The Tax Man Goeth

OK, they’ve inflated profits, padded their paychecks, and stiffed the Treasury by labeling a mail drop in an offshore tax haven as a company’s home. So now we’re supposed to give corporations a pass on paying income tax? When even the upright among corporate chieftains are under suspicion, that’s a request for “more” that even Oliver Twist might think twice about.

But it’s not that far fetched. There’s a lot of quiet Republican support for the idea, and though the issue is on the back burner for now, both Treasury Secretary Paul O’Neill and Council of Economic Advisers Chairman R. Glenn Hubbard are opponents of the corporate income tax. The political barriers to handing out a new break to business on top of this year’s stimulus package and shrinking government revenue are admittedly high, especially when executives are being led off in handcuffs. Democrats are lambasting President Bush for being too cozy with business; Rep. Charles Rangel of New York says demonizing the corporate tax encourages companies to try to avoid it. But a drumbeat of proselytizing by economists and academics is nevertheless pushing the idea that the corporate levy just isn’t working. “The rules are arcane, archaic, and nonsensical,” says Ernest Christian, a Washington attorney and Ford administration tax official.

Such talk makes Robert McIntyre, director of the liberal Citizens for Tax Justice, see red–and red ink for the government. “If you’re going to tax income at all, you have to include corporate income,” he says. “Otherwise, large amounts of income would escape any tax.”

But that is already happening. The corporate levy–which raised $ 151 billion last year, down from $ 207 billion in 2000 when profits were easier to come by–may be an endangered species in its current form. Last year’s take was the lowest since 1994 and accounted for only 7.6 percent of federal revenue, down from 26.5 percent in 1950. Individuals, meanwhile, are picking up a bigger share of the income tax burden. In 1950, corporations kicked in 39.9 percent of the total collected, while individuals ponied up 60.1 percent. Last year, corporations paid 13.2 percent, while individuals forked over the remaining 86.8 percent.

Tax trimming. The official corporate tax rate tops out at 35 percent. But many firms legally skirt a large share of their liability–and sometimes all of it–through tax breaks and accounting maneuvers. A Citizens for Tax Justice analysis of 250 large corporations found that in the late 1990s the average tax paid was less than 22 percent of pretax U.S. profit. The watchdog group’s recent sampling of 10 large firms found that for 1999 and 2000, the take was below 6 percent. The analysis concluded that Microsoft in 2000 had pretax U.S. profit of $ 9.6 billion but paid out only 12.2 percent of that in tax, while General Motors, with 2000 pretax profits of $ 2.95 billion, used various deductions and credits to pay no tax. A General Motors spokesman disputes CTJ’s methodology and says the firm did pay an undisclosed amount of tax. “It’s easy to oversimplify our situation,” he says.

As with many business issues, accounting practices can muddy the water. Corporations typically count deferred taxes as part of their debt to the Internal Revenue Service when publicizing the tax they pay. Those future liabilities are often the result of rules that allow depreciating assets to be deducted much more quickly than the assets are being used up. But the deferred tax may not be paid if a firm keeps building deductions through new capital spending. Groups such as CTJ don’t count deferred obligations when tallying current taxes paid.

One result of aggressive tax avoidance is an increasing gap between the profit that firms report to shareholders (which often affects their stock price) and the amount they tell the IRS. Shareholder profits, for example, are not always reduced to reflect the full amount of deductions and bookkeeping tricks that companies can use to reduce their profits before figuring their tax. So while a lot of attention is focused on reports to shareholders that may give too rosy a view of a company’s finances, the IRS may be getting too bleak a view. Bonus depreciation write-offs in this year’s economic stimulus act will add to the gap, notes economist David Wyss of Standard & Poor’s. Overall, income at large firms could be roughly 50 percent higher than the amount reported to the IRS, estimates Harvard Business School Prof. Mihir Desai. That would be up from about 20 percent about five years ago. “Firms have apparently been finding more-sophisticated opportunities to avoid or evade corporate taxes,” Desai says.

