This post is part of a larger series.

Business Tax Reform

In a previous post, I described business taxes in Philadelphia, including at the local, state, and federal levels. Currently, it is very difficult to survive as a small business in Philadelphia. Making it easier for small businesses to succeed will ultimately help reduce poverty and inequality in Philadelphia. There are several reforms that we can make to improve this situation. On the reverse side, there are large organizations that should be paying more in taxes.

The key issue with business taxes is similar to the key issue for personal income taxes: there is a considerable amount of flat tax on the lowest earners. This makes it disproportionately difficult to succeed as a small business with lower amounts of revenue, since a flat tax is proportionately larger the smaller the revenue is. The only difference is that the flat taxes are considerably higher.

Unfortunately, all of Philadelphia’s business taxes are flat taxes, and several are levied before profits. We need to reform all of these taxes so that they are bracketed, progressive, and have a considerable deduction that makes small businesses more viable. My proposed reforms are exactly like those for personal income taxes.

When I imagined a typical small businesses expenses, profits, and tax obligations, I found that the overwhelming majority of taxes are owed to the federal government, especially via the FICA taxes. However, 28% of the business’s post-profit taxes were local, and a sizable portion of the pre-profit taxes were local. Therefore, there is a lot that can be done in the immediate future to reform business taxes.

1-Local business tax reform

Briefly, let’s review Philadelphia’s taxes. Philadelphia has the following business taxes:

  • Business Income and Receipts
    • 6.25% on profits and 0.1415% on total revenue
    • Exemption on the first $100,000 in gross receipts
    • A proportionate amount of net income (aka profit) is exempt
  • Net Profit
    • 3.8809% for residents, and 3.4567% for non-residents (equivalent to the wage tax)
  • Real estate
    • 1.3998% of the City’s assessed value of property occupied
    • Various exemptions, most notably a 1% discount for paying early
  • Use and Occupancy
    • 1.2% of the City’s assessed value of the property the business occupies
    • $165,300 exemption
  • Other excise taxes
    • Includes things like tobacco, car rental, hotel, vending machine, parking, and sugary drink taxes
    • Also includes a sales tax of 2% for most items

Here are my proposed reforms for each tax:

  • Business Income and Receipts
    • Eliminate the tax on gross income
    • Change the exemption to be equivalent to the basic income required at each filing status
    • Scale the tax on profits as a bracketed, progressive tax
  • Net Profit
    • Introduce an exemption equivalent to the basic income required at each filing status
    • Scale the tax as a bracketed, progressive tax
  • Real estate
    • Introduce the same tax forgiveness programs that exist for homeowners
  • Use and Occupancy
    • Introduce the same tax forgiveness programs that exist for homeowners
  • Other excise taxes
    • n/a

2-State business tax reform

Pennsylvania has the following business taxes:

  • Corporate Net Income
    • 9.99% on the profits of C corporations
  • Income
    • 3.07% on any income taken as profits for all other business types
  • Unemployment
    • 0.6% of gross wages for the employee
    • For employers within the first two to three years of operation:
      • 3.689% on the first $10,000 of gross wages each year for non-construction employees
      • 10.2238% for construction employees
    • For employers after the first two to three years of operation:
      • Standard rate of 7.2916% on the first $10,000 in gross wages per year for employers with a positive reserve balance, and 11.2968% for those with a negative balance
      • Or, a computed rate ranging from 2.3905% to 11.033%
  • Other excise taxes
    • Includes things like fuels, cigarettes, hotels, and utilities
    • Also includes the state sales tax of 6% for most items

The only reform I propose is to make the income tax bracketed and progressive, with a deduction equal to basic income for each filing status.

3-Federal business tax reform

Federal business taxes include:

  • Income
    • Individuals who take profit as income pay through the normal tax brackets and rates, depending on filing status
  • Corporate profit
    • 21% for C corporations
  • Unemployment (FUTA)
    • 6% on the first $7,000 paid to each employee per quarter
    • Most employers are eligible for the maximum credit of 5.4%, so they only pay 0.6%
  • Social Security and Medicare (FICA)
    • Employers pay half, unless you are the business owner taking home profits, in which case you pay both halves
      • Generally, the owners will pay a total of 15.3% on their own gross wages and 7.65% on their employees’ gross wages
    • Social Security is 6.2% of gross wages up to $132,900
    • Medicare is 1.45% of gross wages
    • The employee is responsible for an additional 0.9% in Medicare tax on gross wages over $200,000 (varies depending on filing status)
  • Excise taxes
    • Includes things like fuel, certain types of vehicles, and gambling

Since federal business taxes are largely the same as federal income taxes, my proposal is similar to how we should reform income taxes. We need to increase the number of brackets, deepen the progressive tax by dramatically increasing the higher brackets, and increase the standard deduction to the level of basic income for each filing status.

