Was The Fatal Flaw For This Sensible Tax Bill Simply the Support From Youngkin?

There was absolutely no partisan angle to the policy debate, yet party line votes killed it. It is impossible not to consider that one fatal flaw for the idea was that Republican Governor Glenn Youngkin supported it and suggested the Assembly make the change. But the idea has been knocking around for years, long before Youngkin. A respected tax department official told the House Finance Committee she had been working on the issue for 15 years.

“It shifts the burden from in-state companies to out-of-state companies,” Kristin Collins of the Department of Taxation told legislators. You would think this would be a bipartisan winner.

The tax rule Democrats rejected by defeating House Bill 1866 in House Finance on January 31 has been adopted by at least 39 of the 48 states that have corporate income taxes. The senate version, Senate Bill 1456, was killed January 28.

Most of the states Virginia competes against for business locations and expansions use what is called “market based sourcing” in calculating the tax on income from services. According to the fiscal impact statement prepared by the Department of Taxation (very detailed, as usual) “none of the states contacted reported an unexpected revenue loss as a result of market-based sourcing.”

But the Department of Taxation’s impact statement on this bill did indicate that initially, for the first year or two, Virginia might see a slight drop in corporation income tax as different companies adjusted to the new rules at different paces. Then by the third and fourth years the effect would turn positive for the state, as more companies not located in Virginia but selling their services into Virginia would be forced to pay more in tax.

That short term negative impact was mentioned as the bill died (partisanship was never admitted). Virginia’s legislative money committees really control tax policy — and spending is their top priority, not intelligent tax design. That is being proven again this year when despite massive, ongoing tax surpluses taxpayers can only expect a pittance of a tax rebate. It will arrive right before the election, and it should be reported on the legislators’ campaign expense reports.

What did the failed bill do? As simple an explanation as I can provide follows. When a multistate company pays taxes in all the states where it has locations or sales, a formula is used to determine how much tax is due in those individual states. Under Virginia’s traditional formula going back to the 1950s, when the company is selling a service, the state where the service is performed claims the income, not the state where the service is received.

An engineering firm designing a building in another state would be taxed based upon where the work was done, the office where the designs were prepared, rather than the location of the client who hired them. If the design was done for a Virginia company, an out of state engineering firm would owe little or no Virginia tax. With the market-based rule in the bill that failed, it would owe Virginia tax.

In our modern digital services economy, Virginia taxing on the basis of the place of performance rather than the place of delivery is a very big incentive to do the work in a state with this market-based rule. Then Virginia is left out completely. What really matters is not being out of step, and the change really needs to be made here now because almost everybody else has changed.

It is such a big problem that the Virginia General Assembly has actually made individual exceptions and allowed a few companies to use market-based sourcing in calculating their tax. One of them, the real estate services firm CoStar, testified in favor of the House bill and said the firm would not be building new offices in downtown Richmond if it hadn’t been given this special treatment.

Making individual exceptions is a lousy tax precedent (but lucrative for lobbyists).

Another multinational headquartered in Virginia, Northrop Grumman, sent its lobbyist to complain that they were unclear about the impact on sales to the federal government. They opposed the bill and had not agreed to any suggested clarifications offered by patron, Delegate Joseph McNamara, R-Salem.

As the former lobbyist for Northrop Grumman, those complaints do not wash with me. Years ago, a similar issue arose over the way the state applied sales taxes to federal contracts that combine both the sale of tangible goods and the sale of intangible services. I was at the table on their behalf and a workable solution was found, that I assume is still in place. Corporations have a hard time thinking beyond the next quarter or next tax filing.

McNamara is a certified public accountant, and the state CPA association also testified for the bill. “It’s time for Virginia to make this change,” Emily Walker of the CPA’s told the committee.

But House Finance Chair Vivian Watts, D-Fairfax, said she has long represented federal contractor heavy Northern Virginia, and she also was deeply concerned about how sales to the federal government would be treated, jeopardizing the stream of revenue from these companies. She also couldn’t resist a faint shot at the uncertainty in federal contracting circles under the new Donald Trump administration. He is such a convenient excuse, isn’t he?

So down it went on both sides, House and Senate, joining in the scrap heap Youngkin’s effort to pay rebates to at least some Virginians on the local car tax and to allow service workers to deduct their tip income, a change that still looks probable at the federal level. A rational discussion in 2024 about imposing sales taxes on some select services did not surface again this year, after the Democrats got greedy and tried to turn logical tax policy into a major revenue grab sticking it to business. The resulting pyramid of sales taxes on final retail buyers would have been a major mistake.

Some legislators only want to know how much money is coming in from this tax or that tax and have no interest in wondering, would a different structure have a long-term benefit on the business climate? They still laugh at the Laffer Curve. And the halls of the General Assembly still echo with Speaker A. L. Philpott’s almost 40-year-old arrogant claim when he ran the world, “we’re not going to let a Republican pass a good bill.”