Taxing an Abstraction

Corporate income and accounting has received much attention from lawmakers in recent weeks. The Enron collapse focused attention on the accounting profession – culminating in the all but certain demise of the Andersen partnership – and accounting methods, which have been addressed by several pieces of legislation currently before Congress. As is often the case with complex public policy issues, both the corporate reform proposals and the rhetoric surrounding them do little to address real problems or examine the way current rules and regulations thwart market processes.

Thus far, the House of Representatives passed the “Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002” to establish new Private Regulatory Organizations (PRO) with whom each auditor would be required to register before it could be certified by the Securities and Exchange Commission (SEC) to perform an annual public audit. While a public-private regulatory body may seem like a good idea given the problems with Enron’s books, auditors already participate in the Fair Accounting Standards Board (FASB), which determines Generally Accepted Accounting Principles (GAAP) and regulates the industry.

New rules formulated by new rule-makers will do little to deter unscrupulous businessmen from acting unconscionably, but even if everyone were to adhere to the letter of the law, it is unclear what that would mean. After all, before its implosion, Andersen was already in position to pay out billions in class-action suits for fraud and accounting gimmickry. These class claimants are also positioned to claim payments from Enron, pending liquidation and settlement or trial. So to say that there are not legal mechanisms in place to address these problems is simply not true. Had there been PROs in place last October, the resolution of the entire scandal would probably closely resemble what actually happened.

But worse than new regulations to offer false promises of transparency, the Senate is considering regulations to dictate how corporations organize their businesses and compensation packages. Senators Carl Levin (D-Mich.) and John McCain (R-Ariz.) have proposed a bill to require that corporations treat stock options as a business expense.

Ironically, the senators argue that stock options are a greater proportion of executive compensation because they are not counted as an expense on the balance sheet, but the overriding reason for the shift towards options for executive compensation was the limits on the deductibility of corporate salaries in the 1990s. Now legislators want corporations to somehow account for stock options – which are exercised at different times by different executives under different conditions that are often wholly unpredictable – in the same way that they account for bi-weekly paychecks.

Serious investors recognize the way stock options dilute company stock by making shares available to executives at pre-specified prices, but accounting for their actual effect on earnings-per-share is imprecise. Whatever standard is forced on unwilling businesses will benefit some at the expense of others and harm smaller businesses whose executives’ options, when exercised, may make up a significant proportion of outstanding shares.

But worse than new regulations on executive compensation is new legislation, sponsored by Richard Gephardt (D-MO), to limit the ways businesses can incorporate to avoid tax liability. Some corporations, including Enron, incorporated themselves, or subsidiary partnerships, in the Cayman Islands, or Bermuda to avoid the federal corporate income tax. Some argue that this unfairly robs the treasury of dollars it otherwise would collect for domestic operations, but considering the difficulty in determining who pays corporate income taxes, this may not be such a bad thing. For instance, since Navistar International Corp., an Illinois truckmaker, incorporated in Bermuda, it has invested $3.1 billion in new facilities in the state. The money not diverted towards the treasury was used to develop new lines of trucks and truck engines and contributed to economic development in the state.

A fundamental precept of our system of taxation – as outlined in SFA Folio Collections v. Bannon 217 Conn. 220 (1991) – is that taxpayers may organize their affairs so as to limit their tax liabilities. That is why accountants, tax attorneys, and tax- free trusts exist. Efforts to prevent taxpayers from escaping punitive taxes through exit are simply transferring money that would have gone toward productive use, as with Navistar, Inc., towards the class of tax specialists that exist to limit liability. Aside from this constituency, it is difficult to see who would benefit from new laws preventing corporations from exercising their right to incorporate – or relocate – where they see fit.

It may be difficult to see in an environment with such biases towards new taxes and regulations, but all of these problems could be solved through repeal of the corporate income tax. Corporate income – and corporations themselves for that matter – is nothing more than an abstraction. Rules govern what purchases count as expenses, which can be written off in their entirety, and which purchases count as investments, which must be accounted for over time on a government-mandated depreciation schedule. Research and development tax credits exist to help attenuate this disadvantage for companies that “invest” more than they “expense,” but no one can possibly know if the credit is the right size, or leads to efficient outcomes.

Moreover, much of the creativity to come out of the accounting profession involves ways corporations can look good to investors, but not get socked by the corporate profits levy in the process. In the Enron affair, accountants pretended that securities and forward contracts that appreciated in value had already been exercised and added it to the company’s balance sheet, but to avoid taxes on the income, Enron actually waited to exercise the transactions. These accounting sleights of hand came back to haunt Enron when the value of the contracts and partnerships collapsed after shareholders were already led to believe that they were converted to cash.

It may be difficult politically to repeal the corporate income tax, but it is difficult to understand how “corporations” could ever be forced to pay taxes in the first place. Corporations are nothing more than a legally recognized contractual association between capital owners, investors, property, and the customers. No one knows who pays taxes assessed on corporations, but it is certainly not the legal abstraction and most likely laborers and consumers. Worse, it is estimated that compliance costs exceed 15 percent of the actual tax revenue extracted from corporations.

The corporate income tax encourages accounting irregularities, overseas incorporation, and ungodly stock option compensation. It fails to tax that which it was intended to tax and diverts hundreds of billions of dollars annually away from their most productive use. If legislators were truly concerned about correcting for these problems, the answer is not new regulations and taxes to correct for the futility of previous taxes and regulations, but repeal of the corporate income tax itself.