Like with personal income taxes, FICA is the biggest culprit when it comes to disproportionately impacting smaller businesses. This is even more extreme for business owners, since they are self-employed, and therefore pay both halves of the tax on any profit they take as income. Again, my proposal is similar: make the tax bracketed and progressive on par with the federal income tax brackets, and introduce a standard exemption equivalent to basic income at each filing status.

Reform proposals visualized

It is helpful to visualize the tax brackets that currently are in place for businesses, as compared to potential reforms. First, take a look at our current tax system:

Philadelphia, PA, and Federal Business Taxes on Profit

This is a very broad range of profits, in order to show all of the brackets. However, most businesses are not within this range. In addition, I’ve included the $12,200 standard deduction. Real taxes for businesses are likely to be far more complicated due to various deductions a business may be able to claim, but my hope is that this can at least show the general structure.

Remember, this is just tax on profits, which is the net revenue that the business owner decides to take as personal income, rather than investing back into the business. So, we can think of this as the income taxes for a self-employed person. These taxes are in addition to several taxes on gross income or other operating costs. Imagining a small business, these are the additional taxes:

Assumptions
Gross income: $400,000
Employees: 2 part-time at $20,000 each per year
Property value: $250,000

Taxes
BIRT gross income (0.1415%): $424.5
Real estate (1.3998%): $3,499.5
Use and Occupancy (1.2%): $1,016.4
State unemployment ($368.9 per employee): $1,106.7
Federal unemployment ($42 per employee): $126
FICA for employees (7.65% on employee wages): $3,060

Total: $9,233.1

Taken altogether, this means that it is quite difficult to turn a profit for very small businesses. For starters, there are considerable taxes before profits, and they are all flat taxes. If the business owner doesn’t own the property, this expense will likely be included in rent, rather than as a tax. This creates a hurdle for starting a business, but it becomes far less significant the larger the business becomes, because a flat tax disproportionately impacts lower income ranges. Second, the taxes after profits begin at almost 30%, even for profit below the standard deduction of $12,200. The taxes sharply increase to more than 50% on profits around $50,000-$100,000, and then sharply decrease. Like with personal income taxes, this is due to FICA’s regressive tax brackets. Finally, they level out for very high profit ranges at just above 50%.

Let’s take a look at this closer to the range of profit that most small businesses might be able to assume:

Philadelphia, PA, and Federal Business Taxes on Profit-Zoom

Here you can see more clearly that the FICA, State Income, City Net Profit, and BIRT Profit taxes are collectively creating a flat tax floor of just under 30%, even when profit is below $12,200. Further, FICA taxes for a business owner taking profit home as pay are twice the rates for typical employees, since they must pay the employer and employee portion.

My proposed reforms would remove much of the pre-profit tax obligations, since these disproportionately impact smaller businesses and those just starting out. Additionally, by bracketing each tax, making each tax deeply progressive, and accounting for a basic income deduction, we can eliminate taxes on profit for those with tiny or no profits, reduce taxes for middle-income businesses, and greatly increase taxes for the highest profits.

Like with my proposals for personal income taxes, I am advocating for a change of tax structure, and not specific tax rates. To show one example of what this could look like, I’ve used the same method as before. I’ve used the basic income from the Economic Policy Institute for an individual in the cheapest county in the country, minus taxes to set the standard deduction. This is about $27,000. I’ve applied this deduction to every type of tax. I also used tax brackets and rates from 1963, and then scaled all of the flat taxes to those brackets and rates, with their current rates as the maximum. Below, I’ve charted the full range of tax brackets for business profits:

Reform Proposal- Philadelphia, PA, and Federal Business Taxes on Profit

Again, this exceeds 100% after a certain threshold, but this is just because of the example brackets used. Reformed brackets for today’s taxes could be lowered to account for modern FICA rates and local taxes, or we could implement tax credits in cases where the rate would collectively exceed 100%. Regardless, I want to focus on the structure.

You can see that taxes are zero for those below the basic income level, moderate for middle-profit businesses, and then very high for extremely profitable businesses. In fact, there is an effective maximum amount of profit that one individual can take home. Note that this does not mean that businesses themselves would have an effective maximum profit—this is only for what is taken home as income. Extremely profitable businesses could still reinvest profits in the business, such as through hiring more employees, and this tax would have no effect on that.

