Pennsylvania Corporate Net Income Tax (CNIT)
The Pennsylvania Senate Finance Committee recently advanced two bills, SB 345 and SB 346, that would build on last year’s historic corporate net income tax (CNIT) reform. Under provisions of HB 1342, Pennsylvania’s CNIT rate was reduced one percentage point to 8.99 percent on January 1, 2023. Subsequent 0.5 percentage point cuts are scheduled to occur each year until the rate reaches 4.99 percent in 2031. As we wrote last summer, for Pennsylvania to realize the maximum economic benefits of that reform, the legislature should accelerate the scheduled reductions, revenue permitting. Additionally, policymakers should conform the Commonwealth’s cap on net operating loss (NOL) carryforwards to, at minimum, the 80 percent federal standard. Nearly every other state conforms to the 80 percent federal cap or leaves NOLs uncapped. Legislation recently reported from the Senate Finance Committee advance these goals.
Opportunities to Build on Last Year’s Reform
Under SB 345, policymakers would have the opportunity to build on the 2022 reform by reducing the current CNIT rate to 7.99 percent and accelerating the remaining reductions by five years. Simultaneously, SB 346 would reduce barriers to capital investment and economic growth by expanding Pennsylvania’s corporate NOL provisions to the 80 percent standard by 2026.
Prior to January’s reduction, Pennsylvania had the second highest corporate income tax (CIT) rate in the country. While the passage of HB 1342 was an important start to regaining the Commonwealth’s tax competitiveness, it will take another eight years to fully implement the reductions. A prolonged reform design is not inherently problematic, as several states with formerly high corporate tax rates have followed the model to great success. Policymakers in Indiana succeeded in reducing the corporate rate from 8.5 percent in 2012 to 4.9 percent today. Similarly, North Carolina’s CIT rate was reduced from 7 percent in 2000 to 2.5 percent today and is on track for elimination by 2030. But Pennsylvania is starting even further behind the curve. Not only does the near-decade-long schedule delay Pennsylvania’s ability to attract investment, but it also allows rate reductions to be disrupted in favor of additional spending elsewhere.
The sluggish pace of Pennsylvania’s CNIT reductions evokes memories of the phaseout of the capital stock and franchise tax (CSFT), which was haphazardly paused and restarted for years before finally being eliminated in 2016. As a result, Pennsylvania has earned somewhat of a reputation for being noncommittal on scheduled tax reductions. While firms may be attracted to the idea of low rates in 2031, the inherent uncertainty surrounding future events is likely to give businesses pause about committing to investments in Pennsylvania, undercutting rate reductions’ economic benefits. SB 345 and SB 346 would reduce uncertainty and reinforce policymakers’ commitment to lowering barriers to doing business in the Commonwealth.
Notwithstanding the historic nature of the bill, HB 1342 only afforded a modest rate cut for 2023, leaving the Commonwealth as an outlier in the nation. Under SB 345, the CNIT rate for tax year 2023 would be reduced to 7.99 percent. While it would be preferable for corporations to know their tax rate at the beginning of the year rather than halfway through, a retroactive reduction to the CNIT rate would nevertheless be a positive economic development for the Commonwealth. Pennsylvania would spend the remainder of the year with the 14th highest CIT rate instead of the fifth highest. Then, between January 1, 2024, and January 1, 2026, the rate would be reduced by one percentage point each year until it reaches 4.99 percent. Reaching the target rate five years earlier would eliminate significant tax costs from firms’ investment decisions.
A notable gap in last year’s tax reform was the lack of a provision to expand the Commonwealth’s NOL deduction, an improvement arguably as important as the CNIT rate reduction. Well-designed NOL provisions, like those included in SB 346, would enhance the neutrality of the tax code and smooth business income. NOL provisions help reduce tax burdens on businesses with greater exposure to economic downturns and ensure that, over time, the CIT is a tax on average profitability. This mitigates entrepreneurial risk and helps firms survive contractions and recessions. Without robust, competitive NOL provisions, corporations in cyclical industries pay much higher taxes than those in stable industries, even assuming identical average profits over time.
