Fit to Be Tied

Corporate America and Uncle Sam may finally see eye to eye on tax reform.
Randy MyersMay 1, 2011

Maybe conditions have finally gotten bad enough to inspire something good.

When President Obama came to Washington, D.C., two years ago, he vowed to overhaul the corporate tax code. Featuring the second-highest tax rate in the industrialized world after Japan, it was widely blamed for making U.S. corporations less competitive in the global economy and discouraging domestic investment.

The United States taxes corporate profits at a rate of 35%. State income taxes push the average total burden to 39.2%. By contrast, the average combined rate for the 30 industrialized countries in the Organization for Economic Co-operation and Development is about 25%, and most of those countries, unlike the United States, do not tax profits earned outside their borders.

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Obama’s call for change didn’t bear fruit, as two wars and the push for health-care reform took precedence. But now, for a host of reasons, the President is again talking tax reform. Treasury Secretary Tim Geithner has floated the idea of ratcheting the rate down to the “high 20s” while eliminating many tax credits and deductions. The ostensible end-goal of this “revenue neutral” approach is a simpler and more equitable tax code that generates the same amount of income for the government as the current system, but from a broader tax base.

It’s no shoo-in, but some political observers think too much has changed over the past few years to let this chance for reform slip away. Not only has the federal debt ballooned to around $14 trillion, from $9 trillion at the end of fiscal 2007, but unemployment continues to hover stubbornly around the 9% mark despite seven consecutive quarters of GDP growth. On the political front, the wave of conservative Republicans who swept into Congress in the midterm elections is agitating for smaller government, and nothing says “smaller government” like a reduced tax rate.

Thank You, Japan?

But the single biggest impetus may not come from within the country’s borders, but from without. Japan is considering a 5% cut to its corporate tax rate, which would bring it below current U.S. levels. “I’ve got to believe that fact alone will increase the urgency of Washington to address this,” says Scott Hodge, president of the Tax Foundation, a Washington, D.C.-based think tank.

Corporate tax revenue as a share of GDP

Robin Beran, director of global tax and trade for $42.6 billion heavy-equipment maker Caterpillar Inc., is hopeful. “The U.S. is losing ground rapidly in terms of being a good place to invest or headquarter,” he says. “I think the political environment has moved enough to where we’re going to have a more serious discussion about tax reform. But it may take one of those highly motivating ‘crises’ that Rahm Emanuel used to talk about, such as further job losses or just no job growth, to actually get something to happen.”

Tax reform is never an easy sell. “No matter how you do it, you have people who win and people who lose,” notes Chuck Marr, director of federal tax policy for the Center on Budget and Policy Priorities, a Washington, D.C.-based think tank. “And human beings are loss-averse.”

Consider $18.4 billion Whirlpool Corp. Last year, the appliance manufacturer took advantage of a variety of tax credits to boost its net income by nearly 11%. This year, it expects to generate about a third of its profits just from the tax credits it receives for producing energy-efficient appliances. It also has $2 billion of net-operating-loss carryforwards on its books that can be used to offset federal income tax payments as far out as 2030. Hodge calculates that if Washington were to lower the statutory tax rate to 25%, Whirlpool’s tax-loss carryforwards would immediately be worth 25% less, dinging the company’s book value. Repealing the energy tax credit would shrink its bottom line.

Whatever executives’ personal views on tax reform (Whirlpool declined a request for comment), it is hard to imagine anyone at the company being particularly eager to see tax reform of that sort, at least from a shareholder-return perspective. Nor, one suspects, would there be much cheering from the coal, private-equity, reinsurance, or semiconductor industries, all of which enjoy effective tax rates that are approximately half or less the current statutory rate.

Some banks and pharmaceutical companies are likely conflicted over the possibility of reform, too. Citigroup said in February that it could be forced to write down the value of $52.1 billion in deferred tax assets on its books, which now represent about a third of its book equity, if either the United States or Japan lowers its corporate income tax rate. A change by Japan alone, Citigroup said, would trigger a $200 million charge. And Zacks Equity Research analyst Jason Napodano has estimated that the 14 largest U.S.-based pharmaceutical and biotechnology companies could see their effective tax rate jump to 30% from 23%, collectively, if tax reform eliminated research-and-development tax credits and other breaks they now enjoy.

