Out of Sight, Out of Mind?

As a potential war with Iraq and a stock market rally push corporate wrongdoing and bankruptcy out of the headlines, the Bush administration appears to be plodding along with a proposal to address some of the real lessons brought out by the implosion of Enron and WorldCom.

The great policy change to this point the Sarbanes-Oxley corporate accountability law, which addressed public outrage with corporate officers’ deceitfulness and the accounting industry’s proclivity for misrepresentation. This law established a new accounting regulator and increased the civil and criminal legal risks facing corporate executives who do not devote enough attention to the appropriate treatment of earnings, but did nothing to change the tax policies that encouraged executives at WorldCom and Enron to put their businesses in such precarious position in the first place.

Companies file for bankruptcy to seek legal protection from creditors when they can no longer have the cash to pay the interest and principal on their loans. Both Enron and WorldCom were highly leveraged, which is to say that their debt levels were very high relative to equity. When their businesses did not generate the cash flow necessary to service their debts, both companies filed for bankruptcy.

Both companies took on so much leverage to grow their respective businesses because corporate tax law encourages them to do so. When a corporation makes a profit, it must return 35 percent of it to the federal government. This, in and of itself, is a problem for two reasons: First, the way corporate income is determined is irrational and based on a set of rules that treat corporate expenditures differently. Secondly, when coupled with state corporate income taxes, domestic corporations face the fourth highest corporate income tax rate in the world, a key disincentive for investment in the U.S. for domestic and foreign-based companies alike. This has led many corporations to relocate to other jurisdictions with lower tax rates, although they must still pay U.S. corporate taxes for profits made in this country.

In the first case, capital expenditures must be depreciated over what the government determines the life of the investment to be. Expenses, like salaries, benefits, and much office equipments can be deducted in full the year of purchase. To complicate matters, Congress has also littered the tax code with tax credits for research and development, natural gas extraction, renewable energy, and countless other carve-outs to mitigate the tax burden of a select few. These concentrated benefits available in exchange for political patronage has led many businesses to invest heavily in Washington lawyers and lobbyists to reduce their tax burden and increase returns for shareholders.

When a corporation sees that its operating income will allow the business to turn a profit, it has important choices to make concerning how that money will be used. It can do nothing, in which case the federal government will take 35 percent, or it can return the profits, or a portion of them, to shareholders in the form of dividends. But since dividends are taxed at the shareholder’s marginal income tax rate, the government not only gets 35 percent of the profit, but 35 percent plus the shareholder’s personal tax rate, which can total 70 percent.

This is not a very appealing option for most shareholders, considering that capital gains taxes – the tax assessed on the appreciation of an asset when sold – are only 20 percent, lower than nearly all of the investor class’ marginal tax rate. If the corporation invests anticipated profits in new plant, equipment, or research to grow the business, it can protect a portion of the profits from taxation and provide capital gains from shareholders if the project generates sufficient return to capital.

But the corporate tax code does not just encourage corporations to retain earnings to grow the company instead of issuing dividends, it encourages corporations to use retained earnings to finance borrowing because interest paid on debt can be counted against taxes owed as a business expense. So companies issue bonds, commercial paper, and arrange for bank loans to pay for growth and use operating profits to pay the bills. This reduces tax liability for both the corporation and its shareholders alike.

Unfortunately, it also leads to Enron and WorldCom style meltdowns because it relieves corporations of the burden of paying dividends – real profits that can be deposited in individual bank accounts – to shareholders. Given the double taxation of dividends, corporations that issue them are seen as stodgy and complacent with little room for growth. This surely does not attract shareholders interested in capital gains because of their better tax treatment.

No matter what accounting standards the new regulators impose on corporations, nothing could possible be as effective at ensuring that profits are real than eliminating the double taxation of dividends by allowing them to be deducted like interest payments. Corporations would no longer feel pressure to invest in new projects and borrow huge sums of money to attract investors. The corporations that immediately begin issuing dividends would put pressure on other companies to do so, and those who did not would be under even more pressure from investors to prove that the earnings they retained would really increase the value of the company.

In addition, the corporate tax code must be cleansed of the untenable distinctions between investments and expenses. Debt financing is necessary in many instances because without the cheaper capital, the expected returns would not generate the revenues necessary to make the project worthwhile, after taking the corporate tax into account. Allowing capital expenditures to be expensed would relieve some of the pressure for debt financing.

The Bush administration seems interested in a series of proposals to expand Individual Retirement Accounts (IRAs), increase the amount in capital losses (currently only $3000) that an individual may use to offset his tax liability, and tinker with 401(k) plans to allow for greater flexibility. These proposals have merit, but would do less to promote positive changes in corporate behavior and investor welfare than a more fundamental reform of corporate taxes beginning with equal treatment of both expenses and investments and dividends and interest payments.