Dirty Little Secrets

The overall corporate income tax was featured during the President’s SOTU address and by Republican circles.  I have mentioned that this particular rate isn’t even relevant anymore in posts and down thread comments because corporations here really don’t pay any where near the effective rate.

There are several reasons for this.  First, many of them now set up real or pseudo headquarters in tax and off shore banking havens like the Bahamas or Qatar and place a lot of their operations out of the reach of the IRS.  The second is the efficiency of lobbying efforts in getting them so many loopholes that most corporate revenues become exempt.  Despite this, corporations use public services and create social costs.  Social costs are those costs that the society gets to foot when corporations create problems they or their consumers can pass to the public.  A big example is smoking that creates incredible public health issues or pollution.  BP is definitely not taking care of the tab for its destruction down here and will most likely escape prosecution for costs the spill will continue to wreck on the environment, livings, and health of people and wildlife in the area.  Meanwhile, as an oil business, they are the beneficiary of many, many tax loopholes and direct subsidies.

I was glad to see some hard data–albeit anecdotal–on this phenomenon today in David Leonhardt’s op ed column in the NYT called ‘The Paradox of Corporate Taxes‘.  The narrative begins with the example of Carnival Cruises that has a special, extreme loophole that leaves the majority of its revenues untaxed while  it uses a number of public resources like services of the Coast Guard.  Corporations are cost minimizing and profit maximizing things.  They will employ an army of lobbyists and lawyers to help them. They even produce commercials that tout their environmental friendliness and their patriotism.  I always shake my head at the commercials of companies like GE and Boeing for whom competitive markets are imaginary and no bid government grants are major sources of revenues.  Yet, they act like they are burdened by taxes.

This is so untrue.

Carnival’s biggest government benefit of all may be the price it pays for many of those services. Over the last five years, the company has paid total corporate taxes — federal, state, local and foreign — equal to only 1.1 percent of its cumulative $11.3 billion in profits. Thanks to an obscure loophole in the tax code, Carnival can legally avoid most taxes.

It is an extreme case, but it’s hardly the only company that pays far less than the much-quoted federal corporate tax rate of 35 percent. Of the 500 big companies in the well-known Standard & Poor’s stock index, 115 paid a total corporate tax rate — both federal and otherwise — of less than 20 percent over the last five years, according to an analysis of company reports done for The New York Times by Capital IQ, a research firm. Thirty-nine of those companies paid a rate less than 10 percent.

President Obama indicated that he was willing to simplify the Corporate Tax Code and lower the overall Tax Rate for corporations.  In exchange, he asked Congress to remove all the pork, breaks, and exclusions they’ve granted many businesses–including ones that really don’t need it like the Oil Industry–over the years.  I doubt we’ll see any moves on the latter.  My fear is that will only see movement on the former thus cementing the de-funding of government by the by the very people who benefit from government largess. Many study shows that far more rich and upper middle class Americans and American Businesses use public services and public assets than the poor and working class.  After all, who uses the roads, the airways, the universities, the grants and loans, and the many tax loopholes?

While the official corporate tax rate is among the highest of developing countries, the effective rate is among the lowest of the countries that actually have economies that don’t function as tax havens or off shoring banking centers.  Even Republican economists will pony up that data.

“A dirty little secret,” Richard Clarida, a Columbia University economist and former official in the Treasury Department under President George W. Bush, has said, “is that the corporate income tax used to raise a fair amount of revenue.”

Over the last five years, on the other hand, Boeing paid a total tax rate of just 4.5 percent, according to Capital IQ. Southwest Airlines paid 6.3 percent. And the list goes on: Yahoo paid 7 percent; Prudential Financial, 7.6 percent; General Electric, 14.3 percent.

Economists have long pleaded for an overhaul of the corporate tax code, and both President Obama and Republicans now say they favor one, too. But it won’t be easy.

Indeed, it won’t be easy.  First, it’s difficult for even neutral academics to get a good look at the workings of loopholes because because tax filings are confidential.  Loopholes are everywhere and folks that support simplifying the tax code can’t even get a handle on how widespread or huge the problem.  Publicly held corporations provide for public stockholder reports but even these things are of limited use over time when studying corporate tax avoidance.  My field specializations for my doctorate is International Finance and Trade and Corporate Finance so I lot of my class work and research work is based in corporate finance as well as economics.  I know the literature, models, and theories well.

Here’s a link to Desai (2007) that links corporate tax avoidance to shareholder interest. Desai argues that there’s more involved with corporate tax avoidance than just simply transferring state resources to shareholders although that’s clearly a motivating factor.  Nearly all papers on corporate taxes recognize the high degree of corporate tax avoidance while papers like the Desai study possible underlying motives.  Here’s a kicker from the paper.

Corporate tax avoidance activity, however, may be costly on several margins. Aside from the direct costs of engaging in such activities, managers typically have to ensure that these actions are obscured from tax authorities. In the process, such machinations may afford managers increased latitude to pursue self-serving objectives.

This basically says that shareholders will reward managers for avoiding taxes and because the activity frequently happens in less than market-transparent way, it provides self-dealing opportunities for executives.  Self dealing is one of those issues that comes from moral hazard when any contract or business occurs in an environment of information asymmetry or hidden information.  This paper feeds into the results you see in the Leonhardt op ed.

There still exists the problems of corporate tax havens even in countries with more strict tax codes with less chance loopholes  like the UK.  You can follow that link to the UK Guardian and listen to a podcast from a panel of experts discussing the avoidance problem in the UK.  There is no  equivalent public movement and outrage in the US.  UK residents usually connect the costs and benefits of public service and are less likely to see taxes and select government services as enemies (e.g. tea party people holding signs like hands off my social security and medicare while decrying expansion of benefits or funding sources).