Getting Territorial

For reform to have a chance, political analysts generally agree that President Obama will have to make it one of his signature issues, much as Ronald Reagan did with the Tax Reform Act of 1986, assisted by the Treasury Department. “This issue needs Presidential leadership and the bully pulpit of the White House,” Hodge says.

It would also need the leaders of the congressional committees overseeing tax policy — Dave Camp (R–Mich.), chair of the House Ways and Means Committee; and Max Baucus (D–Mont.), chair of the Senate Finance Committee — to make it the centerpiece of their respective agendas. Baucus told CFO that “it is a top priority. We want to make the system more competitive and fair, and less complex.”

Obama and Geithner have held meetings with business leaders on the subject. Similarly, Camp and Baucus have held hearings on tax reform, but neither has yet made it the top priority on their agenda.

While reform advocates await the outcome of the deficit-reduction battle, which seems likely to include a cut to the corporate tax rate, a bipartisan group of six senators has been trying to push the issue forward. Even before deficit reduction became a national obsession, they were crafting a plan that would, over a 10-year period, reduce the federal debt by about $4 trillion, the target set by the President’s own debt commission, and simultaneously revamp the tax code. The group includes Budget Committee chairman Kent Conrad (D–N. Dak.), Majority Whip Richard Durbin (D–Ill.), and Tom Coburn (R–Okla.).

Whoever champions the issue will have to contend with several long-standing problems, of which two are particularly thorny: the debate over a territorial versus a worldwide system, and the details of revenue neutrality.

Unlike most industrialized countries, which have a territorial tax system that doesn’t tax profits earned outside their borders, the United States has a worldwide system that does, although it tempers the impact in two ways: companies get a credit for taxes already paid overseas, and they can defer taxes on foreign profits until they are repatriated to the United States. But critics say this approach encourages domestic companies to keep profits offshore, and that the United States should switch to a territorial system.

“I’d say policymakers are interested in it, but they also want to make sure that it really would lead to increased investment and jobs in the United States,” says Drew Lyon, a principal with Big Four accounting firm PricewaterhouseCoopers and a former deputy assistant secretary in the U.S. Treasury Department.

A sampling of effective tax rates by industry

It’s not obvious that it would. While it is true that U.S. companies have more than $1 trillion in earnings permanently reinvested overseas, their decisions to invest outside the United States were not driven entirely, or even primarily in many cases, by tax considerations. Texas Instruments vice president and senior tax counsel William Blaylock endorses the territorial model but notes that his $14 billion company recently expanded a wafer-assembly and
-testing facility in the Philippines largely because it already operated there, knew the country well, and viewed it as a successful place to do business. It made an acquisition in Japan because it was available at an attractive price. And it is investing in the United States, too, recently constructing a 1.1 million square foot wafer-fabrication facility in Richardson, Texas. Upon announcing the plant construction, Texas Instruments said it enjoyed proximity to its corporate headquarters, a positive competitive environment, and access to R&D. Blaylock notes that the company also received a “significant” tax credit from the U.S. Department of Energy.

“Tax is a consideration in any investment decision,” says Caterpillar’s Beran. “But I don’t know of any decision we have made where a major plant investment was ever swayed by the tax part of the calculation. In our business, where margins aren’t that high, labor costs, costs for supplies and raw materials, access to suppliers, and closeness to markets are normally more important than taxes.”

“All Else Is Not Equal”

President Obama has called for “revenue neutral” reform that generates the same level of income for the federal government as the current system. Doing that would require eliminating or reining in credits and incentives that will cost Treasury about $102 billion this year. Many business leaders oppose this approach, noting that even after allowing for these “tax expenditures,” U.S. corporations still shoulder a higher effective tax rate — on average about 27% or so, depending on whose numbers you use — than their international competitors. Thus, they argue, a revenue-neutral approach would still leave U.S. companies at a disadvantage.

At the opposite extreme, some argue for revenue enhancement. “All else being equal, reform that’s revenue neutral makes some sense,” says the Center on Budget and Policy Priorities’s Marr. “But the problem is that all else is not equal. The United States is on an unsustainable fiscal path, and that will require gut-wrenching choices. It does not make sense to take corporate taxes off the table.”

