Corporate Taxes: A Mess Begging to Be Cleaned Up

"A dirty little secret," Columbia economist Richard Clarida has said, "is that the corporate income tax used to raise a fair amount of revenue."

He's right. But at the same time, American corporations on average pay some of the highest tax rates in the world. The corporate tax code has turned into the ultimate dead weight: It raises a small and ever-shrinking amount of revenue, yet it's overly burdensome for businesses.

President Obama unveiled a plan to overhaul the corporate tax code yesterday by lowering the tax rate while getting rid of dozens of loopholes, exemptions, and carve-outs. Before we get to the details, let's put some context on America's corporate taxes.

Corporate taxes have been shrinking quickly and consistently for half a century, and they now represent a near record-low percentage of GDP:

Sources: Office of Management and Budget and author's calculations.

In 1945, corporate taxes were roughly equal to personal income taxes, raising $16 billion and $18 billion, respectively. Today, the difference is tremendous. Personal income taxes in 2011 totaled $1.1 trillion, while corporate taxes brought in $181 billion -- a difference of sixfold. As a percentage of all federal taxes, corporate taxes fell from more than 30% in the 1950s to 6.6% in 2009.

At the same time, those complaining that corporate taxes are too high may have a point. Compared with other industrialized countries, the U.S. has one of the highest effective tax rates:

Country

Average Effective Corporate Tax Rate, 2006-2009

Japan 38.8%
Italy 29.1%
Germany 27.9%
Australia 27.1%
Israel 26.9%
Denmark 24.9%
South Korea 24.3%
Finland 24.2%
U.K. 23.6%
France 23.1%
Ireland 22.4%
Sweden 22.0%
Spain 21.8%
Canada 21.6%
Switzerland 20.7%
Norway 19.1%
Singapore 16.3%
United States 27.7%
Average 24.5%

Source: PricewaterhouseCoopers.

This is no way to compete on a global scale.

But there's one problem with this table: The U.S.' average corporate tax rate masks volatility among businesses. Some U.S. corporations get away without paying any taxes at all, while other have rates far above the average.

Electric utility companies, for example, pay an average tax rate of 33.8%, while software companies pay an average of 10.1%, according to The New York Times. Trucking companies pay an average tax rate of 30.9%, while drug companies pay an average of 5.6%. In the five years ended 2010, Boeing (NYSE: BA  ) had an average effective tax rate of 4.5%. Southwest Airlines (NYSE: LUV  ) , 6.3%. Prudential Financial (NYSE: PRU  ) , 7.6%. General Electric (NYSE: GE  ) paid an average rate of 14.3% over the period.

Why are these rates so low? Sometimes companies offset current tax liabilities with losses suffered in previous years. This is the way it should be, and it is similar to the rules individuals enjoy when they lose money on investments.

But deductions, loopholes, and carve-outs are also to blame. When New York Times columnist David Leonhardt asked the four companies mentioned above why their tax rates were so low, their responses were nearly uniform: deductions. Boeing made a big contribution to its pension fund and deducted research for new planes. Prudential invested in low-income housing units, which are tax-deductible. Southwest explained: "For book purposes we depreciate our planes over approximately 25 years, but for tax purposes we get to depreciate them over seven years." General Electric wrote off losses from the financial crisis, but its 1,000-person internal tax department didn't hurt, either.

Or take Google (Nasdaq: GOOG  ) . As Bloomberg reported in 2010, the Internet giant saved $3 billion in taxes over three years by "using a technique that moves most of its foreign profits through Ireland and the Netherlands to Bermuda." Bloomberg elaborated on the strategies, called the "Dutch Sandwich" and "Double Irish":

Google reached an agreement with the Internal Revenue Service in 2006, allowing it to license to a subsidiary the offshore rights to its intellectual property for undisclosed fees ... The U.S. parent's licensing deal is with a subsidiary called Google Ireland Holdings ... Allocating the revenue to Ireland helps Google avoid income taxes in the U.S., where most of its technology was developed.

While this unit is an Irish company, it reports that its management is centered in Bermuda -- exempting it from Irish taxes ... The royalty payments from Google Ireland Ltd. in Dublin take a quick detour to the Netherlands to avoid triggering an Irish withholding tax. In Amsterdam, Google Netherlands Holdings BV paid out 99.8 percent of the $5.4 billion it received from Dublin to the unit managed in Bermuda. The Dutch company has no employees.

