Abstract

This study examines how income tax sourcing rules affect business activity in U.S. states. As technology has enabled companies to provide services to consumers globally, a growing number of governments seek to tax service companies based on the customer location (“market-based sourcing”) rather than the location of the company’s labor and capital. Consistent with market-based sourcing reducing the tax cost of locating marginal labor in the state, I find that state adoption of market-based sourcing increases the total number of employees and total labor earnings in affected service industries by roughly 2 to 5 percent, after controlling for concurrent tax policy changes. I find indirect evidence that the effects are mostly attributable to business expansion rather than employee reallocation across states. Market-based sourcing does not seem to adversely affect state corporate tax revenues. This study provides timely insights for policymakers given increased adoption of market-based sourcing by U.S. states and related international proposals.

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