Three Factor Formula 

Most states with a corporate income tax use what's called a “Three Factor Formula”. Generally, the three factors are Property, Sales, and Payroll.

Let's say each factor is weighted 1/3. If a big manufacturing company locates in such a state, then let's assume 70% of its property would be in that state (30% in other states), 5% of its sales would be in that state, and 70% of its payroll. So, the company determines its entire profit, and reduces it to determine its profit attributable to that state, by doing the following simple math:

33.3% (1/3 weighting in factor) X 70% (property factor) = 23.1%

33.3% (1/3 weighting in factor) X 5% (sales factor) = 1.7%

33.3% (1/3 weighting in factor) X 70% (payroll factor) = 23.1%

Total = 47.9% (profit apportioned to home state)

This is all a process to allocate, or “apportion” the profits. You just add up those percentages, and you get 47.9%. Thus, the company would pay state income taxes at the state income tax rate on 47.9% of the company's total profits. If this company made $10 million in profit, and the state tax rate was 6%, then:

$10 mill. X 47.9% (Apportionment Factor) X 6% (Tax Rate) = $287,400.

Single Factor Formula

Conversely, Iowa has a “Single Factor Formula” for apportioning income. The company pays taxes based on its percentage of sales in Iowa, which in this example is 5%. So, if that same company was located in Iowa, the tax would be:

$10 million X 5% (Apportionment Factor) X 12% (Tax Rate) = $60,000

But this is where the rubber meets the road. Walmart made $36 billion in profit last year. Iowa is roughly 1% of the nation, so let's assume 1% of Walmart's sales were in Iowa, which means 1% of its profit would be apportioned to IOwa. Walmart's Iowa tax liability would be:

$36 billion (profit) X 1% (Apportionment) X 12% (Tax Rate) = $43 million.

Now, let's assume some well intentioned lawmaker at the Statehouse wants to attract Walmart to Iowa, and he says, “We can't bring them here because our corporate income tax rate is too high.” I would ask, “Really? How much will Walmart's Iowa income tax go up if they move to Iowa?” Their total Iowa Income tax if they headquarter in Iowa would be:

$36 biliion X 1% X 12% = $43 million.

No change.

Similarly, Orascom could build its plant in Illinois, South Dakota, Minnesota, Iowa, or Mexico City. The company's market is Iowa farmers whether its product is made here or somewhere else. Its Iowa corporate income tax liability will be the same. Whatever reasons they have for not wanting to locate in Iowa sans subsidies, Corporate Income Tax isn't one of them.

Now, you ask the following. “Isn't it the perception of Iowa's high tax rate that is the problem?” Fine, then let's adopt a Three Factor Formula and lower the rate to 6%. That would have the effect of increasing taxes on Iowa companies, and lowering taxes on out of state companies. In any event, if we lowered the rate to 6%, that would mean giving Walmart in Arkansas a $21.5 million tax break. You see much bang for the buck in giving Walmart a $21.5 million tax break?

More to the point, wouldn't it just be cheaper to spend $10 million on a national advertising campaign to educate corporate CEOs to understand Iowa won't tax their move to the State? Fortunately, we don't even have to do that. Corporations have plenty of accountants they already pay to tell them that.

All this begs the question, of course. Why don't we just stop this madness? Stop giving anyone special breaks. Stop picking winners and losers. Then we can use the savings to reduce the overall tax burden in the State for those already here, as well as for those that are looking to come here. Or spend the money to improve the State in other ways. The right balance is outside the scope of this entry.

This is all a big scam of rent seeking, and it's wasteful. We can very well assess the economic activity from the company we lure here with tax incentives. We are never able to count the jobs lost from the company that left the state (or chose not to come) because the overall tax climate wasn't just a little bit better, or the quality of government service was inadequate.

Regardless of your views on the wisdom of government tax incentives writ large, when someone tries to tell you the Iowa corporate income tax is standing in the way of economic development, hold on tight to your wallet and politely steer them to another priority.