On Tax Reform, It's Time to Change the Debate

Apple CEO Tim Cook pauses while speaking during a Senate Permanent Subcommittee on Investigations hearing in Washington, D.C. Photograph by Andrew Harrer/Bloomberg

Corporate tax reform is a hot topic in Washington, D.C. In a city riven with disagreements, no one disputes this statement: The U.S. corporate tax code is a Byzantine mess.

Case in point: The May 21 Congressional testimony of Tim Cook, chief executive of Apple. The world’s most valuable company, with a stock market capitalization of more than $400 billion, Apple ingeniously and legally took advantage of corporate tax complexity to slash its tax levy dramatically. The tax innovators at the Silicon Valley giant did nothing improper, allowing Cook to tell the Senate Permanent Subcommittee on Investigations, “We pay all the taxes we owe—every single dollar.” Chairman Carl Levin (D-Mich.) didn’t protest. “The facts are mighty clear to me that loopholes in our tax laws and regulations allow many companies, including Apple, to shift enormous amounts of income from this country to other countries,” he said.

The net effect of Apple’s tax legerdemain is to emphasize the gap between Corporate America’s high statutory rate and its effective tax rate. The tax brainpower employed by multinational behemoths such as Apple, General Electric, and Google are savvy tax-minimizers. Little wonder a centerpiece tax reform proposal in Washington is offering businesses a lower corporate tax rate in exchange for eliminating a slew of loopholes. For instance, President Obama has proposed (pdf) cutting the corporate tax rate to 28 percent in return for eliminating “dozens of business tax loopholes and tax expenditures.”

A corporate tax overhaul isn’t in the cards. Lowering the statutory rate and broadening the tax base could translate into a higher effective tax rate for Apple and many other powerful companies. Such industries as oil, pharmaceuticals, finance, real estate, high-tech, and insurance (to name only a few) enjoy lucrative tax benefits. The major players in these industries also employ highly influential lobbyists who can be unleashed on Congress to defend valuable tax perks that lower their cost of business. There’s no getting around it: Corporate America has learned to game the tax system.

The scope of potential resistance is hinted at in a study by Scott Dyreng and Edward Maydew of the University of North Carolina and Mickelle Hanlon of the University of Michigan. In Long-Run Tax Avoidance, they looked at more than 2,000 companies between 1995 and 2004. Their goal was to see how many were sustaining over a 10-year period an effective cash tax strategy below the statutory rate of 35 percent. Their research revealed (pdf) that for 546 publicly traded businesses—approximately 26 percent—legal tax avoidance allowed for a 10-year cash effective tax rate at or below 20 percent, while 9.2 percent were at or below 10 percent. (The median was 28.3 percent.)

Still, the status quo is unacceptable. The message in the effective tax rate is for policymakers to abandon classic tax reform—lower rates and fewer loopholes—for one of two alternative approaches. The first is to target a limited, but critical change. Robert Pozen, senior lecturer at Harvard Business School and formerly chairman of MFS Investment Management, has advocated restricting the deductibility of gross interest expense for corporations. The shift in treatment would reduce the tax incentives for companies to take on too much leverage. Definitely an improvement over the current code.

The second strategy is far more ambitious and intriguing: Change the terms of debate. Drive the corporate tax rate down to single digits with dramatic simplification. Then, to avoid starving the U.S. Treasury of money, substitute a carbon tax. The corporate rate should be low enough that loopholes would no longer be worth spending political capital defending. The substitution of a carbon tax would also ensure that the federal government isn’t in need of revenue, the pitfall of supply-side calls for simply cutting corporate income taxes. Federal fiscal conservatism is a critical long-term budgeting goal. Why not raise government revenue by taxing something we agree isn’t good—environmental damage—and tax less something we like, corporate profits? Worth a try, no?

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