Tennessee Governor Seeks To Make One Of The Nation’s Best Tax Climates Even More Hospitable

Lawmakers and governors in nearly half of the states have cut income tax rates over the past two years and more are now following suit. Before the second month of 2023 came to a close, noteworthy income tax cuts had already been introduced and passed in a number of states. The latest development came last week in West Virginia, where House and Senate leaders reached a deal on income tax rate-reducing reform, something that has been a top priority for Governor Jim Justice (R).

The West Virginia tax deal, which has now passed out of both chambers of the state legislature and will soon be signed into law, cuts income tax rates and enacts property tax relief for business equipment, machinery, and inventory. The agreement also provides a tax credit to offset car tax burdens.

“Each side gave up something, but the result is a more competitive tax code for the Mountain State,” wrote Jared Walczak, vice president of state projects at the Tax Foundation. “More importantly, it brings the state’s income tax rates closer to the national median and reduces the burden of the state’s taxes on capital investment, making West Virginia a more attractive state in which to live and work.”

House Bill 2526, legislation implementing the tax deal, cuts West Virginia’s top income tax rate from 6.5% to 5.12%, while the lowest rate falls from 3% to 2.6%. Future rate reduction would be phased in if certain revenue triggers are met.

Right now, West Virginia has the nation’s twentieth best business tax climate, according to the Tax Foundation’s latest annual index. With enactment of this tax deal, West Virginia’s business tax climate ranking will improve from twentieth to seventeenth best.

A couple of reasons help explain why tax relief has been enacted in most states in recent years and why governors like Jim Justice are so eager to get in on the action. One reason is that states are financially well-positioned to do so, with many sitting on sizable budget surpluses. Another motivating factor is that lawmakers in states that already have a low overall tax burden and hospitable business tax climate — places like Florida, Texas, North Carolina, and Tennessee — continue to pursue further reforms that will provide more relief to taxpayers and make their tax codes even more conducive to job creation than they already are.

Take Tennessee Governor Bill Lee (R) and the new tax reform plan he unveiled last month. Tennessee is home to the nation’s third lowest overall average tax burden and is one of only eight states that does not levy a personal income tax. Despite this relatively favorable fiscal position, Governor Lee’s tax plan makes it clear he does not think Volunteer State lawmakers should rest on their laurels.

Governor Lee’s tax package has been introduced as a single piece of legislation that will be taken up in committee this week. Lee’s tax plan implements a number of changes that would make Tennessee’s tax code less burdensome for businesses. The Governor’s tax package provides employers with significant relief from the three major taxes imposed on them by the state of Tennessee: the franchise tax, the excise tax, and the business tax.

Under the Lee tax plan, the first $50,000 in income would be exempt from Tennessee’s 6.5% corporate tax, referred to as the excise tax. That exemption would provide employers with $94 million in excise tax relief in year one.

Governor Lee’s proposal also provides additional relief through increased exemptions and thresholds for the state’s gross receipts tax, referred to as the business tax, as well as the franchise tax, which is a tax on business property and net worth. Lee’s tax plan increases the business tax exemption level from $10,000 to $10,000,000 and lowers the top rate from 0.3% to 0.1875%. The Governor’s office estimates their proposed threshold increase would remove more than 144,000 employers from business tax rolls.

“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,” Janelle Fritts, a Tax Foundation policy analyst, noted about Governor Lee’s tax proposal. “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.”

Last year, which was the year full federal expensing for research and development (R&D) costs expired, Tennessee became the first state where lawmakers acted to ensure the immediate deduction of research and development costs would continue for state tax purposes. Governor Lee’s tax plan would build upon that 2022 reform by conforming to the federal Tax Cuts and Jobs Act (TCJA) for non-R&D-related costs, allowing businesses to deduct up to 80% of their capital expenditures in year one rather than be spread out over convoluted depreciation schedules.

“This would be an important change,” Fritts notes, explaining that permitting either an immediate or speedier deduction of 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.”

