Monday, October 28, 2013

Businesses May Be Next Target of Higher Taxes - Bloomberg

The personal-taxes-to-personal-income ratio was 11.7 percent in August, almost back to the 12.3 percent long-term average. That eases the pressure on the invisible hand to push for higher tax rates or more aggressive collections.

The federal budget deficit remains huge. But it is declining: The Congressional Budget Office says the shortfall narrowed to $642 billion in the fiscal year that ended Sept. 30, from $1.1 trillion in the 2012 fiscal year. Furthermore, persistent political gridlock in Washington makes big tax law changes unlikely.

Chronic slow growth and limited upside potential for stock and housing prices probably mean that personal taxes won’t grow faster than personal income in coming quarters, restraining growth in the taxes-to-income ratio. However, other forces could influence taxes. Congress and the Obama administration were unable to avoid a partial government shutdown this month and a fight over lifting the $16.7 trillion debt ceiling.

Beyond those twin crises, Washington needs to deal with the long-postponed costs of Social Security and Medicare benefits for the increasingly large number of postwar-generation workers who are retiring. This is the reason that the narrowing of the federal deficit projected by the CBO will end in the 2016 fiscal year. In later years, substantial increases in Social Security and Medicare payroll taxes could cause the ratio of taxes to income, including social insurance taxes, to rise above its long-run flat average of 19.7 percent.

The changes in personal taxes of recent decades have been accompanied by some major changes in corporate taxation. U.S. businesses are clamoring for tax reform, especially changes aimed at lowering the 35 percent top rate, which is about the highest in the world, though it’s down from 52 percent in 1964.

The real rate is 40 percent when state and local government corporate income taxes are included. In late July, President Barack Obama offered to work with Congress to overhaul corporate taxes on the condition that any one-time revenue gains are used to fund spending on programs he favors. In mentioning one-time gains, he indicated that he is, in effect, thinking about eliminating many tax code provisions that reduce the effective corporate profit tax rate well below 35 percent.

The Government Accountability Office estimates that the effective rate on worldwide income for large, profitable U.S. companies averaged 12.6 percent in 2010. When taxes paid to foreign as well as U.S. state and local governments are included, the effective rate rose to 16.9 percent, still only about half the 35 percent top federal marginal rate. Federal corporate tax collections dropped to $181 billion for 2011 from a peak of $370 billion for 2007, at the height of the housing-led boom. They are expected to rise to $288 billion for the 2013 fiscal year, which ended Sept. 30.

An especially contentious issue is foreign earnings of U.S. companies that aren’t subject to taxes until they are repatriated. By contrast, most other developed countries tax only domestic profits. Many U.S. corporations have no incentive to return foreign earnings and pay the U.S. taxes. But there is intense political pressure for them to do so.

In May, Apple Inc. Chief Executive Officer Tim Cook testified before the Senate Permanent Subcommittee on Investigations. The panel headed by Senator Carl Levin, a Michigan Democrat, found that Apple avoided paying $9 billion in U.S. taxes in 2012, and $74 billion over the past four years, largely by basing profitable operations in Ireland, which has consistently used low tax rates to attract foreign business.

Levin called this “the Holy Grail of tax avoidance.” Cook said Apple favored corporate tax reform, including a lower tax rate, but with a reasonable levy on foreign earnings. The adverse publicity led the Irish government to announce plans to change the tax rules affecting Apple and other companies beginning in 2015.

Audit Analytics estimated that total U.S. corporate profit parked abroad rose 15 percent last year, to $1.9 trillion. This partially reflects the 70 percent increase in offshore earnings in the last five years. Offshore profits are normally taxed where they are earned, so companies often use a technique known as transfer pricing to shift earnings to low-tax countries. The tactic sometimes involves moving valuable intellectual property so the high profits from royalty payments will be realized in lower-tax jurisdictions.

A reform of U.S. corporate taxes could reduce the top marginal rate, but at the expense of higher taxes elsewhere. Congressional proposals include a special low tax rate on profit held offshore, which would encourage companies to bring the money home. Eventually, it could mean an end to taxes on overseas earnings, bringing the U.S. in line with other countries. Other ideas being proposed to raise revenue include stretching out depreciation timetables and changes in inventory accounting.

From the standpoint of economic efficiency, trading corporate tax loopholes for lower tax rates makes sense. As companies adapt to special tax provisions, normal market-driven responses are distorted. In any event, major tax reform and simplification for corporate or personal taxes is very unlikely as long as gridlock and partisan animosity persist in Washington.

In addition, the persistence of large federal deficits means the long-run decline in corporate tax rates is unlikely to continue unless lower rates are traded for higher business taxes elsewhere.

Meanwhile, corporate profit and the tax revenue they generate appear vulnerable, even if positive economic growth persists.

Even as corporate taxes as a percentage of profits are going down, taxes as a share of gross value-added of corporate business -- essentially corporate sales -- have been flat since the early 1980s because profit margins have been rising. In recent years, U.S. businesses have slashed labor and other costs in response to the lack of pricing power and declining inflation as well as the meager sales volume growth in the sluggish global recovery.

But productivity growth from cost-cutting and other means is no longer easy to come by. Also, the growth in value from productivity-enhancing technology equipment and software in the decade ending 2011 has been the weakest since World War II. Furthermore, neither capital nor labor has the upper hand indefinitely in a democracy, and compensation’s share of national income has been compressed as profit’s share leaped.

Corporate earnings are also vulnerable to the strengthening dollar, which reduces the value of revenue from exports and foreign earnings by U.S. multinationals. And exports and foreign earnings of U.S. companies are under pressure, especially in developing countries where growth has slowed.

China’s growth is slowing as it shifts to an economy led by consumer demand and away from exports, which are depressed by weak demand from the U.S. and Europe. China has also vastly overbuilt its infrastructure. Vacant cities and other excess capacity could become considerable problems, particularly for the lenders who financed them. Deceleration in China implies slow growth for the other developing countries that have thrived by exporting commodities and components to the Chinese manufacturing juggernaut.

Meanwhile, the prospective tapering of Federal Reserve asset purchases and the related interest rate increases that have already occurred are causing financial harm to those nations.

Earlier, the likes of Brazil, India, Indonesia and Turkey were almost overwhelmed by inflows of hot money that drove up the value of their currencies and financed their large current-account deficits. Now that hot money is rushing out, leaving them with three unsavory choices. They can allow their currencies to slide, which aids exports but also promotes inflation as import prices jump. They can raise interest rates to help retain foreign money, but that threatens growth. Or they can impose capital controls to keep money from leaving, but that discourages future inflows and triggers huge outflows when controls are lifted.

The invisible hand will probably continue to favor taxpayers when the tax-to-income ratio rises considerably above the 12.3 percent long-run average, and it will increase their tax payments when the ratio drops substantially below. The long-term downtrend in corporate tax rates, however, is unlikely to persist unless lower rates are traded for higher business taxes elsewhere.

(A. Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the first in a three-part series. Read Part 1 and Part 2.)

To contact the writer of this column: A. Gary Shilling at

To contact the editor responsible for this column: Max Berley at

A Gary Shilling

A. Gary Shilling, a Bloomberg View columnist, is president of A. Gary Shilling & Co., a consultancy in Springfield, ... MORE

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