The Strenuously Hushed-Up Basic Flaw In The Tax Code

Corporate Tax Dodging In The Fifty States,” a report that the CTJ released today, found that the largest corporations paid little or no state income taxes in any state for the years 2008-2010. In a prior report, the CTJ found that some of the most profitable US corporations paid no federal income taxes over the same period. Both reports point at one of the major problems dogging the US economy: the tax code—and its most fundamental flaw that not even tax reformers dare to mention.

The Internal Revenue Code serves two functions: raise money for the government; and dole out benefits and subsidies to industries, companies, pet projects, individuals, shrimp fisheries, etc. in return for campaign contributions, votes, and fringe benefits such as free plane rides, bundles of cash, sweetheart mortgages, or well-paid jobs for staffers when they move on. It’s the congressional bread and butter. And the economy pays the price.

Tax reform has been in the air in greater concentrations recently. The proposals address some of the symptoms of what’s wrong with the tax code (tax rates, inequality, constraints on business growth, complexity, etc.). But none address the most fundamental flaw that impacts every aspect of the tax code applicable to businesses: the separation of tax accounting from financial accounting.

For example, for the three years from 2008 through 2010, Well Fargo reported $49 billion in earnings, based on Generally Accepted Accounting Principles (GAAP), but it paid zero federal income taxes—it received a refund of $681 million (CTJ). GE reported $14 billion in income in 2010, of which $5.1 billion came from operations in the US. Income taxes? None. Instead, it claimed a refund of $3.2 billion (New York Times).

That these companies were legally able to tell investors that they made a ton of money while telling the IRS that they lost money shows just how absurd the system has become (not to speak of the absurdity that they received hundreds of billions in bailout money from the Fed and from TARP, plus a host of other taxpayer-funded benefits and guarantees).

This whole debacle could be avoided if the portions of the tax code as applicable to businesses were replaced by a single paragraph that states that income taxes are to be paid at x, y, and z rates on income as reported to investors under GAAP.

GAAP allows companies to seduce investors in a myriad ways with inflated profits and asset values. In fact, it incentivizes companies to engage in economically unproductive activities simply to make their numbers look better.

The tax code does the opposite. It encourages the very same companies that reported inflated income and asset values under GAAP to report little or no income to the IRS. The tax code incentivizes companies to invest heavily in economically unproductive strategies, such as massive lobbying or shifting income-producing activities offshore.

Making GAAP the accounting system for tax purposes would have a number of beneficial consequences. Among them:

  • Tax rates could be much lower than current rates because the income they’re applied to is the same inflated income that investors get dished up on a quarterly basis. Rates could be low enough to incentivize companies to re-shore profitable activities.
  • Companies would face a choice: inflate profits and asset values to look good but pay higher taxes as a consequence; or report realistic numbers and pay less in taxes. As an unintended consequence, financial reporting might become more reliable for investors.
  • Companies would have some certainty about income taxes and could commit to long-term investments with less risk.
  • The corporate tax profession could be shifted to productive activities. At GE, for example, the third-grade daughter of one of the employees could spend a few minutes every quarter doing GE’s income taxes (rate tables applied to reported income). Um, I’m being facetious. There will still be issues for professionals to tear their hair out over, such as international activities. But most of the tax professionals now on staff could be retrained to do productive work. IRS personnel would also be retrained, and auditors would follow GAAP in their audits.

Though the list of economic benefits is long, the noise from tax professionals and lobbyists would blow out the national eardrums. Profitable companies that pay no income taxes might dig in their heels. And unemployment might briefly edge up as tax professionals merge into other activities. Yet, the business and economic advantages of using one accounting system for tax and financial reporting, along with much lower tax rates, would be enormous. Alas, as ugly, complex, and dysfunctional as the current tax code is, it remains the congressional bread and butter—and that might never change.

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