Formula Apportionment: Factor Allocation and Tax Avoidance

Abstract

This paper addresses the question of how firms react to tax incentives in a formula apportionment (FA) tax regime. Under FA, the profits of all consolidated entities of a business group are summed and then allocated according to a formula based on FA factors. We hypothesize that firms may change the allocation of real production factors and/or manipulate the FA factor through tax avoidance strategies. Analyzing FA tax effects of the German local business tax with payroll expense as the exclusive FA factor, we find empirical evidence consistent with both hypotheses. Regarding the allocation of production factors, we observe significant tax effects on labor input at the intensive margin but not on labor input at the extensive margin. In addition, we find evidence of an indirect FA spillover effect on capital investment. Our findings on tax avoidance proxies are consistent with tax-induced manipulations of payroll expense as an FA factor to save tax payments.

Acknowledgements

We thank an anonymous reviewer, Richard Sansing (editor), Nadja Dwenger, Katharina Finke, Martin Fochmann, Frank Fossen, Martin Jacob, Reinald Koch, Laurence van Lent, Eva Kristina Matthaei, Nadine Riedel, Dirk Schindler, Kerstin Schneider, Sebastian Siegloch, Martin Simmler, Victor Steiner, Caren Sureth, participants of the Kommission Steuerlehre Annual Meeting 2014, participants of the German Economic Association, Standing Field Committee Accounting Annual Meeting 2014, participants of the NoCeT NHH Bergen Research Seminar 2014, participants of the ZEW Empirical Tax Research Workshop 2014, and participants of the research colloquium 2017 at the Graduate School of Law, Economics, and Society University Würzburg for helpful comments. We thank Marcel Zander for conducting interviews with tax practitioners. For technical support, we are grateful to the Research Data Centres of the Federal Statistical Office and the statistical offices of the Länder (Berlin-Brandenburg), especially Katja Baum, Steffi Dierks, Anja Hlawatsch, Julia Höninger, Matthias Klumpe, Steffen Lauf, and Ramona Voshage.

Notes

1 An exception is the simulation of Altshuler and Grubert (2010). However, due to the lack of empirical research on FA, their simulations are not based on empirical estimates but on hypothesized tax elasticities.

2 For example, businesses may ‘lease’ employees from low-tax establishments to high-tax establishments, as such leasing contracts will not increase the FA-relevant payroll expense in high-tax municipalities. Further, businesses may ‘outsource’ employees working in high-tax jurisdictions to subsidiaries that are not part of the FA scheme.

3 In unreported regressions for firms with only two establishments (two-establishment subsample), we also find weak evidence for spillover effects of labor input on output (measured by sales). However, this outcome is not robust in our baseline specification and should be interpreted with caution.

4 Exceptions exist for sole proprietorships and partnerships with earnings from agriculture, forestry and learned academic professions (e.g. self-employed doctors, tax advisers, architects, engineers). These types of businesses are not taxed by the German local business tax.

5 Before 2008, the German local business tax payments therefore reduced the tax base of the (corporate and/or personal) income tax and its own tax base.

6 Under certain conditions (e.g. wind power stations), there are also special apportionment schemes, which are not based on payroll expense (Scheffler, 2011). Considering their limited scope of application, these special regimes are not relevant for our analysis.

7 Marcel Zander conducted the interviews as part of a related project. We are very thankful to Marcel Zander for supporting this research.

8 Riedel (2010) uses a weighted tax rate differential with sales as a weighting factor. However, in our study, such a measure would not be appropriate because we further consider spillover effects on sales and investments. Thus, sales might also be distorted by FA tax incentives. In addition, it remains questionable if FA tax incentives are better represented by a weighted tax rate differential or by an unweighted tax rate differential, as in our case.

9 Corresponding to § 2 of the German Local Business Tax Code (German: Gewerbesteuergesetz), the tax is relevant only for ongoing business operations in Germany.

10 Apart from the municipality, the district (‘Kreis’) is the smallest regional administrative body in Germany. For German cities, the district is often identical to the municipality (in German ‘kreisfreie Städte’). This holds for all larger German cities and for small, regionally important German cities (e.g. Ansbach, Gera, Magdeburg, Straubing). Hence, controlling for changes in economic trends at the district level is well suited to our identification strategy.

11 The official title of the data is ‘Research Data Centres of the Federal Statistical Office and the statistical offices of the Länder, AFiD panel for the manufacturing and mining industries, 1995–2008’; see also http://www.forschungsdatenzentrum.de/bestand/afid-panel_industriebetriebe/index.asp.

12 The German titles of the surveys are as follows: ‘Investitionserhebung bei Betrieben des Verarbeitenden Gewerbes sowie der Gewinnung von Steinen und Erden’ and ‘Monatsbericht bei Betrieben des Verarbeitenden Gewerbes sowie der Gewinnung von Steinen und Erden’.

13 All estimates and the within R² are calculated with the Stata® xtreg command. The xtreg command is more conservative for clustered standard errors than the areg command. As the xtreg command does not calculate adjusted R², we used the areg command for calculating the reported adjusted R² only.

14 In an unreported cross-check, we also tested the impact of TaxD on Sales share only for firms with two establishments (two-establishment subsample with 38,126 observations). In these regressions, we obtain a negative regression coefficient, which is significant at the 10% level. However, the corresponding results are not robust if we consider the small-group sample or the full sample.

15 One might argue that part of the lower Payroll per hour ratio might be due to a reduction in overtime hours and the corresponding overtime compensation. Taking into account that a one-percentage-point increase in the tax rate reduces the Hours per employee ratio by 0.634 percentage points and the Payroll per hour ratio by almost the same value (0.546 percentage points), the impact of overtime compensation should be almost negligible. Adjusting hours worked by a small amount (e.g. 0.6%) will not result in a notable change in the average payroll over all hours worked. Even for an extremely high overtime compensation of 100%, a 0.6% change in hours worked will result in a change in average payroll per hour worked of only 0.006%.

16 Taking into account the relatively weak empirical evidence in Table 8 as well as the identification problems of tax incentives for firms with a high number of establishments, we abstain from calculating quantitative estimates for the regression coefficients of Table 8.

17 This is demonstrated by a comparison of our baseline regression results in Table 6 (Payroll share), Tables 7 and 8 (other dependent variables) with the corresponding results for lagged TaxD in Table 9 (Payroll share) and Table 12 (other dependent variables).

18 The reason is the relative nature of the Payroll per hour ratio. Under the tax avoidance hypothesis, the tax impact on this variable is driven not only by reduced payroll at establishment i but also by an increase in payroll at establishment j. By contrast, the incidence hypothesis implies that the payroll at the establishment j will not be affected by an increase in the tax rate facing establishment i. Hence, there must be a stronger tax effect on the payroll expense at establishment i.

19 This is primarily driven by the fact that the average ratio between the payroll expense and the tax base of the local business tax (an adjusted pre-tax profit) from 1997 to 2008 was approximately 4.08 in the German manufacturing industry. For this calculation, we use representative balance sheet data for the manufacturing sector reported in the statistical special publication 6 (German: Statistische Sonderveröffentlichung 6) of the German Federal Bank. Hence, if the tax burden on profit increases by one-percentage-point, the required reduction in the wage payment would clearly be less than 1%, as aggregate wages are much higher than the assessment base of the German local business tax.

20 We use representative balance sheet data for the manufacturing sector reported in the statistical special publication 6 (German: Statistische Sonderveröffentlichung 6) of the German Federal Bank (http://www.bundesbank.de/Navigation/DE/Statistiken/Unternehmen_und_private_Haushalte/Unternehmens%abschluesse/Tabellen/tabellen.html).