Pennsylvania’s annual, acrimonious budget season will take place this year under far more uncertain conditions than usual, with skyrocketing Medicaid costs and a foggy future for federal outlays to the commonwealth and its counties and municipalities.

That’s all the more reason to achieve a bipartisan victory on tax policy, proposed by Gov. Josh Shapiro, that will improve Pennsylvania’s economic competitiveness while making its business tax system simpler and fairer.

That means catching up to nearly 30 other states by closing a loophole exploited by Pennsylvania’s neighbor (and corporate tax haven), Delaware, while also accelerating planned reductions in the commonwealth’s corporate net income tax (CNIT).

At the same time, Harrisburg leaders must continue to monitor closely the state’s corporation tax revenue, to ensure the theory — that lower tax rates will not lead to proportionally lower revenues, due to increased business activity — actually works out in reality. The early returns from the first tick down in the CNIT aren’t great, but the reduction was small enough that it’s hard to draw any conclusions just yet.

Altogether, given political and economic uncertainty, the commonwealth must tread carefully in pursuing revenue reductions and spending increases. That includes predicating the state’s fiscal well-being on as-yet unrealized sources of income: recreational marijuana and skill-games taxes. Mr. Shapiro and his negotiators must be willing to accept a lower, possibly significantly lower, top-line spending figure in order to maintain nimbleness during a likely bumpy road ahead.

TAX HAVEN

Delaware is the First State in order of ratifying the Constitution, and in order of corporate headquarters in the United States — at least nominally. That’s because of the state’s unusually lax corporate legal and tax regime. Here’s how it works.

States, including Pennsylvania, tax corporations on the basis of the business the corporation conducts within the state. But what companies incorporated in Delaware do is set up subsidiaries in each state that perform accounting tricks between themselves and the main corporate entity, which have the effect of funneling all profits into the Delaware-based corporation. The state subsidiaries officially have zero profit, which means no corporate income taxes in higher-tax states.

This is possible in states, like Pennsylvania, that allow “separate reporting” of revenues. In such a system, the corporation only has to tell Pennsylvania about the profit its Pennsylvania subsidiary makes — which is, again due to those accounting tricks, officially zero.

What Pennsylvania can do is join 28 states in requiring “combined reporting” of business activities to Harrisburg. This creates no additional administrative burden, because the federal government also requires combined reporting. These states run the blue-red gamut from New York to Texas to West Virginia.

About 10% of corporations that operate in Pennsylvania have the resources to take advantage of the Delaware loophole, and the amount the state stands to gain from closing it is hard to calculate, according to the left-leaning Keystone Research Center. A few years ago, the organization estimated that the new tax haul could be over $300 million per year — more than enough to offset recent declines in CNIT revenues due to lower tax rates.

KEYSTONE COMPETITIVENESS

For years, Pennsylvania businesses have begged Harrisburg to reduce what was once one of the most onerous corporate income tax burdens in the U.S. In 2022, the General Assembly passed and former Gov. Tom Wolf signed Act 53, which lowered the CNIT from 9.99% to 8.99% for 2023, with scheduled reductions of 0.5% every year until 2031. The final rate would be 4.99%, moving the commonwealth from one of the highest-tax states for corporations to the bottom 15.

In this year’s budget, Mr. Shapiro would accelerate the pace of reductions so the state reaches 4.99% in 2029, not 2031.

While Pennsylvania must be careful not to engage in a race to the bottom — competition among states for corporate investment can lead what is, in essence, a destructive price war — this move is prudent given the commonwealth’s meager growth and (well-earned) reputation as a high-regulation, business-unfriendly environment. The Shapiro administration has made reversing that reputation a priority, and has clearly succeeded in areas such as permitting efficiency.

Accelerating the CNIT reductions, especially when paired with closing the Delaware loophole, will maintain positive momentum without seriously threatening the state’s bottom line.

Vigilance is essential, however. While the state saw a 15% year-over-year increase in CNIT revenue in fiscal year 2022-2023 (the year begins July 1), it saw an 8% decrease in FY 2023-2024, when the rate reductions kicked in. This is roughly in keeping with the extent of the tax cuts, but in theory the commonwealth should see CNIT revenues decrease at a lower rate than the tax rate (or possibly increase) as more business activity occurs in Pennsylvania. If that proves not to be the case in coming years, Harrisburg should reconsider its strategy.

CAUTION AND COOPERATION

These corporate tax decisions are occurring in a time of unprecedented uncertainty for the country’s economy and politics, including looming questions of Washington’s trustworthiness to fulfill its obligations to states, counties and municipalities. Mr. Shapiro has filed suit against several federal agencies under the Trump administration for failing to disburse promised funds — a strong response.

Still, just as America’s trading partners are looking to shore up their own economies faced with possible decoupling, so should states prepare for a possible world with significantly lower levels of federal support for programs and policies. Even if governors and attorneys general succeed in forestalling Mr. Trump’s (and Elon Musk’s) unilateral decisions, it’s possible Congress will also tighten the purse strings (though, of course, local representatives have much more to lose from turning off the federal spigot).

This all means that fiscal caution and political cooperation must be the order of the day in the Keystone State. Bickering and grandstanding will do nothing to stabilize the situation, here or in Washington. A good place to start is coming to a quick agreement about closing the Delaware loophole while accelerating corporate tax cuts.

— Pittsburgh Post-Gazette via TNS