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Replacing the Scandal-Plagued Corporate Income Tax with a Cash-Flow Tax, Cato Policy Analysis No. 484

Replacing the Scandal-Plagued Corporate Income Tax with a Cash-Flow Tax, Cato Policy Analysis No. 484

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Published by Cato Institute
Executive Summary

Americans have been inundated with financial

scandals at large corporations during the past two

years. In many cases, unethical behavior and poor

oversight of corporate management are to blame.

But a deeper look reveals that the flawed structure

of the corporate income tax has been a key driver of

corporate waste and inefficiency. The tax code distorts

financial and investment decisions and spurs

executives to hunt for tax shelters.

Three fundamental flaws in the corporate

income tax are behind the distortions and tax

shelters. The first flaw is that the corporate

income tax rate is very high. Currently, the U.S.

statutory corporate rate is the second highest

among the 30 major industrial countries. That

high rate reduces investment, encourages firms

to move profits abroad, and provides incentives

to push the legal margins of the tax code.

The second flaw is that the corporate tax base of

net income or profits is inherently complex because

it relies on concepts such as capital gains and capitalization

of long-lived assets that are difficult to

consistently account for in a tax system. Costs of

capitalized assets are deducted through depreciation,

amortization, and other rules. The tax rules

for capitalized assets and capital gains are repeatedly

exploited in corporate tax shelters. These rules

also cause economic distortions as they interfere

with capital investment, business reorganizations,

and other decisions. Capital gains taxation and capitalization

would be eliminated under a replacement

"cash-flow" tax system.

The third flaw is the gratuitous inconsistency

of the tax code. Examples include the different

tax treatment given to debt and equity and the

different rules imposed on corporations and the

half dozen other types of businesses. Such inconsistencies

played a key role in the tax shelters

exploited by Enron and other firms. Worse, they

have created large costs to the economy by distorting

capital markets and channeling investment

into less productive uses. A cash-flow tax

would eliminate these distortions and put all

businesses and investments on an equal footing.

This study discusses the most serious corporate

tax distortions and examines fundamental

reforms to fix them. One option examined is a

full repeal of the corporate tax. Another option is

replacing the corporate income tax with a cash-flow

tax. The study concludes that implementing

a cash-flow business tax would build on

President Bush's tax cuts, help prevent future

Enron-style scandals, and permanently boost the

economy.
Executive Summary

Americans have been inundated with financial

scandals at large corporations during the past two

years. In many cases, unethical behavior and poor

oversight of corporate management are to blame.

But a deeper look reveals that the flawed structure

of the corporate income tax has been a key driver of

corporate waste and inefficiency. The tax code distorts

financial and investment decisions and spurs

executives to hunt for tax shelters.

Three fundamental flaws in the corporate

income tax are behind the distortions and tax

shelters. The first flaw is that the corporate

income tax rate is very high. Currently, the U.S.

statutory corporate rate is the second highest

among the 30 major industrial countries. That

high rate reduces investment, encourages firms

to move profits abroad, and provides incentives

to push the legal margins of the tax code.

The second flaw is that the corporate tax base of

net income or profits is inherently complex because

it relies on concepts such as capital gains and capitalization

of long-lived assets that are difficult to

consistently account for in a tax system. Costs of

capitalized assets are deducted through depreciation,

amortization, and other rules. The tax rules

for capitalized assets and capital gains are repeatedly

exploited in corporate tax shelters. These rules

also cause economic distortions as they interfere

with capital investment, business reorganizations,

and other decisions. Capital gains taxation and capitalization

would be eliminated under a replacement

"cash-flow" tax system.

The third flaw is the gratuitous inconsistency

of the tax code. Examples include the different

tax treatment given to debt and equity and the

different rules imposed on corporations and the

half dozen other types of businesses. Such inconsistencies

played a key role in the tax shelters

exploited by Enron and other firms. Worse, they

have created large costs to the economy by distorting

capital markets and channeling investment

into less productive uses. A cash-flow tax

would eliminate these distortions and put all

businesses and investments on an equal footing.

This study discusses the most serious corporate

tax distortions and examines fundamental

reforms to fix them. One option examined is a

full repeal of the corporate tax. Another option is

replacing the corporate income tax with a cash-flow

tax. The study concludes that implementing

a cash-flow business tax would build on

President Bush's tax cuts, help prevent future

Enron-style scandals, and permanently boost the

economy.

