Is This the Way to Solve America's Problems?

After a brief respite, the economy is showing signs of faltering again. Government expenditures have ballooned, while tax revenues are dwindling. Although the massive intervention during the market meltdown may have helped avoid an even more extreme collapse in stocks, people strongly disagree about what if any role government should play in the future -- and how long freely available borrowing will allow it to continue spending more than it brings in.

It's with that backdrop that the President's Economic Recovery Advisory Board released its report on tax reform last month. Despite all the uncertainty about what will happen to individual tax rates in 2011 and beyond, the report focuses largely on the less well-understood portion of the federal government's revenue: corporate taxes.

Free money?
Corporate tax revenue makes up a relatively small part of the overall federal budget. In the government's 2010 fiscal year, corporate tax revenues were $176 billion, compared to nearly $1.8 trillion from individual income taxes, combined with payroll tax collections for Social Security and Medicare.

But the government is counting on rising corporate tax receipts to provide a growing share of total revenue going forward. The Office of Management and Budget projects that corporate tax revenue will more than double to $415 billion by 2014, compared to more modest growth on a percentage basis for other revenue sources. Budget proposals go even further to increase corporate tax revenue going forward.

The PERAB report sheds some light on how proposed changes could affect corporate taxation. Although this portion of the report spans 30 pages, its suggestions boil down to the following:

• Corporate tax rates in the U.S. are among the highest in the world, and lowering them could make U.S. businesses more competitive.
• To make up for lost revenue, broadening the corporate tax base may be necessary. Possible solutions include eliminating or reducing certain tax breaks, or forcing other business entities such as partnerships and LLCs to pay corporate-level tax.
• Changes to the way the U.S. taxes international business operations could reduce the incentives that companies have to structure their businesses to avoid U.S. taxation entirely.

The report's findings present an interesting dilemma. Cutting corporate tax rates could boost economic activity, but at the cost of already scarce tax revenue. Various reform measures could boost tax revenue, but potentially at the cost of cutting economic activity. Is there a way to have our cake and eat it, too?

Haves and have-nots
From an investing perspective, shareholders need to know whether their companies have benefited from the existing corporate tax structure in order to figure out if a change could hurt them. Recent tax data is suspect because the recession has had a big impact on both profits and tax liabilities. But a 2007 study that looked at effective tax rates from 2004 to 2006 showed that six companies enjoyed double-digit percentage reductions in their effective tax rates because of favorable taxes on foreign earnings. Here they are:

Source: Tax Notes.

By structuring their operations to take maximum advantage of favorable foreign jurisdictions, companies like these can reduce or eliminate U.S. taxes legally while still paying substantial taxes elsewhere.

Past efforts suggest that reform might work. In 2004, companies got a favorable tax break if they repatriated money from overseas operations. As a result, effective tax rates for many companies increased as they took advantage of the tax provision. Hewlett-Packard (NYSE: HPQ) and Eli Lilly (NYSE: LLY) each saw their effective tax rates rise by 5 percentage points or more, with Merck and Pfizer also reporting substantial gains.

The big question
For corporate tax reform to work, companies need to have less incentive to game the system by strategically placing operations and assets out of reach of the U.S. government. Lower tax rates might well accomplish that, especially if accompanied by a change in the way foreign revenue is taxed. If the best decision for companies is to pay more tax to the U.S. and less to foreign governments, then it's a potential win both for those companies and the U.S. government.

Taxes are complicated, and the coming political fight on these and countless other tax provisions, including individual income tax rates, the estate tax, and capital gains and dividends, will be long and fierce. Keeping an eye on the proceedings, though, can give you advance notice of changes that could dramatically affect the stocks you own.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.