Corporate Income Taxes:Trends and Forecasts Presentation to the President’s Advisory Panel on Federal Tax Reform March 8, 2005 Douglas A. Shackelford University of North Carolina and NBER
Overview • Look back • Corporate income taxes are in a long decline • Why have they declined? • International competition • Alternative organizational forms • More effective tax planning • Tax shelters • Mobility of income • Look forward • Feasibility of the corporate income tax in an information economy
Corporate Income Tax as a Percentage of Federal Revenue and GDP Source: Office Management and Budget, Fiscal Year 2005 Budget, as reported by the Tax Policy Center.
Why Have Corporate Taxes Declined? • International competition has eroded corporate taxes as a revenue source • Lower rates at home and abroad • Smaller base—e.g., accelerated/bonus depreciation, R&D deductions and credits • Other organizational forms (e.g., S corp) • The corporate income tax is a special levy on companies that access capital through the public equity markets • Other techniques to undo two levels of tax • More effective tax planning
International Competitiveness: Reducing Corporate Tax Rates Source: Gravelle, J. “The Corporate Tax: Where Has it Been and Where is it Going?” National Tax Journal 57 No. 4 (December, 2004): 903:922.
S Corporations: Eroding the Corporate Tax Base 2004-2010, projected. Source: IRS Statistics of Income.
Business Net Income by Type of Entity Source: Drew Lyon, PriceWaterhouseCoopers, Presentation at the 6th Annual Tax Council Policy Institute Symposium, February 11, 2005. Underlying data from IRS statistics of Income.
Other Ways to Eliminate Double Taxation • Year-end bonuses in privately-held firms • Debt shifts business profits to the lender’s tax return since interest is deductible • Employee stock options • Total deductions from stock option exercises were 10% of total pretax income for the 100 largest U.S. companies in 2000. However, total deductions exceeded total pretax income for the Nasdaq 100. (Graham, Lang, and Shackelford, Journal of Finance, 2004)
More Effective Tax Planning:Book-Tax Gap • The gap between accounting earnings and corporate taxable income widened during the late 1990s • e.g., Desai (2002) finds $155 billion of unexplained book-tax gap in 1998 • Perhaps book is overstated • Earnings pressure may have led to inflated, fictional earnings in the late 1990s • Corporate Tax Shelters
How about Book-Tax Conformity? • Argument given for conformity: If companies are overstating book profits and understating taxable income, then require them to report the same figure to shareholders and the taxing authority and you fix two problems. • Not a good idea • Conformity ignores the critically important role that accounting information plays in the markets.
Corporate Tax Shelters • Legal noncompliance • Meet the letter, but not the spirit of the law • Reduce taxable income but not book income • Little public data so estimates of their magnitude are difficult • Leasing transactions estimated to cost $4 billion for one year (Joint Committee on Taxation, 2004)
Shelters Today • Market has cooled • Recession reduced demand • Bad publicity • IRS has become more aggressive • Big 4 withdrew partly because shelters threaten to undermine the profitable Sarbanes-Oxley audit work. • Market could revive • Booming economy—high profits, high taxes • Recent IRS defeats embolden taxpayers • Big 4 spin off their tax practices
Income Mobility • The tax system relies on information from the historical cost accounting system • The accounting system is struggling to measure income where the primary assets are intangibles. • As a result, taxable income is becoming increasingly difficult to measure. • These measurement problems provide opportunities for tax planners and raise doubts about the long-term viability of income taxes • Problems increase with globalization
Old Days • Factors of production • Largely immobile—heavy industry • Bricks and Mortar • Large unskilled/skilled labor force • Production of goods • Income • Primarily sales less production costs • Biggest accounting questions—inventory, depreciation
Today • Factors of production • Highly mobile--intellectual • Intangibles and highly technical • Small, highly educated labor force • Service-oriented • Income • Affected mostly by people and intangibles • Biggest accounting questions—realized and unrealized intangibles • What is a brand name worth? • Where does a telephone call take place?
Is an Income Tax Feasible in the Future? • A tax system built on income can only last as long as we can define income with some precision. • A tax system depends on market frictions that make it difficult to undo the tax. In old days you could not easily dismantle the plant. Today you can move profits around the globe with transfer prices or a plane ticket. • Is it feasible to think that income can be a basis for tax measures in the future?
Tax Planners Need Differences in Tax Rates • Tax the Same Income Differently • At Different Times • E.g., current tax holiday on repatriated cash • In Different Places • U.S. vs. foreign-source • In Different Organizational Forms • Flow-through entities, tax-exempt organizations, pensions • Depending on the Savings Vehicle • Stock held in an 401(k) vs a mutual fund vs personal account • Tax Similar Income Differently • E.g., new lower rates on U.S. manufacturing