Why the current income tax structures, for both corporations and individuals at both the federal and state levels, need an overhaul:
In May 2001, Wal-Mart Stores Inc. issued an appeal to big accounting firms: Find us creative new ways to cut our state tax bills.
Ernst & Young LLP swung into action. Senior tax experts at the big accounting firm swapped ideas via email and in a series of meetings. At least one gathering, according to an internal Ernst & Young calendar, took place in Wal-Mart’s headquarters in the “Tax Shelter Room.”
Ernst doesn’t specialize in cost accounting. Wal-Mart isn’t calling on one of the big four to help it realize efficiency gains in its distribution process. The mass retailer wants to shuffle around income classifications, set up LPs and LLCs, and find ways to allocate depreciation and amortization schedules in states to maximize the paper expense as early as possible:
State income-tax rates for corporations average about 6.9%, and come on top of a federal statutory rate of 35%. Tax rates vary from state to state, and some states have no corporate tax at all on certain income. That provides ample opportunity for so-called tax arbitrage, in which companies allocate expenses and revenues between states in order to minimize taxes owed. That practice has been going on for decades. Some such strategies are perfectly legal. The government considers others to be abusive.
States are looking to go after Wal-Mart for trying to minimize its real tax expense (which, interestingly, means the retailer is trying to hard to maximize its reported operational expenses):
Ernst & Young’s contributions to Wal-Mart’s state-tax minimization project are outlined in a raft of documents filed in recent months in North Carolina state court, where the state’s attorney general is challenging a Wal-Mart tax-cutting structure involving real-estate investment trusts. The material, which includes company emails and memos, provides a rare window into accountants’ role in generating tax-reduction ideas at one major company.
Corporations have what amounts to an almost inexhaustable out here, however. They argue it’s merely an attempt to raise capital through better business management. And the effect, presuming legality, is to do just that.
If state government regulators discover a novel tax reducing scheme, they are hard-pressed to bring successful charges against the purveyor, as they tend to run into the ex post facto trap. The WSJ article offers reports on candid commentary from an Ernst executive in his discussions with Wal-Mart:
“We don’t think there is much the state taxing authorities can do to mitigate these savings to Wal-Mart, however some states might attempt something if they had advance notification,” he wrote. “We think the best course of action is to keep the project relatively quiet….there just seems to be too many opportunities for it to get out to the press or financial community and we all know they are difficult to control, particularly when we are dealing with a client as well-known as Wal-Mart.”
So hand-wringing occurs. State (and in the case of high-profile national cases like the Enron collapse, federal) legislatures then pass legislation to address these specific tax reducing tactics.
Federally, that adds to Title 26 of the USC, and the 17,000 page beast grows even longer. There are endless opportunities for sharp accountants to find new schemes in that labyrinth. Often that involves taking certain financial operations to other countries (something Ireland has benefited enormously from), or selling assets to foreign investors and then paying those investors (who do nothing with the assets) to ‘rent’ the same assets, at a pre-tax cost to the company that is slightly higher than what it would have been in retaining ownership (so the investor comes out ahead) but that is more than made up for in tax bill reductions for the company doing the selling and subsequent renting. On net, this means the domestic company makes an inefficient decision and sends money overseas, neither of which benefit the US economy.
But accounting firms are moving increasingly in the direction of this sort of tax minimization work, not only for firms but also for affluent individuals. With double-digit annual growth in the number of US millionaires, and a similarly rapid rise in the number of ‘super rich’, and the proliferation of low-cost tax software, the H&R Block variety of routine tax preparation is becoming a thing of the past for tax professionals.
Parenthetically, there are three major accounting ‘branches’: Managerial (or ‘cost’–this actually involves working toward bettering business operations by cutting out duplication and streamlining production processes), financial (putting out, complying with, and reviewing corporate earnings reports), and tax. Managerial is growing steadily along with the economy at large. It is mostly done by companies in-house, and is where many accountants migrate to after working on the financial side (although this has seen lots of growth due to Sarbox regulations) for one of the big four. Tax, meanwhile, has become more specialized.
