Streetwise Professor

September 2, 2012

The Bane of Corporate Existence: the Corporate Income Tax

Filed under: Economics,Politics — The Professor @ 1:56 pm

The NY attorney general has subpoenaed a dozen private equity firms-including Bain Capital-over their use of a certain tax strategy.  The political motivations here are pretty obvious, so I will leave that as an exercise for the class.  I want to focus on one statement in the article that speaks volumes about the US tax code:

The tax strategy — which is viewed as perfectly legal by some tax experts, aggressive by others and potentially illegal by some — came to light last month when hundreds of pages of Bain’s internal financial documents were made available online.

So different tax experts look at the same strategy and their conclusions run the gamut from “A-OK” (“not risky or even aggressive” in the words of one) to “pushing it” to “lock-’em-up.”

A perfect testament to the dysfunctional arbitrariness of the tax code.  An invitation to spend large amounts on tax advice and tax planning-which is a waste of real resources.  A source of uncertainty and risk that interferes with business planning and distorts resource allocation.  And crucially, a source of discretion for government authorities that they can use to reward favored companies and punish disfavored ones.

Note that the authorities can use the tax code to dragoon those it has targeted even if the likelihood of a successful prosecution is small.  The costs of tax litigation can be immense, and the risks greater.  And there is a profound asymmetry between the government and the targeted company.  If the government loses, no big deal.  Yeah,the prosecutor loses face,  but s/he usually has a way to minimize that.  If the company loses, however, the costs-in dollars and cents, and possible imprisonment-can be very large.  (Note that tax prosecution of political enemies is a favorite tactic in Putin’s Russia, cf. Khodorkovsky.  There’s a reason for that.  It is a very powerful cudgel-or knout, if you will.  It would be naive to think this a uniquely Russian phenomenon.)

The economic case for corporate taxation and capital taxation is dubious even when you abstract from the realities of the tax code. When those byzantine, Kafkaesque realities are considered, it is pretty clear that the deadweight costs of the system are large and that it should be scrapped, or thoroughly overhauled.  Unfortunately, that will never happen because (a) there is a widespread belief that “corporations” should pay taxes as a matter of fairness (a view ironically pushed by those who go ballistic at the notion that corporations are persons on certain legal dimensions), and (b) the tax code got the way it did for political economy reasons, i.e., there are those who benefit from this byzantine provision or that, or who have a competitive advantage in exploiting the complexity of the tax code.

I think it was Milton Friedman that pointed out that tax reform occurs when politicians figure they’ve given out all of the tax breaks they can, they take them away in a tax simplification effort so they can sell the favors again in the future.

The AG’s action gets attention only because of the Romney connection: and arguably, the Romney connection is the only reason for the AG’s action.  But it should get attention for a completely different reason: it demonstrates how arbitrary and subject to abuse the tax system is.

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  1. The strange and beastly corporate income tax is necessitated by the reliance on personal income tax. If you consider a proverbial incorporated banana stand vendor, he can more or less interchangeably pay himself a salary, pay himself dividends, or accumulate retained earnings in the banana stand. If you don’t tax corporate earnings, anyone can create a corporate entity to get paid through, and turn it into a personal tax free piggy bank.

    Corporate earnings are, of course, a malleable concept to the point of being fictional in the short run, full of judgment calls on depreciation rates, whether things should be capitalized or expensed, when non-performing assets should be written down, not to mention all kinds of tax credit pork. I think most rational economists would scrap both the corporate and personal income tax, and go with a VAT, which wouldn’t require an army of tax accountants, lawyers, and lobbyists, would distort labor markets less and generally be a far more efficient of plucking the goose with a minimum of squawking.

    Of course, the left screams that it’s regressive (which could be avoided by exempting basic staples, and not relying on the tax code for public assistance like the EITC); the right fears the VAT’s efficiency would result in a higher tax collection as a percentage of GDP (cynically belying their feigned horror of deficits and claim to fiscal responsibility, not that anyone has taken that seriously ever since ‘Reagan proved deficits don’t matter’); and of course both parties benefit from a system that lets them show they’re looking out for constituents and donors with tax breaks and lets them hold the tax code over the head of potential non-donors/enemies.

    Comment by curmudgeonly troll — September 2, 2012 @ 5:32 pm

  2. @CT-pretty much spot on. Consumption taxes are much preferable, but in the US there is no real political support for them. So we have the present personal/corporate income tax monstrosity.

