Proposed Tax Increases Hit State’s Economic Drivers
Tax increases on Connecticut’s key industries don’t solve the state’s fiscal problems and could undermine our economic recovery,” says CBIA President and CEO Joe Brennan, responding to Gov. Malloy’s 2016-2017 state budget proposal.
Now in the hands of the legislature’s Finance and Appropriations committees for analysis and likely modification, the proposal includes significant structural changes to the state’s tax system that could derail Connecticut’s economic comeback just when it was beginning to pick up steam.
Once a budget bill is out of committee, the full legislature has until June 3 to vote on it.
“A lot can happen between now and then,” says Brennan, “We’re strongly urging lawmakers to scrutinize the proposed budget to find additional cost savings and reject the harmful tax increases.”
Crunching the Numbers
The governor’s two-year, $40 billion budget closes a large part of a projected $2.2 billion current services deficit over the biennium with a combination of spending cuts to areas such as healthcare, social services, and education and revenue increases that fall mainly on Connecticut’s job creators.
State employee labor costs are left essentially untouched, with no state employee concessions or early retirement incentives included in the plan. The budget does, however, include $343.5 million in raises and cost-of-living adjustments for state employees. The state’s workforce is expected to shrink somewhat through attrition.
Of the $914 million in proposed revenue increases over two years, businesses will be hit with over half:
$496 million: and that’s after taking into account the governor’s proposed elimination of the business entity tax, a $250 fee levied on pass-through entities (companies that pay their business taxes through the personal income tax) every two years.
The proposal significantly reduces vital investment incentives, cancels previously scheduled tax reductions, and permanently extends the corporate tax surcharge. Specifically, the tax measures would:
- Reduce the value of investment incentives for research and development, capital purchases, and other key economic drivers by reducing the caps on business tax credits from 70% of a company’s tax liability to 35% in 2015, 45% in 2016, and 60% in 2017 and later.
- Cap the use of the net operating loss (NOL) carryforward at 50%. The NOL carryforward is an important tax mechanism to encourage investment and entrepreneurial activity in Connecticut. It acts as an incentive for a company to, for example, take the considerable financial risk of developing a new product: which may take from five to 20 years: by allowing the company to use operating losses incurred during the development period to offset future tax obligations once that product begins to generate a profit. It also acts as an incentive for the company to continue to manufacture the product in the state.
- Make permanent the 20% corporate tax surcharge that was scheduled to be eliminated this year. The surcharge increases the corporate tax rate in Connecticut from 7.5% to 9%.
- Continue for two years the credit cap reduction for the insurance tax that was scheduled to be eliminated this year.
- Increase numerous fees paid by businesses, including an $80 increase in fees levied by the Office of the Secretary of the State on pass-through entities.
The budget also includes a reduction in the state sales tax, which increased four years ago to 6.35%. It would dip to 6.2% in November and 5.95% in 2017.
Overall, the governor’s budget proposal increases spending by 3.3% ($632.6 million) in FY 2016 and 3.1% ($617.2 million) in FY 2017.
More with Less
Tax increases on businesses combined with increases in overall spending is an approach to state budgeting that does not sit well with Connecticut business leaders, says Brennan.
“Business confidence in Connecticut is critical to economic growth,” he says. “To maintain that confidence, the state must break a cycle of deficits and tax increases.”
Colin Cooper, CEO of aerospace manufacturer Whitcraft LLC in Eastford, agrees.
“If you look at this in the context of what’s been going on for the last several years, I’d like to see more of the budget gap closed by reduced spending rather than increased revenues,” says Cooper. “My overall feeling is that Connecticut doesn’t have a revenue problem; I think it has a spending problem. The point I try to make to folks is that in our industry we sell to large OEMs. They really require us year-over-year to do more with less. I’d love to see that mindset really take hold in state government.”
The Best Way to Grow Tax Revenues
Over the past several years the state has worked hard to attract and keep its key job-creating businesses, such as manufacturers, biopharmaceutical companies, financial services firms, and others.
And it’s been working; with steadily improving job numbers, Connecticut’s economy is finally shaking off the effects of the recession.
But the state’s key economic base industries: and the thousands of small businesses and their employees throughout Connecticut that provide them with products and services: will be hit hard by the tax increases in the governor’s budget.
“Connecticut has excellent economic potential, and we shouldn’t close budget gaps by discouraging the very companies that are driving our economic recovery,” says Brennan.
Aware of the difficulty faced by the governor and lawmakers in trying to balance a budget in the face of large deficits, Brennan is nevertheless critical of tax increases that will inhibit economic activity and long-term revenue growth.
“The best way to grow tax revenues is to grow our economy,” he says. “Although we’ve seen better job numbers recently, we’re not reaching our full economic potential, and we won’t until we improve our economic competitiveness. By rasing costs on key industries, we’re making the state less competitive.”
Brennan notes, for example, that imposing the 20% corporate tax surcharge permanently will move our tax rate from “middle of the pack to one of the higher rates in the country.”