A disproportionate chunk of tax schemes involve the state of Delaware. Like Ireland in Europe, or the UAE internationally, the otherwise obscure First State (when was the last time you heard of anything, Senators excepted, happening in Delaware?) has the most corporately-friendly and developed body of tax policies in the country. The article offers a typical example:
Under Texas law at the time, a limited partner from out of state was exempt from Texas’s corporate franchise tax. As a result, scores of companies, including Wal-Mart, reorganized their Texas operations into limited partnerships. The general partner, which was subject to state taxation, was typically a subsidiary based in Texas. But the limited partner, often owning as much as 99.9% of the entity, would be based in Delaware or another tax-friendly state. The result: up to 99.9% of the profits of the Texas operation would flow to that out-of-state limited partner, making that income tax-free.
Wal-Mart’s revenue is primarily generated in the US, so it is more focused on state tax restructuring than most companies are. But why shouldn’t our federal tax structure be set up to do what Delaware has done, albeit on an international stage?
A consumption tax in place of the federal income tax strikes me as the best way to do this. Such a change would create a magnet for manufacturing and encourage MNCs who started in the US to bring their headquarters back home.
It has other positives. The economic benefit employers see in utilizing illegal immigrant labor gets a major boost from those illegals often not paying federal income taxes, meaning their wages can nominally be 20% less than those of the native working class and still have the same real purchasing power, so the native guy is at an inherent disadvantage. The FairTax, in creating a monthly rebate for all citizens based on family size, turns this around entirely. With $200 coming in at the end of the month, and facing no disadvantage in having to pay income taxes that illegal workers are not subject to, the working class native now has the advantage at the starting gate.
More than $350 billion in revenue is ‘lost’ by the federal government through the overreporting of deductions, and the underreporting and undercollection of income. That’s more than twice the size of this year’s federal government deficit. A consumption tax will not eliminate cheating, but it has an enormous built-in advantage over the income tax–it always takes two parties instead of sometimes just one to filch.
There are lots of ways I can fudge numbers on my tax return without any way of being caught short of a detailed audit (which happens to less than 1% of individuals, and that small fraction is disproportionately comprised of people who are members of partnerships, S Corps, and LLCs).
But if the tax is only levied at the point of sale, the buyer can help detect avoidance (as he can now for in the collection of state sales taxes). There is little incentive for him to say anything about it, though, since he stands to benefit directly from that avoidance. However, if there is some incentivizing reward for him in anonymously reporting avoidance to authorities, it does provide some added level of potential detection (turning conspirators against one another in illicit drug sales using a similar reward strategy seems to me a worthy idea to consider as well).
Adam Smith’s four maxims of an optimal tax code–equity (progressive, corporations with lots of cash can hire firms to find ways around paying), certainty (if you do your own taxes, you struggle with uncertainty every April, awaiting that letter from the IRS saying you owe more than you thought you did), convenience (advice from the tax accountant: Keep records of everything!), and efficiency (corporations spending money to pay sharp accountants to make business decisions based not on total utility but on tax efficiency)–do not describe the federal income tax in the least.
A consumption tax, in contrast, fulfills all of them. Regarding equity, you pay when you have the wherewithal to do so–that is, when you’re making the purchase. You cannot go into debt for tax bills you’re unable to pay. Everybody (including immigrants and foreign travelers) pays in.
In terms of certainty, it’s simple. If it’s a new item or a service, it is subject to the consumption tax. If it is a used item, it is not.
Perhaps its biggest advantage is in convenience. Imagine not having some percentage of each paycheck being diverted to various tax lines. You pay your taxes when you buy groceries and go to the movies. That’s it. You never have to think about it.
As for efficiency, the annual cost of compliance (including the loss of potentially productive time) is north of $200 billion, according to the Tax Foundation. A national consumption tax would require only an augmentation of the current systems already in place to ensure sales taxes are collected. Further, while an income tax punishes people for making money and encourages them to spend it (small wonder our national savings rate hovers around zero), a consumption tax does just the opposite–it encourages people to create wealth and discourages them from squandering it.