Tuesday, June 19, 2007

The Best Argument for Abolishing the Corporate Income Tax

Courtesy of Megan McArdle from janegalt.net:

Why I'm in Favor of Abolishing the Corporate Income Tax

How many times have we heard columnists or activists foaming at the mouth about those evil corporations that don't pay their "fair share" of taxes? Well, since I have to wait for the copier repairman to finish up some work, I'm going to take this opportunity to plug one of my pet causes: abolishing the corporate income tax.

Now, I know what you're thinking. If you're a conservative, you're thinking "Right on!" If you're a liberal, you're thinking "typical pro-business yuppie." (You make more money than I do. Trust me. I'm currently the executive copy girl in a construction trailer.) If you're one of those activists, you're thinking "When the revolution comes, she'll be the first one with her back against the wall." Too true, and it will save me a lot of time waiting for common sense to wither away and true Naderism to arrive. And probably I'm not going to convince you. But the rest of you, listen up, because I've got compelling arguments with which to convince you, or your friends, if you're already a believer.

Background: How the Corporate Tax Works
Corporations are taxed on their revenue minus their expenses. This is different from the way people are taxed, because the government assumes that the expenses necessary to operate a person are roughly the same from person to person. You may think you need a widescreen TV with picture-in-picture and dolby surround sound in order to support basic life functions, but the government doesn't. Therefore, it taxes you on your revenue -- the money you make for selling your services -- and leaves it to you to figure out the expense part.

The problem with doing likewise with corporations is that they are very different from each other. An aluminum smelter, for example, may have very high revenues, but because there is a lot of competition in the market, it may cost the smelter 99.5 cents to make every dollar it earns. Since the corporate tax rate is 35%, the aluminum smelter would be making an after-tax profit of -34.5 cents for every dollar in revenue. This would quickly put the smelters out of business, and we'd all have to go back to shingling our houses and desperately gulping Mountain Dew out of our hands before it all ran through our fingers.

My old consulting firm, on the other hand, by my rough calculations experienced a 450% return on the cost of my labor and associated overhead (although that figure leaves out the various layabout nephews, current and former mistresses, and assorted friends' children employed by the owner of the company to write reports nobody read. I view those as a personal expense, although the IRS, unfortunately, did not.) 35% of revenue hardly makes a dent in the profits. That is why the government takes into account expenses as well as revenues when calculating taxes.

Argument One: Corporations aren't People
As my favorite macroeconomics professor pointed out, it is impossible to tax a corporation because the corporation is just a fictional entity designed to pass profits back to its owners. When you say you're going to "tax a corporation", the corporation doesn't go to the money farm to harvest some more cash to give to the government so we can expand job training for unwed mothers -- some real person is going to pay that tax. When you put a tax on wages, such as social security or the unemployment tax, the employer doesn't say, "oh, well, profits dropped 15% this year; better tell Merrill Lynch to issue a 'sell' rating" -- they pay their employees less, both to lower the tax burden and to recover the lost profits. They hire fewer employees, because each employee is now more expensive. This costs real people money. When you up the corporate tax, either the employees pay, because the firm can't afford as many of them; the customers pay, because the firms have to raise their prices to cover the taxes; or the shareholders pay because dividends are lower and the company is worth less. And before you liberal types start rubbing your hands in glee at the thought of those pained shareholders, keep in mind that the largest shareholders in companies are insurance companies, which invest in stocks in order to make the money they need to pay off when your house burns down; and pension funds, making the money to take picketing US Steelworkers off the streets and put them into good homes. The other big holders are mutual funds, which is what most of us have our 401(k)'s in. So when you say "I want to tax corporate profits", try silently saying to yourself "so that Mom can sell the condo in Florida and move in with me."

Argument Two: The Corporate Income Tax Costs the Economy More than it Earns
The Corporate Income Tax brought in $204.9 billion in 1998. My tax professor (a Democrat) estimated the cost of corporate compliance in that year to be $300 billion. That's just the direct cost -- what corporations paid tax lawyers and accountants.

This labor is unproductive. It adds no new wealth to the economy; we are paying people simply to transfer money from one place to another, a net economic loss. Particularly so because the money isn't being transferred into any sort of wealth producing investment, such as a store or manufacturing plant. This doesn't mean that we shouldn't have any government or regulations -- the police add no new wealth to the economy, but I still want them around. It just means that we have to weigh the cost of the regulations against the benefit we get out of them. In this case, we make $204.9 billion off the corporations, but at the expense of taking $300 billion worth of resources out of the economy which could have been building widgets or thinking up a new recipe for fat-free muffins.

Nor is $300 billion the only cost. Remember, those corporations won't stump up on their own: you need IRS agents to check on them. And congressional staffers to write laws closing "loopholes". And courts to take corporations you think aren't complying. And reporters to write foamy-mouthed editorials about how corporations aren't paying their "fair share". More importantly, there is a hugely distortionary effect on the economy, because corporations spend an enormous amount of time and money trying to structure transactions to get around taxes. All of this activity is economic dross, and its so widespread I've given it its own section.