At 40 percent of the current year’s CIT liability, Pennsylvania’s NOL carryforward cap is a national outlier. Pennsylvania, Illinois, and New Hampshire are the only states to impose a state-defined carryforward cap (and Illinois’ limit is set to expire at the end of 2024). At a minimum, the Commonwealth should conform to federal NOL provisions that allow previous years’ losses to offset up to 80 percent of the current year’s tax liability. Raising or eliminating the cap would give businesses the opportunity to prioritize human and physical capital investment, generating greater productivity and wage growth in the long run.
Challenges to Reforms Might Be Overstated
While economically beneficial, an argument sometimes made against cutting CIT rates and expanding NOL provisions is that wealthy corporate owners will pocket the savings and average workers will be passed by. But this argument fundamentally misunderstands the incidence of corporate taxation. Despite what the name might suggest, corporate income taxes are borne in large part by the labor factor of production. Corporations are able to shift a significant amount of the corporate tax burden to workers in the form of lower wages, fewer job opportunities, and higher costs of finished goods. But the same is also true for tax savings.
When taxes are cut, corporations tend to pass on the savings to labor. This is because businesses are nearly always in competition with each other—for market share and for experienced, efficient workers. The competition for employees is especially intense in today’s tight labor market. In March, there were nearly 1.5 open jobs in the Commonwealth for every unemployed Pennsylvanian. Corporations have little incentive to hold onto tax savings if they could invest it in greater productivity and increasing long-term revenues. So, perhaps surprisingly, cutting corporate taxes can collectively benefit average Pennsylvanians as much as, if not more than, Pennsylvania’s capital owners.
Another potential hurdle to rate reduction acceleration and NOL expansion is the structural deficit projected to emerge by the end of fiscal year 2024. In January, the Commonwealth’s Independent Fiscal Office (IFO) forecasted a $1.5 billion deficit in FY 2024 that could grow to $2.3 billion in FY 2025 before averaging roughly $3 billion each year between FY 2026 and FY 2028. While not a concern to be dismissed out of hand, there are three reasons those projections could pose less of an obstacle to the proposed reforms than initial estimates may indicate.
First, general fund revenue collections reported in April were $2.5 billion above the IFO’s estimate for the fiscal year to date (FYTD). The CNIT alone generated over $1 billion more revenue than the IFO had projected for the same period.
Second, while many economists have predicted that a mild-to-moderate national recession may occur in 2023, nearly halfway through the year, some are beginning to wonder if the highly anticipated contraction might end up being a Godot recession—one that is expected but never shows up. The IFO noted that even if the national economy entered a recession in 2023, the Commonwealth’s economy would likely remain flat. If Pennsylvania’s economy follows the national trend and outperforms expectations, general fund revenues would likely exceed projections as income tax revenue tends to track with directional changes in the economy and was one of the limiting factors under the IFO’s revenue projection.
In fact, Pennsylvania policymakers have reasons for optimism regarding the strength of the economy. Key national and state-level economic indicators entering the second quarter remain strong. Pennsylvania’s April unemployment rate was 4.1 percent, the lowest since April 2000. The labor force participation rate (62 percent) continues to increase, and the estimate of unemployed Pennsylvanians has declined to its lowest level since January 2001.
Third, Pennsylvania’s structural deficit is driven by spending outpacing revenue. Importantly, revenues are not declining, nor are they flat. In the IFO’s five-year budget outlook, net revenues are expected to grow an average of $1 billion per year between FY 2023 and FY 2028.
The Commonwealth should not have a revenue problem, but if such concerns remain, the legislature should consider implementing tax triggers before pausing or reversing CNIT cuts. Such a policy might delay reaching the target CIT rate, but it would establish a responsible mechanism to implement future rate cuts and would be preferable to the unpredictable and unwieldly strategy employed to phase out the CSFT.
As industries reconsider supply chain design and economies adjust to life after the pandemic, now is the time for policymakers to retool Pennsylvania’s tax system. Lawmakers should seriously consider accelerating the corporate net income tax (CNIT) rate cuts and raising the net operating loss (NOL) carryforward cap. Doing so would set the conditions for economic growth and benefit employers and employees alike.
