Friday, January 29, 2016

The Debate over Tax Policy

Debate over tax policy is an obviously crucial issue because it impacts everything from various government services like police and infrastructure and judicial system and military funding, to having a successful educational system, and so forth.

Between the two political parties, one area of debate which hasn’t really been brought to close scrutiny is corporate taxation. Republicans argue that America has the highest corporate tax rate at 39.1%, which is well above the Organization for Economic Cooperation and Development (OECD) average of 24.1%. Democrats point out that if you look at the effective tax rate, the largest corporations of the S&P 500 are paying effective tax rates well below that level and typically average out to around 15%.

Essentially, due to years of lobbying the politicians, corporate lawyers have continuously changed tax rules to lean in favor of the largest of corporations. Transnational corporations effectively manage a type of tax arbitrage, where profits are realized in subsidiaries headquartered in parts of the world where the taxes are the least, and losses are realized in subsidiaries which are located in regions where taxes are the highest. Usage of subsidiaries with addresses in countries that act as tax havens, like the Cayman Islands, Switzerland and Ireland, have become a common practice. As a result, revenue to the government from the S&P 500 companies has plummeted over the years as can be seen below:

Corporate Taxes as a Percentage of Federal Revenue
1955 . . . 27.3%
2010 . . . 8.9%

Corporate Taxes as a Percentage of GDP
1955 . . . 4.3%
2010 . . . 1.3%

Individual Income/Payrolls as a Percentage of Federal Revenue
1955 . . . 58.0%
2010 . . . 81.5%

Since 2014, the above figures have generally stayed precisely the same. In other words, as corporations paid less, an even greater burden has been placed on individuals. About 54 of the S&P 500 corporations paid no taxes at all, with the majority getting refunds. For example, from 2010 to 2014, General Electric (GE) made $33 billion in profits, but paid zero in income taxes, and actually received $1.4 billion in tax refunds over that same stretch of time.

One way companies have been cutting their taxes is by corporate inversion, in other words, moving their headquarters offshore to cut their taxes. There is a progressive solution which is given the complicated name of single sales factor apportioned corporate tax. This simply means that if a company has only X percentage of its sales in the United States of America, it only pays taxes on X percentage of its earnings. So if a corporation has a mere 30% of its sales in the United States, it only pays taxes on 30% of its earnings. This was proposed by economist Michael Udell of the District Economics Group. Unfortunately, lobbying groups for special interests manage to succeed in allowing this concept to even be brought before Congress.

Real estate investment trust (REIT) structures have an effective tax rate of close to 10%, and are typically publicly traded real estate management companies that pay-out 90% of their taxable income as a dividend to shareholders. Supposedly, 75% of the REIT’s assets are supposed to be real estate. Over the past decade, however, many corporations have switched to REIT structures to cut their tax obligations. For example, prison management companies like Correctional Corporations of America (CXW) and GEO Group Inc. (GEO), cell phone tower management company American Tower (AMT), document storage company Iron Mountain (IRM), and timber company Weyerhauser (WY) avoided taxes altogether using a REIT structure, and it appears that the railroads and power line management companies may adopt this structure as well.

Setting aside corporations, what about taxes on individuals? Franklin D. Roosevelt had a top tax bracket for the rich of 91%. Of course, that isn’t 91% of all income as our tax system is a graduated structure with brackets. In today’s dollars, every dollar made above something like $1.4 million was taxed at 91 cents at the dollar. This tax bracket was lowered to 70% under President Kennedy and then cut down to as low as 28% under Ronald Reagan, and since then has been raised. What do we have today? A top rate of 39.6% for every dollar made above $406,751, and the rich rarely ever pay that. Most of the rich don’t have a salary that can be taxed as income but earn their money from a portfolio of stocks and bonds.

Taxes on cash dividends used to be taxed as ordinary income; however, that tax has been cut so those dividends are now taxed at 15%. Taxes on corporate bonds are taxed at the ordinary income rate, but if you put the corporate bonds into a fund or a unit investment trust, and then have the bond’s interest payments payed out as dividends to unit holders of that trust, you effectively lower that rate to 15%. Municipal bonds are free of federal taxes and, depending on the bond, may be free of your own state tax as well. Sales from long-term capital gains – stocks held more than a year – are taxed as a rate of 15%. As a result, the rich in the top 1% typically end up paying at an effective tax rate of 15%, which is well below the middle class that typically ends up at a 35% tax bracket. This is why famed investor Warren Buffet of Berkshire Hathaway (BRK.A) pointed out that his tax rate was well below that of his own secretary.

As mentioned, in the 1980s, Reagan cut the top tax bracket down to 28%. To make up for the decrease in government revenue, Reagan raised the payroll tax 11 times, which amounted to the largest tax increase on the middle class in history. He is better remembered for his tax cuts, but those cuts only benefitted the richest in American society.

Bottom line, not only is the bulk of the government revenue now coming from individuals, a great deal more is now coming from the middle class than it was in the 1950s. So, we went from a system in which the bulk of the tax burden was on capital and far less on labor. Now we are in a system where labor is subsidizing capital.

One of the dominant economic theories is supply side economics, which suggest that greater economic growth is achieved if capital is not taxed and is freed up to invest in assets which encourage job growth and grow the economy. However, historical data counters that narrative. Through what is referred to as globalization, U.S. multinational corporations have been investing since the 1980s in assets offshore seeking cheaper labor costs to enhance profit. For those assets not invested, they are hoarded in savings in other countries to the point where over $2.1 trillion of the S&P 500’s free cash is held in offshore tax havens.

The United States exhibited its highest growth rate in the 1960s when the highest marginal tax rate was initially at levels of 90%, 77%, and 70% throughout that decade, and far higher corporate tax revenue was collected as well. When wealthy elites paid their fair share of taxes, the country benefitted, and both the public and private sectors worked in better balance. Now we appear to be in a system where there is a distribution of wealth from the bottom 90% up to the wealthiest Americans. As a result, the middle class is shrinking, and our infrastructure is poorly funded and falling to disrepair. Republicans continually advocate for flat taxes, which act as yet another tax cut for the rich and further increases the tax burden on the middle class and the poor. Putting in place a more progressive tax structure while eliminating loop holes would aid in growing the middle class, and re-invigorating economic growth.

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