Wednesday, February 2, 2011

Paradox of Corporate Taxes

David Leonhardt has another excellent and provocative article in The New York Times, this time about the paradox that US corporate taxes are at once among the highest in the world and also don't generate a lot of revenue.

Arguably, the United States now has a corporate tax code that’s the worst of all worlds. The official rate is higher than in almost any other country, which forces companies to devote enormous time and effort to finding loopholes. Yet the government raises less money in corporate taxes than it once did, because of all the loopholes that have been added in recent decades.

“A dirty little secret,” Richard Clarida, a Columbia University economist and former official in the Treasury Department under President George W. Bush, has said, “is that the corporate income tax used to raise a fair amount of revenue.”

This is a classic example of what I call 'policy persistence' - the lock in effects you get from the benefits a small and highly motivated group gets from a policy makes it very hard to undo.

Economists have long pleaded for an overhaul of the corporate tax code, and both President Obama and Republicans now say they favor one, too. But it won’t be easy. Companies that use loopholes to avoid taxes don’t mind the current system, of course, and they have more than a few lobbyists at their disposal.

The official position of the Business Roundtable, one of the most important corporate lobbying groups, is telling. The Roundtable says it supports corporate tax reform. But it actually favors only a reduction in the tax rate. The group refuses to say whether it also favors a reduction of loopholes. In effect, the Roundtable wants a tax cut for its members regardless of how much the tax code is simplified — or whether the budget deficit grows.

Of course this is all good business for economists. A small army of economists at accounting firms like PriceWaterhouseCoopers run around selling 'transfer pricing' services. This service is particularly useful for multinational corporations. Through internal pricing among its divisions located in different countries, it can shift all the profits on its books to divisions in low tax countries. Thus GE in the US makes very little profit.

G.E. is so good at avoiding taxes that some people consider its tax department to be the best in the world, even better than any law firm’s. One common strategy is maximizing the amount of profit that is officially earned in countries with low tax rates.

Of course such a flawed tax system creates serious costs for an economy but our democratic process makes it hard to fix.

The problem with the current system is that it distorts incentives. Decisions that would otherwise be inefficient for a company — and that are indeed inefficient for the larger economy — can make sense when they bring a big tax break. “Companies should be making investments based on their commercial potential,” as Aswath Damodaran, a finance professor at New York University, says, “not for tax reasons.”

Instead, airlines sometimes buy more planes than they really need. Energy companies drill more holes. Drug companies conduct research with only marginal prospects of success.

Inefficiencies like these slow economic growth, and they are the reason that both conservatives and liberals criticize the corporate tax code so harshly. Mitch McConnell, the Republican Senate leader, says it hurts job creation. Mr. Obama, in his State of the Union address, said that the system “makes no sense, and it has to change.”

A lot of economists agree. Then again, any system that creates as many winners as this one won’t be changed easily.


Jeff Alworth said...

This is clearly a political, not economic, problem. The tax code is perhaps the best example, but far from the only one. The patchwork of defense contracts, supported in Congress by powerful legislative patrons, is another.

While everyone agrees in that the system doesn't work, they all think their tax loopholes and incentives are divinely-sanctioned. Politically, the incentives are just as screwed up as they are economically. What's good for the country--sorting out the tax code and trashing the various exemptions and incentives--is terrible for the legislators who receive financial backing and local support for them. It's all well and good to cut these until your voters are pissed to lose their perks and the donors are threatening to cut off the spigots.

Moreover, the byzantine process--particularly in the Senate--that makes stopping change radically easier than systemic overhauls. And actually, it's a lot easier to make the problem worse: adding a little perk to please constituents or a local business looking to ramp up production on new widgets--no problem.

So the tax code grows and nothing changes.

Jeff Alworth said...

Oh, and there's also lots of ways to demagogue the issue, which will make substantive change even less likely--though you can expect a huge amount of stemwinding and grandstanding over the next year or two on the issue.

Elijah said...

That article is neither excellent nor provocative. While I ultimately agree with some of the author's conclusions, the piece itself is mainly political rhetoric. And inconsistent political rhetoric at that.

Compare, for example:

"Thanks to an obscure loophole in the tax code, Carnival can legally avoid most taxes."


"Carnival pays so little tax partly because of a provision that lets some shipping companies legally incorporated overseas...avoid taxes."

A loophole is this context is an ambiguity or omission in the text through which the intent of a statute may be evaded.

So, which is it, an ambiguity / omission, or an intended consequence? Well, I read the Internal Revenue Code as specifically carving out income of this sort. In other words, this is not a loophole, but exactly what Congress intended.

Of course, reasonable minds can disagree on whether this is appropriate...