Replacing the corporate income tax with a cash-flow tax.

• Author: Edwards, Chris

Americans have been inundated with financial scandals at large corporations during the past two years. In many cases, unethical behavior and poor oversight of corporate management are to blame. But the corporate income tax has also been a key source of corporate inefficiency and scandal. The tax code distorts financial and investment decisions, and spurs executives to hunt for tax shelters.

These tax problems are highlighted in the 2,700-page report on Enron Corporation by the congressional Joint Committee on Taxation (JCT 2003a). Enron is just one company, but it took a team of JCT investigators a year to figure out how all its tax shelters worked. The JCT's efforts were a mirror image of the efforts of Enron, the accounting firms, and investment banks that put Enron's tax shelters into place originally. The JCT (2003a:16) concluded that Enron "excelled at making complexity an ally." While an ally to Enron, tax complexity is an enemy to productive corporate management and efficient investment decisionmaking.

Enron-style tax sheltering has not been the only type of corporate tax scandal in the news. Attention has also focused on the growing number of U.S. companies reincorporating in low-tax jurisdictions, such as Bermuda. U.S. firms can save taxes on their foreign operations by creating a foreign parent company for their worldwide operations. At the same time, there are growing concerns about the uncompetitiveness of the U.S. corporate tax because of the high statutory rate of 35 percent and the complex rules on foreign investment (Edwards and de Rugy 2002).

The corporate income tax is also feeling pressure from financial innovation on Wall Street. A recently decided case in the U.S. Tax Court, which involved Bank One's use of derivatives, was an 8-year battle with a trial that produced a 3,500-page transcript and 10,000 exhibits (Simpson 2003: C1). The corporate tax system is having trouble keeping up with today's complex and globalized economy.

The corporate income tax has three fundamental flaws. The first flaw is that the U.S. statutory tax rate is the second highest among the 30 major industrial countries (KPMG 2003). That high rate reduces investment, encourages firms to move profits abroad, and provides incentives to push the legal margins with complex tax shelters.

The second flaw is that the corporate tax base of net income or profits is inherently complex because it relies on concepts, such as capital gains and capitalization of long-lived assets, that are difficult to consistently account for in a tax system. Costs of capitalized assets are deducted through depreciation, amortization, and other rules. The income tax rules for capitalized assets and capital gains are repeatedly exploited in tax shelters, and they distort capital investment, business reorganizations, and other decisions.

The third fundamental flaw is the gratuitous inconsistency that Congress has injected into the tax code. One example is the different treatment given to corporate debt and equity. Another example is the different tax rules imposed on corporations and the half dozen other types of businesses. Such inconsistencies have played a key role in the tax shelters exploited by Enron and other firms. Worse, they distort capital markets and channel investment into less productive uses.

This article discusses the most serious corporate tax distortions and examines fundamental reforms to fix them. One option examined is full repeal of the corporate tax. Alternately, the replacement of the corporate income tax with a cash-flow tax is discussed. A cash-flow tax would eliminate most of the serious distortions in the corporate tax system by eliminating capital gains taxation, replacing capitalization with expensing, and creating financial neutrality between debt and equity. By cutting individual dividend and capital gains tax rates and providing partial expensing treatment for business investment, the 2003 tax law was a good first step toward corporate tax reform (see JCT 2003b).

Tax Shelters: Finding Fundamental Economic Solutions

Corporate tax avoidance has been on the upswing by most accounts, though there are no firm estimates of the magnitude of these activities. The upswing has been spurred by sophisticated tax planning made possible by advanced computers and software, Wall Street financial innovation, global competitive pressures, and the high U.S. corporate tax rate. The increase in tax avoidance has been costly in time and money for both companies and the government. Accounting and Wall Street firms have developed high levels of expertise at combining disparate parts of the tax code to engineer tax savings. But that expertise costs money: tax shelter promoters have been paid as much as $25 million for a single deal (U.S. Treasury 1999: vi, 23). Enron paid $88 million for advice on 12 tax shelter deals between 1995 and 2001 (JCT 2003a:107). For the government, it can cost $2 million just to litigate a single tax shelter case (U. S. Treasury 1999: v).

