Oklahoma Tax Reform Plan Would Put State in Top 10
Tax reform was front of mind for Oklahoma lawmakers during the 2022 legislative session, but major structural reforms didn’t cross the finish line. Those efforts, however, were not wasted, as they appear to be on the verge of paying off this year with a package of bills that would significantly improve Oklahoma’s competitiveness at a time when residents and businesses are more mobile than ever.
House Bill 2695 would repeal the state’s franchise tax; House Bill 2285 would create a flat income tax of 4.5 percent, with revenue triggers for additional rate reductions in the future; and House Bill 1375 would repeal the state’s throwback rule and shift the state’s apportionment formula from three-factor to single sales factor.
If all were enacted, Oklahoma’s overall rank on the State Business Tax Climate Index would break into the top 10, improving from 23rd to 9th (absent policy changes from other states).
Shifting to a Lower, Flat Income Tax
Oklahoma’s current top rate of 4.75 percent is the ninth lowest of states that levy a wage individual income tax, tied with North Carolina. A reduction to 4.5 percent would continue to improve Oklahoma’s competitive edge, bringing the state closer to neighboring Colorado’s 4.4 percent and even further below the national median of 5 percent. The revenue triggers included in the bill would ensure that the state continues to lower its income tax rates when revenues meet certain benchmarks over time.
More than simply lowering rates, however, HB 2285 also changes the income tax from a graduated system to a flat rate. The top rate of Oklahoma’s six-bracket graduated rate income tax currently kicks in at $7,200 for single filers and $12,200 for joint filers. This means that the overwhelming share of all taxable income is exposed to the top marginal rate, creating a system that is already close to flat in practicality. However, the Sooner State would still benefit from shifting to a true flat tax.
The economic literature on graduated-rate income taxes is unfavorable, since economic decision-making takes place on the margin—people and businesses make decisions when thinking about their next dollar of income, not the income they’ve already earned. In this case, that means looking at the top marginal rate, which is the relevant rate for most Oklahoma taxpayers and for nearly all pass-through business activity. Furthermore, while recent rounds of rate reductions have yielded moderate rates, graduated-rate income taxes tend to be far easier to raise. It’s worth noting that Oklahoma already has some protections in place to keep income tax rates from rising, but a flat income tax would act as a signal that Oklahoma is dedicated to keeping its tax burden low, including to nonresident businesses and individuals who may not know the ins and outs of Oklahoma laws.
Flat taxes are also meaningfully simpler than graduated rate taxes in several ways. Under a flat tax, it is easier to forecast revenue and project the revenue effects of potential tax changes. It is also easier for taxpayers to estimate their tax liability and how it would change under different income scenarios, which enhances tax transparency and potentially improves economic decision-making. It accords better with taxpayers’ impressions of their tax burdens based on headline rates, such that individuals and small businesses may be more attracted to a state with a relatively lower flat rate than one with a graduated-rate system yielding a similar liability. And it simplifies taxpayers’ decisions about whether to work or invest more on the margin, since all marginal returns to labor and investment are exposed to the same rate.
Legislative action in 2022 kicked off something of a flat tax revolution, with five states enacting flat income taxes—a significant number when compared to the four other states who have shifted to flat taxes since the start of state income taxes. Two states that historically had nearly-flat income taxes—Mississippi and Idaho—succeeded in adopting truly flat taxes as of January 1, and Georgia will do the same in 2024. Oklahoma should follow these examples and improve its attractiveness among states.
Franchise Tax Elimination
Franchise taxes—or capital stock taxes—are levied on a business’s net worth instead of its income or ability to pay. As such, franchise taxes cause economic distortion and, in states with larger capital stock taxes, hit businesses especially hard in times of economic downturn. Oklahoma limits this damage by imposing a low rate and capping payments at $20,000, but the franchise tax still functions as a nuisance tax: businesses must track asset values and remit these taxes at the cost of considerable time and effort, with relatively little benefit to the state.
Capital stock taxes used to be much more common, but over time, lawmakers began to realize their negative economic impact. Accordingly, many states reduced such taxes or repealed them altogether. Kansas phased out its capital stock tax prior to tax year 2011. It was followed by Virginia and Rhode Island in 2015 and Pennsylvania in 2016. Mississippi is in the process of phasing out its capital stock tax, which should be eliminated by 2028. Likewise, Connecticut is also phasing out the tax and is expected to complete the process by 2024.
With strong revenues emerging from the pandemic, Oklahoma is in a good position to follow these states’ lead. Lawmakers should use this opportunity to cease reliance on a tax that discourages investment, imposes high compliance and administrative costs, and disregards ability to pay.
Single Sales Factor Apportionment
When C corporations conduct business in multiple states, they must determine what share of their income is taxable in each involved state, a process known as apportionment. Currently, states can use three factors in their apportionment formulas: the shares of total property, payroll, and sales that a firm has located in each state. Historically, most states weighted these factors evenly, and Oklahoma still does. However, there is a pronounced trend toward giving greater—or even exclusive—weight to the sales factor.
Doing so generally benefits in-state companies by exporting some of the tax burden to companies with less of a physical presence (though still sales) in that state. As long as Oklahoma retains its current apportionment formula, it will tax in-state investment more heavily than single sales factor states will. Following most states and adopting single sales factor apportionment would help Oklahoma compete in a changing tax landscape.
Throwback Rule Repeal
In states where firms have no nexus for taxation due to a lack of jurisdiction, a firm’s sales to that state result in “nowhere income.” Throwback rules—like that in Oklahoma—are designed to reclaim “nowhere income” from a state that has no legal authority to tax it and give that income back to a state with jurisdiction over the taxpayer. Under Oklahoma’s throwback rule, sales of tangible personal property are figuratively “thrown back” across state lines and incorporated into the numerator of Oklahoma’s sales factor—even though the state would not otherwise be able to claim that income.
This process results in Oklahoma’s throwback rule punishing businesses that sell out of state, encouraging them to relocate to—or at least locate distribution facilities in—other states. Throwback rules increase a firm’s in-state income by increasing its sales factor ratio. The more the sales factor increases, the larger a company’s effective tax rate becomes. Effective rates on the income actually generated in-state can become so high as to make certain types of business activity unviable in states with such rules, and businesses have adjusted to this reality. Studies suggest that, over time, tax avoidance strategies eliminate most or all revenue gains from throwback rules. It may seem “fair” that a business is taxed on this income, but if one state punitively taxes them in response, and they can avoid the extra tax by selling from elsewhere, most will.
As such, repealing the throwback rule would be a sound investment in Oklahoma’s economy and would work alongside a shift to single sales factor apportionment in order to attract businesses to the state.
The changes put forth in this package of bills would represent significant pro-growth change for Oklahoma. The state currently ranks 23rd on the State Business Tax Climate Index, a measure of the competitiveness of state tax structures. With a shift to a flat income tax of 4.5 percent and the repeal of the state’s throwback rule and franchise tax, Oklahoma’s score would improve to 9th overall (absent policy changes from other states), a huge jump that reflects the significance of the proposed changes. Oklahoma’s spot in the top 10 would be well-deserved, flowing from a strong tax code that would set the state up for success in an increasingly competitive tax landscape.