…the amount of tax legally avoided by UK business is estimated to be anywhere between £40bn and £120bn. In a country on the verge of deep cuts to public services, the money would go a long way.

The government is estimates that it misses out on up to £42bn of tax avoided by some of the biggest names on the British high street, others put the figure at more than £100bn. It’s not illegal, but it is highly technical and a game of cat and mouse between tax inspectors and corporate tax lawyers continues to be fought and loopholes closed off.

Now, a group called UK Uncut has taken to demonstrating in town centres where the high street shops of alleged tax avoiders are seen as targets for sit-ins and other protests.

Here’s another interesting academic study (Kim et al, 2010) on the role of corporate tax avoidance and firm-specific stock price crash risk.  This abstract is full of corporate finance jargon so let me quote it and then decode it for you.

Tax avoidance facilitates managerial rent extraction and bad news hoarding activities for extended periods by providing tools, masks, and justifications for these opportunistic behaviors. The hoarding and accumulation of bad news for extended periods lead to stock price crashes when the accumulated hidden bad news crosses a tipping point, and thus comes out all at once. Moreover, we show that the positive relation between tax avoidance and crash risk is attenuated when firms have strong external monitoring mechanisms such as high institutional ownership, high analyst coverage, and greater takeover threat from corporate control markets.

Management extraction is another term for management self-dealing on the part the bonus class of CEO who typically try to get as much personal wealth and income from their jobs as possible and can do so because they can hide a lot of what they are doing.  This basically says that they will and do hide information as much as possible and that will eventually accumulate and lead to a collapse in firm value–then stock price–when the market and the stock owners finally figure it all out.  This conclusion is made for one firm, but I suggest you extrapolate it to cover the behavior of nearly every CEO and you can only image how many corporations’ value is overstated and how risky that can be to any one with any kind of money in equity.  This, of course, also implies that when a huge firm that goes into bankruptcy or is be bailed out by the tax payer soaks up even more public funds and economic activity as it crashes and burns.  Again, this is as much a social cost as a BP Oil Spill or a failure to build safe levees and bridges under a government contract.

One of the most amazing things to me in the Leonhardt article is the discussion of one more way that GE games the government.  Put this in context of having  Jeffrey Immelt as the head of President Obama’s Council On Jobs And Competitiveness given that we’ve said that corporate tax avoidance is about as much about corporate CEO self-dealing as it is about other things.  This is one of those Fox meet Chicken Coop moments.

G.E. is so good at avoiding taxes that some people consider its tax department to be the best in the world, even better than any law firm’s. One common strategy is maximizing the amount of profit that is officially earned in countries with low tax rates.

Carnival pays so little tax partly because of a provision that lets some shipping companies legally incorporated overseas (Panama, in Carnival’s case) avoid taxes. The fact that Carnival’s executives sit in Miami and or that many passengers board in Baltimore, Los Angeles, Miami, New York and Seattle doesn’t matter. Nor does the fact that Carnival isn’t paying much tax in Panama.

Companies that pay relatively high rates tend to be those that are not expanding rapidly and that are not as ingenious as G.E., at least on taxes. The average total tax rate for the 500 companies over the last five years — again, including federal, state, local and foreign corporate taxes — was 32.8 percent. Among those paying more than the average were Exxon Mobil, FedEx, Goldman Sachs, JPMorgan Chase, Starbucks, Wal-Mart and Walt Disney.

One of the reasons that Financial Firms can’t avoid taxes is that they can’t hide their transactions easily since their ‘cost of goods sold’ is basically money. Also, these firms are highly regulated. Some type of external auditor is around the operations nearly every quarter.

Again, the corporate finance and accounting research literature spends a lot of time on models showing distortions in financial decision-making brought on by tax avoidance behaviors.   You have companies that actually make investment decisions based on the role of taxes.  This especially plays out when states and municipalities remove local taxes to entice physical plant investments to their backyards. Country level tax rates play into the mix also.  That’s when loopholes can attract specific businesses.  There’s a problem with these kinds of incentives if over done.

For example, we had a lot of companies that ‘recapitalized’ or replaced equipment during the Reagan years because of better tax treatment of depreciation costs.  Currently, we have some whopper tax incentives for capital gains and recapitalization when much of our current capital is under utilized which probably distorts the stock market, firm value, and appraisal of future firm earnings.  Here’s an example of that from the Leonhardt op-ed.

“Companies should be making investments based on their commercial potential,” as Aswath Damodaran, a finance professor at New York University, says, “not for tax reasons.”

Instead, airlines sometimes buy more planes than they really need. Energy companies drill more holes. Drug companies conduct research with only marginal prospects of success.

Inefficiencies like these slow economic growth, and they are the reason that both conservatives and liberals criticize the corporate tax code so harshly. Mitch McConnell, the Republican Senate leader, says it hurts job creation. Mr. Obama, in his State of the Union address, said that the system “makes no sense, and it has to change.”

The President is correct in his assessment. The deal is that we’ve been here before.  President Obama frequently gives speeches based in things that make sense while doing the complete opposite in practice.  This is what scares me about this current talk.  If we lower the corporate tax rate without removing the loopholes and distortions, we will be in a much worse shape than we are right now.  Unfortunately, that’s what I see to be the likely outcome of this discussion because very few people know anything about this subject other than political memes.

It’s important that you actually follow and understand this decision because we do live in a world of scare resources.  Every one loses when public resources are brought out of a larger market to become part of a market with self-dealing.  It’s basically another example where the top one percent exhorts money out of every one via lobbying of dim and ideological politicians like Mitch McConnell.  We usually don’t see the dead chickens until long after the fox has left the building.