by Nick Khouri, Vice President
|This Advisor examines changes in the state’s single business tax that took effect this year, points out the levy’s revenue—which was expected to increase slightly—appears actually to be decreasing, and speculates as to why.|
Michigan’s single business tax (SBT), the state’s largest general tax on business, generates more than $2 billion each year.
In late 1995 the state enacted legislation that fundamentally altered how the SBT is levied on multistate firms. The changes are the so-called “single factor sales” amendments, and they went into effect this tax year (1997). When the bills passed, analysts were projecting that the changes would lead to a small tax increase in 1997 and 1998 ($8.1 million and $11.2 million, respectively); early data for 1997, however, show a sharp decline in SBT revenue. Instead of going up, quarterly estimated SBT payments so far this year are down 16 percent from the prior year. Although we are many months away from obtaining conclusive data, early indications suggest that the statutory changes to the SBT are reducing state revenue much more than expected.
The 1995 Changes
In December 1995, after extended debate, changes were enacted in how the SBT applies to firms that have economic activity in other states as well as Michigan; the tax credit for small businesses also was expanded, beginning in 1998. For purposes of paying its SBT obligation, multistate firms always have been required to “apportion” their national economic activity to Michigan. Prior to this year, the apportionment formula was calculated using 50 percent of their in-state sales, 25 percent of their Michigan payroll, and 25 percent of their Michigan property.
- The sales-payroll-property apportionment was changed from 50-25-25 percent, respectively, to 80-10-10 percent for 1997 and 1998 and 90-5-5 percent beginning in 1999. Firms that have more Michigan payroll and property than sales would enjoy a SBT cut, and firms that have a greater physical presence outside than in the state would see a SBT increase.
- To offset partially the state revenue reduction from the change in the apportionment formula, the capital acquisition deduction (CAD), an SBT tax deduction allowed for the purchase of real and personal property, was substantially reduced for multistate firms.
- If the SBT changes are ruled unconstitutional, the tax will revert to the old CAD calculation and the sales-payroll-property apportionment move back to 50-25-25 percent in 1997, 60-20-20 percent in 1998, and 70-15-15 percent each year thereafter. To date, there have been no court challenges.
When the changes were enacted, it was recognized that most multistate firms would undergo a considerable change in their SBT tax liability, but analysts estimated that there would be a rough balance between the big “losers” and “winners.” For 1997, officials estimated a net $8.1 million increase in SBT revenue. For 1998, they projected a net cut of $4.3 million: the apportionment and CAD changes would boost state revenue $11.2 million, but the expanded small business credit would reduce state revenue by $15.5 million.
1997 SBT Collections
In any tax year, firms pay their SBT in five installments: four quarterly estimated payments—in April, July, October, and January—and a final annual reconciliation in April of the following year. Since most firms have a January-to-December tax year, the first SBT payment under the new law was due this past April 30. Exhibit 1 presents SBT collections of quarterly estimated payments in the first two quarters of tax year 1997.
There clearly is a problem with SBT collections. First-quarter payments (April, May, and June data) were 25.6 percent below last year. Second-quarter collections (July and August data only) are better but still 5.4 percent below 1996. For both quarters, the total is down $135.4 million—15.7 percent—from the prior year.
The falloff in SBT revenue cannot be blamed on the economy. The base of the SBT is largely compensation and profits. So far in 1997, Michigan compensation, including pay and fringe benefits, has increased a healthy 4.5 percent, and profits, at least nationally, are up 7.9 percent from last year. It is obvious that in a state where the employment rate is under 4 percent, the business tax base should be expanding, not shrinking.
FY 1996–97 SBT Revenue
For the 1996–97 fiscal year, SBT collections differ from the 1997 tax-year quarterly payments presented in Exhibit 1 in two ways. First, the state’s fiscal year runs from October to September, and the tax year of most SBT payers runs from January to December. Second, SBT net collections comprise not only quarterly estimated payments but also annual reconciliations (pay-ins) and refunds, both of which are based on the prior year’s economic activity.