The Internal Revenue Service, U. S. Treasury, and courts are kept busy as each new tax shelter is discovered and then squelched through statutes, regulations, enforcement, and litigation. In 1999, a major Treasury Department study on tax shelters noted that at least 30 new narrow provisions had been added to the tax code in the prior few years in response to particular abuses (U. S. Treasury 1999: iv). These new rules in turn force taxpayers and their advisers to abide by growing lists of anti-abuse statutes, penalties, reporting requirements, and disclosure rides.

One might think that these wasteful efforts could be reduced if corporations simply stopped acting improperly. But there is usually no clear-cut right or wrong in the income tax avoidance cat-and-mouse game. Most corporate tax disputes involve different interpretations of the rules, not straightforward cheating. Many issues are so gray that tax disputes between companies and the IRS can remain unsettled for 10 years or more.

Given this level of legal uncertainty, companies have strong incentives to push the tax code's limits. After all, no taxpayer has an obligation to pay more than what is owed, and the government cannot tell them for sure what an illegal tax shelter is. One expert noted that "virtually all tax shelters comply with the literal language of a relevant (and perhaps the most relevant) statute, administrative ruling, or case" (Bankman 1999: 1775). With regard to Enron tax shelter activities, then JCT chief of staff, Lindy Paull, testified, "I don't know if you could call it illegal" (Behr 2003: El).

There is debate regarding the best way to crack down on tax shelters from a legal point of view. Some experts support more detailed rules, while others support stronger general standards. Ultimately, a large and sustained reduction in tax sheltering can be achieved by changing fundamental economic incentives, not by adding endless layers of new rules. The U.S. Treasury (1999: 6, 9) noted that tax "shelters typically rely on some type of discontinuity in the tax law that treats certain types or amounts of economic activity more favorably than comparable types or amounts of activity." For example, the tax code favors debt over equity financing by allowing corporations a deduction for interest payments but not for dividend payments. That discontinuity has spurred companies to design complex financial structures that have many features of equity but are treated as debt for tax purposes.

Another problem are the narrow benefits carved into the tax code by Congress. A classic example was recently reported by the New York Times (Johnston 2003: C1). Decades ago, Congress carved out a tax exemption for small insurance companies--those with less than $350,000 in premiums--to help farmers and others get coverage. The Times reports that a host of millionaires and noninsurance companies have seized the opportunity to set up insurance company shells that do little actual insurance business. Instead, these tax avoiders transfer billions of dollars of assets to these shells to generate tax-free earnings--all legally.

If the tax code were instead built on a neutral and transparent base, it would make administration and compliance easier for taxpayers and the government. It would also reduce tax inequalities between companies, which is one cause of corporate tax sheltering. As the Treasury Department noted, effective tax rates are "viewed as a performance measure, separate from after-tax profits. That has put pressure on corporate financial officers to generate tax savings through shelters'" (U. S. Treasury 1999: 28). That problem would be reduced if effective tax rates were similar across companies and industries.

High Rate Exacerbates All Corporate Tax Problems

Corporate income tax rates are tumbling across nations in the Organization for Economic Cooperation and Development. The average top rate in the OECD fell from 37.6 percent in 1996 to just 30.8 percent by 2003 (KPMG 2003). That compares with a 40 percent rate in the United States, including the 35 percent federal rate and an average 5 percent state rate. The United States now has the second highest statutory corporate tax rate in the OECD next to Japan.

Countries are realizing that high corporate tax rates discourage inflows of foreign investment and encourage domestic companies to invest abroad. As world direct investment flows soared from about $200 billion to $1.3 trillion annually during the 1990s, countries have sought to attract their share of investments in automobile factories, computer chip plants, and other facilities (Edwards and de Rugy 2002). Extensive empirical research has concluded that tax rates are important in channeling these cross-border investments (Hines 2001). As just one current example, the world's third largest memory chip maker, Infineon Technologies, recently announced that it may move its headquarters out of Germany partly...