Tax Avoidance Inc.

Corporations today believe they owe it to their stockholders to minimize business taxes any way they can.
March 2004
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Many years ago, when I was a young economist, it became clear to me that commercial banks, by using certain investment strategies, could legally avoid paying any federal corporate income taxes whatsoever. I asked a senior banker why his bank continued to pay what could have been so easily avoided. His answer had to do with the notion of paying one's "fair share" and an obligation the bank had to its shareholders to avoid being seen as taking undue advantage of tax loopholes.

My, how times have changed. Now, the received wisdom is that corporations and businesses owe it to their stockholders to minimize taxes by whatever means they can. Rather than avoiding censure for not doing their share in supporting governments, tax minimization and tax avoidance have become part of a corporate profit center.

The latest installment on the tax-avoidance-at-all-costs game is the revelations relating to that world-class corporate bad boy, WorldCom. According to a court-directed report filed by former Attorney General Richard Thornburgh, the company probably evaded hundreds of millions in state taxes by illegally shifting profits from states that collect certain corporate taxes to those that do not. For example, the parent company charged its subsidiaries billions of dollars in royalties for licenses and intellectual property rights as well as strategic plans that were dubbed "management foresight." The charges were a ploy to drain income away from operations in states that charged income taxes and to channel it into operations in states, such as Mississippi, that do not tax intellectual property royalty income. The report indicated that WorldCom saved perhaps $350 million in state taxes between 1998 and 2001.

Of course, dodging state taxes is only a part of the larger WorldCom show. Its former top officials are already heading to trial for $11 billion in accounting "irregularities" that led to its bankruptcy in 2002. One of the more egregious slick tricks was to capitalize billions of dollars in current charges and artificially inflate profits--which were sheltered from taxation. Moreover, the corporate indiscretions are wrapped up in allegations of thievery by top officials who looted corporations and, of course, their stockholders to line their own pockets. Contrary to the view of my banker friend of years gone by, neither the reputation of the firm nor the fate of the stockholders really mattered when fast money was to be made.

It is clear from all this that the future role of corporations in any tax system is murky and contentious. In fact, the corporate income tax has faded greatly at the federal level (less than 10 percent of tax revenues) and into irrelevancy at the state level (around 5 percent, on average). Big corporations are able to minimize taxes, if not avoid them altogether. States, whipsawed by the desire to save jobs, be cost-competitive and be business-friendly have lowered tax rates, provided exemptions and credits and have eagerly ratcheted down the burden. For example, a major corporate tax "reform" has been to change the weighting formulas so that corporations that have plants and employees within a state get more generous tax breaks than those that make sales within the state. With the footloose nature of capital assets and the vastly increased ability to cherry-pick points of production and sales, the formulas, to put it mildly, are subject to manipulation.

Tax purists argue that the concept of corporate income has always been flawed and subject to special handling, to say nothing of leading to distortions. Ultimately, the burden of corporate income taxes falls on individuals, since the corporations themselves are no more than a conduit--a commercial vessel of convenience for combining individual activities while limiting legal liability. In fact, one of the political advantages of the corporate income tax is the uncertainty as to exactly who ends up paying it. Myriad assumptions are needed to guess what the impact of the tax is since economists' profit- maximizing models of behavior often do not square with observed investor or managerial behavior.

There are no easy answers to the corporate income tax puzzle, especially at the state level. But, as with Internet sales, it is clear that the base of the tax has eroded under interstate and international tax competition. The vast scope of ownership of corporations makes the integration of the corporate and the individual income difficult.

If there is an individual income tax, however, there needs to be one on corporate income as well, simply to avoid vast accumulations of wealth occurring outside of the tax system. With the pending demise of the estate tax at all levels, the ability to enjoy the full bounty of that accumulation free of taxation would be unlimited. As my banker friend pointed out years ago, some ways of minimizing taxes might benefit a privileged few but prove unacceptable to a majority that are not so materially blessed.