In addition, the state’s research and development tax credit, which would be significantly limited by the governor’s budget proposal, is critical for a relatively high-cost state like Connecticut if we’re to be able to compete with other, lower-cost states and countries.
Pete Gioia, CBIA vice president and economist, explains.
“CBIA surveys show that in any given year, between 50% and 75% of businesses in Connecticut develop new products or services through R&D efforts,” he says. “These products can be priced at a premium for a while and are not commoditized. When Connecticut firms try to sell only commodity products, they get clobbered by lower-cost southern states and overseas competition. So R&D is essential to Connecticut firms’ survival in our state.”
The Job Multiplier Effect
The proposed budget’s tax increases, says Gioia, hit the very industries that can power real economic growth in the next decade: companies that can provide jobs for current residents, new graduates, and employees in other companies that supply these industries.
He points out that the industries affected most by the reductions in tax credits and the NOL carryforward: manufacturing, bioscience, and financial services: have huge job mulitplier effects.
“Think about it. Every job those industries create adds one to six additional jobs throughout Connecticut,” he says.
“You may not work directly for one of these firms, but your success as a metal fabricator, real estate agent, service worker, car mechanic, copier salesperson, builder, retailer, restaurateur, and so on depends on output from these economic powerhouses. All of those people will feel it if companies that are directly affected pull back operations and investment in Connecticut in favor of other states that have a more stable, strategic tax policy.”
When that happens, says Gioia, reducing incentives such as business tax credits and the NOL carryforward to increase revenues in a given budget period could backfire further down the road.
“Over this biennium, the state may get an initial revenue boost by slashing incentives,” he says. “But over time, as business operations seek more favorable tax climates, revenues may erode.
“These incentives are used by companies that are investing in their operations and have decided on Connecticut for the future of their workforce. By cutting these tax incentives, you are causing companies to reconsider that decision.”
Indeed, CBIA’s most recent quarterly credit and economic survey shows that businesses definitely care about state taxes. Eighty-eight percent of respondents said that state tax considerations are very important in their decisions concerning investment and company location.
Economic Development Tools
Some people may not understand the purpose or significance of economic development tools like business tax credits and the NOL carryforward. Some may even consider them tax dodges or gifts that allow businesses to simply avoid paying taxes.
The reality, however, is something altogether different.
The R&D tax credit, for example, is the state’s primary tax policy fostering innovation and driving sustainable job growth, says Bonnie Stewart, CBIA’s vice president of government affairs and general counsel.
“The tax credit is earned by companies that make investments in Connecticut R&D jobs or facilities as specified in the legislation,” says Stewart. “The credit was established to encourage specific investments in Connecticut and has resulted in a significant increase in R&D jobs in the state.”
She points out that the credit can be claimed only for specific R&D investments and activities conducted in Connecticut and only after the specified investment has been made. In addition, credits are rigorously audited by the state Department of Revenue Services.
“Since the R&D period for most products is extremely long [consider, for example, a new drug or jet engine], there is usually no cost to Connecticut until years after an in-state investment is made,” says Stewart. “In the meantime, the economic activity resulting from R&D activities and jobs is generating significant tax revenue for the state.”
The structural changes to the tax code proposed in the governor’s budget strike a serious blow to business confidence, because they introduce uncertainty and instability into Connecticut’s tax environment.
Since companies plan for investment in cycles of seven to 10 years, they need to be able to count on a consistent and predictable state tax system when planning and making decisions about where to invest and create jobs.
When state government periodically threatens to remove or reduce incentives for investment, companies can’t factor them into their planning with any confidence, which in turn puts innovation, growth, and hiring on hold: or worse, moves it elsewhere.
A few years ago, CBIA commissioned a study by professional services firm PwC (PricewaterhouseCoopers) that analyzed Connecticut’s tax system and the impact of potential changes to the tax code on the state’s business climate. The report identified several characteristics of a competitive tax system, including low compliance costs, attractiveness relative to neighboring states, and stability.
According to the report, tax systems should be stable for several reasons, including the fact that if policymakers constantly tinker with the tax code, it’s hard for businesses to make long-range decisions, which discourages investment in the state.
“It’s difficult to overstate the importance of tax policy to Connecticut’s economy,” says Stewart. “It has the ability to help or hinder economic development. It can help employers create more jobs and compete globally, or it can weigh them down with higher costs and force them to relocate certain activities to tax environments that offer better incentives for taking the financial risks associated with expanding operations or developing new products.”
Different Policy Choices
“I agree with the governor that Connecticut has made progress and is going in the right direction,” says Brennan. “But our concern with this budget proposal is that it puts the brakes on the momentum we’ve seen in recent months in business investment and job growth.”
He remains hopeful, however.
“We want to continue to grow our economy and create jobs, and I think we can do that. I’m very optimistic about the future in Connecticut. We’ve got great companies and obviously a great workforce. So I think we can have a growing, vibrant economy, but we need to make some different policy choices in order to get there.”
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