How Tax Reform Adds Up

Two proposals would play out in dramatically different ways for business

Back in 1986, the last time Washington rewrote the tax code, it was easy for business to figure out what was happening: Congress turned tax reform into voter bait by cutting individual taxes by $120 billion. Then it paid for the largesse with a $120 billion tax hike on companies.

Now Washington is at it again, with aides to President George W. Bush hinting that rewriting the tax code may be his key goal for 2006. But this time, business' outlook isn't so clear. The President's Advisory Panel on Federal Tax Reform has proposed two ways to clean up the code, and the impact on companies could vary widely. As a result, Big Business could be deeply splintered if the President pushes sweeping reform.

To help sort the winners from the losers, BusinessWeek asked accountants Ernst & Young LLP to crunch the numbers. Their analysis -- the first of its kind -- shows how the changes would play out for hypothetical companies.

At first glance, business' interests would seem clear: Support the panel's consumed-income tax, which would cut the overall tax from 25.9% of corporate income to 7.2%. By contrast, its simplified income tax plan would raise taxes for three of the four businesses created by E&Y, though that could be more than offset by tax cuts for investors.

Either system would mark a sharp change. Under today's code, industry-specific tax breaks create wide differences between the tax return of, say, a carmaker and a software developer. The new plans propose to wipe out 40 of those targeted breaks. Under those plans, what a business makes would matter less than where it makes and sells its products and how it finances itself.

For some industries, reform could cut taxes but hurt business. Take homebuilders and real estate agents, who are up in arms about the panel's proposal to curb the mortgage interest deduction. If that change drives down home prices, the housing industry won't be satisfied even if its own tax bill shrinks.

Under both plans, corporate tax rates would fall from today's top 35%. The new income tax would peg the rate at 31.5%; the consumption tax, 30%. Both would also change the way income from foreign operations is taxed, largely exempting revenues from foreign sales.

The other big difference: how capital equipment is written off. Today, companies must deduct such costs over many years using up to eight different schedules. For most businesses, the new income tax would collapse those depreciation schemes into one. Overall, that would be a bit less generous than today, but it would create big winners among heavy industry and losers among firms that mainly use short-lived equipment like desktop computers. The consumption tax would go much further, allowing companies to deduct the entire cost of equipment in the year they buy it. In exchange, companies could no longer deduct trillions in interest expenses.

How do these shifts sort out? For the four companies invented by E&Y, here's how taxes would change -- and why:

TechLabs Co. This $5 billion outfit could develop software or make specialized computer equipment. Its production is in the U.S., but 40% of sales are overseas. Under the simplified income tax, lost deductions for state and local taxes and domestic manufacturing would more than offset the rate cut, raising TechLab's taxes by 8%. But under the consumption tax, TechLabs hits the jackpot. Its income from foreign sales escapes tax entirely, producing a mind-boggling 364% tax cut.

A real-life TechLabs might not enjoy such a windfall. Today, many companies shift their income from patents and licenses to low-tax countries while claiming expenses in the U.S. For businesses that enjoy such big breaks today, a consumption tax may not be so rewarding.

GlobeSpan Corp. Under the simplified income tax, this $40 billion multinational loses big tax breaks and sees its deduction for depreciation shrink by $57 million. Even with a lower rate, it pays 12% more tax. GlobeSpan would do much better under the consumption tax, largely because first-year expensing of its $800 million in capital investments outweighs the loss of its interest deductions.

HomeGrown Inc. Domestic manufacturer HomeGrown earns 90% of its $10 billion in sales in the U.S. and borrows heavily. With the simplified income tax, loss of the domestic production deductions helps boost its taxes by 11%. Under the consumption tax, however, the company can exempt foreign revenues while expensing $246 million in capital costs. That outweighs its loss of interest deductions and cuts its tax by 43%.

ServiceGiant Corp. This $1 billion company could be a publisher or a systems integrator. Because it doesn't have much debt or equipment, it won't be affected by most of the proposed changes. But the rate cuts would trim 3% off its tab under the new income tax or 12% under the consumed-income levy.

Either plan would create big new tax incentives for individual investors. While many companies might pay the IRS more under the simplified income tax, the overall tax on corporate income -- including individual taxes on capital gains and dividends -- would fall. For instance, HomeGrown's $25 million corporate tax hike is more than offset by a $40 million tax cut for its investors. For many companies, "nearly all the good news happens at the shareholder level," says Thomas S. Neubig, E&Y's national director of quantitative economics and statistics.

The E&Y analysis makes big assumptions about how these four companies do business. For instance, adjust the mix of imports and exports, or of debt and equity, and some tax cuts could turn into hikes. But for businesses trying to figure out what sort of reform they like, these numbers could be a good early test.

By Howard Gleckman

    Before it's here, it's on the Bloomberg Terminal.