# Presentation: 787792

## Corporate Income Taxes:Trends and Forecasts

- Presentation to the President’s Advisory Panel on Federal Tax Reform
- March 8, 2005
- Douglas A. Shackelford
- University of North Carolina and NBER

**Notes:**
Thank you for this opportunity to discuss corporate income taxes. I applaud your efforts to assist the President in reforming our tax system. 

## Overview

- Look back
- Corporate income taxes are in a long decline
- Why have they declined?
- International competition
- Alternative organizational forms
- More effective tax planning
- Tax shelters
- Mobility of income
- Look forward
- Feasibility of the corporate income tax in an information economy

**Notes:**
Let me outline my comments.  First, I want to look back and show that corporate income taxes have been in a long decline.  Next, I want to explore a few reasons why that might be, namely, international competition, alternative organizational forms and more effective tax planning, focusing on tax shelters and the increased mobility of income.  Then I want to look ahead and ask whether the corporate income tax is feasible for the future, given the difficulties of measuring income in an information economy. 

## Corporate Income Tax as a Percentage of Federal Revenue and GDP

-      Source:  Office Management and Budget, Fiscal Year 2005 Budget, as reported by the Tax Policy Center.

**Notes:**
This graph shows corporate income taxes as a percentage of total federal revenue (pink) and GDP (blue).  With both scalars, the story is the same.  Corporate taxes declined steadily from the 1950s to the 1980s with some stabilization over the last 20 years.  This stabilization, however, is misleading.  Despite a decade of record profits, the corporate income tax never recovered to the levels of the less prosperous 1970s.

## Why Have Corporate Taxes Declined?

- International competition has eroded  corporate taxes as a revenue source
- Lower rates at home and abroad
- Smaller base—e.g., accelerated/bonus depreciation, R&D deductions and credits
- Other organizational forms (e.g., S corp)
- The corporate income tax is a special levy on companies that access capital through the public equity markets
- Other techniques to undo two levels of tax
- More effective tax planning

**Notes:**
Why have corporate taxes declined in importance?  I think there are at least three reasons. 

First, nations compete for business and most business is very mobile in today’s economy. This competition has constrained all countries’ ability to extract corporate tax dollars. 

Second, the legal benefits of the corporate form are attainable without facing corporate income taxes, especially with the S corporation.  In fact, I view the corporate income tax as a special levy on companies that have to access capital through the public equity markets.  This special levy has driven many businesses toward organizational forms that provide corporate protection without the corporate income tax.  In addition, firms have also adopted other techniques to eliminate double taxation.  

Third, tax planners may have become more effective. 

## International Competitiveness: Reducing Corporate Tax Rates

-       Source:  Gravelle, J.  “The Corporate Tax:  Where Has it Been and Where is it Going?”  National Tax Journal 57 No. 4 (December, 2004):  903:922.

**Notes:**
Let’s focus first at the decline in the corporate income tax rates.  Accordingly to a recent study by Jane Gravelle, marginal effective tax rates are at all-time low (see pink above).  Statutory rates (in blue above) are only one percentage point above their historical low.  These patterns are not unique to the U.S.  Around the world, corporate income tax rates have been falling.  

## S Corporations: Eroding the Corporate Tax Base

- 2004-2010, projected.  Source:  IRS Statistics of Income.

**Notes:**
Another legislative change that has eroded the corporate income tax base is the S corporation.  The business profits of an S corporation are only taxed on the individual shareholder’s tax return. The S organizational form is restricted to privately-held business.  Thus, businesses that do not need to access the public equity markets (and some of these businesses are very, very large) enjoy the legal protection of the corporate form without incurring the corporate income tax.  As you can see from this chart, the IRS anticipates the popularity of S corporations to continue to rise.

## Business Net Income by Type of Entity 

-         Source:  Drew Lyon, PriceWaterhouseCoopers, Presentation at the 6th Annual Tax Council Policy Institute Symposium, February 11, 2005.  Underlying data from IRS statistics of Income.

**Notes:**
It is important to note that the erosion of the corporate income tax does not necessarily mean that business income is going untaxed.  Instead much of the taxation of business profits is now showing up on the individual tax returns of shareholders in S corporations (and other flow-through entities). This point is nicely made with a slide that Fred Goldberg recently showed this panel.  I have reprinted here.  It shows that total business net income from flow-through entities, principally the S corporation, recently exceeded total business net income from firms filing corporate tax returns.  I’m not sure that this pattern will hold with post-recession returns, but it does demonstrate the growing importance of flow-through entities.    