No one should fault Google for doing this. It's following the law to maximize shareholder value.

But what should get under your skin is that only a company as rich as Google -- one that can afford the legions of accountants, tax lawyers, and lobbyists -- can arrange such a deal. If you're a small mom-and-pop business owner, try setting up a "Dutch Sandwich" through TurboTax. It doesn't work. You're stuck with a 35% tax rate while richer companies pay far less. There are really two corporate tax codes: one for those who can afford to exploit it, and one for everyone else. That's wrong. And since the largest companies with the biggest incomes are the most wily at exploiting the tax code, corporate tax revenue as a share of the economy is nearing irrelevancy.

Enter President Obama's plan to overhaul the tax code. In short, it lowers the top corporate tax rate to 28% from 35% while removing layers of loopholes and deductions. Deductions that tweaked how inventory is calculated; oil and gas subsidies; using insurance companies as tax shelters; and deductions for private jets, among others, would all be on the chopping block. Companies would be required to pay a minimum tax on profits earned overseas (minus a deduction for foreign taxes paid) to discourage routing income through tax havens. Offshoring your production? Say goodbye to writing off the relocation costs.

Is the president's plan (and it is merely a plan; most of it will probably never become law) perfect? No. It's short on details, and what details are available can be -- and will be -- rebutted by many.

It claims, however, that "the President is committed to corporate tax reform that does not add a dime to the deficit, over the next decade or thereafter." That ultimately means some companies will pay more taxes than they do now, and others will pay less. Tax rates will go down while the tax base will be widened. When you grasp the distortions that current loopholes and deductions create, this is exactly what needs to happen. Tax reform that doesn't affect the budget deficit while creating a more level playing field is always a step in the right direction.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Google and Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (21)

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  • Report this Comment On February 23, 2012, at 1:48 PM, CrankyTexan wrote:

    >>> it claims, however, that "the President is committed to corporate tax reform that does not add a dime to the deficit, over the next decade or thereafter." <<<

    Yeah, and there's no way Obama could be lying. Just like Obamacare "reducing health insurance premiums" or unemployment never getting worse than 8%.

    Morgan, instead of taxing, taxing, and more taxing, did you ever consider the government reducing spending?

  • Report this Comment On February 23, 2012, at 2:25 PM, DJDynamicNC wrote:

    "No one should fault Google for doing this. It's following the law to maximize shareholder value."

    I must respectfully disagree with this statement. I can and do fault Google for this. I expect better from a corporate citizen. Google prospers in part because of the legal framework the United States provides, the founders prosper in part because of the education they received here (Larry Page attended University of Michigan, a public institution), and they benefit every day from the wealth of the businesses with whom they do business, which is also due in part to the economic environment of the United States.

    I went out of my way to register my business in New York State even though my biggest clients are all Canadian and I will be a Canadian citizen, because I live in New York and grew up in New York and I owe New York for the economic climate which enabled me to prosper and I feel responsible for paying my dues and investing in the next generation (some of whom may become my clients, by the way).

    So it's good to see this being addressed in a systematic way.

  • Report this Comment On February 23, 2012, at 2:28 PM, CrankyTexan wrote:

    >>> I owe New York for the economic climate which enabled me to prosper and I feel responsible for paying my dues and investing in the next generation <<<

    If you care about the next generation, you might want to do something about the national debt that is being handed to them.

  • Report this Comment On February 23, 2012, at 3:31 PM, medicalquack wrote:

    Ok I'll be my broken record here again with this comment, tax the data selling corporations who make billions selling free taxpayer data they get mining the web, they are all doing it and my infamous example here with Walgreens making under $800 million in 2010 with selling data, so there's a whole lot more out there.

    After all I have to pay a federal excise tax when I buy a tire to help keep our road up, so this fair to me and why should corporate USA profit so immensely at the cost of both privacy and income limitations of the 99%. Lump this right in with their corporate taxes and use a sales tax model.

    http://ducknetweb.blogspot.com/2012/02/start-licensing-and-t...

  • Report this Comment On February 23, 2012, at 4:03 PM, mdk0611 wrote:

    1. While labled tax reform and simplification, the Obama plan can also be called a "loophole shuffling" plan. There are significant loopholes retained or created. The difference is that a different bunch of constituants benefit from them.

