Posted on 07/22/2002 12:07:30 PM PDT by Stand Watch Listen
In the wake of the Enron and WorldCom accounting scandals, President George W. Bush and lawmakers are demanding transparency on balance sheets and financial statements. The Senate just passed a bill sponsored by Banking Committee Chairman Paul Sarbanes (D-Md.) loaded with new regulations and increased criminal penalties while increasing the power of trial lawyers to sue for real and alleged misconduct. Much of it is likely to survive the conference with the Republican House, and Bush is expected to sign whatever comes to his desk.
But some experts say no matter how many new regulations are passed, or how many penalties are imposed, accounting for corporate transactions will remain all but completely opaque because of the incredible complexity and burdensomeness of the U.S. tax code.
"Because the corporate income tax is so complicated, companies are forced to go to the Pricewaterhouses to help them set up complicated structures to minimize their taxes," says Chris Edwards, director of fiscal-policy studies at the libertarian Cato Institute and former senior economist at the congressional Joint Economic Committee. "The way companies structure themselves around the world with various tiers of subsidiaries of subsidiaries of subsidiaries and partnerships, and this sort of thing, is because the tax code drives them to do that to minimize their taxation, and that makes it very difficult for investors to figure out how a company is structured."
Right now, in the midst of an accounting hysteria that has been fanned into a business panic, the tax code is being talked about only on the left. Collectivists are pushing laws at every level to close the tax strategies or loopholes that Enron and other companies have used to reduce their tax burden. "The refusal of the Bush administration and House Republicans to deal with the tax-shelter issue is coming home to roost," exclaimed Rep. Lloyd Doggett (D-Texas) in a press release in January. "There are other 'Enrons' out there making end runs around our tax code, ready to implode at the expense of taxpayers without fancy accounting firms," he intoned ominously.
Feeling the heat, top Republicans on the House Ways and Means Committee and the Senate Finance Committee have signed on to even more-complicated bills to stop U.S. companies from reincorporating in offshore jurisdictions to minimize their tax burdens ? in effect complicating the complications that Congress created earlier.
Edwards and others say the loopholes are symptoms of a tax policy that not only undermines American competitiveness but creates confusion for shareholders. The U.S. corporate tax rate, raised in the Clinton administration's first year to 35 percent (40 percent if average state and local taxes are included) now is higher than the average 31 percent rate for European Union countries and is the fourth-highest among developed countries in the Organization for Economic Cooperation and Development, according to a recent survey by KPMG LLP. And the number of pages of federal tax rules ? the tax laws, tax regulations and various IRS rulings ? has risen from 400 pages in 1913 to 45,663 pages in 2001. "No one completely understands the tax code," Edwards says. "No one!"
To make corporate transactions more transparent, Edwards says the tax system should be overhauled to reduce corporate taxes and reform a tax code that sometimes taxes corporate income two or three times. "If you had a simple cash-flow tax and you simply taxed companies at some low rate, cash in minus cash out, you wouldn't be able to create financial shenanigans. It would be clear and obvious to everyone how much is owed," the Cato scholar says.
Right now, legitimate companies are fearful of what actions to take tax-wise, and this could be a factor in the market's decline, says John Barry, a chief economist at the free-market Tax Foundation. With European countries continuing to slash tax rates for their businesses, U.S. companies must seek to reduce their tax burden as much as they legally can to stay globally competitive and produce returns for shareholders, he argues. Yet they fear being demonized by politicians, the media and the IRS.
With reason. In an unprecedented move in mid-July that many call a gross violation of taxpayer privacy, the IRS released the names of business executives and other public figures who had sought advice from accounting firms about tax shelters, even though those individuals had not been charged with any crime and it had not been proved the tax shelters were illegal. "I think where corporate tax folks are finding themselves between a rock and a hard place is, on the one hand, you have an IRS and now a Congress that is trying to wall off options to reduce taxes and, on the other hand, you have your professional obligation to stockholders, employees and customers to reduce your tax burden," Barry tells Insight.
William Gale, an economist at the liberal Brookings Institution, says blaming the earnings and accounting controversies on the tax code is hogwash. "The tax code is always a convenient whipping horse, and people always want to whip it, but let's get it straight here," Gale tells Insight. "There was corruption and dishonesty, and that's what got them in trouble, not the tax code."
Certainly none of the tax reformers with whom Insight talked said that the tax code justified companies using taxes as an excuse to deceive shareholders about earnings, as it appears Enron and WorldCom have done. But they say there would not have been nearly so many opportunities for chicanery in a simplified tax system and that deception would have been infinitely more easy to spot. "A complex tax code provides a fertile field in which to operate for those who have low standards of morality and ethics and wish to do something wrong," says Ernest Christian, a former deputy assistant Treasury secretary who now is chief counsel to the Washington-based Center for Strategic Tax Reform.
Take Enron's much-discussed partnerships that allegedly were used to hide its corporate debt [see "Buried Treasure," Feb. 11]. Companies set up partnerships to escape the double taxation of corporations. Corporate earnings are taxed once at 35 percent but, if the companies pay dividends to shareholders ? who are, after all, the owners ? those earnings are taxed again at individual rates as high as 38.6 percent. Whereas, with earnings in partnership, "that money is taxed one time at the individual level, [and] that is a huge advantage because you're not double-taxed on that income," Barry says.
If there were not this double taxation, Enron would have had a harder time setting up its partnerships, because there would have been no tax incentive for investors to join them, says Larry Abraham, a specialist in international investments who is publisher of the Insider Report financial newsletter. "If you did not have the convoluted tax law, you wouldn't have the limited partners ponying up to become limited partners to shelter their income," Abraham tells Insight. "There wouldn't be any economic incentive to do it. ? The tax law creates phony economic incentives that convolute real economic consequences."