## Other Ways to Eliminate Double Taxation

- Year-end bonuses in privately-held firms
- Debt shifts business profits to the lender’s tax return since interest is deductible
- Employee stock options
- Total deductions from stock option exercises were 10% of total pretax income for the 100 largest U.S. companies in 2000.  However, total deductions exceeded total pretax income for the Nasdaq 100. (Graham, Lang, and Shackelford, *Journal of Finance*, 2004)

**Notes:**
The problem with the C corporation, of course, is two levels of taxation on business profits—one at the entity, the other at the shareholder level.  S corporations and other flow-through entities are only one way to eliminate one level of tax.  Privately-held C corporations can pay bonuses at year-end to employee-shareholders and eliminate the corporate income tax.  Larger, publicly-traded firms often resort to leverage.  Since interest payments are deductible, the returns to debt are only taxed on the lender’s tax return.  Similar tax-reducing payments can be achieved by locating intangible assets in low-tax jurisdictions. Employee stock options can also eliminate double taxation. The company borrows from their employees and “repays” them with stock.  My research with John Graham and Mark Lang shows that the deductions from employee stock options can wipe out large portions of the corporate tax base.  For example, we estimate that in 2000, total deductions from stock option exercises were 10% of total pretax income for the 100 largest U.S. companies.  However, for the Nasdaq 100, the deductions exceeded total pretax income.  In other words, the business profits from the high technology industry were largely taxed on the returns of the employee-shareholders who exercised options.

## More Effective Tax Planning:Book-Tax Gap

- The gap between accounting earnings and corporate taxable income widened during the late 1990s
- e.g., Desai (2002) finds $155 billion of unexplained book-tax gap in 1998
- Perhaps book is overstated
- Earnings pressure may have led to inflated, fictional earnings in the late 1990s
- Corporate Tax Shelters

**Notes:**
In short, the corporate tax base is under attack from many directions.  Nonetheless, some studies suggest that these explanations cannot fully explain the shrinkage of the corporate tax base.  They report that, even after adjusting for legislative changes to the tax base, stock option compensation, and differences in accounting for foreign profits, among other items, the gap between the accounting earnings reported to shareholders and the corporate taxable income reported on the tax return has been spreading.  Assuming accounting earnings are not overstated, which they may be, this book-tax gap has led many to speculate about the importance of corporate tax shelters .  

## How about Book-Tax Conformity? 

- Argument given for conformity: If companies are overstating book profits and understating taxable income, then require them to report the same figure to shareholders and the taxing authority and you fix two problems.
- Not a good idea
- Conformity ignores the critically important role that accounting information plays in the markets.

**Notes:**
Before we look at the corporate tax shelters, I would like to address one change that some, with the best of intentions, contend would improve both book and tax reporting: book-tax conformity. Their argument goes as follows: If companies are overstating book profits and understating taxable income, then require them to report the same figure to shareholders and the taxing authority and you fix two problems at once.  I don’t agree.  It’s fine if tax and GAAP naturally reach the same accounting procedure.  In fact, it’s simplifies overall accounting costs.  However, to blindly tax a firm’s net income (or, alternatively stated, to constrain the information that it provides to its shareholders to its taxable income figure) ignores the critically important role that accounting information plays in the markets.  It’s important that this information not be subject to tax minimization pressure.  

## Corporate Tax Shelters

- Legal noncompliance
- Meet the letter, but not the spirit of the law
- Reduce taxable income but not book income
- Little public data so estimates of their magnitude are difficult
- Leasing transactions estimated to cost $4 billion for one year (Joint Committee on Taxation, 2004)

**Notes:**
Now on to corporate tax shelters.  Until recently, a loose collection of tax plans, known as corporate tax shelters, were substantially reducing, and in some cases eliminating, the tax liability of some U.S. companies.  These shelters met the letter, but not the spirit, of the law.  I would term them legal noncompliance.  The best of them reduced taxable income without affecting book income.  It is nearly impossible to estimate the magnitude of these tax shelters using publicly available data.  Nevertheless, all indications are that shelters were non-trivial.  For example, the Joint Committee estimated that the elimination of one shelter (leasing transactions) generated $4 billion of tax revenue in a single year.  

## Shelters Today

- Market has cooled
- Recession reduced demand
- Bad publicity
- IRS has become more aggressive
- Big 4 withdrew partly because shelters threaten to undermine the profitable Sarbanes-Oxley audit work.
- Market could revive
- Booming economy—high profits, high taxes
- Recent IRS defeats embolden taxpayers
- Big 4 spin off their tax practices

**Notes:**
Today corporate tax shelters have fallen out of favor.  The recession blunted demand—no profits, no tax planning—and companies and firms have been tarred with bad publicity from shelters.  The IRS has also become more aggressive.  In addition, one of the primary suppliers, the Big 4 accounting firms, have withdrawn from the market in part because of penalties and negative publicity but also because shelters threaten to undermine the highly profitable audit work that they have enjoyed since Sarbanes-Oxley.

The shelter market could revive if the economy, and thus income taxes, begin to boom again, if recent IRS setbacks embolden taxpayers, and perhaps if the Big 4 spin off their tax practices, thus freeing tax planners from the conservatism brought about by Sarbanes-Oxley.

## Income Mobility

- The tax system relies on information from the historical cost accounting system
- The accounting system is struggling to measure income where the primary assets are intangibles.
- As a result, taxable income is becoming increasingly difficult to measure.
- These measurement problems provide opportunities for tax planners and raise doubts about the long-term viability of income taxes
- Problems increase with globalization

**Notes:**
Now I would know like to address why I believe that tax planning has become more effective in the last couple of decades.  

