Taxes: Ready to Rumble

If you thought the fight over health care was tough, wait until the White House tries to raise corporate taxes.

The budget deficit, bloated by the costs of President Barack Obama's stimulus plan and the sharp fall in tax receipts due to the recession, will hit $1.4 trillion in fiscal 2010, for the second year running—more than twice what it was in 2008. If Obama sticks to his pledge to keep the Bush tax cuts for families earning less than $250,000 a year, the move will add a projected $230 billion a year on average to the deficit over the next decade.

That leaves only one viable source for the hundreds of billions in extra tax revenue needed to sponge up all that red ink. With his Jan. 14 proposal to raise up to $117 billion through a levy on the nation's largest financial institutions, Obama took a stab at increasing corporate taxes. It won't be the last. "The pressure to raise more from the business sector will only intensify," says Anne N. Mathias, a tax policy analyst for the Washington Research Group. Few expect the Democrats to push hard for a big corporate tax hike before midterm elections, and the prospects for boosting any taxes just got a lot harder with the Democrats' stunning loss in Massachusetts. Yet Mathias and others believe the risks of a squeeze on companies will rise sharply by yearend, when Congress and the President will have to extend the Bush tax cuts for the middle class before they expire.

Corporate lobbyists are girding for a battle, especially over the lucrative tax breaks that U.S. multinationals get on their foreign earnings. Thanks to a massive pushback last year—some of it coming personally from CEOs such as IBM's (IBM) Samuel J. Palmisano, Caterpillar's (CAT) James W. Owens, and Cisco's (CSCO) John T. Chambers—the Administration backed down from its proposals to raise some $160 billion by hoisting taxes on U.S. companies' overseas profits. The multinationals were able to convince many in Congress, including prominent Democratic legislators like Senate Finance chair Max Baucus, that the proposed hike in taxes on overseas operations would make it harder to compete in global markets, since foreign rivals generally pay lower rates.

The next hints of how Obama plans to press his tax agenda will appear in February, when the White House releases the 2011 budget. "We expect them to bring all [of last year's] proposals back" with only minor changes, says Ralph Hellman, head of government relations at the Information Technology Industry Council, a trade group. "They might even add a few other things to hit us up further."

The most disputed of those tax hikes would sharply limit companies' ability to defer taxes on income earned abroad until those profits are repatriated to the U.S. Another would reduce multinationals' power to lower U.S. taxes through favorable accounting of their foreign tax credits. A third proposal would end a complex maneuver that lets multinationals shift profits from high-tax countries to tax havens: It's been dubbed "check-the-box" because companies can effectively make some foreign subsidiaries disappear for U.S. tax purposes by checking a box on their tax filings.


Because of those and other benefits, many U.S. multinationals pay far less than the statutory rate of 35%. According to a study by Jack T. Ciesielski, publisher of The Analyst's Accounting Observer, a newsletter for securities analysts, health-care and pharma companies in the Standard & Poor's 500-stock index paid a median effective tax rate of 22.7% in 2008; info tech companies paid 25.9%; and financials were at 29.2%. Many individual companies did even better. Ciesielski calculates that Pfizer paid an effective rate of 17%. A Pfizer spokesperson says that its effective rate was more like 22% after adjusting income for special items.

By contrast, smaller companies that have kept their operations largely in the U.S. don't benefit from those breaks, so they pay much closer to the full rate. Despite fierce corporate resistance, the Administration wants to rebalance the two sectors' tax burdens. The President and his economic advisers also argue that the tax code encourages companies to ship jobs abroad. "We are well aware of the competitiveness issues," says one high-ranking Administration official. "But we ought to insure that the tax incentives aren't skewed to favor production overseas." White House and Treasury officials declined to comment on specific corporate tax proposals in the budget, though they acknowledge some changes have to be made in their strategy. "We recognize that it's not credible to just recycle stuff that went nowhere last year," says the official. "But we think some of those ideas remain worthy of consideration, [and] some are more doable than others."

Rosanne Altshuler, co-director of the Tax Policy Center, says the "check-the-box" measure, considered by many to be the international practice most open to abuse, remains highly vulnerable. Peter R. Merrill, a former chief economist with the congressional Joint Committee on Taxation who is now with PricewaterhouseCoopers, believes the Administration could also target new areas. Take, for example, "transfer prices"—the internal prices a company sets when it transfers its own assets or knowhow to a foreign subsidiary. The IRS, suspecting that multinationals often use this method to shift profits to lower-tax locations, has stepped up enforcement of transfer-pricing rules. Stiffer new regulations could be next.

