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All posts by Dan Whalen,
Providence, RI (resume)

Thursday, October 13, 2011

Corporate Taxes

"As a share of GDP, the U.S. had the second lowest tax rate, behind only Iceland.  In 2009, U.S. corporate taxes had fallen to only 1.3 percent of GDP, from 4 percent in 1965."
"American companies often function at a competitive disadvantage in the global economy. They pay one of the highest corporate tax rates of any of the industrialized countries."

                Ummm…what?

                I absolutely grantee that corporate taxation will be a hot topic this election year.  Why?  Because it has all the makings of a great controversy.  It’s contentious, timely (what with the sour economy and all) and most importantly, kinda tricky to understand.

                First off, what are “corporate taxes”?  They’re a corporate entity’s equivalent of your income taxes.  They’re a portion of a corporation’s profits (their “income”) that is surrendered to the government every year in the form of a tax. 

                The justification for them are simple: the government has provided that company with certain benefits and services (infrastructure, legal systems, patents/copyright protection, contract enforcement, etc.) and since the corporation needed those things to be able to do business, it’s only fair that they contribute to their cost. 

(NOTE - Any corporation in the US will have to pay these taxes twice, once to the Federal government and again to the state in which they are based.  For the purpose of this post, when I say “corporate taxes,” assume I mean Federal.   State Corporate taxes systems vary a lot, so in the interest of keeping this post succinct I’ll leave them out for now.)

                Ok, so now that we know what they are, what do we think of them?  Do American corporations pay a particularly high, or a particularly low tax rate? 

    Guess what?  The most accurate response to that question is “kinda both.” (I know - I just can’t give a straight answer to anything, can I?  Legend has it that Harry Truman got so tired of hearing economic advisers say “on the one hand this, but on the other that” that he once told to his staff to go find him a one-handed economist.)

                Here’s the thing.  In the US, corporations actually have a variable tax rate.  I don’t know of any other industrialized nation that does that (although there might be one out there.  If you know of one, post it in the comments section below). 

                MOST other first world nations take somewhere to the tune of 20% to 25% of their corporation’s profits in taxes every year.  And the incidence of taxation will be universal and fixed: whether you’re a midrange fishing pole manufacture or a huge furniture sales depot, you’d pay 20% of your profits in taxes in Russia, 25% in Portugal, and so on.

                But in the US, those same two producers will be subject to a variable rate that caps out at 35%.  The result is that any given corporation, no matter who they are, may wind up paying anywhere between 0% and 35% of their annual profits in taxes.  Again, this is a pretty unique system.

                There’s one funky legal hitch to all this.  The way the IRS statues are worded, corporations technically “start off” with a rate of 35%.  But every time a company files their taxes, they have opportunities and options to dismantle that initially stated rate, step-by-step, through a series of different deductions, exemptions and credits, until a "personalized" final rate, uniquely determined for that particular entity is arrived upon.

   That’s why it is technically correct to say that US corporations face some of the highest taxes in the world, but it’s also correct to say that they pay a lower one, or at least one comparable to that of their foreign counterparts.  The start-off point is very high (35%), yet after all of the many adjustments and tax breaks, US corporations end up owing much less then that lead-off stated rate.     

                So how are the rates decided?  Is there some lottery?  Or an impartial judge?  Or maybe it’s all been sorted and worked out long before, in a place far away, what exactly your company’s taxes should be.

                The truth is: it’s all those things and more.  Through dense web of loopholes, deductions, credits, adjustments and a little bit of luck and cleverness, a tax rate is chipped and whittled down from that whopping 35% down to a more comfortable rate.

Here’s some examples of how it happens:

                Company size is the first filter.  Taking away 35% of a Mom and Pop pizza chain's profits would leave maybe a couple tens of thousands a year, hardly enough to pay Mom and Pop’s home mortgages and grocery bills.  So a company posting a profit of $50k or less pays at most 15%.  $50k to $75k start off facing 24%, etc.  The start-off rate builds gradually as your profits increase.  The 35% rate only truly applies to those making $335k and up. 

                Next up, let’s look at your finances.  Say you are a company with $1 million in cash lying around, and no plans for what to do with it in the upcoming year.  You might as well see if you can grow those savings.  You could let it sit in a bank for a year and earn a bit of interest.  Or you could make a year-long loan to another company and charge them interest.

                But if you lend it to a state, city or any municipal government for a year - for them to put a new roof on the school, or repave the hospital parking lot - and charge them a low interest rate, the Fed will usually chip another couple of percents off your tax rate (the more typical practice is to not charge taxes on the interest your company makes off of the loan to the town, but the end effect is similar to what I've described).

                Sure, there’s some risk in that.  There’s no way to guarantee that the loan be paid off in time, or even at all!  But if you’re really looking to reduce your tax rate, it might just be worth it.  Heck, if lending $1 million to a city could reduce your tax burden by say 5%, and 5% of your profits is more than $1 million, that city could just take your money and run, and you could still make something off of the deal.

                Next, let’s look at the goods and services that a firm actually makes.  Is it something that benefits society as a whole?  Like medicine?  Or housing?  Pharmaceutical companies that spend a significant amount of time and money developing treatments for certain diseases can get a tax reduction for doing so.  Contractors who build low income housing, or certain public works projects (like parks or highways) sometimes can get tax breaks as well.

                Some point out that in practice, this results in an unfair give-away to the companies that would have done these projects and worked on these drugs in the first place.  The projects had the potential to be profitable even before the tax breaks were on the table.  Even without them in place, some company would still be willing to do these projects, or so they argue.  And that’s a pretty good point.

   BUT others counter that, saying, sure, some people will get an unnecessary leg up.  But the tax break will also attract those on the margins - that is, firms who are currently on the fence about developing those products - into the business.   

