Sunday, August 05, 2007

America's Corporate Tax & Market Distortion

One of the most troubling failures of the Republican led congress (which is no more) is their failure to substantially reform the US corporate tax code. I wrote an article that summarizes how the corporate tax is applied at an overview level and the fact that today the US is among the least competitive corporate tax regimes among developed countries. The Economist recently chimed in, too, with an article titled "Tax Reform - Overhauling The Old Jalopy" which does a decent job of summarizing the situation and stating that an average tax rate of 27% without major deductions would accomplish the same thing as our current tax rate of 34%. Not mentioned by the Economist is how this backfired on us with the Alternative Minimum Tax, when a simplified tax methodology with lower rates and a broadly applied based ended up netting millions of middle Americans, including the middle class.

All of these articles miss a more troubling trend, however - the issue isn't as much the tax methodology applied to EXISTING companies (who have strong incentives to stay in place) but how the tax impacts NEW companies that are choosing where to set up shop and what sort of structure to utilize for their business. This photo is a cornerstone of the Accenture "Headquarters" in downtown Chicago - Accenture is the surviving consulting firm from the Arthur Andersen debacle (grist for a future post as I am an alumni) that chose to locate their headquarters in Bermuda rather than the United States, primarily to minimize their income tax burden.

There hasn't been a rush of companies doing what Accenture has done for two main reasons 1) existing companies can't easily pull up their roots and relocate 2) private equity has found another solution for high corporate tax rates.

The private equity solution for high corporate tax rates involves taking the company "private" and loading it with debt. The company still "technically" pays the corporate income tax but the amount of income subject to tax is generally reduced dramatically by the fact that interest is tax deductible and these bought out companies pay tremendous interest on the large debt burden. Their equity base is shrunken and the company is highly leveraged so that they can make large profits assuming that the company is able to continue servicing its debt.

Another element of the private company solution is the fact that partnerships treat their assets as capital gains (assuming they are held one year so that they qualify) and they also find ways to avoid the corporate taxes through complicated partnership agreements (the partnerships still pay taxes, but there are more options for minimizing the tax than under the corporate tax methodologies). The pros and cons of this "tax break for the ultra wealthy" has been playing out in the newspapers recently - according to an article in Barron's on June 25 in the "Top of the Market Section" if Blackstone (which recently went IPO):

"A key risk to Blackstone's shares is the threat of higher taxes... Blackstone assumed a 17% tax rate for last year (when state as well as federal taxes are taken into account), but that could rise by 20 percentage points if Congress moves to force the firm into a corporate structure... another tax break... enables them to treat as a capital gain the "carried interest," or 20% profit, they earn on increases in their firms' investment funds. This income is taxed at the preferential 15% federal capital-gains rate, rather than the top 35% levy on ordinary income."

Thus our non-competitive corporate tax structure is fueling the buyout boom and creating a gigantic tax arbitrage opportunity by favoring private companies loaded with debt over steady, well capitalized companies facing a 34% tax burden (plus state costs, which add a few percentage points).

When you see the news about all of the companies, laden with debt, that are forced to lay off employees or defer investments for the future note that a large portion of the problem was driven by our corporate tax regime. And when you see other news about growing companies choosing to list and domicile in more favorable climates (this is rarer, since it is easier to go private, but it will occur more and more over time) note that this is also caused by our tax policies.

As I have noted previously, the failure of our Republican congress to improve our tax competitiveness will haunt us for years to come. Tax reform for corporations (I don't consider "raising" taxes to be reform) is not even on the distant horizon with the Democrats in power.

Cross posted at Chicago Boyz

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