The multinationals are hardly standing down in the face of potential tax hikes. They're focusing their arguments on employment, a hot-button issue with the jobless rate at 10%. If you make U.S. multinationals less competitive abroad, they argue, their overall sales and profits go down, and that hurts everyone in their organizations. "You will lose jobs in the U.S.," says Kenneth J. Kies, a prominent tax lobbyist whose firm, the Federal Policy Group, represents General Electric (GE) and Microsoft (MSFT). "That's the last thing we ought to be doing."

Instead, says Brigitte Schmidt Gwyn, who oversees tax policy for the Business Roundtable, competitiveness would be bolstered by reducing the 35% U.S. corporate tax rate—the second-highest in the developed world. Accepting something closer to the 26% average among the 30 member nations of the Organization for Economic Cooperation & Development, in exchange for eliminating the biggest tax breaks, would benefit many companies. Obama has said he would consider such a trade-off, which resembles proposals made in 2007 by the head of the House Ways & Means Committee, Representative Charlie Rangel (D-N.Y.), to get the corporate rate down to 30.5%.

In a nod toward such a move, the President commissioned a task force led by former Federal Reserve Chairman Paul Volcker that, among other things, is looking at how to reform corporate taxes while ending the worst loopholes. The panel has solicited ideas from business on what breaks it could forgo in return for a lower overall rate.

The trouble is, few in business believe the Administration will do a "revenue-neutral" deal in which the money the corporate sector saves by paying a lower rate is balanced out by the new money raised by Uncle Sam when loopholes are finally closed. The notion that the business community overall would pay no more was key to Rangel's proposal, but the Administration has not backed the idea. The need for more revenue is just too huge—a point, say lobbyists, that Administration officials often make in private meetings. "Sure, they say they are open to broadening the base and lowering the rate," says the Technology Council's Hellman. "But they are also clear about their desire to raise another $200 or $300 billion." Lawrence Summers, Obama's top economics adviser, is also skeptical about claims that U.S. tax rates are uncompetitively high. "If you look at taxes paid by corporations as a fraction of profits, they are quite low relative to international standards and historical American standards," he says.

All this has left business executives convinced they remain in the Administration's sights. They vow not to get suckered again, as many believe happened in 1986, when Congress last did a major rewrite of tax rates. By the time negotiations for the 1986 act were over, Congress had hiked the corporate share of the tax take to pay for cuts for individuals.

Much of the business community is stonewalling. In their submissions to the Volcker panel, groups like the National Association of Manufacturers (NAM) have been reluctant to go beyond general support for tax reform. "If we say we're ready to give up something to get lower rates, chances are they'd hear the first part but not the second," says Dorothy B. Coleman, NAM's head of tax policy.


In Congress, the Republicans—and middle-of-the-road Democrats chastened by their party's growing unpopularity—will hesitate to back any tax increases without serious spending cuts. "We see the fiscal problems as more driven by spending," says a top aide to one Republican member of the Senate Finance Committee. "If the purpose of any tax reform is to come up with more money, it will be very hard to get bipartisan support." Under pressure from Senators Judd Gregg (R-N.H.) and Kent Conrad (D-N.D.), the White House and Democratic leaders have agreed to form a bipartisan commission that would recommend ways to rein in the deficit. Whatever grand bargain the commission might reach to hike taxes and cut spending would not be made public until after the midterm elections, and Congress would vote on the package in its entirety. Backers argue that this would provide the political cover needed to make tough decisions—though Gregg blasted the Democratic plan as too weak to be effective.

Rangel, too, is angling to revive his reforms. Now he's pushing to drop the corporate rate to 28%. "There is tremendous potential for simplifying the corporate tax code and lowering the rate further," he says. Adjusting depreciation schedules to slow writedowns would help a lot, he argues. So would ending $31 billion in tax breaks for the oil and gas industry—another stalled Administration proposal likely to return. To date, Obama has shown little interest in Rangel's latest ideas.

With the loss of their filibuster-proof majority, Democrats will face an even tougher task getting any tax hike through the Senate. Still, the savviest lobbyists are quietly preparing for the day a "just say no" strategy doesn't cut it. The head of one major trade association, who played a key role in stalling Obama's tax proposals last year, has begun meeting with members to figure out, when forced, "what our bottom line is—what would we be willing to give up?"

The pressure is steadily building. Already, the House wants to end the current tax treatment of the "carried interest" earnings of private equity fund managers, which allows them to pay capital gains rates of 15% rather than higher income rates. The Administration is likely to pick up the cudgel on this one, too. As one House aide to a prominent Democrat puts it: "[Companies] had better engage, because a lot of these items will be taken away anyway."

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