The issue is the mobility of income.  All financial information in a firm flows from the same source—the historical cost accounting system, on which the tax system is overlaid.  Accountants are struggling to define and measure income in an economy dominated by intangible assets. These measurement problems provide opportunities for tax planners and raise doubts about the long-term viability of any tax system built on income. For example, derivatives enable firms to hedge and diversify without selling assets and triggering taxable events.

Income mobility becomes increasingly problematic with globalization.  With firm assets across the globe, within-firm transfer pricing can now shift income to low-tax jurisdictions.  Not surprisingly, a disproportionate amount of income is now recognized in tax havens and other low-tax jurisdictions.  

## Old Days

- Factors of production
- Largely immobile—heavy industry
- Bricks and Mortar
- Large unskilled/skilled labor force
- Production of goods
- Income
- Primarily sales less production costs
- Biggest accounting questions—inventory, depreciation

**Notes:**
To understand the problem, let’s look back in time. For much of the 20th century, the key factors of production for the major U.S. corporations—primarily manufacturers—were largely immobile.  Large production facilities, heavy equipment, large labor forces, producing goods for shipment.  Gross income was straightforward—sales less the costs of manufacturing the goods.  The thorniest accounting questions involved determining the costs included in inventory and depreciation of the plant and its equipment.  Taxable transactions mostly involved the movement of goods through the production and sales cycles.

## Today

- Factors of production
- Highly mobile--intellectual
- Intangibles and highly technical
- Small, highly educated labor force
- Service-oriented
- Income
- Affected mostly by people and intangibles
- Biggest accounting questions—realized and unrealized intangibles
- What is a brand name worth?
- Where does a telephone call take place?

**Notes:**
Today, the key factors of production are highly mobile.  They are intangible assets (brains, information) that most likely never appear on a balance sheet.  The quality of a highly skilled labor force is often the most important economic asset. The thorniest accounting problems involve intangibles.  For example, what’s the value of a brand name or a customer list?  When do we recognize the value enhancement from a firm’s R&D, from its investment in human capital?  

How do you measure profits when the key profit center is in people’s heads?  Many transactions are unobservable and impossible to locate in a specific jurisdiction.  For example, where does a telephone call occur?  When the caller dials the number?  When the phone is answered?  Who can tax it?  The country from which the call originates, is received, or travels through?  Accountants are struggling to answer these questions for financial reporting purposes.  So, it should be no surprise that these measurement problems are undermining the foundation of the income tax system.

## Is an Income Tax Feasible in the Future?

- A tax system built on income can only last as long as we can define income with some precision.
- A tax system depends on market frictions that make it difficult to undo the tax.  In old days you could not easily dismantle the plant.  Today you can move profits around the globe with transfer prices or a plane ticket.
- Is it feasible to think that income can be a basis for tax measures in the future?

**Notes:**
The key question is whether a tax system built on such an difficult-to-measure unit as income will be feasible in the future.  A tax system depends on market frictions that impede attempts to undo the tax.  In old days you could not easily dismantle the plant.  Today you can move profits around the globe with transfer prices or with a plane ticket.  

## Tax Planners Need Differences in Tax Rates

- Tax the Same Income Differently
- At Different Times
- E.g., current tax holiday on repatriated cash
- In Different Places
- U.S. vs. foreign-source
- In Different Organizational Forms
- Flow-through entities, tax-exempt organizations, pensions
- Depending on the Savings Vehicle
- Stock held in an 401(k) vs a mutual fund vs personal account
- Tax Similar Income Differently
- E.g., new lower rates on U.S. manufacturing

**Notes:**
Let me close with a challenge. An indication that tax reform succeeds will be a reduction in the need for tax planners.  Tax planners make a living because they legally capitalize on inefficiencies in the tax system. 

The key to reducing the need for tax accountants and lawyers is the elimination of differences in tax rates.  Whenever you tax the same income differently, you provide an opportunity for a planner to reduce taxes.  

Here are some examples of current policies that create a demand for tax planners.  

Tax the same income differently at different times.  A recent example is the tax holiday for repatriated foreign profits.  

Tax the same income differently in different places.  An example is the sourcing rules in the international arena.

Tax the same income differently in different organizational forms.  We have already discussed this issue with S corporations, but untaxed parties, such as tax-exempt organizations and pensions, are playing an increasingly important role in tax planning.  

Tax the same income differently depending on the savings vehicle.  For example, stock returns are treated differently depending on whether the stock is held in a 401(k), a mutual fund or a personal account.  

Finally, tax similar income differently.  A recent example is the lower tax rates for domestic manufacturing.  

These types of rate differences provide tax planners with endless opportunities to shift wealth from the Treasury to taxpayers for a fee.  What’s the best way to narrow rate differences?  An old answer: Lower the rates and broaden the base. 

Thank you very much.  I look forward to your questions.