Tennessee Tax Plan: Details & Analysis
Tennessee joined the ranks of no-income-tax states in 2022 with the phaseout of the Hall Tax on interest and dividend income. But with other states upping their game to attract ever-more-mobile people and businesses, lawmakers and the governor are not content to leave Tennessee’s business taxes in their current, uncompetitive form.
Gov. Bill Lee (R) recently outlined his own plan—the “Tennessee Works Tax Reform Act of 2023”—to make Tennessee stand out in the post-pandemic economy. The Tennessee tax plan goes beyond simple rate reductions and, if enacted, would make several pro-growth changes to Tennessee’s tax code, helping the state move in the right direction on business taxes.
The governor’s stated plan to conform to the federal treatment of capital investment, adopt single sales factor apportionment, and reduce the business gross receipts tax rate would strengthen the state’s economy, even if the proposed three-month sales tax holiday on groceries would not be as effective as intended.
Under the governor’s plan, Tennessee’s franchise and excise tax (the state’s corporate income tax) would conform to IRC Section 168(k), the federal provisions of the 2017 Tax Cuts and Jobs Act that allow businesses to deduct 100 percent of their capital investments in the year they incur those costs, also known as full expensing. This would be an important change, as the immediate deduction of all business investment is a key driver of future economic growth, and can have a larger pro-growth effect per dollar of revenue forgone than cutting tax rates. Full expensing boosts long-run productivity, economic output, and incomes, because investments that were not profitable under long-term depreciation rules become profitable under full expensing.
Generally, when businesses calculate their income for tax purposes, they subtract business costs. This is fitting, as the corporate income tax is meant to be a tax on business profits—in general, revenues minus costs. Requiring these deductions to be spread out over a number of years changes the nature of the tax.
Due to inflation and the time value of money, a dollar in the future is always worth less than a dollar today. Delaying deductions for the cost of business investments means that the real value of the deductions will always be less than the original cost. Ultimately, this treatment makes the corporate income tax biased against investment in capital assets, as other business expenses (e.g., labor, advertising, and supplies) can be written off in the first year. This is especially harmful to businesses in capital-intensive industries like manufacturing. With changes in demand—both in quantity demanded and what’s being demanded—and the current supply chain crisis, tax policies that make it more expensive to retool or build out manufacturing capacity are particularly undesirable now.
Although 18 states currently conform with the federal treatment of capital investment, the impact begins to erode this year with the federal phaseout of full expensing and its eventual sunset. Last year, Oklahoma became the first state to make full expensing permanent, and Mississippi appears on the cusp of doing so as well, with similar legislation pending in Oregon and elsewhere. Tennessee should consider following Oklahoma’s example by keeping this pro-growth policy on the books permanently.
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 share of total property, payroll, and sales that a firm has located in each state. Historically, most states weighted these factors evenly, and Tennessee 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 Tennessee retains its current apportionment formula, it will tax in-state investment more heavily than single sales factor states will. Following the majority of states and adopting single sales factor apportionment would help Tennessee compete in a changing tax landscape.
In addition to a corporate income tax and a franchise tax (levied on a business’s net worth instead of profits), Tennessee also imposes a tax on gross receipts, which it calls the business tax. The Tennessee Works plan would lower the top business tax rate from 0.3 percent to 0.1875 percent and increase the exemption level from $10,000 to $10,000,000. Notably, this plan would also adjust revenue sharing to hold localities harmless for any revenue loss they would incur. Lessening the burden from the gross receipts tax would be an important step toward making Tennessee’s business climate more attractive.
Unlike corporate income taxes, which target actual profits, gross receipts taxes are applied to a company’s gross sales, without deductions for business expenses like employee compensation or cost of goods sold. Even with rates as low as Tennessee’s, gross receipts taxes can cause economic damage. Business-to-business transactions are not exempt, so the same economic value is taxed during each transaction in the production process. This compounds the effect of the tax, which can lead to higher prices for customers, lower wages for workers, or more limited job opportunities.
Gross receipts taxes hit businesses and industries with lower profit margins or more stages in the production process harder than high-margin businesses that are vertically integrated. Differential rates attempt to adjust for these differences on an industry-by-industry basis but do so imperfectly. Gross receipts taxes can be particularly severe for start-ups and entrepreneurs, who typically post losses in early years while still owing gross receipts payments. Due to the uncompetitive nature of the tax, only seven states currently levy gross receipts taxes.
It’s worth noting that the business tax does not bring in much revenue for Tennessee. In fiscal year 2022, the tax brought in only $283 million—1.4 percent of state tax collections—but it still causes large compliance burdens for businesses. Taking many businesses off the rolls with a larger exemption and lowering the top rate of the tax are both steps in the right direction, although large compliance burdens remain for the businesses still paying. The local portion of the business tax adds difficulty to any talks of full elimination, although the proposed revenue-sharing adjustment sets the stage to solve that problem in the future. Finding a solution to address local funding concerns would be well worth it to remove both the tax and compliance burdens from businesses.
Sales Tax Holiday on Groceries
A less growth-oriented facet of the Tennessee tax plan is a three-month sales tax holiday on grocery items. Though well intended, a sales tax holiday on groceries is poorly targeted as a vehicle for tax relief, especially for those with lower incomes. Because those with higher incomes tend to spend proportionally more on groceries, and because SNAP and WIC purchases are already exempt from the sales tax, the benefit from this tax holiday will tend to skew towards middle- and higher-income individuals. Sales tax holidays also fall short as an inflation response. Consumers are feeling the sting of high prices right now, but those prices are generally the result of a large number of dollars chasing after a small number of goods. Taking away the tax on purchasing those goods does nothing to help supply keep up with demand.
While Tennessee has fewer options for giving one-time money back to its residents than states with an income tax would, lawmakers can consider using the surplus to increase their pension contribution, add to the state’s rainy day fund, pay off capital debt, or deposit into a fund for future tax relief that would be permanent and better targeted.
Taken as a whole, these tax reforms represent pro-growth changes for Tennessee. Two of the proposed policy changes—the enactment of full expensing and a reduction in the business tax top rate—would improve Tennessee’s ranking on the State Business Tax Climate Index, a measure of the competitiveness of state tax codes. Tennessee currently ranks 14th overall on the Index, but it ranks 45th on the corporate income subcategory. With the governor’s proposed changes in place, the state would rank 13th overall, and its corporate income ranking would jump to 35th.
Full expensing, single sales factor apportionment, and business tax reforms would increase Tennessee’s attractiveness among states at a time when tax competition matters more than ever.