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     Nov 26, '13


THE BEAR'S LAIR
A rational system of corporate tax
By Martin Hutchinson

US Senator Max Baucus (D-Montana) has come up with a proposal that corporate cash balances held outside the United States should be subject to a one-off tax at 20%, expected to raise US$400 billion on the $2 trillion of overseas cash, which the good senator can throw around to favored constituencies.

At the other extreme, the US Chamber of Commerce wants to have all non-US income free from US tax, an incentive to outsource everything including the logo for most US corporations. Then there's the question of dividends, still taxed at 35% corporate rate and again at 20% when received by individual shareholders. In other words, US corporate taxation is a mess. So I thought this column would take a crack at designing a rational system.

Chamber of Commerce types want the US to adopt a system whereby it taxes only domestic income, similar to the tax systems employed by most foreign countries. However, that simply encourages companies to "manage" their international tax, inventing fanciful values for their intellectual property and thereby



sheltering much of their income in tax havens. It also provides a massive incentive to companies to outsource as much as possible of their operations, leaving only a thin domestic sales operation in the US, since they would pay tax at 35% on domestic activities but close to zero on international activities, once tax haven and licensing possibilities had been maximized.

Even though corporate profits were at record levels of almost 10% of GDP in 2012, corporate tax receipts at $242 billion were far below their 2007 peak of $370 billion and represented only 1.5% of GDP compared to 2.0% of GDP in 1994 and 1.6% of GDP in 2004, both years like 2012 of emergence from recessions. For a different measure, corporate taxes represented only 21% of individual income taxes in 2012 compared to 24% in 2004 and 26% in 1994. Far from being decades of supply-side tax cuts, the last 20 years have seen most of the benefits of any tax reductions go to large multinational corporations, while individual taxes of one sort or another have risen. The vast increase in the number and remuneration of lobbyists in Washington, DC, in the last two decades has produced the inevitable result - a relative decline in the corporate tax burden.

The solution to this is simple. US corporations must be taxed on the whole of their worldwide income and not just that remitted to the United States. However, the tax should be levied at a rate of only 25%, well below the current uncompetitive rate of 35%. Naturally, foreign taxes paid will be offset against US tax, at least up to a total of 25% of non-US income.

There will still be a tendency to dump profits in tax havens to offset jurisdictions where profits are taxed at much more than 25%, but tax planning to this extent should be of little concern to the US tax authorities. The most important feature of this reform will be to eliminate the current tax incentive to outsource operations, thereby creating a near-zero tax rate rather than a 35% tax rate. To the extent operations are outsourced to such countries as India and China, where taxes are significant, there is of course no direct saving. But as we have seen once operations are outside the United States, games can be played with "transfer pricing" and intellectual property to reduce the overall tax charge. Taxing worldwide income immediately will remove those games.

The other essential tax reform, which will itself remove many of the loophole games that currently disfigure the tax code and reduce tax revenues, should relate to dividend taxes. As with most policies he instituted, president George W. Bush designed his dividend tax cut of 2003 very poorly.

He recognized the overall problem of double taxation, by which dividends are taxed once at the corporate level and once at the individual level. This resulted in taxes on dividends of 60% or even 70% when state taxes are included. However, his solution of reducing dividend taxes at the individual level to 15% was the wrong one. First, it allowed leftist demagogues and even President Obama to demonize the apparent tax favoritism shown to rich dividend recipients. Second, it created no extra incentive for corporate management to return profits to taxpayers since income paid out in dividends was still fully taxed at the corporate level.

The non-deductibility of dividends at the corporate level also encouraged stock buybacks, often using the cheap leverage so helpfully provided by Ben Bernanke. This did little for ordinary shareholders, who did not have close contacts with the brokers that were used to buy the company's stock. But it did a lot for the company's senior management, whose stock options benefited from the reduction in outstanding shares. A further problem was that company management was very bad at predicting economic and market cycles.

The result was it often bought back stock at market tops, only to eventually be forced to reissue shares at market bottoms as the leverage used to finance the buyback had become an intolerable burden on the company's finances. Like many operations in modern corporate finance, buybacks were beneficial to management and doubtless to the brokers undertaking them on behalf of the company, but damaging to ordinary shareholders since the buybacks made the stock less liquid and, if badly timed, produced a direct loss for long-term shareholders.

The solution to these problems is to make dividends tax deductible at the corporate level. Instantly, any excuse for stock buybacks disappears because the debt-related interest no longer would have any special advantage compared to dividends, and a dollar used in a buyback instead of a dividend would still be a dollar on which corporate tax must be paid. Meanwhile, the US Treasury gains because dividends are increased and then fully taxed in the hands of their recipients, often at high rates.

Dividend tax-deductibility also removes any incentive for tax-shelter games. Shareholders gain no advantage from a spurious tax-shelter deal, or from some uneconomic leasing deal undertaken for tax advantage, because the money parked in the tax shelter or used for leasing could instead be distributed to them directly as dividends. Artificial tax structures such as REITs and Master Limited partnerships would also disappear, because investors would gain the same tax advantage from any company that paid out its income in dividends to them. Effectively, every company would become an MLP, but the dividends paid out would no longer be taxed in the recipient's hands at preferential rates.

With these three tax changes: immediate tax on worldwide income, tax-deductibility of dividends and a reduction in the corporate tax rate to 25%, the US economy would greatly benefit, tax receipts would increase and shareholder returns would be maximized as follows:
  • Most of the $2 trillion estimated to be parked in offshore accounts would immediately be returned to domestic shareholders as dividends, and taxed as income to the recipients. Sen. Baucus would be happy. It would simply then be necessary for the House Republicans to ensure that the money was not spent on useless government fripperies.
  • The current tax advantages of offshoring operations would disappear, increasing employment in the United States.
  • The tax advantage of leverage would disappear, since both debt and dividends would be tax deductible at the corporate level. Corporate cash flow would thus be healthier, leverage and bankruptcies would decline, and emergency share issues in bear markets would be avoided.
  • There would no longer be any political mileage for the argument that dividend recipients were unfairly tax advantaged; they would be taxed on dividends as on any other income.
  • Spurious tax-shelter and leasing deals would disappear, as would spurious option grants and share buybacks, which would result in extra corporate income tax, so be unjustifiable.
  • Even those who believed in the Modigliani-Miller Theorem could no longer use it as justification for excessive debt. Overall, the cost of capital would decline, as share prices rose to reflect companies' lower cost of dividend-paying equity.
  • Jobs would be created from five sources: (1) the immediate return of the offshore money; (2) the removal of incentives for offshoring; (3) the reduction in the US corporate tax rate to 25%; (4) the disappearance of tax shelter and leasing deals; and (5) the reduction in the cost of US equity capital.

    It's a simple enough reform. And if Congress and the administration were to pass it, we would know that good policy, of either political slant, at last had a decent chance against the bad policy produced by politicized deal-mongering and lobbyists. Unfortunately, its chances in the present political climate remain slim.

    Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.

    (Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)





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