WILMINGTON—U.S. law, as is well known and well reported, allows companies to incorporate in Delaware (or any other state) and be governed by that state’s laws and tax code. Delaware doesn’t tax “intangible assets,” and this encourages companies to move parts of their business to Delaware to avoid taxes in other states. This has led to Delaware being labeled a “tax haven.”

But what is less understood is the role that other states play in allowing this. Those states, which collectively lose billions of dollars in tax revenues when companies put parts of their business in Delaware, could stop that from happening if they wanted to. But, for various political reasons, they don’t, depriving themselves of revenues that could fund education, infrastructure, and other basics. If Delaware is a “tax haven” for public companies who want to avoid paying state income tax, it’s because other states allow it to be so.

To understand how and why states are losing out on this money, it’s important to understand how the “Delaware loophole” works: A company sets up a subsidiary in Delaware, and transfers an intangible part of its business there—say, its trademark or naming rights. Then its other locations outside of Delaware pay money to the subsidiary in order to use that trademark. Since intangible assets are not taxed in Delaware, the company doesn’t have to pay taxes on the money that was transferred to the subsidiary. The company can deduct the cost of the royalties on its state returns in other states where it operates, and thus avoid a large share of the state income taxes it would have otherwise owed. It is the laws of states other than Delaware that allow this system to work.

The company perhaps most well-known for using this strategy is Toys “R” Us, which faced a lawsuit about transferring money earned in South Carolina to a subsidiary in Delaware in 1993, the first time the practice received much public scrutiny. According to the lawsuit, Toys “R” Us retail stores across the country were paying a Delaware subsidiary called Geoffrey LLC to put the name Toys “R” Us on their stores, and to use trade names such as the store’s mascot, Geoffrey the Giraffe. The company deducted the money paid to the Delaware subsidiary from their in-state earnings in other states, and thus reduced their tax burdens there. Toys “R” Us allegedly moved money from other states to Delaware, where, because the trademark is an “intangible asset,” it isn’t taxed. Toys “R” Us lost the lawsuit in South Carolina, but could still use this practice in other states. (Toys “R” Us did not return requests for comment on its tax strategy.)

A 2013 study showed that firms with a Delaware-based tax strategy are able to reduce their state tax burdens by 15 to 25 percent compared to other firms. In total, this leads to other states being stiffed by $6.6 billion to $9.5 billion, according to the study, whose lead author was Scott Dyreng, a professor at Duke’s Fuqua School of Business. “The state of Delaware is indeed a domestic tax haven in the sense that its corporate laws appear to enable firms to significantly reduce state tax burdens,” Dyreng and his co-authors, Bradley Lindsey and Jacob Thornock, write.

Yet there’s a way for states to recover these lost revenues. They can adopt what’s called combined reporting, which requires companies located in a state to include the net profits of all their domestic entities in a combined firm; this allows a state to determine a company’s tax burden by looking at its property, payroll, and sales. Other states give themselves “add-back” authority by law, allowing tax collectors to disallow deductions a company takes in order to avoid paying state taxes. There’s also what’s called the “economic nexus” doctrine, under which a state claims a right to tax a corporation’s income earned within the state if the company has a sufficient economic footprint there. South Carolina assessed taxes on Toys “R” Us using this economic-nexus strategy after winning the right to do so by law in 1993. “It costs a lot of states revenue, but those states have the means to fix it, and they chose not to,” David Brunori, a research professor at The George Washington University, told me, about the Delaware loophole.

But states are hesitant to change their tax laws. Michael Mazerov, a senior fellow at the Center on Budget and Policy Priorities, says states worry that closing the loophole will cause businesses to move elsewhere to get more favorable tax treatment. More to the point, politicians who want to be seen as business-friendly don’t want to add new corporate taxes, so instead they leave the Delaware loophole in place, allowing companies to quietly avoid paying taxes. And besides, multi-state businesses usually lobby against bills in legislatures that would lessen their tax burdens. In the end, states lose out. “It hurts every parent with a kid in public schools. It hurts every college student who has less financial aid than they need because the state doesn’t have revenue,” Mazerov said.

He has tried to get states to crack down on the Delaware tax loophole. Around 25 states have adopted combined reporting and aren’t vulnerable to corporations trying to shift income to Delaware, he told me. About half of the remaining states have weak laws; some, like Florida, have no such laws. “Some of the laws that have been passed are very weak—I consider them fig leaves,” he said.  

Even worse, he said, not only do some states not close the Delaware tax loophole, but they enact other tax breaks to attract companies, further limiting state revenues. In Pennsylvania, for instance, corporate income taxes are making up a diminishing share of tax revenues over time, according to the nonpartisan Pennsylvania Budget and Policy Center. In 1972, corporate revenues made up 28 percent of state revenues. Today, they make up around 17 percent. The center estimates that the state, which is perpetually mired in budget crises, could reap between $200 million and $400 million more per year than it otherwise does if it adopted combined reporting and restored some of the business taxes that have been cut in recent years. But Marc Stier, the organization’s executive director, says that the state “is unwilling to raise taxes at all, particularly on corporations and the wealthy,” he said.

Of course, raising taxes may not be of much use anyway. The tax code provides many ways for companies and individuals to lower their tax burdens. Mazerov, of the Center on Budget and Policy Priorities, says that once one loophole is closed, accountants search for and often discover a new one. “What happens is that the corporations have the best and brightest working on their taxes,” Brunori said. “They can figure out how to minimize their payments.” The Delaware loophole itself originated in the late 1970s, when the state was trying to attract bank holding companies, and accountants figured out how to use it for other companies too. However, as long as states continue to turn a blind eye, it won’t take much clever accounting for companies to continue routing revenues through a place where they won’t get taxed.