Permanent Fixes: Two Sets of Books?

Much is being said and written about impact on the US economy and federal deficits of our punitive nominal marginal tax rate on corporate income (35% currently) and the sometimes irrational strategies followed to avoid payment of it. Based on data reported by the Bureau of Economic Affairs National Income and Product Accounts, we can say that corporations currently, on average, pay an effective income tax rate of about 20% of before-tax profits and that the taxes so collected account for about 15% of federal revenues. Those numbers are meaningless without some context, so here are the histories of both. Note the "congressional tinkering gap" between current nominal and effective rates, realizing that some companies and industries pay the nominal rates while others get concessions and sometimes pay little or nothing.

The idea for this posting came from current headlines about Facebook having no current income tax bill in spite of earnings of more than a billion dollars. It was reported by both Fox News, with the slant that President Obama attacks oil companies for big tax breaks but gives a free pass to political supporters such as Facebook, and by The Huffington Post with a slant that corporations in general are bad and aren't paying their fair share. Business Insider tried to clear up the confusion by reporting that Facebook pays very high taxes over time and that the reason for no current tax liability is that taxes were paid in advance for the vesting of restricted stock grants at the time of the IPO. It's very confusing and far from transparent.

The details for corporate accounting and tax computations are complex and obscure, largely because it is necessary for them to keep two sets of books, one for reporting to the public and their shareholders, and one for calculating their tax bills. The reasons for the two sets of books are explained by The Tax Foundation website:

For all practical purposes, U.S. corporations must keep two sets of books: one set to comply with Generally Accepted Accounting Practices and the other to comply with the Internal Revenue Code. GAAP rules are intended to promote uniform statements that accurately convey the financial history, health, and prospects of a business, while the tax code is intended to generate revenues for the government but also achieve certain public policy goals. It is only natural that these two methods frequently produce very different results.[14] (The footnote refers to Cecilia Whitaker's "Bridging the Book-Tax Accounting Gap," 115 Yale L.J. 680, 2005.)

So, for reporting to their investors and potential investors and the SEC, it is in the best interest of corporations to report dependable steadily rising earnings. Of course “earnings” are somewhat subjective, depending on timing of incomes and expenses and on treatment of non-cash charges. GE was infamous during the Jack Welch years for “managing” earnings, within the GAAP guidelines of course, to be able to report those steadily rising earnings in support of the stock price. It worked.

But, for reporting to the IRS, it is in the best interest of corporations to avoid and delay taxes as long as possible because taxes require cash payments, and cash is not subjective.

Before going any further, let’s be clear that the taxes under discussion here are federal corporate income taxes only and do not include payroll taxes or state and local income and property taxes paid by corporations. Lobbying and legal expenses required to fight a tax system always standing ready to make special provisions are also excluded. Let's also recognize that taxes on dividends paid from after tax profits to shareholders and taxes on capital gains received by investors are excluded. So, focusing just on corporate income taxes greatly understates the total tax burden borne by corporations and their owners.

And, let’s acknowledge that there is confusion because of domestic and international profits, since profits earned outside the US are not taxed until the money is repatriated. The president has recently criticized corporations for moving operations out of the US to avoid taxes. They are just complying with and taking advantage of tax law in the same way that homeowners deduct mortgage interest and charitable contributions, so there is no justification for criticizing the companies.

My initial response to The Tax Foundation quote above is to wonder why in the world should the taxes a corporation pays not be based on "the financial history, health, and prospects of a business" rather than on "public policy goals?" If we believe that Congress is wise enough to appropriately pick winners and losers, to know which industries and companies to subsidize and which to tax heavily, to know better than private citizens and investors what the future holds, we might consider public policy based tax rates to be reasonable. But we have seen enough failed strategies and unfavorable unintended consequences of congressional tax tinkering to know that is not the case.

So, here is my two part suggestion:

Shut down the second set of books and establish a marginal tax rate of 20% on all corporate earnings reported to the public using the GAAP rules.
Cease taxation of dividends and capital gains in order to reward rather than punish those willing to invest in the United States economy.

That strategy would dramatically increase transparency, increase fairness, kill much of the non-productive special interest lobbying (giving congress persons more time to read the bills they vote on), rapidly accelerate investment, increase demand for employees, increase tax revenues, and boost GDP. And, as a result, we would see the national debt begin shrinking as a percent of GDP.

I’m sure there would be some unintended consequences, but I’d love to have a chance to see what they are. They might even be favorable.

Follow @dkw2020