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Americans have been inundated with financialscandals at large corporations during the past twoyears. In many cases, unethical behavior and pooroversight of corporate management are to blame.But a deeper look reveals that the flawed structureof the corporate income tax has been a key driver of corporate waste and inefficiency. The tax code dis-torts financial and investment decisions and spursexecutives to hunt for tax shelters.Three fundamental flaws in the corporateincome tax are behind the distortions and taxshelters. The first flaw is that the corporateincome tax rate is very high. Currently, the U.S.statutory corporate rate is the second highestamong the 30 major industrial countries. Thathigh rate reduces investment, encourages firmsto move profits abroad, and provides incentivesto push the legal margins of the tax code.The second flaw is that the corporate tax base of net income or profits is inherently complex becauseit relies on concepts such as capital gains and capi-talization of long-lived assets that are difficult toconsistently account for in a tax system. Costs of capitalized assets are deducted through deprecia-tion, amortization, and other rules. The tax rulesfor capitalized assets and capital gains are repeated-ly exploited in corporate tax shelters. These rulesalso cause economic distortions as they interferewith capital investment, business reorganizations,and other decisions. Capital gains taxation and cap-italization would be eliminated under a replace-ment “cash-flow” tax system.The third flaw is the gratuitous inconsistencyof the tax code. Examples include the differenttax treatment given to debt and equity and thedifferent rules imposed on corporations and thehalf dozen other types of businesses. Such incon-sistencies played a key role in the tax sheltersexploited by Enron and other firms. Worse, theyhave created large costs to the economy by dis-torting capital markets and channeling invest-ment into less productive uses. A cash-flow taxwould eliminate these distortions and put allbusinesses and investments on an equal footing.This study discusses the most serious corpo-rate tax distortions and examines fundamentalreforms to fix them. One option examined is afull repeal of the corporate tax. Another option isreplacing the corporate income tax with a cash-flow tax. The study concludes that implement-ing a cash-flow business tax would build onPresident Bush’s tax cuts, help prevent futureEnron-style scandals, and permanently boost theeconomy.
 Replacing the Scandal-Plagued Corporate Income Taxwith a Cash-Flow Tax
by Chris Edwards
_____________________________________________________________________________________________________
Chris Edwards is director of fiscal policy studies at the Cato Institute.
Executive Summary
No. 484August 14, 2003
 
Introduction
The corporate income tax will raiseabout $150 billion in fiscal 2003, whichaccounts for about 8 percent of total federaltax revenues.
1
Despite some popular percep-tions that large corporations are able toevade much of their tax liability, most largecorporations pay a huge amount of tax tothe federal government. Consider Wal-Mart.It paid $3.02 billion in current federalincome taxes in 2002 on pretax U.S. profitsof $9.52 billion.
2
That works out to an effec-tive tax rate of 31.7 percent.Of course, Wal-Mart and other corpora-tions do not actually bear the burden of thecorporate tax; they simply act as tax collectorsfor the government. The actual burden of cor-porate taxes falls on individuals as workers,consumers, and investors. The extent to whichthe burden falls on each group is subject tomuch debate with no clear answers.
3
Supposethat Wal-Mart’s $3 billion tax in 2002 wasfully borne by its 1.1 million U.S. workers. Theeffect would be to reduce each worker’s annu-al wage by $2,727. But no matter which groupactually bears the burden, corporate incometaxes create the fiction that $150 billion of fed-eral spending is “free” because the cost is invis-ible to the general public.The corporate income tax is generally con-sidered the most complex and distortionary of all federal taxes. Jane Gravelle concludes thatthe “one fundamental aspect of the tax law thatappears to cause the greatest tax distortions isthe double tax on corporate income,” whichoccurs because corporate profits are taxed atboth the corporate and individual levels.
4
Thatdistortion has caused concern since the begin-ning of the income tax, but the costs are risingin today’s competitive and globalized economy.The observations that Stanford economistsMyron Scholes and Mark Wolfson made in1991 are still true today:The United States is out of sync withmost of the rest of the world in tax-ing corporate income so heavily rela-tive to non-corporate income. Inmost other countries, corporateincome is taxed more favorably byallowing shareholders to take a taxcredit for corporate taxes they payindirectly as shareholders, by impos-ing low shareholder-level tax rates, orby imposing relatively low corporate-level tax rates.
5
Scholes and Wolfson concluded that“unless the tax system is changed to makeU.S. corporations less tax disfavored relativeto partnerships, investment bankers andother organizational designers will continueto search for ways to gut the corporate tax.”
6
That comment was prescient, given the sub-sequent aggressive tax avoidance efforts byEnron and other companies. The U.S. corpo-rate tax is not gutted yet, but policymakerslargely have themselves to blame for recentcorporate tax avoidance scandals. After all,policymakers have not responded to the real-ity that nearly every major industrial nationhas cut its statutory corporate tax rate tobelow the U.S. rate.
7
The recent tax bill passed by Congressincluded shareholder tax cuts that are a firststep toward solving the corporate tax prob-lem. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the toptax rates on dividends and capital gains to 15percent.
8
However, those tax cuts are set toexpire after 2008, and the tax bill did notaddress many serious distortions in the cor-porate income tax. For those reasons,Congress needs to pursue a major corporatetax overhaul or a full corporate tax repeal.Former treasury secretary Paul O’Neill’smusings about abolishing the corporateincome tax were not far-fetched, given thegrowing strain the tax is under in the com-petitive global economy.That growing strain was highlighted in therecent 2,700-page report on EnronCorporation’s tax sheltering activities by thecongressional Joint Committee on Taxation.
9
Enron is just one company, but it took a teamof JCT investigators a year to figure out how all
2
Policymakershave not respond-ed to the realitythat nearly everymajor industrialnation has cut itsstatutory corpo-rate tax rate tobelow theU.S. rate.
 