    2. While I have not read it for a number of months, I believe the Bowles-Simpson Plan had an interesting idea regarding overseas entities. The overall proposal was for a move to a territorial system. However, I recall that it was limited to "active" trades or businesses. This would exclude the inellectual property deals that fill up the PO Boxes of Bermuda attornies (barristers?) while leveling the playing field for operating businesses.

    3. When calculating the historic percentages of tax revenue from corporations, I think you have to take into account the creation of the "S" Corporation and the LLC during that period. Particualrly over the last 15-20 years, a lot of tax revenue that would have been classified as corporate has been counted as personal. If I were to bet, I'd lay my money on the biggest drop in tax revenues comes from individual taxpayers in the bottom 50% of income earners.

  • Report this Comment On February 23, 2012, at 8:40 PM, CaptainWidget wrote:

    <<I must respectfully disagree with this statement. I can and do fault Google for this. I expect better from a corporate citizen. Google prospers in part because of the legal framework the United States provides, the founders prosper in part because of the education they received here (Larry Page attended University of Michigan, a public institution), and they benefit every day from the wealth of the businesses with whom they do business, which is also due in part to the economic environment of the United States.>>

    Google in no way prospers in any part due to the legal frame work of the United States. They are a very large risk just recently (FROM the united states) of being put completely out of business by arbitrary SOPA legislation.

    The US legal frame work is heavily tilted against what Google does, the US internet infrastructure is slow and inefficient, harming Google's core business. And their tax burden is overwhelming.

    The fact is that Google would likely be more prosperous if they were based in Singapore or Hong Kong, countries with much faster internet speeds, less opportunity cost at tax time, and easier business regulations. Google prospers from the hard work of the creators, the talents of the employees, and their own ingenuity. They could do that from Somolia if they felt like it. Google is the prototype of a non-geographic business. The US should feel fortunate to have them within their borders, we shouldn't treat them like milk cows lucky to have the federal government's caring hand help them survive. I'd say they're paying a perfectly acceptable share of taxes.

    More importantly, they're a public company. Their obligation is to their shareholders, not to random people who think they owe more. If you want Google to pay more taxes, buy shares and throw around your weight. Until you get to 51% however, I doubt they're going to listen much. And IF you get to 51%, I have a strong suspicion you'd change your tune.

  • Report this Comment On February 24, 2012, at 7:31 AM, investisseuse wrote:

    What always strikes me when reading the comments of those who defend tax loopholes is the lack of expatriate perspective. In countries where the idea of commonwealth is still alive citizens understand that that is what makes quality of life affordable for all. I'm your customer today-you are mine tomorrow. If I prosper at your expense, eventually you won't be able to buy my products. It's simple.

  • Report this Comment On February 24, 2012, at 10:18 AM, JGDTexas wrote:

    Where was the analysis of the Obama tax proposal that addressed it's own loopholes and rewards or punishments for various industries????

    It seems Corp taxes are a farce since it's a cost of business passed on to consumers. And then it's a disadvantage to US business versus any others with lower rates. All this would only seem to give Wash DC the power to play the lobbyists, play crony capitalism, and be corrupt if they want. If there ever was a case for the fair tax that didn't pick winners and losers, this mess of a tax code of ours is the case.

  • Report this Comment On February 24, 2012, at 12:25 PM, slpmn wrote:

    Captain Widget - "They could do that from Somolia if they felt like it."

    That statement illustrates more than any other that you have absolutely no understanding of DJDynamicNC's point, which is unfortunate; even more so, because so many others stop their analysis of complex issues at the same level as you. I recommend digging a little deeper.

  • Report this Comment On February 24, 2012, at 3:05 PM, CaptainWidget wrote:

    <<That statement illustrates more than any other that you have absolutely no understanding of DJDynamicNC's point, which is unfortunate; even more so, because so many others stop their analysis of complex issues at the same level as you. I recommend digging a little deeper.>>

    You could not have posted a more vague, pointless, and uninformative rebuttal if you tried.....

    Could you perhaps point out HOW my point illustrates a lack of understanding?

  • Report this Comment On February 24, 2012, at 8:05 PM, colleran wrote:

    Why corporate tax reform won't work. GE spent $26,340,000 to lobby legislators in 2011 (According to OpenSecrets.org). ConocoPhillips spent $20,557,043. And so on. Sad to say, these and other large companies will never let it happen.

