The first two parts of this series of posts looked at quick hits and then larger principles that I believe Joe Biden should focus on in rescuing the mess that is the U.S. Tax Code. We need to restore both tax fairness and revenue effectiveness, both of which are in rough shape today.
Business and corporation taxes, the subject of this third and final part, are the tougher row to hoe here because they are really screwed up. They have become the victim of both anti-regulation ideologues, convinced that corporations should pay zero taxes, as well as the classic grifters looking for a simple government handout, what economists call rent-seeking (an old term that has little to do with the common perception of “rent”). In the latter case, companies do not really have any ideology other than seeing how much political power and tax favors they can purchase in order to get cash from the government via any screwy twisting of the tax code.
And screwed up it is. After the last comprehensive tax legislation, passed in late 2017, corporate tax collections dropped like a stone. In the first year of this new framework, corporations paid on average 11.3% of their income, most likely far less than your personal marginal income tax rate. In 2018, 91 companies out of the Fortune 500 paid zero dollars in federal income taxes.
I dealt with this issue of how to tax a business a couple of years back, and some of those thoughts, with a more Biden-directed take, are replicated here. We start by recognizing that corporations now appear to pay taxes in inverse correlation to their political power. In other words, the more politically powerful you are, the less you pay in taxes as a percentage of income.
Ghosts of special interests past
Continuing a theme from my prior two posts, the thousands of tax deductions, credits, and special computations reducing business taxes from statutory rates are almost all “special interest.” They were largely written by lobbyists for rich clients and inserted into tax laws in closed sessions by politicians on the take. And once in the tax code, they take up permanent residence, haunting the economy even when priorities have changed.
The numerous oil and gas industry tax favors are the best case in point. There favors have wreaked environmental havoc as gas and oil have been extracted from otherwise unattractive lands, through fracking and other destructive technologies. All this as the country desperately needs to move away from carbon-based energy. The tax ghosts drive the business model.
Corn-based ethanol tax favors were initially seen as a way to get non-oil energy technologies past a technological hump. They were supposed to lead to the feasible extraction of energy from farm waste and natural prairie plants such as switchgrass. Instead, the farm economies of states like Iowa are now dependent on a multi-billion-dollar government subsidy, planting corn on every available acre to be turned into ethanol. This is the rare issue on which both environmentalists and conservative tax experts agree. But Iowa has been a swing state in the Electoral College, and so change will likely not happen.
My Tax Realignment and Closure Commission idea discussed in prior posts can apply here as well. Pick a number, say one in 10,000 business tax returns. If they benefit from a particular rule, then it is by definition a special interest, and the rule should be marked for sunset. These rules almost always favor the well-connected businesses while smaller “mom and pop” businesses foot a much larger bill in relation to their income and assets. It is time to bury these tax ghosts.
Restore the relationship between taxable income and GAAP income.
Business income can be a tough thing to figure out. Recall that I used a classic textbook definition of income in Part Two: “Income is an increase in wealth that has been realized.” The major difference between business income and personal income, I would assert, is not its measurability, but rather the irrelevance of realization, or the turning into cash equivalents at some point. Much of the massive wealth of Amazon, for instance, has nothing to do with anything realizable. Realized profits were minimal or negative for years while the company exploded in size and market wealth. But that “unrealized” increase in wealth is measurable to a large extent. “The market” does it every day for the biggest companies and trades largely on unrealized wealth.
Measuring this increase in wealth is what every audited financial statement attempts to do when it adheres to GAAP, the accounting profession’s Generally Accepted Accounting Principles. The promulgation of these principles rests with the Financial Accounting Standards Board. FASB is an independent organization with representatives from multiple sectors of business and government, and its standards for defining income and asset valuation are accepted by the Securities and Exchange Commission as independently audited, verifiable and fair.
FASB has required more and more assets over the years to be valued on the financial statements using mark-to-market accounting, even when the increase in wealth is unrealized. Mark-to-market accounting moves the “GAAP income” number much closer to the ideal “increase in wealth” income.