And it won't do much good to close these and other loopholes without fundamental tax reform, says Bruce Bartlett, senior fellow at the free-market National Center for Policy Analysis and a deputy assistant Treasury secretary in the George H.W. Bush administration. "We've been trying to close loopholes for 40 years," he tells Insight. "It didn't work because the lawyers who work for big corporations get paid a lot more money than the people who draft legislation for Congress and who work at the IRS, and they're very clever. It's really a never-ending struggle."
One of the biggest loopholes for companies to escape double taxation is something Bartlett says Congress never will get rid of: borrowing money by issuing bonds. Since interest on corporate debt is tax-deductible, but shareholders have to pay taxes on their dividends, there is a greater incentive for companies to create debt by borrowing money to finance their operation rather than to create equity by issuing new shares.
"Almost every other major country has some relief for this double taxation by giving corporations some sort of deduction for dividends paid, or giving shareholders some exemption for dividends paid. The United States is the only country that doesn't do anything along those lines," Bartlett says.
"As a consequence, corporate profits have fallen, dividends have fallen" and companies have been encouraged to take on riskier financing schemes that may put shareholders in jeopardy, Bartlett says.
Brookings' Gale concedes that "the treatment of debt versus equity fuels a lot of the borrowing behavior and the use of borrowing to generate tax shelters." He even adds, "One of the groups that really don't want elimination of the corporate tax are big corporations, because the tax on dividends gives them a reason to keep money in the firm." But Gale still is against getting rid of the double taxation because "it would give huge windfall gains to existing shareholders for no reason at all."
There are disagreements on how to overhaul the tax code to get rid of double taxation even among tax reformers. Bartlett wants to shelve the corporate income tax and tax individual shareholders on a company's earnings as if it were a partnership. Barry says keep the corporate tax, but don't tax dividends and capital gains. In the broader picture, some tax reformers want a flat-rate income tax that doesn't tax savings on investment, while others want to scrap the income tax in favor of a national retail sales tax. But one thing they all agree on is that taxes should be territorial and stop at the water's edge.
At the root of offshore partnerships and subsidiaries is the fact that the United States is one of the few countries that taxes worldwide income. When a U.S. company sells its products abroad, it is taxed by the foreign government yet still has to pay the same corporate tax rate on its profits abroad to the U.S government. There are some tax offsets to make up for the foreign tax, but many of those, such as for foreign sales corporations deductions, have been struck down by the World Trade Organization, and others do not compensate for all the foreign taxes paid. This puts U.S. firms at a huge competitive disadvantage, experts say.
Dan Mitchell, senior fellow at the conservative Heritage Foundation, points out that a U.S. company doing business in Ireland would have to pay 35 percent of its profits to the U.S. government on top of the Irish taxes, but a Dutch firm only would have to pay the Irish corporate tax rate of 10 percent because the Netherlands doesn't tax foreign-source income. And tax reformer Christian adds that since foreign profits are taxed at the point U.S. companies bring them home but often are deferred if those profits are invested abroad, firms are discouraged from using their foreign earnings to create new jobs here.
To get around this, some U.S. companies have announced plans to reincorporate in offshore low-tax jurisdictions while keeping the base of their operations here ? a process called an inversion. This year, a number of well-established companies have announced that they are reincorporating in Bermuda, including Stanley Works, a 159-year-old tool manufacturer in Connecticut. Democrats long have decried this, and now leading Republicans have joined them to try to put a stop to the practice. Iowa's Charles Grassley, the ranking Republican on the Senate Finance Committee, has joined with committee chairman Max Baucus (D-Mont.) in sponsoring a bill to stop inversions by arbitrarily defining companies with a certain percentage of their operations here as U.S. companies. Grassley admits there are problems with the tax code, but calls U.S. companies that seek to reincorporate unpatriotic. "These are American companies, and their hearts should be in America," he told MSNBC.
A milder bill by Rep. Bill Thomas (R-Calif.), chairman of the House Ways and Means Committee, would put a three-year moratorium on inversion coupled with measures to ease the tax burden on U.S. companies competing internationally. The Bush administration quietly criticized the anti-inversion provisions of both bills.
Mitchell says there are good tax items in Thomas' bill, but the option of inversions will be necessary for U.S. companies to compete until the United States moves to a territorial tax system. He also points out that, contrary to media reports, companies that have inverted still will pay taxes on their U.S. income, just as foreign companies who conduct business here do. What no longer will be taxed is their foreign income. (Brookings' Gale said inverted companies could escape some U.S. taxation by having the U.S. subsidiary borrow from the foreign parent, but Mitchell said this practice is highly regulated.) Furthermore, Mitchell tells Insight, a moratorium on inversions could harm U.S. jobs and benefit foreign competitors. "Better for Stanley to be chartered in Bermuda than have to sell out to a foreign company or to lay off workers because of smaller market share," he says.
Mitchell says the fear of crackdowns on the financial freedom of U.S. companies is one of the factors driving investors away and keeping the market down. "A lot of money is getting very nervous that maybe it should go to Hong Kong or someplace else if our people basically screw up at Treasury," he says.
Cato's Edwards argues the term "inversion" barely would be heard again if the United States were to go to a simplified territorial tax such as House Majority Leader Dick Armey's proposed 17 percent flat tax. Then, companies from all over the world would flock to incorporate and invest in the United States and would not be setting up nearly as many of the complex subsidiaries and partnerships, Edwards says.
"With a low tax rate, we wouldn't worry too much about companies trying to move their profits abroad," Edwards observes. "If the United States had a 17 percent Armey flat tax, there would be a huge rush of global corporations to move their profits into the United States. European countries would have trouble, but it would be great for us."
John Berlau is a writer for Insight magazine.
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