  • Report this Comment On February 24, 2012, at 10:34 PM, CrankyTexan wrote:

    >>> Why corporate tax reform won't work. GE spent $26,340,000 to lobby legislators in 2011 (According to OpenSecrets.org). ConocoPhillips spent $20,557,043. And so on. Sad to say, these and other large companies will never let it happen. <<<

    A successful bribe requires two parties. Someone has to offer a bribe, and someone has to accept the bribe.

    Liberals whine about lobbyists, but they never complain about the corrupt politicians who accept the bribes.

  • Report this Comment On March 02, 2012, at 3:31 PM, donbcms wrote:

    Not ONLY Corporate BUT ALSO Income Tax REFORM, CAN and MUST BE MADE TO WORK!! The "Tax Code" has $1.1 TRILLION in "breaks, exemptions & loopholes"; Plus 45% paying NOTHING?? There is your "DEFICIT".

  • Report this Comment On March 02, 2012, at 3:35 PM, drborst wrote:

    @CrankyTexan

    I'm a liberal and I hate the politicians who accept bribes. But really, is that even worth saying? I'd prefer they were procecuted instead of incurring my feeble wrath.

    But the money GE and ConocoPhillips spent isn't a bribe (they likely wouldn't report that). It's lobbying money. It seems it is meant to legitimately change the rules in their favor. Which, while is smells like a bribe, isn't under current US Law.

    I think the problem isn't the money corporations spend nor is it the money politicians take. The problem is corporations find it profitable to spend that money in the first place.

    I'd say Obama's plan is a small step in the right direction, but ending all tax breaks would be a much better plan, and the optimal solution would be to find a way to prevent politicians from tinkering with the tax code ever again.

    @Morgan

    I appreciate your attempt to compare tax rates in the table, but is it really that simple? Aren't European corporate taxes on the VAT? Is there some brilliant data pull you could perform to prove your point about corporation to corporation variation (which you called volatility, but I think that word typically describes time based variation in economics). Is was a bit New York Times-y of you to get all anecdotal on your loyal data driven readers...

    The Obama plan isn't perfect

  • Report this Comment On March 02, 2012, at 4:03 PM, DJDynamicNC wrote:

    "Liberals whine about lobbyists, but they never complain about the corrupt politicians who accept the bribes."

    That's false, actually. We just recognize that the problem is a matter of aligning incentives.

    So long as the incentives in place are heavily weighted towards corruption, then perfectly decent human beings will become corrupted, corrupt human beings will thrive, and honest human beings will be rare. Replacing every politician in Washington with a brand new batch would do almost nothing to change things, because the same incentives would be there.

    It doesn't matter who is in the band if they're always playing the same song.

    So the reason you don't hear us complain about corrupt politicians is A) because we want to solve the problem at the source, rather than symptomatically, by addressing the incentives, and B) because you don't read liberal blogs, where we bitch constantly about corrupt politicians and EVERYTHING ELSE. :lol:

  • Report this Comment On March 03, 2012, at 12:15 AM, tsuneson wrote:

    if revenue is needed I think all should pay their fair share If corporate america needs a tax break then it should be done on how well it compensates its employees.

    I suggest to raise more revenue then maybe we should tax all the money used to lobby and run campaigns including superpacs.

  • Report this Comment On March 04, 2012, at 11:20 PM, critter88 wrote:

    The whole area, unfortunately, is much more complicated. First, Obama (and most politicians) provide tax incentives for investments that he favors, such as green energy. But these tax incentives result in very low taxes, so Obama calls you a tax dodge and wants tax reform. Can't have it both ways. Second, as one writer noted, most business income are earned by "flow through" entities that don't pay corporate taxes. This advantage is reduced if the corporate tax rate is reduced so they are now saying tax reform is unfair to them because their advantage over corporations will shrink. They want something to make up for losing part of that advantage.

  • Report this Comment On March 05, 2012, at 10:37 AM, rehani wrote:

    Captain Widget - your logic makes me laugh.

    If Google could do better in Somalia, they would be there already. Fact is, Google and Goldman Sachs and IBM and a hundred others - want the security and comfort of the US borders, but hate paying for it.

    They pay (lobby) politicians instead, and for 1/100th of what they would have to shell out in taxes, they get the code amended to include their favorite loopholes...

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