Flatten the Corporate Tax Code

By Howard Gleckman It's time that Congress and President George W. Bush think seriously about dumping today's corporate tax system. An article in the Mar. 4, 2002, issue of BusinessWeek looks at U.S. companies that rang up huge profits from 1996 to 2000 but paid little or no federal income tax (see "Tax Dodging: Enron Isn't Alone"). With the help of the Institute on Taxation & Economic Policy, BW found a long list of corporations -- from General Electric to Colgate Palmolive to Enron -- that slashed their tax bills by aggressively taking advantage of the tax code. As far as we could tell, everything these companies did was perfectly legal. And that's the problem.

The current tax code is unfair and inefficient. It drives CEOs to do deals they would never dream of for strategic reasons, just to benefit from some tax break. It rewards financial engineering instead of productive business practices. And for all that, the corporate tax generates only about 10% of all federal revenues.

How bad is today's approach? In 1998, companies with assets in excess of $250 million reported $744 billion in profits to their shareholders. But they told the IRS they made just $458 billion. And that gap -- $287 billion -- is growing, says Harvard economist Mihir Desai, who calculated the figures.

HOLE HUNTERS. The effort to avoid taxes is driving strategy at many companies. Instead of being in business to make stuff, they exist largely to dodge taxes. Companies spend billions of dollars on accountants, consultants, and lobbyists -- all hired to find or create loopholes. A long-time observer of General Motors says the smartest people on the company's payroll are its financial engineers, not the folks who design, build, and market cars.

One result: Corporations keep at least two sets of books -- one for the IRS and one for shareholders. Tax accounting is so complicated that investors have no idea how much companies actually pay.

Treasury Secretary Paul H. O'Neill has one fix: Abolish corporate taxes entirely and simply pass the tax liability through to a company's shareholders. O'Neill's idea makes some sense. But politically, it's a nonstarter.

CONTORTIONISTS. However, another promising idea has been floating around for years: Replace the existing corporate income tax with a business cash-flow tax, which is a lot like a flat tax for companies. The system is simple: Take total income, subtract the cost of equipment and (in some versions) labor, and pay tax on the difference.

To understand why this makes sense, it's important to think about the loopholes that have riddled today's tax code. Most boil down to two pretty simple issues: Companies turn taxable equity into tax-deductible debt, and they fiddle around with the timing of both income and expenses.

Take the debt and equity problem. Companies get to deduct the interest they pay on debt. But they can't do that for payments to stockholders, such as dividends and capital gains. So businesses go through all sorts of contortions to turn stocks into bonds. That's what Enron did. And many tax shelters that are widely marketed by accounting firms and investment bankers are designed to perform just such financial prestidigitation. But a cash-flow tax would hit stocks and bonds the same way, and the debt/equity shuffle would come to an end.

TIME OUT. It's the same with timing shifts. For financial reporting to shareholders, companies try to book income right away, but they want to push expenses into the future. These moves make earnings look as strong as possible. By contrast, when it comes to IRS reporting, they want to front-load costs, which they can deduct. But they want to delay taking income to make their taxes as low as possible.

For example, if a company buys a new widget stamper, it depreciates the equipment for financial purposes as slowly as possible, since it must reduce earnings to reflect the gear's gradual loss of value. By contrast, for tax purposes, it wants to deduct the costs as quickly as it can. But incredibly complicated tax rules govern how to do that, which create lots of opportunities for financial manipulation.

A cash-flow tax would cut through all this mess. It says a company can take an immediate tax write-off for the full cost of its investments. You spend the money, you get the deduction. No more timing games.

MAJOR IMPROVEMENTS. This is hardly the answer to all the problems with America's corporate tax rules. And changing to a new scheme would generate big headaches. But it would fix many post-Enron problems: The most egregious tax scamming would end. Government would get out of the dicey business of subsidizing some business activities while penalizing others. Shareholders might actually be able to figure out what their companies are paying in tax.

And, best of all, businesses might refocus their energies back to producing goods and services. Now that's worth thinking about. Gleckman is a senior correspondent in BusinessWeek's Washington bureau. Follow his views every Tuesday in Washington Watch, only on BusinessWeek Online

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