There are at least two other potential stumbling blocks to a revenue-neutral approach. First, the biggest tax incentives apply to most U.S. corporations rather than specific industries, so eliminating them could cause widespread pain and pushback from the business community.

Second, even eliminating every corporate tax expenditure probably wouldn’t get the corporate tax rate down to a level the White House or the business community would like to see. Martin Sullivan, an economist and contributing editor with Tax Analysts, a nonprofit publisher of tax news and analysis, said at a recent House Ways and Means Committee hearing that it might not be possible to get the statutory rate below 30% and still remain revenue neutral.

Still, not everyone in the business community is irreversibly opposed to the concept. “I don’t fear revenue-neutral corporate tax reform,” says David Lewis, vice president of finance and corporate finance for $23 billion pharmaceutical firm Eli Lilly and Co. “But for me, the devil is clearly in the details. You have to look at the trade-offs you make. If we could achieve a lower rate, a territorial system, and have innovation incentives — on a revenue-neutral basis — it would be worth doing.”

A Role for the CFO?

Hodge says CFOs could give the reform effort more momentum by agitating for change not just in Washington but also with the nation’s governors.

“The federal corporate tax rate is a millstone around the necks of the 50 states,” he argues. “If every state were to become like Nevada and eliminate state-level corporate income taxes, each would still essentially be imposing the highest corporate tax rate among industrialized nations because our federal rate is that high. So governors need to start getting engaged on this issue, and CFOs, because they are on the ground in those states and typically have pretty good relationships with governors, can go a long way toward stirring up chatter outside the Beltway. The pressure has to come from more than just the business community and its stakeholders.”

Despite the increased talk of corporate tax reform and the many factors that argue in its favor, political and tax analysts say it is unlikely to happen quickly. Before President Reagan was able to shepherd the 1986 tax legislation into law, for example, the Treasury Department released two comprehensive reform proposals in 1985 without success. It wasn’t until the eve of his 1986 reelection that Reagan was able to forge a bipartisan agreement on meaningful change.

Some analysts argue that something could happen before the next Presidential election, but Mark Weinberger, global vice chairman of tax for Big Four accounting firm Ernst & Young and former assistant secretary of the Treasury for tax policy under President George W. Bush, isn’t among them.

“I am 100% optimistic that we will have tax reform,” he says. “You can’t be competitive over the longer term under the current system, and the deficit issue will draw attention to the tax side as well as the revenue side of our national balance sheet. However, I am a lot less sure that it will happen before the next Presidential election. In fact, I don’t think we are going to have it before then.”

Randy Myers is a contributing editor of CFO.

Should Tax Reform Go All-In?

Many analysts say it would make more sense to tackle the entire tax code at once rather than focus solely on corporate taxes. As Ernst & Young global vice chairman of tax Mark Weinberger notes, corporate taxes now account for only about 9% of federal revenues, in part because of the increased reliance on payroll taxes and the fact that an increasing number of businesses have chosen to operate as pass-through entities, such as partnerships and S corporations. At those firms, profits pass through to the owners, who are then taxed at individual rates. “You’re leaving out 75% of the business entities in this country that contribute 40% of businesses’ net income and a third of business tax receipts,” he says.

And it could be hard to get the corporate rate low enough to be globally competitive yet still meet President Obama’s goal of revenue neutrality by trimming corporate tax expenditures alone. But the tax code is full of plump incentives for individual taxpayers that could be targeted, including the deduction for mortgage interest that the Office of Management and Budget expects to cost $104 billion this year; the exclusion for health insurance, which will cost $177 billion; and the charitable deduction, which will cost $51 billion.

Tackling corporate and individual taxes separately also could result in a corporate rate lower than the top individual rate. That could encourage corporate executives to “hide” some of their salary in their companies and take it out later in a form that takes advantage of potentially lower tax rates on dividends or capital gains.

Finally, cutting only the corporate rate and simultaneously eliminating corporate tax incentives could penalize pass-through business entities. They would be left paying taxes at the higher individual rate, and would lose the tax incentives they now enjoy. — R.M.