A zero percent corporate tax rate? It’s not such a stretch

I got thinking the other day about tax rates. What can I say? This is an occupational hazard for a career CPA, even one who is purportedly retired. This being a presidential election year, there are numerous plans afoot among the various Republican candidates, the current administration and several folks in Congress about how to reform our current tax system.  

The catchiest one from a marketing point of view was Herman Cain’s 9-9-9 plan.  His personal issues forced him out of the presidential race, but the commercial was a keeper. Short, sweet and easy to understand: 9 percent personal tax; 9 percent corporate tax; 9 percent national sales tax. He advocated throwing out the current tome-size tax system and greatly simplifying our tax code.

I am not endorsing the 9-9-9 approach. What I am saying is that compared to the complex mess we have now with all manner of exemptions and special subsidies, simplicity does have a certain raw appeal.

From an economic theory viewpoint, corporate rates are the easiest to consider.  What would be the ideal corporate tax rate? Ready for a zinger? They should be zero percent. Wait: Is Rich off his meds today?  No, the simple truth is that corporations do not pay taxes.  That’s ridiculous, comes the retort. For example, Apple Computer sends checks to the feds and to California and other states.  So, of course they pay taxes. Yes, well, literally they do, but ultimately they do not. They absolutely can’t because corporations, despite what you may have heard elsewhere, are not alive. Only people pay taxes (live ones directly and sometimes the heirs of recently deceased ones).  

Corporate taxation is insidious, because it is actually paid by others. Who really pays corporate taxes? We can say with certainty that it’s split among three groups: customers, stockholders and employees. The breakdown among those groups has been the subject of much research, but no accepted answers, because the offload of a corporation’s tax burden can be split up in an infinite combination of ways.

Customers pay part as a result of paying higher prices. Employees pay part by receiving lower wages. Stockholders pay part by receiving lower or no dividends.     

Here is an example:    

Corp A                                                    Corp B

35% Tax Rate                                           0% Tax Rate    

Sales price (to Customers) 

$35,385                                                   $34,000

Cost of Wages (Employees)

$20,000                                                   $23,000

Pre-tax profit 

$15,385                                                   $11,000

Taxes                    

$5,385                                                      $0

Net Profit (Stockholders)        

$10,000                                                     $11,000

% Profit                

28.3%                                                        32.3%

Corp A’s income statement shows a corporation which pays the current 35 percent U.S. corporate tax rate. Despite the fact that some, like GE last year, pay zero, many do pay at this rate. Corp B’s income statement shows a corporation with no income tax expense. Both sold the same product.

Say it was a car. With no tax to pay, Corp B was able to earn a higher net profit, both in percentage terms as well as in dollars. Notably, Corp B chose to charge less for the car it sold and at the same time pay higher wages. Why would it follow this approach? Because it is a win-win-win outcome.  All three groups are better off. Plus Corp B is in a strong competitive position because it can charge less, thereby potentially increasing its market share.

It’s fun to play with the theory of zero percent corporate tax rates, but actual corporate tax rates vary in the industrialized world from about 12 percent (Ireland) up to the Japanese rate of 41 percent. At a federal rate of 35 percent, the USA is at the high end. When various state taxes are layered in, the overall rate paid by U.S. companies can go over 40 percent — an uncompetitive spot.  Even though my  zero percent example is extreme, it makes an essential point. When you hear about operations being moved offshore and that U.S. companies are less competitive because of the high rates here, consider that corporate tax policy has a huge impact on corporate decision-making. Large companies typically sell in many countries. When they are deciding where to deploy their resources, they have a fiduciary responsibility to their owners to make prudent business decisions. Simply put, if you can make a higher profit selling in a low-tax country versus the high taxes in the USA, that’s strong motivation to sell in the low-tax country.

What about the argument that the government loses out in this scenario? It’s specious. If corporations have less to pay in taxes, the savings go to three groups. If customers pay less for an item, they have more money to spend on some other item or to save for the future. If part of the savings goes to employees, they have extra income subject to personal income tax. Why would a company use some of the tax savings to pay more to employees? Simple: to attract better employees (nonunion situations).

Many folks will cynically assume that a company would just keep all the savings and sit on the cash. That is nonsense! No nonfinancial company is in the business of piling up cash.  There’s a logical reason — it’s a lousy investment. Companies create growth by reinvesting their profits in research and development, in plant and equipment, in employee training, in expansion. If they have cash beyond those needs, they will institute or increase dividend payouts to their shareholders.

Want corporations to create more jobs in the USA? Lower corporate tax rates.

Richard Shanley, CPA, is a retired audit partner of the accounting firm of Deloitte & Touche. He lives in Salisbury.