its tax shelters worked. And the JCT was stillunable to determine how much tax Enronshould have paid between 1995 and 2001because the IRS needs to spend many morehours auditing those returns.
10
The efforts of the JCT team were a mirror image of the hugeefforts of the experts at Enron, the accountingfirms, and investment banks that put Enron’stax shelters into place to begin with.The brainpower spent on Enron’s taxes isa just a fraction of the vast brainpower spenton the 2.2 million corporate income taxreturns filed each year.
11
Most of the 54,846pages of federal tax rules relate to businessincome taxes.
12
The JCT concluded thatEnron “excelled at making complexity anally.”
13
Although it was an ally to Enron, taxcomplexity is an enemy to productive busi-ness management and sound investmentdecisions. A typical large corporation spendstens of millions of dollars per year on taxplanning and paperwork. This paper drawson the numerous Enron tax shelter deals tohighlight the serious efficiency and complex-ity problems of the corporate income tax.Enron-style tax sheltering has not been theonly type of corporate tax scandal in the news.Attention has also focused on the growingnumber of U.S. companies moving their placeof incorporation to low-tax jurisdictions, suchas Bermuda. U.S. firms can save taxes on theirforeign operations by creating a foreign parentcompany for their worldwide operations. At thesame time, there are growing incentives for for-eign companies to acquire U.S. companiesbecause the United States has a bad tax climatefor multinational headquarters.
14
Those developments have prompted knee- jerk denunciations of corporate wrongdoingand a batch of ill-conceived Band-Aids fromCongress. But something more fundamentalthan a sudden decline in ethical standards orpatriotism in corporate boardrooms is goingon. The more fundamental issues include thehigh U.S. corporate tax rate, the uncompeti-tive and complex corporate tax rules, global-ization, and tax reforms by foreign govern-ments. In addition, Wall Street “financialinnovation is growing rapidly and the tax lawhas not kept pace,” as the TreasuryDepartment noted in a major study of taxshelters in 1999.
15
For example, the total valueof financial derivatives issued is estimated tohave jumped from $3 trillion in 1990 to $127trillion today.
16
A recently decided case in theU.S. Tax Court involving Bank One’s use of derivatives concluded an eight-year battle anda trial that produced a 3,500-page transcriptand 10,000 exhibits.
17
Clearly, the complexmodern economy is creating unprecedentedpressure on the antiquated income tax system.In the next section I examine how the cor-porate tax shelter issue has developed in recentyears and contrast legalistic and fundamentaleconomic solutions to the problem. Then I dis-cuss the three fundamental structural prob-lems with the U.S. corporate tax: the high statu-tory tax rate; the inherent complexity of anincome tax that relies on capital gains taxationand capitalization; and the gratuitous inconsis-tency that Congress has injected into theincome tax, such as the different rules for cor-porations and other types of businesses.In the final part of the paper I consider tworeform options. First, I consider full corporatetax repeal. Second, I examine replacement of the corporate income tax with a low-rate busi-ness cash-flow tax. A cash-flow tax would elim-inate many current complexities (e.g., deprecia-tion) and distortions (e.g., debt favored overequity) that haunt the current tax code. Cash-flow taxation has been part of numerousreform plans over the years, including aBrookings Institution tax plan from the 1980sand then–house majority leader Dick Armey’sflat tax of the 1990s.
18
I conclude that recentscandals and rising tax competition make thisan excellent time to repeal the corporate tax orreplace it with a business cash-flow tax.
Tax Shelters: Legalistic vs.Fundamental EconomicSolutions
Every few years, the income tax generatesanother cycle of tax avoidance scandals. Inthe 1970s and 1980s, the main focus was on
3
Although it wasan ally to Enron,tax complexity isan enemy to pro-ductive businessmanagement andsound investmentdecisions.

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