In this fiscal year, the nearly 16 percent decline in quarterly payments has been offset by an unexpected rise in the SBT annual reconciliation payments made in April, which reflected 1996 economic activity: Annual reconciliation payments in April and May were $175.5 million above the prior year. It must be kept in mind, however, that this increase in annual payments is more a reflection of what happened in 1996—before the effective date of the tax law change—than a precursor of future collections.
Net SBT payments (including quarterlies, annual reconciliations, and refunds) are about even with the prior year, but far below the consensus estimate (arrived at by both legislative and executive branch budget forecasters) of last May. Exhibit 2 compares actual year-to-date collections with the official full-year SBT projection.
As of the end of August, SBT net collections are 1.0 percent above FY 1995–96. The consensus revenue estimate, used as the basis for the FY 1996–97 budget, assumed a 5.3 percent annual growth rate. If full-year collections rise only 1.0 percent, SBT revenue will be $98.3 million short of the target.
The shortfall actually could be even bigger than $98 million. Since the first two quarterly payments for the 1997 tax year have fallen below the prior year, collections for the remaining months also may fall, perhaps even below the year-to-date growth rate of 1.0 percent. If so, the final SBT shortfall may be as high as $150 million.
There are two reasons not to panic, however. First, against expectations, SBT collections still could finish the year strong. Second, a year-end shortfall in the SBT may be offset by unexpected revenue growth in other areas, primarily individual income tax collections and lottery profits. Nevertheless, if the consensus revenue group were meeting today, most analysts would recommend a sharp downward revision in projected SBT revenue for the current fiscal year.
Why the Potential Shortfall?
It is too early to reach a firm conclusion on why SBT revenues have been so weak in 1997. Recognizing that there are not yet adequate data, let me offer some possibilities.
- It may be simply a problem of timing. The tax winners under the recent law changes may have adjusted their quarterly estimated payments to reflect their lower tax burden, while the losers may have not yet recognized their increased liability and (1) failed to increase their 1997 quarterly payments and (2) thus will owe more than usual in the annual reconciliation payment next April. This makes some sense since the tax winners mostly are in-state firms knowledgeable about the law change, but most of the tax losers are out-of-state companies.
Resolution of the timing problem, however, does not solve the current fiscal year revenue problem. Although under the timing-problem theory, next year’s annual reconciliation payments will be higher, the collections are not accrued back to the current year. Thus, for budget purposes, SBT revenue still will be short this year but higher than the consensus estimate for next fiscal year.
- The winners may be filing under the new law, but losers may be filing under the “fall-back” provision. Many analysts argued that the SBT changes are unconstitutional, and, as a result, the legislation includes a provision setting out an alternative calculation. Some firms that have ended up with a higher tax liability may be taking the position that they are best served to file under the alternative SBT calculation and force the Department of Treasury to assess the additional tax.
- Part of the mystery simply may be an accounting error on the part of Treasury. Some of the surprising growth credited to annual reconciliation payments filed last April may, in reality, have been from quarterly estimated payments for 1997.
- Finally, it is possible that analysts just missed on the original estimate back in 1995. Projecting fundamental changes in a $2 billion tax never is easy, and estimating the revenue change from the 1995 SBT amendments presented a special challenge in that Treasury had to infer much of the underlying data on the use of the CAD by multistate firms.
Michigan is enjoying the strongest economy in more than a generation. Yet revenue from the state single business tax, which is based mostly on profits and worker compensation, is declining. Fiscal year tax collections essentially are level with last year, and 1997 quarterly estimated payments are 16 percent lower. It is possible that SBT revenue could fall $100–150 million below the earlier official estimates.
Although it is too early to confirm the reasons for the SBT revenue slowdown, it seems most likely that the changes that were enacted in 1995 and took effect this year are responsible for the shortfall.