Let’s take a closer look at this proposed reform in a smaller profit range:

Reform Proposal- Philadelphia, PA, and Federal Business Taxes on Profit-Zoom

Here, we can more easily see the impacts of the proposed reforms. The standard deduction makes it so businesses earning a modest profit will pay zero in taxes, and all amounts above the deduction increase incrementally.

Next, I have charted my proposed reform as compared to the current tax rates. This first chart shows all tax brackets, so the range of profits is very large. Take a look below:

Current Versus Reform- Philadelphia, PA, and Federal Business Taxes on Profit

You can see that my proposal severely reduces taxes for smaller and less profitable businesses, while dramatically increasing taxes for those beyond a profit threshold of about $100,000. There is no regressive portion due to FICA, and there is an effective maximum profit.

Finally, here is the zoomed in version, set to profits that are more realistic for most businesses:

Current Versus Reform- Philadelphia, PA, and Federal Business Taxes on Profit-Zoom

Here it is even clearer that the impact for small businesses is extremely beneficial. For virtually all small businesses, they would be paying zero taxes or far lower taxes.

Pre-profit and operating cost taxes

Next, I’d like to take a look at the pre-profit taxes, which raise operating costs for businesses. Here are the basic assumptions I made earlier for an imaginary small business, for reference:

Assumptions
Gross income: $400,000
Employees: 2 part-time at $20,000 each per year
Property value: $250,000

Taxes
BIRT gross income (0.1415%): $424.5
Real estate (1.3998%): $3,499.5
Use and Occupancy (1.2%): $1,016.4
State unemployment ($368.9 per employee): $1,106.7
Federal unemployment ($42 per employee): $126
FICA for employees (7.65% on employee wages): $3,060

Total: $9,233.1

Again, FICA makes up the majority of this cost, so reforming FICA at the federal level is critical. Federal unemployment tax has minimal costs, so reforming that tax is not a priority.

BIRT on gross revenue should be eliminated entirely, since this is a flat tax on operating costs.

Real estate tax is the same as for any property, and is paid by whoever owns the property. It should remain in place—but the property owner should be allowed to have similar exemptions as homeowners have if the business is below a certain size or has been in the property for a long period of time. For instance, the Homestead Exemption gives homeowners a $40,000 deduction on the home’s assessed property value, and the Long-time Owner-Occupied Program (LOOP) freezes assessed value increases if they more than triple and the owner has been in the home for more than 10 years. A parallel for business taxes could be a certain level of deduction if the business is below a certain size, such as under 10 employees and with revenue below $1 million a year. Small businesses that have been in a property for more than 10 years could have a parallel to LOOP, as well, so that neighborhood businesses are not pushed out as property values soar in gentrifying neighborhoods. In many cases, the landlord would experience this benefit, and he would no longer be forced to raise rent for the business.

The Use and Occupancy tax is motivated by the fact that the State will not allow any class of taxable thing to be taxed at different rates—so businesses and homes cannot have different property tax rates. Most cities rely on higher business property taxes, but Philadelphia has not had this option. The Use and Occupancy tax effectively creates a higher property tax for businesses, which helps get around this requirement. Ideally, the State would change this requirement so that Philadelphia can consolidate these taxes. There is nothing inherently wrong with the tax, especially considering that businesses likely use more public services than homes. However, like the property tax, it should have a considerable deduction for businesses below a size threshold, and it should incorporate deductions to encourage small businesses and prevent displacement.

Finally, there is Pennsylvania’s unemployment tax. The burden of this tax is disproportionately high the smaller a business is, since, like FICA, it is a flat tax on gross wages paid out. More should be done to remedy this. Like with other taxes, we could bracket and scale this tax progressively, depending on the size or profits of the business. We can also introduce a deduction that would cover most small businesses. Finally, we can eliminate the cap on wages that are taxed in some cases, such as for very large and very profitable businesses.

Large non-profit organizations

Nonprofits are exempt from federal income taxes, and if they are registered under the State’s nonprofit laws, they can be exempt from many local taxes. Most significantly, these include property taxes and taxes on profits. Part of this is because nobody is allowed to take home revenue as profits within a nonprofit organization. All net revenue has to be reinvested into the nonprofit. So, in practice, all taxes on profit are non-applicable. In Philadelphia, this means nonprofits are exempt from the following taxes:

  • BIRT
  • Real estate
  • Use and Occupancy
  • Local, State, and Federal income taxes for profit (not really applicable anyway)

Because nonprofits are, by their nature, not allowed to take out a profit, the exemptions for real estate and Use and Occupancy taxes are most significant. This exemption is a great thing in most cases—we want to encourage nonprofit activity. However, there are some significant cases where it feels much less like encouraging local nonprofits in the community, and much more like large businesses taking advantage of this beneficial tax status. And, nonprofits own 10% of property value in Philadelphia, or $14.1 billion. $13.6 billion of it is tax-exempt, so this is a significant loss in resources to the City that are not always evened out by the benefits the organization provides.