Though many states provide bonus depreciation though federal conformity like Governor Lee is proposing for Tennessee, the TCJA’s phase out of federal bonus depreciation means that legislators and governors will need to pass new legislation to provide full expensing for state tax purposes. If Congress fails to rectify the matter again this year, more states can be expected to take such action.

“States are going to have to make sure that fixed date conformity is in the best interest of taxpayers,” says Ryan Ellis, an IRS-enrolled agent and president of the Center for a Free Economy. “They may need to have different dates for different federal tax items to capture maximum value for state taxpayers. The full expensing phasedown is a good example of this, along with research expensing and other TCJA timing issues.”

Lawmakers in a few states have already begun taking the necessary action to maintain full expensing. “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,” Fritts noted. “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.”

Governor Lee’s tax proposal also changes the methodology for corporate tax apportionment to one that does not disincentivize in-state investment. Right now Tennessee is one of only 13 states that does not use what’s known as the single sales factor (SSF) formula for determining corporate tax liability, but Governor Lee’s proposal would change that. Tennessee still uses the three factor formula that many states have moved away from in recent years, which calculates corporate tax liability based on in-state sales, in-state payroll, and in-state property holdings. Critics of the three factor formula say it causes the tax code to treat Tennessee businesses worse than out-of-state businesses.

“As long as Tennessee retains its current apportionment formula, it will tax in-state investment more heavily than single sales factor states will,” Fritts wrote. “Following the majority of states and adopting single sales factor apportionment would help Tennessee compete in a changing tax landscape.”

Governor Lee has proposed tax relief for employers that, if enacted, will help Tennessee stay competitive not only with fellow no-income-tax states like Florida and Texas, but also with its neighbor to the east, North Carolina. While Tennessee has the nation’s fourteenth ranked business tax climate, North Carolina’s is now in the top 10.

In fact, North Carolina will soon have no corporate income tax to speak of and, unlike Tennessee, the Tar Heel State does not impose a gross receipts tax on businesses. As part of the bipartisan budget deal signed into law by Governor Roy Cooper (D) in November 2021, North Carolina’s corporate income tax is scheduled to be phased out completely by the end of this decade, making North Carolina one of only three states with no corporate income tax.

Critics of Governor Lee’s tax proposal may contend it’s a “give-away to business” and that it mostly benefits business owners and investors. Such criticism, however, is rebutted by the growing body of research and cross-ideological acknowledgement that business tax burdens aren’t borne by companies and firms, but by actual people, including workers and consumers.

The past decade has seen the solidifying of a bipartisan consensus that the burden of business taxation is not borne by corporate shareholders alone, but is also paid by workers and consumers in the form of depressed wages and higher prices. That’s how corporate tax rate reduction came to be a shared goal of both Presidents Barack Obama and Donald Trump.

The debate is no longer about whether or not the cost of corporate taxation is paid in part by workers and consumers, but the degree to which it is paid by them. Even the left-of-center Tax Policy Center projects that 20% of the corporate income tax burden is paid by labor. The Tax Foundation’s Stephen Entin, meanwhile, estimates that workers bear approximately 70% of the burden of corporate taxation.

“Over the last few decades, economists have used empirical studies to estimate the degree to which the corporate tax falls on labor and capital, in part by noting an inverse correlation between corporate taxes and wages and employment,” Entin writes. “These studies appear to show that labor bears between 50% and 100% of the burden of the corporate income tax, with 70% or higher the most likely outcome.”

A 2015 study published by economists Kevin Hassett and Aparna Mathur found that a 1.0% hike in corporate tax rate leads to a 0.5% decline in wage rates. That report looked at 66 countries over a 25 year period, finding the federal government would collect more revenue as a result of a corporate income tax increase, but that the revenue growth would be less than the drop in workers’ wages.

That a federal corporate income tax cut has benefits that flow through to workers is a view that is now so bipartisan that the past decade has seen presidents from both parties pursue corporate tax rate reduction. Likewise, the state tax relief for employers proposed by Governor Lee, if enacted, would not only make Tennessee a more attractive destination for investment, it would make Tennessee a more profitable place for workers to earn a living and support a family.