How Taxes Distort Business
Today is Tax Day in America. When April 15th happens to fall on a weekend, the IRS generously permits us to extend the filing ritual until the following Monday. But since Monday was a holiday in the District of Columbia known (without irony) as Emancipation Day, we all enjoyed an extra bonus day to comply. And for the most part, comply we do: the voluntary compliance rate, defined by the IRS as taxes timely paid as a percentage of taxes owed in aggregate, is nearly 82%. Compare this with Italy, for example, where tax evasion is a national pastime. For a nation born out of tax resistance, we Americans tend to grumble but not revolt.
We also tend to view taxes only in terms of personal pain: the financial costs of paying, the compliance costs of dealing with the paperwork, and the psychic costs of worrying about it all. It is precisely this pain, experienced only by individuals, that upends the left-wing rationale for imposing taxes on business entities, estates, and all manner of transactions. Only people pay taxes. When someone talks about raising taxes on “greedy corporations,” they’re really calling for higher consumer prices for those corporations’ goods and services.
But the larger impact of taxation is found in the countless and profound ways it changes human activity. Charles Adams, the great tax historian, devoted his career to examining the enormous sociological and cultural impacts resulting from how states raise revenue. Adams called taxes a “prime mover of history,” from ancient Egypt through the Middle Ages, from Enlightenment Europe to Colonial America and all the way up to our present world of offshore tax havens. Taxes, Adams maintained, are far from the price we pay for civilization. Instead they are mean, petty, and arbitrary, causing existential struggles for the poorest people in societies across history. Taxes not only fund wars and enrich unworthy rulers, but also create crippling distortions in every economy the world has ever known.
The impact of taxes on ordinary people in modern America, including the lengths to which some will go to avoid them, is well-represented in our national psyche. We’ve all heard anecdotal horror stories, usually involving someone’s finances being destroyed by a sudden IRS seizure. Americans also view the IRS as wanton and political in its enforcement actions, which makes sense. Even experts can’t agree how much a hypothetical family owes in any given year.
The distortive impact of taxes on US and multinational businesses is also extraordinary, albeit not as much discussed. While monetary policy causes malinvestment through artificially low interest rates, high tax rates and burdensome complexity similarly cause firms to radically alter their business decisions. And just as interest rates affect the length of production, tax rates (and rules) dramatically affect decisions about the capital structure of companies.
Having spent many years working on the tax aspects of M&A deals, I can attest that far too many business decisions are driven almost wholly by their tax ramifications. Consider just the following:
- Bizarre and byzantine legal entity structures. Take a look at the spaghetti-like organizational chart of many corporations and you may be shocked by the number of legal entities that exist as subsidiaries below a parent corporation. Given the non-tax compliance work such a structure requires (e.g., corporate filings, board meetings, and minutes in multiple jurisdictions), the only purpose for such a structure in most cases is tax reduction.
Apple, Google, and Microsoft, for example, have employed infamous structures like the “Double Irish” and the “Dutch Sandwich” to conduct European operations. These structures advance two common goals for tech companies: (i) all European revenue rolls up into a European parent company in a low-tax jurisdiction like Ireland; and (ii) European intellectual property rights are owned by an entity in a tax haven like the Caymans or the Bahamas, which licenses the use of said property to a second European company. The second company ends up with little taxable income after deducting all of its licensing fees. In some cases revenues are funneled through Ireland to the even-friendlier Dutch, who then remit remaining profits to the zero-tax tropical haven.
- Capital structures that overwhelmingly favor debt over equity. If you want to know how “leveraged buy-out” entered our lexicon, look no further than the disparate tax treatment afforded to corporate interest payments vs. dividend payments. As a general rule, firms can deduct interest payments made to third-party creditors and bond-holders (there are limitations on the deductibility of high-yield and related party debt, but even these limitations are rife with workarounds). The contractual obligation to pay interest creates a deductible expense which must be paid regardless of whether the corporation is profitable. By contrast, dividends are paid out of earnings and profits rather than accrued as an expense. They don’t decrease corporate net income like an expense, and payment is triggered only in certain situations.
