Corporate Taxes — How Does America Stack Up?
The Intro
We always hear that corporate taxes are too high, but also that major corporations are avoiding paying them. So what gives? This week we dive into corporate taxes, discussing how corporations are taxed and how they avoid paying taxes. Some of the concepts are similar to what we talked about in our post on income taxes, so check that out in case you missed it or want to brush up.
We’re going to save tax policy and a review of Donald Trump’s tax plans for future posts, and hopefully avoid the Part III curse of trilogies (hello Rush Hour and Pirates of the Caribbean) by doing at least two more posts on taxes. I guess that makes the next post the The Prisoner of Azkaban of taxes and this the Chamber of Secrets… of taxes. So let’s talk tax secrets, cool? Cool cool cool.
The Details
The Ins and Outs of Corporations and How They’re Taxed
In this post, the term “corporations” means companies that don’t have “pass through taxation.” Pass through taxation applies to businesses that are set up as sole proprietorships, partnerships, S corporations, and LLCs, where the owners of the business typically receive a proportional share of the business’s profits at the end of the year and only pay individual income tax on their share of those profits. The tax is “passed through” the corporation to the owners. We’re ignoring those companies because the tax rules are quite similar to individual income taxes, as covered in Part I. Instead, we’re focused on C corporations, the form used by the companies that come to mind when talking about corporate taxes (Apple, General Electric, ExxonMobil etc.). C corporations often have many owners, or shareholders, who share in corporation’s profits in the form dividends.
Instead of pass through taxation, C corporations and their shareholders are subject to “double taxation,” meaning the corporation is taxed on its profits, which are then distributed as dividends to the shareholders. Those shareholders then pay additional taxes on the dividends. Of course, other countries tax like this, but only in the United States is this branded as “double taxation.
Just like individual income tax rates, corporate tax rates are progressive and tiered. They range from a 15% rate on profits less than $50k up to a marginal rate of 39% for profits between $100k and $335k. After a C corporation earns $10M or more the tax rate falls back to 35%, creating a maximum effective rate of 34% to 35%, applied after paying all operational costs, like the salaries of all employees, officers, and directors. This tax also doesn’t include state taxes, which end up being largely irrelevant when you’re in the world of international income (more on that below).
So where does America stack up with those rates? If you look at statutory tax rates among OECD countries, the United States is way off to the right (we’re red). But if you look at the effective tax rate, what corporations are actually paying, we’re pretty middle of the road.
The statutory or “headline” rate is the tax rate you see if you look in the tax code, whereas the effective tax rate compares taxes paid to a more economic measure of a corporation’s income. A complex web of deductions, credits, deferrals, and other strategies reduces taxable income, driving the effective tax rate well below the statutory rate. This is an important distinction that most proponents of lower corporate taxes gloss over, so keep those comparisons in mind.
How Corporations Avoid Paying Taxes
Corporations can deduct most of their basic expenses such as salaries, benefits, insurance, travel expenses, losses from debt, interest payments, marketing expenses, and legal fees. One of the largest deductions corporations use is the deduction for depreciation. Let’s look at an example of depreciation:
You own a landscaping business run by lawyers called “The Lawn Firm,” and business is good. The Lawn Firm buys a new truck for $25k. Each year, that truck depreciates, or loses, about about $5k of its value. This loss allows the company to take a tax deduction, reducing taxable income. If the company deducts $5k each year for the next five years, that’s called straight-line depreciation and the truck is completely written off in five years. In general, the tax code also permits businesses to accelerate their depreciation deductions — to front-load the deductions relative to actual economic wear and tear. Of course, the IRS isn’t dumb, so if you sell the truck for more than the depreciated value, you’ll owe depreciation recapture taxes. Let’s say that being the wily landscaping lawyer that you are, you sell the truck for $10k in year six, after depreciating the truck to zero in year five. You would now owe taxes on that $10k as income. But if you’re a corporation with complex operations and staff to manage your taxes, you would have found some other deduction, like a new, bigger truck that’s depreciating, to reduce that $10k in income. This system allows cash to come and go untaxed, kind of like The Blaze suspects Trump has been doing.
Depreciation is a normal, legal strategy, and it’s just scratching the surface on tax avoidance. The tax system for U.S. corporations with international income is enormously complex, but basically the offshore business income of those corporations is not taxed by the United States until the cash profits are “repatriated,” or brought back home. As a result, there is an estimated $2.6 trillion (T.. for trillion) of untaxed corporate profits sitting overseas. The vast majority of major public corporations, including the likes of Apple, Microsoft, Wal-Mart, Google, Johnson & Johnson, Coca-Cola, Dell, eBay, Pfizer, Merck, etc., keep profits in subsidiaries in low tax countries like Ireland or the Cayman Islands for this reason. How do profits end up in these tax havens? A system called transfer pricing, Here’s an example: Apple Bermuda buys iPhones from Apple China for a very low price, sells them to Apple USA for a higher price, who then sells them to Americans at a slightly higher price. This causes low revenue in Apple China and Apple USA, and thus low taxable profits in those countries, and high profits in Apple Bermuda, where tax rates are low to zero. In addition to goods like iPhones, services and intangible assets like patent and trademark licenses are used in transfer pricing schemes. They also often have great names like the Double Irish, the Dutch Sandwich, the Bermuda Black Hole, and the underrated Indian Headnod (j/k that one isn’t real, but that video is hilarious and culturally informative).
Companies stashing profits overseas eventually have to pay tax in order to bring the cash back to the U.S. and distribute it to their shareholders. But most are likely expecting a “tax holiday” from Congress, such as the one in 2004 that temporarily capped the max tax rate on repatriated profits at 5.25%. That plan was sold to the American public as a way to increase investment and job growth domestically, which seemingly didn’t happen. And so in 2015, amidst reports of $2+ trillion in offshore profits, President Obama with evidence in hand pushed for a 14% tax on profits held overseas and a 19% tax thereafter, whether the profits were repatriated or not. That effort never really went anywhere though. Thanks Obama.
This year, Bernie Sanders released a list of the top ten worst tax avoiders. While most major corporations use these strategies, these ten were the most aggressive.
What Does It All Mean?
When we think about corporate taxation, Mitt Romney kinda had it right, in that corporations are people too my friends. Every corporation is made up of groups of humans, serving as shareholders, employees, and customers, making taxes on corporations taxes on humans. When we think about taxing corporations, we should think about how we want to tax different groups of humans that make them up. It’s not easy to figure out exactly which humans end up shouldering the cost of the corporate income tax, but the relevant Congressional scorekeepers treat the tax as falling 75% on investors and 25% on workers, and “investors” includes both billionaire hedge fund managers and Grandma’s retirement account.
All that said, regardless of your beliefs on tax policy and whether corporate taxes should be higher or lower, the fact remains that while corporations’ profits continue to rise, the tax rate they pay has largely decreased.
These trends suggest a relationship, but no conclusive evidence exists as to what the relationship actually is or how it works. Kind of like millennial dating. Finally, as a parting thought, in addition to being used by corporations to avoid taxes, foreign jurisdictions also play a massive role in enabling tax avoidance for individuals. The New York Times recently published a fascinating investigative piece on how one man tried to hide $400M from the government and his wife, with divorce proceedings exposing all the detailed mechanics.