Bermuda-bound. But as the current flap over corporate moves to offshore tax havens like Bermuda shows, it’s not always smooth sailing. In this sleight-of-hand tactic, a U.S. corporation sets up a firm in a foreign tax haven. It then turns the U.S. operation into a subsidiary of the foreign company. The payoff is a reduction in U.S. income tax. Connecticut-based tool and hardware maker Stanley Works estimated it could save $ 30 million a year by reincorporating in tax-free Bermuda, a plan it canceled after mounting public and congressional criticism. Such offshore headquarters “make a sucker out of working Americans and companies that stay in the United States and pay their fair share of taxes,” says Republican Sen. Charles Grassley of Iowa. “The headquarters may be little more than a filing cabinet and a mailbox.”

Corporate perfidy, meanwhile, may be souring the atmosphere for legitimate reform. The saintly rationale for moving offshore is to escape or reduce U.S. tax on foreign sales and to compete better against overseas companies that may get better tax breaks on their exports and foreign income. But the sucker punch is that a firm may also arrange spurious tax-deductible loans through the foreign affiliate and thus cut tax on its U.S. operations. University of Michigan law Prof. Reuven Avi-Yonah suggests calling the boardroom bluff. “From where is the corporation managed and controlled?” he asks, noting it would be rare for executives to actually relocate to a tax haven.

Crackdowns by Congress on a range of corporate tax behavior may be coming. Proposed rules would require firms to more fully disclose the inner workings of their tax returns, and the IRS, once berated as too tough, is winning lawmaker support for an assault on flaky tax shelters. A ban on federal contracts to firms moving abroad is pending, and Congress is debating tougher restraints. The IRS, meanwhile, has begun an attack on both corporate and investor tax shelters using existing powers. New York tax attorney Marc Teitelbaum warns that strategies such as paper relocations offshore could be ruled invalid if they lack a business purpose other than to avoid tax.

Part of the problem with the corporate tax is that benefits for specific industries and companies have created a labyrinth “beyond the mind of man to comprehend,” says Christian. Edward McCaffery, chair of the University of Southern California Institute on Federal Taxation, says the code’s complexity and pliability penalize smaller firms. “Accountants have been making a killing by peddling complex tax shelter schemes to minimize or avoid the corporate tax. Big firms can afford that; mid- and small-size firms often can’t,” he says.

Divvying up. One proposed reform that might sit well with a public disgusted by recent corporate behavior is eliminating the double taxation of dividends. Now, they are taxed as corporate profit and then again as income received by shareholders. That can diminish the appeal of dividends and give cover to corporate managers who prefer to hoard or invest a firm’s profits. Some plans would remove one level of tax, but others would go all the way by killing both the corporate and personal levy on dividends. That kind of approach, some argue, could revive dividends and bolster stock prices.

Political reality is causing some proponents of change to push for major refurbishing of the corporate tax in lieu of repeal. Jason Thomas, staff economist at Citizens for a Sound Economy, suggests promoting simplicity and investment by revising depreciation rules that require the cost of new equipment to be deducted over time. He would let firms deduct the entire cost when the item is bought. Congress, meanwhile, is considering proposals to reduce the taxation of foreign profits of U.S. firms and to reshape incentives for exports.

But no matter what the level of enforcement or collection, critics say the corporate tax hits more than just the rich and powerful. “It is a cost that is passed on to consumers in higher prices, to investors in reduced dividends or capital gains, and to workers in lessened wages,” says economist Thomas.

To all of which Lee Sheppard, an attorney and contributing editor of Tax Notes, has a ready answer. The corporate tax, she says, is not a cost that is passed on but comes straight out of profits. “Corporations just don’t want to pay taxes; there’s a lot of whining.” What the antitaxers are waiting for is a calmer and financially robust climate in which they can get more respect.

Paying Uncle Sam

Over the past half century, individuals have been paying an increasing share of the income tax burden, as companies have found more and more ways to lower their tax bills by maximizing deductions, deferring taxes, and using offshore tax havens, and milking other shelters.