Argument 3: The Corporate Income Tax is Extremely Distortionary
I've talked elsewhere about the lengths that companies go to in order to avoid, among other things, taxes. One of the most egregious of these is the way that taxes favor debt. Now, corporations prefer debt to equity anyway, for the same reason that you'd rather take a loan from your parents than sell them part of your house. What makes this preferance so compelling, however, is that while corporations have to pay dividends or repurchase shares out of their after-tax profits, they can deduct any interest on debt. Suppose I have a project that is projected to return 8% -- every dollar I invest yields me $1.08 at the beginning of the year. We'll posit 0 inflation and a risk-free environment so that we don't have to get into tiresome concepts like the time value of money. Now assume that I don't have the cash to make the investment, but I can borrow money at 9%. In a tax-free world, this would give mea return of -1%, and I would pass up the opportunity to own my very own fur-bearing trout ranch. However, if I am a corporation, I can deduct that 9% -- call it $9 annual interest on a $100 loan. Since the corporate tax rate is 35%, I have just lowered my tax bill by a little over $3. Add that $3 to the $8 I'm getting off the trout, and suddenly it's an attractive business opportunity. The trout are no more fruitful, their pelts no more soft and lustrous -- the tax status makes all the difference.

So why is this bad? Partly because it encourages companies to make investments that have a negative economic return -- the actual economic return of 8%, with an actual economic cost of lending the money of 9%. (Yes, this is simplistic. Work with me.) But mostly because it allows companies to take on more risk than they otherwise would. As I said in the above-referenced post, debt makes the company riskier in ways that equity does not, because corporations, not being people, can't borrow money from their parents and therefore get into real trouble when they can't meet their interest payments. The tax exemption, added to the innate preference for debt, means that companies will leverage themselves right up to the point where Moody's threatens to drop their rating to "run for the hills!". People are always over-optimistic about the outcomes of the projects they are pursuing, as you know if you've ever attended a budget meeting or a bridal shower. Add in a little shoddy accounting and you get Enron.

There are numerous other ways in which companies engage in distortionary behavior; entire firms exist for the sole purpose of arranging asset swaps between firms or entities that can't deduct the assets, and firms or entities that can -- every major investment bank has several groups pretty much solely devoted to this purpose. This makes money for the corporation, but it doesn't create new wealth; it merely transfers money from the government's pocket to its own. Meanwhile, all those people and resources that could be utilized to actually produce something are paid instead to engineer the transfer.

The standard activist response is to close the "loopholes." This is discussed in our next section:

Argument 4: It is Impossible to Close the Loopholes
I am all for closing loopholes that are special breaks generated by friendly legislators. Most loopholes, however, do not fall under that category. Most loopholes have to do with items that are legitimately treated as expenses for some purpose. For example, if you eliminated the debt deduction, you would get rid of a lot of fur-bearing trout ranches -- but there are companies that require a high level of capital investment in order to operate, such as automakers. They finance their physical plant with debt, partly for the tax break, but also partly so that they can match the financing cost of the equipment to the life of the equipment. During a bad year, with those debt payments coming in, it wouldn't be a good idea to slap them with an enormous tax bill too -- not unless we've decided as a nation that we'd rather drive Yugos. Many of the "loopholes" decried by Nader and his ilk fall into this category -- corporations engaged in clearly distortionary, but legal behavior, in order to minimize their taxes.

So why can't we eliminate this? There are several reasons. The first is the same reason that it's impossible to entirely eliminate computer hacking, or burglary -- they've only got to find one way in, while you have to close all the doors. As fast as you write the new laws, an army investment bankers, accountants, and tax attorneys will get busy seeking a way around it. I'm sure Nader would like to outlaw this as well, but since this would amount to a law against thinking, it would be impossible -- although he may not realize this, given how successful he's been at implementing such a plan among his own followers.

The second reason is that there's a fine line between necessary and unnecessary transactions, and picking where that line falls will remain more of an art than a science. The harder we try to crack down, the more time and money we waste arguing whether the trout pelts really need to be stored at the dry cleaners before they're sold.

And the third goes back to those costs we talked about in Argument 2. The more laws we write to try to close loopholes, the more congressional staffers we need to write them, judges to interpret them, IRS staffers to enforce them, tax lawyers to brief companies on them, etc. And the effect is geometric, not arithmetic -- the more tiny, specific laws we write, the more impossible the tax code becomes to comply with, as complexities generate ever more conflicts and gray areas, and the code itself passes beyond the comprehension of a single person, thereby making it impossible to completely tell whether or not you're in compliance. This unpredictability adds risk, raising the cost of capital and reducing the willingness of companies to invest. This latter cost is impossible to quantify, but we could quantify most of those direct compliance costs -- and I would be willing to bet that they far exceed any revenue generated by "closing the loophole".

Argument 5: Eliminating the Corporate Income Tax Makes Corporate Welfare Harder
At last, an argument even a Naderite could love. Much of that corporate welfare consists of tax deductions, credits, or what have you, that the public perceives as "free" because we're not handing them a fistful of cash. Eliminating the corporate income tax will force voters to ask themselves whether we actually like Chiquita bananas enough to hand them a wad of our hard earned cash every April 15. When we think about all of the unproductive activity we'd be eliminating by eliminating the corporate tax, lets not forget all those high-priced lawyers eating tax deductible dinners with your congressman in order to convince him that his latest client desperately needs a tax break for the Good of the Nation.

The corporate income tax costs the economy much more than it produces in revenue. Eliminate it and watch a flood of economic activity be unleashed as all those unemployed accountants, tax lawyers, and IRS agents get to work inventing the next Furby. Recoup any lost revenue by eliminating the capital gains tax and treating capital gains as ordinary income in order to equalize the tax treatment of debt and equity, and it will be a long time before we see another Enron.

Summary for Those Who Started to Nod off in the Third Paragraph and Skipped to the Bottom
The corporate income tax is very bad. You should be against it. Email this link to any of your friends who question this.

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