    The ProfessorComment by The Professor — September 2, 2012 @ 7:25 pm

  3. Would love to agree with all, because you are right, but the VAT is no panacea – it is an administrative nightmare, and the costs usually associated with it exclude the economic costs of work in the so called “black” or as I prefer to call it the free economy. There is some evidence that there might be severe mis-allocations of resources since certain areas of the economy are easier to evade in than others, though there is a school of thought that smaller entrepreneurs, working class people benefit the most(not the case here at all). Let us not even consider the damage done through rebating VAT charges on exports – while intra-Europe it may not make a lot of difference (though corruption of the tax authorities in Greece, Spain and Italy may have helped destroy some industries ability to compete), it certainly has affected everyone else who does not charge VAT or recover the losses through compensatory tariffs (which are illegal under the WTO, I think).

    The issue of money and privilege is central to any discussion of tax reform: while Tip Oneal famously said that money is the lifeblood of politics, let’s not forget, however, that a lot of opposition to easing dividend taxation came from large corporations whose bureaucrats – I’m sorry, managers objected to those pesky shareholders draining funds from the company reducing the size (and pay base) of their selfless managers. Politics exists outside of Washington, too.

    Milton had the pols dead to rights – as all politics is the pursuit of privilege using state power (violence) to gain advantage, it is in the interest of the political class to create obstacles and then get paid to get rid of them. The most egregious and funny example was Boss Tweed’s use of the “Black Horse Cavalry” to hold up the New York salt industry. Unknown by most Tweed had only two official positions in NY: Deputy commissioner of Sanitation (i.e. controlled about 60% of the patronage jobs in NY County), and State Senator; the “Black Horse Cavalry” was a group of State Senators he lead who realized they could get more money selling their votes in a block than individually. The Salt miners around Syracuse got shaken down as follows: every year they would introduce punitive tax legislation, and kill it for a fee.

    While I hope most examples aren’t as bad as this, we must remember that there are two sides to any transaction the sellers ( the Pols) and the buyers. while the salt merchants can be held blameless in their response to their shakedown, many others are not so blameless. If having a vat was a cure-all why the problems in Europe?

    The issue is the size of the state, the creation and maintenance of clienteles through state subsidies and their willing participation in their own corruption. Everyone is drinking this Kool-Aid.

    Comment by sotos — September 2, 2012 @ 8:12 pm

  4. @sotos it’s very hard to argue that the VAT is more complex than the 1040 and the corporate income tax put together. of course, there is no tax that does not distort or cause a deadweight loss.

    Comment by curmudgeonly troll — September 3, 2012 @ 9:00 am

  5. @CT & Sotos. All real world tax systems are messy in their own special ways, and politicians manipulate those systems to achieve political objectives. Consumption taxes are preferable conceptually, but real world consumption taxes like the VAT have features that make them less efficient than they could be. That said, I would probably take a VAT or other consumption tax with its inevitable warts than the current income tax/corporate income tax monstrosity.

    And let’s not forget another key point that Friedman tirelessly pointed out. The real tax burden is measured by government spending, because that represents the real resources commandeered by the government. The deadweight burdens of taxation systems are added to the deadweight costs of inefficient spending. As a rule of thumb, the deadweight burden of the tax system will increase with the square of spending. That is a frightening thought. Given that, moreover, modest differences in the efficiency of tax systems (e.g., consumption vs. income) can add up to big differences in deadweight cost.

    The ProfessorComment by The Professor — September 3, 2012 @ 11:23 am

  6. Conceptually I agree with you and Milton: the issue is the size of Government (“The issue is the size of the state, the creation and maintenance of clienteles through state subsidies and their willing participation in their own corruption.”). I am just not sure how VAT would work out in practice. Where it is introduced there has been a growth in government, not a diminution. Re the tax code, yes it is a nightmare – 35 years ago Walter Wriston described the tax code as being like G-d in that it passed all human understanding and things have only gotten worse. Realistically, our problem is that we will end up with BOTH. It is too attractive to attack “malefactors of great wealth” to ge4t rid of an income tax and it is too bi a source of potential goodies to be handed out by pols.

    I have no argument with the economics, just the political economics of trying this now, in our current state.

    Comment by sotos — September 3, 2012 @ 5:25 pm

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