While this makes sense conceptually, it creates an enormous incentive to load firms with debt. Many private equity deals prior to the Crash of ’08 were financed with 7 parts debt to equity or even more. In many instances the debt was sliced into dozens of tranches across multiple co-lenders, which reduces business risk but maintains the tax benefit. By relentlessly applying revenue to debt service, and thus taking a big interest deduction, private equity firms in the boom years were often able to sell companies 3 to 5 years later for many times their purchase price. They also kept their own risk exposure low: if the company tanked, their loss was limited to their equity investment.
- Keeping cash overseas. US corporations with multinational operations have little incentive to repatriate foreign earnings, where Uncle Sam will reward them with a 35% hit for their efforts. In an era of cash-rich companies like Apple, it makes far more sense to keep those earnings offshore indefinitely, maybe permanently. A tax deferred is a tax avoided, or at least the next best thing. A very complex anti-deferral regime known as Subpart F was passed by Congress in the 1960s, but many of its rules can be avoided through the kinds of complex structures discussed earlier. And the Trump administration proposal for a tax holiday for dividends from foreign subsidiaries (last tried in 2004) has been met with howls by the Left and relative indifference by the House Ways and Means committee. At present US multinationals have every incentive to keep their allegedly $2.6 trillion in foreign earnings invested overseas indefinitely.
- Trafficking in tax losses, sort of. When reports that Trump’s companies had paid no income taxes surfaced, commentators hinted at complex schemes of tax evasion. In fact, Trump’s tax planning simply featured a plain vanilla net operating loss, one of the most common features of US corporate tax law. No “loophole” was involved, but rather a simple calculation whereby his companies incurred tax losses: allowable deductions and credits exceeded taxable income for a given year or years. These losses are permitted to be carried forward and applied against income for (up to) the next 20 years. Carry forward of operating losses has been part of tax law since the 1920s, and absolutely does permit large companies to balance the benefits of leveling out their tax burden over a series of profitable and unprofitable years.
What has changed is the ability of companies to openly traffic in tax losses through the acquisition of other companies with existing tax losses. The infamous Section 382 rules, passed in the 1950s, do indeed present limitations on acquisitions that seem to have no business purpose other than inheriting the tax losses of another company. But as usual, Congress created a full-employment act for lawyers and accountants by making things so hellishly complex that some practitioners spend an entire career performing Section 382 “studies.” But to the extent possible, US companies still attempt to use tax losses in one entity or year to balance out taxable income in other entities or years.
- Creative transfer pricing. Transfer pricing relates to the rules for pricing goods or services between related companies under common ownership. Imagine Apple owning a subsidiary that makes glass for iPhones, along with another subsidiary that assembles them. The three-way transactions for parts and assembly services are subject to both GAAP and tax transfer pricing rules. In theory, such companies should deal with each other on an arm’s length basis. But as with all things tax-related, complexity yields real financial benefits. In short, multinational companies do everything they can within their complex structures to allocate deductible expenses to high-tax jurisdictions and taxable income to low-tax jurisdiction. How they do so, and whether it’s allowed for audit or tax purposes, has become an enormous industry unto itself that profoundly changes business behavior.
There are countless other examples of how the tax code directly influences firms to make tax-driven decisions. Ultimately, CEOs and CFOs of large multinational companies view taxes as a cost of doing business like any other. They will spend one million dollars on legal and accounting fees for tax planning if it saves two million, and who can blame them? In fact, one can argue they have a duty to shareholders to explore every last loophole. The question is opportunity cost: how much time, manpower, and money are spent finding ways to minimize taxes that could be spent on a company’s core business? And in turn, what are the social and cultural consequences of it all? It’s a question Charles Adams tried to answer, even as we try to ignore it.