Unfortunately, “taxable income” for large corporations usually bears little resemblance to GAAP income. The hundreds of aforementioned special interest “ghosts” reduce the taxable income of major corporations to near-zero, while the $10 million family-held corporation gets much less tax relief.
The more of these “ghost loopholes” you close, the closer taxable income and GAAP income converge, and the more equity would be restored to the corporate tax system.
Tax corporations more like people
While visiting Iowa in 2011 during the run-up to his presidential bid, Mitt Romney famously said, “Corporations are people, my friend.” You may be surprised to hear that I believe he was correct, and also wrong, in more ways than he knows. Court decisions have made business entities increasingly legally separate “persons” from their owners, oddly except for taxation purposes. We need to re-think that separation.
In taxation we often mix the two concepts. Investors and business owners want many of the benefits of the corporate “separate person” shield, especially when bankruptcy looms, which I call “taxpayer-funded failure insurance.” At the same time, business owners want their profits free from “double taxation,” saying here that “I am the business.” And so we have evolved this system of “privatizing gains” and giving them tax preferences, while “socializing losses,” allowing even the worst-run companies to stiff employees, lenders, vendors, and the government under the guise of “separate personhood.” Take your pick. Is your business a “person” separate from you the owner, or is it not?
In many cases, the answer is “obviously not.” While a family business of independent plumbers may have some legal protection for the business via a limited liability company (which is not a corporation), in reality they are really just “selling their labor” in a manner similar to an Uber driver. And as I argued in the prior post of this series, even “regular employees” of businesses are not that different from this perspective if we evaluate the “labor transaction” correctly.
However, when the business is organized as a classic corporation (note that “S corporations” are more like the prior paragraph), owners increasingly become “investors” more than “employees.” Indeed, you could even quantify that “degree of separation” for tax purposes if necessary.
There is also a simple income progressivity measure here. When net business incomes are in the range of “normal” personal incomes, then they more likely are not really “separate persons.” A good progressive rate structure on business taxes can reduce the sting of the tax bill for those at the bottom of the business income scale.
Stockholders have long complained that they are “paying taxes twice,” once through business taxes and once through personal taxes on dividends. I have long argued that this is a bogus argument. All cash streams are taxed multiple times as they flow through the economy, because this flow of cash is how wealth is literally created. The question here is whether you want the business to be a “separate legal person” from yourself. If the answer is “Yes,” then you are not being “double taxed.” My personal stock investment in, say, Proctor and Gamble, should have nothing to do with how much tax that the business pays. We are separate legal entities, each generating our own “wealth stream,” and I should pay my personal taxes on any dividends I receive from them.
International taxes and intellectual property
Increasingly corporations have become “stateless,” thriving under the laws of no country. A former employer of mine installed a small group of lawyers and I.T. staff in an office building in Zug, Switzerland, with the task of “moving” the ownership copyrights and other intellectual property assets from their “home companies” to corporate shells created countries with favorable tax treatment on intellectual property (IP). These assets reside solely in the internet ether, often untouchable by any nation trying to tax their wealth.
Using national boundaries to evade taxes has become the most difficult business taxation problem to solve. But again, this is mostly a problem with “purchased power.” Big corporations have the resources and political capital to use international boundaries to hide from taxes, while the smaller domestic companies basically foot the bill.
There are any number of published deep dives into this problem, each with suggestions on how to measure wealth and capture taxes from the new world of international digital transactions. What most of them have in common is the realization that the United States has virtually zero power here to “go it alone.” As I have argued about international trade in general, this is a problem that cannot be solved even by bilateral, one-on-one agreements. The problem cries for a multilateral solution and international cooperation, at a time when the President trashes all attempts at multilateralism in foreign and economic policy.
The short answer here is that abuses of international taxation by the big players like Amazon and Apple could be brought under control with political will and by a President who engages with other free-market national leaders on this issue. Every first-world nation struggles with this problem. A Joe Biden presidency could, and likely will, prioritize this. We desperately need to vote this President and Mitch McConnell’s toxic Senate out of office.