The clear example are the “eds and meds” institutions. Philadelphia is home to several very large universities, hospitals, and research institutions. Think of the University of Pennsylvania, Drexel University, Temple University, and all of their affiliated hospitals and other institutions. All of these are nonprofits, and therefore paying no property taxes or Use and Occupancy taxes. Despite their nonprofit status, many of these organizations are earning extremely high amounts of net revenue, and many individuals within these organizations are taking home incredibly high sums as compensation. This effectively allows some people to share in the immense “profit” of the net revenue, but as an employee.

Here are a couple examples of the largest organizations, based on their most recent tax forms from GuideStar. These are the 10 nonprofits based in Philadelphia with the highest gross revenue in tax years 2017 or 2016:

Screen Shot 2019-04-15 at 7.58.57 PM

The taxes paid are mostly payroll taxes, so FICA and unemployment taxes. Most of that is going to the federal government. The important part to note is that these organizations are paying nothing in property taxes. I added two columns to the right to show what their obligations would be, and it is over $221 million. If we included every nonprofit, it would be just under $355 million, so the largest organizations are clearly occupying the vast majority of real estate value among nonprofits.

Nonprofit organizations that are above a certain size in terms of revenue, value of real estate, assets, or in compensation paid should be required to pay property taxes and the Use and Occupancy tax. Clearly, if an organization can afford to pay its executive staff in the $1 million+ range, it can afford to pay taxes. There is a lot of “profit” within many of our larger nonprofits. The exact threshold isn’t as important as generally ensuring that large, profitable organizations that can afford to pay taxes should pay taxes. For example, we could set the threshold at a generous $50 million in real estate value, and only if the organization’s net revenue is above $10 million or 10% of gross revenue. This way, only extremely large nonprofits that have considerable net revenue would be obliged to pay property taxes and Use and Occupancy taxes.

Similar initiatives have been attempted in Philadelphia and elsewhere. In 1985, the Pennsylvania Supreme Court ruled that nonprofits have to meet five criteria to receive their local tax-exempt status. Many local governments used this to collect payments from large nonprofits that were not meeting these criteria. For instance, in 1994, then Mayor Ed Rendell issued an executive order to collect something called “Payments in Lieu of Taxes” (now known as PILOTs) from large nonprofits. He brokered a deal with Penn for $2 million a year for six years. Rendell explained his strategy as, “either you strike an agreement with us as to an appropriate PILOT payment, or we’ll just enforce the case law and tax you like any regular landlord.” However, no such arrangement has been made since, and the current administration and city council are reluctant to do this. Activists are still pushing for another PILOT initiative.

A report from the Lincoln Institute of Land Policy outlines other PILOT initiatives. They note that they have found 117 municipalities in 18 states with PILOT initiatives, mostly in the Northeast. The overwhelming majority of PILOTs are small, temporary payments brokered in closed-door meetings. They have depended largely on the bargaining power and abilities of local officials and institutions involved, and the final amount is almost always a small fraction of what would otherwise be owed in taxes. Boston is the only city with a uniform system in place, and even then it only collected $15.7 million in 2009. Most generate under $5 million per year among all nonprofit institutions.

Fortunately, Pennsylvania has the legal framework required to pressure or force institutions to pay their fair share. There is the 1985 court case, and more recently, a law passed in 1997 that clarifies the definition of a tax-exempt charity even further. Due to this, local lawmakers and elected officials already have the power to collect property taxes and the Use and Occupancy tax from most large nonprofits.

Conclusion

In short, we need to make similar reforms to business taxes as taxes for individual income earners. Taxes need to be reduced greatly for smaller businesses and increased for larger and more profitable businesses through shifting to a bracketed, progressive system with basic income deductions. Additionally, we need to establish criteria within Pennsylvania’s legal framework to collect property and Use and Occupancy taxes from large nonprofits.

All of the proposed tax changes can only happen through legislation at every level of government. Since changes to federal and state tax laws are more difficult, we should focus on changing Philadelphia’s taxes immediately, with a long-term goal of reforming other taxes. And, Philadelphia can start collecting taxes from large nonprofits immediately. All that is needed is the political will.