaps this “distressed locality” approach will prove more popular than the single-sales factor for manufacturers, and for the sake of those localities let us hope so.  But don’t be surprised if a future JLARC report concludes it just didn’t work as planned.