Is Our Corporate Tax System Irrational?

by: The Sociology of Finance

My guess is that just about everyone reading this headline would answer in the affirmative. Critics of the American tax system have a lot to complain about, including unnecessary complexity, a tilt towards large businesses over small, government subsidy boondoggles, and internationally high marginal (yet sometimes extremely low effective) rates. This article won't attempt to tear apart the entire system, but instead focus on one aspect that raises my hackles: preferential tax treatment by industry.

Making some industries pay more than others is a way of saying that capital will not be optimally allocated if the industrial playing field is level. And maybe there is some logic behind this idea. After all, some infant technologies or industries important for national security might be starved for capital if they had to compete for investors with the likes of a Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B) or Coca-Cola (NYSE:KO). Or perhaps some capital-intensive industries should receive indulgence regarding depreciation allowances or new construction to encourage domestic investment.

The problem is that when one actually looks at the taxes companies from different industries actually pay, there seems to be no rhyme or reason. Instead, the main determinants of taxes paid appear to be factors such as 1.) The extent to which the firm's assets are in intellectual property rather than physical plants, equipment, and hard assets; 2.) The extent to which the firm's revenue comes from abroad (or can be legally classified as such); 3.) Whether your firm needed a taxpayer bailout or otherwise experienced crisis in recent times; 4.) Whether or not consumers are in love with the firm. All four factors significantly lower tax rates.

Who Paid What

Below is a summary of the effective tax rates paid in FY 2012 by the largest publicly traded domestic firms (Source: Morningstar). While tax rates fluctuate from year-to-year and some companies run into special situations like Amazon's (NASDAQ:AMZN) unusually low margins yet high effective rate, the table seems to be a reasonable representation of who is paying what these days:

There's a few things to note on this table that don't really add up to me:

The energy supermajors get hosed: Exxon (NYSE:XOM), Chevron (NYSE:CVX), and ConocoPhillips (NYSE:COP) regularly occupy the top positions in effective tax rates. This is due to a variety of factors, including the pressure on politicians to tax oil companies when regular people are feeling the pain at the pump. Altria (NYSE:MO) is also in the category of companies that politicians love to hate, and its tax bill is usually quite substantial. Yet what is likely more important is that these companies either cannot or will not stash cash abroad. These companies tend to return substantially all free cash flow to shareholders via dividends and buybacks rather than build mountains like Apple (NASDAQ:AAPL). It is hard to say exactly to what extent this is because of management's capital policy or the fact that profits from real assets are more difficult to transfer to an Irish subsidiary. Regardless, it is clear that the energy industry is more than pulling its own weight, and that its unsavory reputation with the general public is undeserved, at least when it comes to tax shenanigans.

Bailout recipients get a free pass: Citigroup (NYSE:C) and Bank of America (NYSE:BAC) have been crawling their way back to profitability. And while they are slowly making good on their bailout commitments to the Treasury, they have massive deferred tax assets from prior losses that they can credit towards future tax payments. So current profits are essentially tax free. In my opinion, this is patently unjust. We taxpayers saved these broken institutions and took on a lot of risk to do so. We gave them a clean slate, so it is only fair that the slate actually be wiped clean as far as tax assets. Instead, the financial sector's grownups like Wells Fargo (NYSE:WFC) and Berkshire Hathaway have to do the heavy tax lifting. This is not exactly incentivizing good behavior, and is also true for GM (NYSE:GM), which has a similar sweet deal.

Tech companies are the tax wheeler-dealers: By and large, the big tech names pay a bit more than half the tax rate of the oil supermajors. Last year, Google (NASDAQ:GOOG) led the charge, paying an effective rate of 19.41%, followed closely by Qualcomm (NASDAQ:QCOM) and Cisco (NASDAQ:CSCO). Compared to these companies, AAPL's controversial effective tax rate of about 25% seems steep. These lower rates that tech companies enjoy are due to a mixture of sales from abroad and the centrality of intellectual property in the business model. From a legal perspective, it is not too hard for AAPL to ascribe the profits from an idea cooked up in Cupertino to a shell company warehousing patents in Ireland. On the other hand, CVX has a more difficult time establishing that oil and gas products made in one place and sold in a second should be counted for tax purposes as if it were made in a third.

And this gets to the root of the issue: the preferential treatment of industries via loopholes and tax breaks causes significant economic distortions. Right now, our tax system is essentially saying that XOM's business is horrible for our society and needs to be discouraged, AAPL's business is so-so and BAC's business needs special inducements because it is so beneficial. And maybe that's how it should be. But we should come to such conclusions after reasoned debate, not differential abilities to weasel out of paying Uncle Sam due to legal or accounting technicalities.

Something Needs To Change

The preferential tax treatment that bailout recipients and tech companies enjoy makes no sense. The banks and GM are no longer on the brink of collapse, and tech companies are drowning in capital, so there's no reason in my mind to give them a better deal than energy companies. The policy implications are clear to me:

1.) If you want to lower corporate taxes, look to give breaks to the companies that pay the most right now, not an AAPL or GOOG that already has a comparatively sweet deal. It is ironic that people with low tax sensibilities seem most interested in giving breaks to companies that already pay relatively little, not companies with the biggest tax burden.

2.) If you want a revenue-neutral reform, close the intellectual property and tax asset loopholes so you can lower taxes on a ConocoPhillips or Berkshire Hathaway.

3.) If you want to increase corporate taxes, an across the board rate hike is the wrong way to go. Energy companies pay quite enough already, thank you very much, but would have to foot the bill while nimbler tech firms will largely avoid increased taxes. An across-the-board rate hike would just increase distortions.

In other words, we need thoughtful, common-sense changes to our corporate tax policy that more evenly share the burden across industries and that focus on real economic activity rather than legal fictions.

Do As I Say, Not As I Do?

All that said, my opinion regarding policy does not exactly line up with my material interests because I am long AAPL and American International Group (NYSE:AIG) and do not have any positions in energy companies right now. But I can intellectually separate what I think will be good for my portfolio from what I think is sound policy. And given that I don't expect any reform out of Washington anytime soon, I might as well take a ride on the gravy train while I can.

Disclosure: I am long AIG, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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