A company unsure of whether or not it wants to get into producing these particular goods and services might be enticed enough by the promise of a tax break to convert an ED pill lab for Epi-Pen testing.  More producers means more products, more competition and lower prices!  Or so they argue.  And that’s a pretty good point.

It’s not an easy call to make.  I’d be skeptical of those who come down confidently on either side of the issue.

                Finally, what’s happening with your company overseas?  The US cannot collect taxes in places that are not the US (duh), so when an American company does business abroad, they will pay taxes in that country only, as long as those profits are kept there. 

                Say I do a lot of business in Iceland every year.  Iceland has a pretty low corporate tax rate compared to the rest of the world.  So why would I bring the cash back home and pay high taxes on it when I can keep it in Icelandic banks or invest it back in my Icelandic plants? 

                This really isn’t a tax break or loophole, but it is a reality of international commerce that makes some very successful companies able to avoid the taxes you’d expect them to be paying.

                Here’s another overseas financing issue.  In an effort to encourage companies to keep most of the action state side, we’ve built up sizable pile of impediments to doing business overseas (the initial assertion that there is some sort of economic benefit in penning commerce into your borders in the first place is pretty weak.   I mean, the world’s most economically successful tiny nations, like Hong Kong, Singapore, or the UK, are also ones with very "open to the world" economic cultures.  But that’s a different story).

                ANYWAYS, one of the ways the Fed often goes about trying to keep businesses as domestic as possible this is by charging companies tariffs or taxes to return some financial assets back to the US that were acquired abroad.  A "bringing the money home fee," if you will.  The thing is, the fees are usually different if the item is coming from say, the Cayman Islands, than if it’s coming from Ireland. 

                So what if that asset can be cheaply transferred from the country that would trigger a higher "bring it home" fee (like Ireland), to one with a low one (like the Caymans), AND THEN into the US?  Then the asset can make its way back to America through the back door and dodge the entrance fee.   

                I could go on for forever with these.  There are hundreds of them, maybe thousands.  Suffice it to say, very few corporations pay the full 35%.  The majority of firms in the US end up paying somewhere in the middle of that range.  Somewhere to the tune of 21%-25% or so is probably most typical (this rate, the one ultimately paid after all the adjustments, is called the "effective rate").   

              HOWEVER it’s not uncommon for some major, house-hold name corporations not to pay taxes at all (there is a tax loophole out there for everyone!) 

                General Electric is a notorious tax avoider.  As a company that produces pretty much everything, the amount of tax credits and exemptions available to GE abound.  As a result, this company, which posts $5 billion in profits from US operations alone, has managed to pay an average of a 14% tax rate over the past decade.  In fact, it actually received a tax refund of $3 billion in 2010!  (I bet they spent hundreds of millions to get the accounting and legal team together to pull that one off...)

                GE got a lot of bad press for this, but is it really fair to blame them?  Their tax payments are the result of perfectly legal benefits packages that we have been building into our economic sphere over the past decades.  It’s not the result of some shady book-cooking.  They just accepted the gifts that were given to them.  I mean, do we expect GE to want to pay higher taxes anymore than we do?  When the Fed issues you your rebate check, do you tear it up?

                At the same time, it's certainly worth debating whether or not it’s fair for any Fortune 500 company to have zero tax burden.  But if you really want to see a change in tax systems in the US, you won’t get anywhere barking at taxpayers (like GE).  It’s the policy- and law- makers who are ultimately responsible for levying taxes and seeing to it that they are paid.

Jeff Immelt, the CEO of GE has said over and over that he’d rather operate his company in a reality where his taxes were higher but fixed from year to year, than one where they are as variable as we currently have.  Now, why would he want that?

                He’d want it for the same reason that I want insurance on my car.  A high fixed rate like Immelt is talking about would function as a type of insurance, a premium paid in the present to get rid of the uncertainty associated with costs of doing business in the future (namely, tax costs).  And there is a great deal of uncertainty involved.  In 2001, they paid 28%.  In 2008 they paid 5%.  By 2011 they were paying 7%.  Who knows what it will be in 2012?

It becomes tricky for GE to make plans for the next 12 years when they don’t know what their tax bills will be like in 12 months.  All these deductions and exemption are part of individual, unconnected systems and statues.  Any one of them can be revoked, repealed, restructured, or flat out denied to GE at any point without warning.

          In a weird way, it is kind of a lottery, at least in the long run.  What will be their tax bill in 2015, 2020, 2040?  You might as well just spin the wheel of fortune to know. 

For some case studies and real world stories of the making of a corporate tax bill, check out these stories:
The Paradox of Corporate Taxes

1 comment:

  1. I guess the thing that bugs me is people's tendency to lump all these dodges, exemptions and deductions as one single monolithic issue with one single monolithic result. Either "corporations get hand outs and that's unfair" or "corporations are unfairly overtaxed and NEED these breaks." In reality, these attitudes deny how complex the issue of "tax policy" really is.

    For example, in the above linked article "10 Big Corporate Tax Breaks, and Who Benefits," the author states:

    "Credit for Low-Income Housing Investments -
    As you might expect, this one gives tax breaks to companies that develop low-income housing. It’s the rule that’s responsible for so many larger new developments setting aside 20 percent or 40 percent of their units for people whose income is well below the area’s median gross income.

    Who benefits: Real estate developers."

    Really? JUST real estate developers? What about poorer families? Don't they benefit from having housing? What about local governments who would otherwise have to try to find ways of helping low income citizens find a place to live? To say incentives for developers to build homes for the poor only benefits the developers is obviously incorrect. Tax breaks like these really can create a lot of social benefits too. Its not as black and white as people seem to need it to be.

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