For the past decade, policymakers from both sides in Harrisburg have proposed cutting Pennsylvania’s corporate net income tax (CNIT) rate from 9.99%, but have been unable to agree. on one approach – so far. With the enactment of HB 1342 as part of the 2022-23 state budget, lawmakers finally succeeded in reducing what had been the nation’s second-highest corporate tax rate.
Effective January 1, 2023, the Pennsylvania corporate net tax rate will decrease by 1 percentage point to 8.99%. Each year thereafter, the rate will decrease by 0.5 percentage points until it reaches 4.99% in early 2031. In addition, the law includes a provision that will increase the amount of capital investment that business owners can deduct on their tax returns the year in which the investments were made. The legislation leaves a few things to be desired, but overall Pennsylvanians will be well served by the reforms the law sets in motion.
In June, the Tax Foundation testified before a committee of the Pennsylvania Legislature on how structural tax reforms could benefit Pennsylvanians facing the challenges of inflation. Several of the recommendations, including reducing the net corporate tax rate and increasing the amount of capital investments that can be immediately expensed, were included in the final version of HB 1342.
Unlike policies that provide short-term financial relief (such as tax exemptions, direct cash transfers, or rebates), these structural tax reforms can help the state economy meet inflationary demand. Moreover, the reforms will continue to produce economic benefits after the inflationary period is over.
The eventual depth of the CNIT reduction in HB 1342 exceeded that of the House and Senate bills – 7.99% and 5.99%, respectively – that passed in their original chambers more early this year. Governor Tom Wolfe (D) had proposed a CNIT rate of 4.99% which would have been more than offset by an aggressive near-combined reporting structure. This would have added complexity and uncertainty to the Commonwealth tax structure while limiting the benefits of the rate reduction. The final version of HB 1342 included the governor’s tariff but excluded his add-on plan. When fully implemented, the new rate of 4.99% could be the seventh lowest corporate rate in the country.
Until the passage of HB 1342, Pennsylvania’s tax code also contained a particularly large bias against small business expenses associated with investing in machinery, equipment, and other short-lived capital assets. Instead of these expenses being deductible in the year they occurred, the Pennsylvania tax code required that most of them be deducted over time according to an amortization schedule. At the federal level, Section 179 of the Internal Revenue Code (IRC) allows small business owners to offset the cost of investment by allowing the deduction of up to $1 million of investment in year in which the investments were made. Most state allowances meet this standard, but Pennsylvania allowed only $25,000 in immediate expenditures for Section 179 property. It was tied for the smallest amount nationwide.
With the enactment of HB 1342, the Commonwealth now complies with the federal deduction of $1 million adjusted for inflation. This is a positive development for small business owners and their employees, as the additional capital formation increases productivity, encourages wage growth and increases production – all needed at the state level to combat inflation and ward off the worst effects of an impending recession. The adoption of well-designed net operating loss (NOL) provisions for midstream companies would also contribute to these ends. Although NOLs were not addressed in HB 1342, there are many compelling reasons to re-engage this topic in future legislation.
The combined impact of the CNIT rate cut and Section 179 expansion is perhaps best illustrated by Pennsylvania’s change in ranking on our State Enterprise Tax Climate Index. Prior to the passage of HB 1342, Pennsylvania’s overall structural ranking was 29th out of 50. The personal income tax structure ranked 19th, and the corporate income tax structure ranked 44th. In 2023, the Commonwealth will rank 23rd overall.
HB 1342 was a great start to making the Commonwealth competitive again, but nothing is inevitable until it happens. If there is a downside to the reform of HB 1342, it is the nine years it will take for the CNIT rate to reach 4.99%. On the one hand, several states with formerly high rates have followed the phased annual reduction model. In this sense, Pennsylvania’s elongated reform design is not unique or necessarily concerning. On the other hand, the slow pace of the CNIT cuts conjures up memories of the phasing out of the Capital Stock and Franchise Tax (CSFT) in Pennsylvania, which was halted and restarted haphazardly for years before being eventually deleted.
The legislator had the opportunity to boldly cut the CNIT rate this year and structure opportunities for future rate cuts around well-designed revenue triggers. Instead, the Commonwealth will enter 2023 with a CNIT rate that will still be the fifth highest in the country. Under this design, it could be several years before rates are competitive enough to entice businesses back into the Keystone State.
In the meantime, legislators should resist the temptation to treat CNIT reform with the same skepticism as the elimination of the CSFT. Instead, they should continue to advance structurally neutral, free-market tax legislation in the spirit of Indiana, Iowa, and North Carolina. These states also started with incremental changes, but each year improved or accelerated tax reforms passed in previous legislative sessions.
Indiana has consistently reduced its corporate income tax (IRS) rate over the past 10 years. In 2012, the corporate tax rate was 8.5%. Today it is 4.9%. Iowa passed comprehensive tax reforms in 2018, then accelerated those reforms with excess revenue in 2022. When fully implemented, Iowa will have a more neutral tax base, a flat income tax rate personal tax rate of 3.9% (from 8.98%), and a fixed corporate income tax rate of 5.5% (from 12%). These reforms moved Iowa from the fifth most structured tax code before 2018 to the 15th most structured tax code once the reforms were fully implemented. these reforms in 2014, 2015, 2017 and 2021. Pennsylvania is expected to follow suit.
Pennsylvanians should be encouraged by the reforms this legislation has set in motion. If the reforms of HB 1342 were fully implemented today, Pennsylvania’s corporate structure would rank 27th out of 50, a drastic improvement from its current 44th. The Commonwealth’s overall tax competitiveness ranking would drop from 17th to 29th.
To maximize the benefits of the ongoing reforms, the legislator should consider accelerating the reductions in the CNIT rate. Then, to amplify their effect, policymakers should conform the Commonwealth’s treatment of net operating loss carryforwards to the federal standard of 80% while similarly extending carryover provisions to midstream companies, as almost does. all other states.
Lawmakers should also consider reforming the Commonwealth’s treatment of income. It should remove the current income class structure that does not allow losses from one type of income to offset gains from another. The current design discourages small business owners filing joint returns from locating in Pennsylvania.
Finally, Pennsylvania policymakers should comply with the federal treatment of corporate capital investment and should consider making total capital investment spending permanent at the state level. Many other states already comply with this provision of the Tax Cuts and Jobs Act, but it will begin to expire in early 2023. Oklahoma anticipated the change and recently became the first state in the nation to make full spending permanent. at the state level. . Pennsylvania can work on a reputation for tax competitiveness by becoming the second state to do so.
According to state treasurer, Pennsylvania was on course to end fiscal 2022 with a surplus of $6.6 billion. However, she also noted that the Keystone State could face a deficit by the end of fiscal year 2025. By prioritizing structural tax reforms, lawmakers have made a responsible choice. Such reforms can generate recurring salary and employment benefits, unlike a one-time relief check or a new program. The HB 1342 reforms are a good start to making Pennsylvania-based companies more competitive and fueling productivity and wage growth in the Commonwealth. As Harrisburg lawmakers consider how to move forward, they should build on current reforms with confidence and with an eye on the successes of states that were once in their position.