How America was Tricked on Tax Policy. Bret N. Bogenschneider
than an asset deal, and then finds out the next day when the stock deal is disclosed to the tax department, that the depreciation on assets held by the target company does not step up to the price paid on a stock deal but it does an asset deal. And, the difference can amount to many millions for a sizeable target company.
Deception #6. High business tax rates reduce economic growth by reducing the economic return on investment
The income tax is a voluntary tax in the sense that reinvesting profits into the business generally reduces the tax base (or the amount of taxable income) that is subject to tax. Simply put, any income tax is levied on the tax base, which is the amount of profit minus any deductions. Business deductions can be claimed by, for example, reinvesting in or expanding an existing business or business line. Consider a small dry-cleaning business that generates $100,000 of profit each year. If the owners open a new dry-cleaning store, then they can apply various deductions related to expenses and depreciation from the new store against the profits from the existing stores. These expenses might total $60,000, netted against the profit from the other stores, and so reduce the tax base from $100,000 to $40,000. Therefore, the business expansion automatically reduces the tax base from the existing profitable business lines. For this reason, rapidly expanding businesses often pay no income tax at all, even when they have high profits and positive cash flow. Therefore, the income tax on business can be understood as a voluntary tax. Other types of tax, especially earned income tax, are not voluntary in this way because those earnings generally may not be delayed or offset by other deductions.
The companies that are most concerned about income taxes are accordingly those that are not expanding by reinvesting their profits, especially large corporations given the tendency of large firms to operate without capital reinvestment. If a large corporation operates the business as an annuity, to generate economic rent from business lines without having to reinvest profits or expand, then income taxes are likely to apply on profits from existing business lines. In this case, the corporation has not taken advantage of the voluntary nature of the income tax system by reinvesting profits to reduce the tax base. One objective of tax policy in a capitalist society is to encourage capital reinvestment to foster economic growth, and if this does not happen for some reason then capitalism gets sick and does not function as well as it should. Hence, where a company operates its business as an annuity and does not have any capital reinvestment plans, then that company is not as likely to facilitate economic growth. A tax policy expert might say it’s a good time for the company to pay some tax, since there are apparently no plans to expand the business by capital reinvestment. Hence, the remittance of corporate tax by a company that operates its business as an annuity, without plans for capital reinvestment, does not seem harmful to economic growth, because the capital converted into tax was not going to be reinvested anyway.
This lesson regarding the voluntary nature of the tax system can be applied even more broadly to international tax policy. Imagine a multinational corporation that is profitable in many different jurisdictions. The company needs to make some capital reinvestment in the form of research and development or similar capital expenditures. These investments will result in an income tax deduction currently (or going forward into the future in the form of depreciation and amortization), but only in the jurisdiction where the capital is deployed. The company can choose in which jurisdiction it will make these capital reinvestments. So, in which jurisdiction will the company reinvest—a low-tax jurisdiction or a high-tax jurisdiction?
Economic theory says that the company will select a low-tax jurisdiction because any profits arising from the investment will be subject to less tax. However, any tax lawyer or accountant worth their salt would select the high-tax jurisdiction. This is because the investment gives rise to tax deductions immediately, and those deductions have value right away. Tax deductions are also worth more in the higher-tax jurisdiction to the extent that they offset profit in the high-tax jurisdiction; in other words, by reducing taxable income in the jurisdiction with the higher tax rate, the gross amount of taxable income is reduced by more than claiming those tax deductions in, say, a tax haven where the value of tax deductions is $0 (e.g., a 0 percent tax rate). The time value of money further requires that deductions taken today are worth more than deductions tomorrow. Furthermore, because large corporations usually can shift income by transfer-pricing techniques into low-tax jurisdictions, corporate tax planners simply presume the ability to shift income and thereby not pay tax at high rates.20
This technical explanation explains why nearly all capital investment flows into countries with relatively high corporate tax rates, such as Germany, South Korea, Japan, and (previously) the United States. Large corporations nearly always invest into high-tax jurisdictions, contrary to the predictions of economic theory. Corporate tax cuts paradoxically have the effect of reducing the attractiveness of that country for capital reinvestment. A multinational company seeking to maximize the value of present tax deductions would instead choose to reinvest capital into the higher-tax jurisdiction. But this is true only where the multinational firm is already profitable in the higher-tax jurisdiction, but this will nearly always be the case and should be presumed in the design of tax policy.
Another widely held belief about taxes and tax policy is that corporations are subject to two layers of taxation—once at the firm level, and again at the shareholder level—often referred to as double taxation. Tax commentators often refer to the double taxation of corporate profits as harmful to economic growth and as a justification for reducing the corporate rate. This is nonsense. The second layer of shareholder-level tax never has a chance to arise if the corporation continues to grow and reinvest profits into existing business lines, and accordingly, does not elect to pay dividends. As a general matter, large corporations are not forced to pay shareholder dividends because the Internal Revenue Service does not enforce the accumulated earnings tax under IRC §531 et seq. against those corporations, so any shareholder-level tax is simply delayed indefinitely until the corporation chooses to pay dividends, or never. Also, even if dividends are paid by the corporation to shareholders, not all shareholders are taxable on dividends received, such as when shares are held by a pension or sovereign investment fund, in a retirement plan such as a 401(k), or by any other nontaxable shareholder. Tax advisors to large corporations generally do not expect to pay a higher rate of corporate tax irrespective of the corporate statutory tax rate, which is why they choose to operate in corporate form in the first place. The availability of corporate-level tax deductions, lack of tax enforcement by the Internal Revenue Service especially in respect to transfer pricing by multinational firms, and the potential to delay the levy of tax at the shareholder level by not paying dividends represent several reasons why the corporate form is selected by tax experts for the operation of large business irrespective of the corporate statutory tax rate.
Deception #7. The working poor don’t pay taxes because income tax rates are progressive
The tax system that applies to the wealthy and large corporations differs significantly from that which applies to workers who are paid wages and are immediately subject to taxes on that labor income. This is because nearly all earned income is currently subject to tax. Earned income is also generally not offset or reduced by deductions. Any earned income is taxed immediately on the full amount without any reduction. In contrast, the wealthy and large corporations are usually able to delay (or “defer”) tax or not pay tax on the full amount of profits. Earned income is therefore always part of the tax base and almost never reduced by deductions. The progressive rate structure of the income tax does not offset these disadvantages. Labor income may always be disadvantaged under that system of automatic deferral of taxation for capital income but not labor income irrespective of any progressivity in the tax rates if there is the possibility of deferral to capital. For example, if the statutory tax rate on capital were set at 99 percent, and the tax rate on labor at only 10 percent, if deferral was still available to capital, the tax system might still favor capital despite the significant difference in the statutory tax rates. It simply is not possible to coherently discuss tax policy solely in terms of statutory tax rates without knowledge of the availability of deferral to capital under the tax laws.
Taxes are levied on earned income relatively simply: by multiplying the tax rate times the tax base. And, the tax rate on earned income is high.