ABOUT CORPORATE TAXES
I have written a number of posts on taxes. These include 1) social security 2) the AMT 3) withholding 4) state income taxes 5) taxes under the Democrats. This post is focused on corporate income taxes.
Corporate income taxes are levied on corporations. Many businesses use different legal structures like an “S Corporation” or “Limited Liability Corporation” (LLC) rather than setting up as a Corporation (or C-Corp as known in the tax world). The LLC or S-Corp structure means that whatever money the company earns passes through to the owners of the company and they report it on their regular tax return.
People use the LLC or S-Corp structures to avoid the US Federal Corporate Tax liability. The C-Corp tax structure means that income is subject to “double taxation” – it is taxed both at the corporate level and then taxed AGAIN when cash is passed down to the ultimate owners of the corporation in terms of dividends. Individuals who own shares in the corporation are also taxed via capital gains taxes whenever they sell the shares that have appreciated in value.
For the purposes of this post I am going to focus on the corporate tax system, and not the other S-Corp or LLC tax structures which essentially go under the Federal tax system on individuals.
HOW THE CORPORATE TAX IS CALCULATED
US Federal Corporate tax rates are “graduated” just like they are for individuals; however, for the largest corporations, you can assume that they generally are near 35% (for all amounts > $18M in income) and everything > $100,000 is at or more than 34%.
Companies calculate their net income for financial reporting purposes (Generally Accepted Accounting Principles or “GAAP”) and this is the starting point for the US Federal Corporate tax return, analogous to how the state income tax returns start with the Federal tax form for individuals. There are a number of adjustments where the US Federal Tax code differs from GAAP – most notably depreciation. When stock options are exercised there is also a tax deduction that is not present for GAAP purposes; thus the recent shenanigans with options price back-dating (where executives retroactively chose dates that were favorable to them for option pricing) is causing massive tax headaches and restatements at companies where the executives exercised those illegally backdated options. By illegally pricing the options, the companies effectively over-paid their taxes, because companies get a tax deduction based on the gain when options are exercised by employees.
Corporations fill out a tax form 1120. This form follows a typical income statement with revenues less costs of good sold, deduct other expenses, and determine net income. Schedule M3 is used to reconcile the book to tax differences listed above, plus many more.
While the differences from GAAP to tax are complex enough to fill several hundred blogs, in general if you apply the Federal tax on corporations plus state taxes you get an “effective tax rate” of approximately 39% (corporations can deduct state taxes on their Federal returns, and state taxes average about 6.6% on top of the 34% rate, which works out to about 39%).
On the company’s income statement you can see the “provision for income taxes” which is calculated at the “effective tax rate” which is used for GAAP financial reporting as well as “income taxes paid” which is a note below on the income statement. Exxon, for example, had a provision for income taxes for the 9 months ended 9/30/06 of $18.2 billion dollars and actually paid taxes of $18.6 billion dollars during that same time period. The closeness of these 2 numbers can vary by company.
Corporations are different than people is that they can run a loss and pay no taxes at all. Individuals can be in a situation where they don’t owe taxes, but that is usually only because they are making a tiny amount of money (or are a student). Generally, individuals make money, and they owe taxes (whether it is withheld or paid at the end of the year). When a company starts up, it is assumed that they will lose money for some period of time, and will begin making money later. When the company starts making money, they can “net” their prior losses against their current income in what is known as a “tax loss carryforward”. There are limits on this capability, but broadly speaking if a company loses $10M one year and makes $10M the following year they will be able to apply the loss from the prior year to the current year and minimize their taxes paid to the government.
CORPORATE TAX REVENUE FLUCTUATIONS
While the corporate tax rate and rules have remained generally consistent over the last decade or so, the amount of tax PAID fluctuates significantly along with the economy. When the economy is performing poorly, such as it was in the 2002 time period, corporate tax receipts by the Federal government are lower because corporate taxes are lower. In recent years, corporations have done well in the United States, resulting in significantly larger payments by corporations to the Federal government.
Federal tax collections hit bottom at $148 billion in 2002; in 2005 collections surged to $278 billion dollars, almost doubling in three years. The rates and policies were pretty much unchanged during the period; the increase was almost solely due to higher corporate profits. Corporate taxes as a percentage of gross domestic product (GDP) hit a low of 1.4% in 1984; in 2005 they were up to 2.3% of GDP, and 12.9% of total Federal receipts. See this excellent article from the tax foundation (a non-profit group dedicated to tax reform and optimal tax policies) for additional data. The state portion of the corporate taxes also fluctuated significantly during this time period.
Planning for state and Federal entities is difficult when the revenue base is subject to fluctuations. Compared to other sources of revenue, such as property taxes and sales taxes, corporate taxes are the most likely to vary significantly from plan, which can cause budget deficits or unexpected surpluses.
CORPORATE TAX COMPETITIVENESS
Although sometimes this seems like news to the Democrats, in fact behavior changes due to incentives and the world is not static. In the same way that retirees and the wealthy flee states with high state income tax rates for states like Nevada with more favorable tax rules, corporations change their mix of activities in order to minimize their tax liabilities. In fact, corporations are duty-bound to conduct their activities in a way that minimizes taxation, within the law, of course.
The Unites States used to have a favorable corporate tax policy, but now the US has the WORST tax regime of all the OCED (developed) countries. According to the Tax Foundation:
“We’re number one… Today, the combined U.S. corporate tax rate stands at 39.3 percent. That means America now has the highest statutory corporate income tax rate in the world—even higher than socialist Sweden and welfare-states Germany and France.
According to the tax foundation, the US would need to cut our tax rate by 25% just to be in the “middle of the pack” among industrial countries.
One of the sad failures of the Republican congress was their inability to address this issue of competitiveness while they had control of the legislature. With the Democrats in control tax return or improving the competitiveness of our tax policy is nowhere on the horizon.
It is unbelievable that even socialist countries such as Germany and Sweden have grasped the fact that high corporate taxes impact investment and jobs but the United States, the leading free market nation in the developed world, has not. But sadly, this is the case.
Other countries have prospered by lowering the corporate tax rate, notably Ireland with a 12.5% rate and Slovakia, which rescued its floundering economy by implementing sensible flat tax policies. This trend has taken hold worldwide but not in the United States, for whatever reason.
Of all the failures of the Republican congress, their inability to set long term policies in place that contribute to our productivity and competitiveness is one of the worst. Our corporate tax policies, at the worst in the OCED, really tell the tale.