• Colin Doyle CFO

Elizabeth Warren’s corporate tax plan sounds reasonable. It isn’t.

By Karl W. Smith

Senator Elizabeth Warren really hates it when corporations that report billions of dollars in profit pay little or no tax to Uncle Sam. (She’s totally steamed about Amazon.)

As a policy-oriented presidential candidate and scholar of business law, Warren favors technical solutions to perceived problems, and last week she tackled this one in a post on Medium. She proposed what she called a real corporate profits tax on the most profitable 1,200 U.S. companies, a measure that seemed compelling in its simplicity and appeal to fairness. On closer examination, however, her plan would distort the U.S. tax code and degrade corporate governance.

To see why, it's important to realize that corporations calculate their profit using at least two different accounting methods. The first method, using guidelines from the Securities and Exchange Commission, determines how corporations calculate the earnings they report to Wall Street. A separate set of accounting guidelines from the Internal Revenue Service is used to formulate corporate tax bills.

Warren argues that companies game the system, using one method to report high profit to investors and drive up their stock price, and another to report low profit to the IRS to keep taxes down. By that logic, she contends, highly profitable companies ought to be taxed on the higher of the two figures.

But it doesn’t really work that way because the two sets of guidelines have different objectives. Scrapping one or the other would cause all sorts of problems.

The SEC guidelines are designed to minimize corporate fraud and misrepresentation. The goal is to prevent managers from fooling a company’s owners, the shareholders, about how much the company is earning. Before the SEC was established in 1934, corporate managers had been known to pull all sorts of elaborate scams.

One of the most common was to set up a shell company owned exclusively by the managers. The managers would then have the main corporation purchase goods or services from the shell company at inflated prices. This would drain profits from the main corporation while enriching the management.

Once the scheme had gone as far as it could, the managers would have the main corporation declare bankruptcy, leaving its shareholders with nothing. To prevent the shareholders from catching on ahead of time, the managers would issue profitability statements using obscure accounting tricks.

So the SEC forced corporations to calculate profits using generally accepted accounting principles. GAAP has a number of provisions that most people would consider odd, but are important for discouraging misrepresentation. For example, revenue is counted when it is earned, regardless of when it's received.

That means, for example, that when shoppers buy gift cards for Christmas, the money they spend doesn’t count as revenue to the company that issued the gift card. Only when a customer actually uses the gift card to buy something does the company get credit for earned revenue.

From the shareholder point of view, this makes sense. A gift card is a promise to deliver something later. A company that makes a bunch of promises it can’t keep isn’t actually earning revenue or making a profit that shareholders are likely to see.

The GAAP standards are conservative, so many companies emphasize alternative accounting measures that cast their performance in a more favorable light. Inc. chief executive Jeff Bezos, for example, has said that he doesn’t much care whether his company ever earns a profit as calculated by GAAP; his goal is to maximize another measure called free cash flow. That seems to be fine with his investors because the stock price has kept rising even though Amazon has usually reported quarterly losses or scant profit during most of its 22 years as a public company.

The IRS allows, and in some cases demands, that companies deviate from GAAP. For example, the IRS does not allow a corporation to deduct any expenses from its profit until money is actually spent. GAAP, on the other hand, requires a corporation to deduct losses from profit as soon as it's probable that the loss will occur.

This makes sense when you consider that the IRS is primarily interested in keeping shareholders honest, not management. The corporate income tax was first introduced to keep taxpayers from cheating on their individual returns.

The personal income tax originally applied only to the wealthiest 3 percent of the population, and Congress was concerned that much wealth would be sheltered inside corporations to avoid paying the tax. The corporate income tax discouraged that trick.

The corporate tax eventually evolved into a tool for tax fairness. Investors are expected to pay corporate tax on top of any taxes on capital gains or dividends. For this to work, however, the corporate tax has to be designed so that the burden actually falls on investors rather than workers.

If corporations respond to the corporate tax by reducing the number of workers they hire or the speed at which they expand, that doesn’t just lead to lower profit but to fewer jobs and lower wages. For this reason, the IRS allows companies to count losses they incurred in the early years of growing the company against a later year’s taxable income.

Warren singled out Amazon as a symbol of tax unfairness because it reported $9.4 billion in profit in 2018 but paid no federal. One of the factors reducing Amazon’s tax bill, however, was the hundreds of millions of dollars in losses the company was still carrying from previous investments.

Amazon also benefited from other credits that Congress created to encourage investment, including the research and development tax credit that cut $419 million off of its tax bill.

If Warren’s real profits tax were passed, these incentives to invest in the U.S. rather than abroad would be blunted. Whatever else one might think about Amazon, it has invested a staggering amount in the U.S. economy over the last two decades and says it has hired nearly 50,000 new employees per year since 2012.

More subtly, Warren’s tax would reduce the incentive to take risks. Since companies can now deduct losses from future taxes, it can pay to make a few risky investments. Warren’s tax would only apply to companies making over $100 million in profit and so there’s no provision in it to account for negative income from risks that don’t pan out.

Instead, the real profits tax would encourage companies to structure their finances to reduce GAAP profits in good years and increase them in bad years. General Electric Co. became notorious for using this type of trick, which its executives employed to convince investors that GE was a steadier company than it really was. Giving corporations a financial incentive to copy that type of behavior would reduce transparency and fight the goals the SEC is trying to achieve.

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