Corporate Income Tax Credits
Tax credits are economic development subsidies that reduce a company's taxes by allowing it to deduct all or part of certain expenses from its income tax bill on a dollar for dollar basis.
Tax credits are usually granted for a particular kind of corporate activity a state wants to promote. Investment tax credits, which allow companies to subtract from their tax bill amounts spent on new facilities and/or equipment, are a boon for capital-intensive manufacturing industries. Research and development (R&D) credits are especially lucrative for pharmaceutical and high-tech companies.
Both the federal and state governments grant “job creation tax credits” to companies for hiring workers. In some cases, the credits are granted only for hiring disadvantaged workers. This is the case with many state enterprise zone programs and the federal Work Opportunity Tax Credit (WOTC or “WAHT-see”). WOTC is designed to encourage employers to hire “hard to employ” workers such as ex-offenders, workers leaving welfare, recent food stamp recipients, low-income veterans or the disabled. WOTC is widely used by employers of low-wage, low-skill workers, especially in the fast food and retail sectors. Other tax credit programs give credits for hiring any new workers. Credits typically range from $1,000 to $5,000 per worker.
The theory underlying these credits is that certain types of corporate investments are crucial for boosting development and therefore deserve special tax treatment.
How tax credits work
Corporations pay federal income tax on their profits, and most states levy a corporate income tax as well (sometimes called a business franchise tax). The tax collected by each state is the state's tax rate multiplied by the company's in-state taxable profits. For companies that do business in more than one state, the state calculates the amount of taxable profits using an apportionment formula. Typically, the formula includes the shares of a company's nationwide payroll, assets, and sales that are in a particular state (learn more about tax formulas).
Tax credit programs are created by laws passed by federal and state legislatures. Tax credits are entitlement subsidies. Unlike discretionary subsidies, which are individually negotiated between a company and a taxing jurisdiction, tax credits are available to any company that meets the program's criteria. Those criteria may restrict the credit to companies in a particular industry, or to companies that invest over a certain amount of money, locate in a certain part of a state, hire disadvantaged workers, pay a certain wage, etc.
While tax credits cannot be negotiated on a case-by-case basis with companies since they must be incorporated into a state's tax code, many companies successfully lobby for the creation of tax credits tailored to their profiles. In several recent high-profile development deals, state legislatures have created new tax credits to subsidize specific companies considering locating in the area.
Tax credits are different than tax deductions. A tax deduction is subtracted from a company's income before the amount of tax is calculated, lessening the amount of profit subject to taxation. Say a company spends $5,000 on new equipment. If a state allows the company to deduct that amount from its profits, the company subtracts $5,000 from its profits; if the income tax rate is 10 percent, the company saves $500 in taxes.
Tax credits are subtracted from the amount of tax owed rather than from a company's income. In the example above, if the state allows the company to take a credit equal to the amount it spent on equipment, the company saves $5,000 in taxes. (Tax abatements, which typically reduce property taxes, are similar to credits in that they knock off a percentage of a company's final tax bill -- for example, a company receiving a 50-percent property tax abatement pays only half the property tax it would otherwise owe).
Companies claim tax credits when they file their tax return. Sometimes companies are required to submit documentation proving they fulfilled the terms of the credit; other times states rely on sporadic audits to confirm compliance. Many tax credits allow companies to claim the amount, or a percentage of the amount, of investment up to a certain dollar figure. Credits for job creation often set a specific figure a company can claim for each qualified job created.
Some states' credits are so generous that the credit wipes out the company's entire state income tax bill. If a company's credit exceeds its tax bill for the year, the company is often allowed to “carry forward” the leftover credits for use in future years. In many states, it is not uncommon for a company building a new facility to pay no state income taxes at all on the plant's profits for years.
Accountability and outcomes
Critics of tax credits question whether tax credits are effective in increasing the activities they attempt to promote, or whether those activities would occur regardless. For instance, the definition of what exactly “research and development” constitutes is often quite vague and may be stretched to include many activities that appear to be routine functions rather than a search for new knowledge, products, or processes. Even with true R&D, there is no assurance that the credited activity would not have been made in the absence of the credit. Similar issues arise with regard to job creation and investment credits.
These are important questions to ask, since tax credits are extremely expensive and often last for years. Among all the development subsidies states offer, tax credits are the most harmful to state budgets. Tax credits often do not undergo the same scrutiny in the state budgeting process as do direct economic development expenditures. Rather than necessitating an allocation of funds, tax credits take the form of forgone tax revenue. In the end, tax spending has the same effect as direct spending -- reducing the money available for state services and programs. Most states do not tally the amount of revenue lost to tax credits, making them one of the less accountable subsidies.
Some programs are better than others at targeting credits to companies that create good jobs and/or invest in development that would not otherwise occur. Requirements such as wage, healthcare, environmental, and local hiring standards help to ensure that companies subsidized with public money have a measurable, positive impact on local communities.
Most tax credits are structured so that companies receive the subsidy only after meeting the program's criteria – that is, they are paid only for what they actually do, not what they plan to do. This is a smart way to structure a subsidy, but it still requires state governments to be vigilant in monitoring and enforcing the provisions of tax credits laws. Many (but not all) tax credit laws contain reporting requirements detailing what documents a company must collect or complete to demonstrate compliance. The better laws also contain clawbacks that empower the state to reclaim the amount of the credit, with interest or penalties, if the company is found to be noncompliant with the terms of the program.
Researching tax credits
Corporate income tax credits are the most poorly disclosed tax breaks. No state requires corporate tax returns to be made public, and very few states have any kind of company-specific disclosure data that reveals how much a company didn't pay because of a tax credit.
Since you can't see a company's state tax return, you will probably have to make a good-faith estimate of the value of a tax credit to a company, using the information available. If the company is publicly traded, there should be a mention of the credit in the financial statements it files with the Securities and Exchange Commission and which are made public through the EDGAR system on the SEC website (www.sec.gov). See, for example the 10-K annual report.
Otherwise, state development departments may be able to estimate the amount of the credit. If the deal you are researching is large enough to warrant media coverage, there may be published estimates of the credit amount. Information on Work Opportunity Tax Credits is sometimes available from state WOTC coordinators. However, in many states, the coordinators do not collect comprehensive data, or else have a policy of not divulging the information.
Some states publish tax expenditure budgets that compile the total amount of money the state lost to each kind of corporate tax credit without company-specific information.