Americans have been inundated with financialscandals at large corporations during the past twoyears. In many cases, unethical behavior and pooroversight of corporate management are to blame.But a deeper look reveals that the flawed structureof the corporate income tax has been a key driver ofcorporate waste and inefficiency. The tax code dis-torts financial and investment decisions and spursexecutives to hunt for tax shelters.

Three fundamental flaws in the corporateincome tax are behind the distortions and taxshelters. The first flaw is that the corporateincome tax rate is very high. Currently, the U.S.statutory corporate rate is the second highestamong the 30 major industrial countries. Thathigh rate reduces investment, encourages firmsto move profits abroad, and provides incentivesto push the legal margins of the tax code.

The second flaw is that the corporate tax base ofnet income or profits is inherently complex becauseit relies on concepts such as capital gains and capi-talization of long-lived assets that are difficult toconsistently account for in a tax system. Costs ofcapitalized assets are deducted through deprecia-tion, amortization, and other rules. The tax rulesfor capitalized assets and capital gains are repeated-ly exploited in corporate tax shelters. These rules

also cause economic distortions as they interferewith capital investment, business reorganizations,and other decisions. Capital gains taxation and cap-italization would be eliminated under a replace-ment “cash-flow” tax system.

The third flaw is the gratuitous inconsistencyof the tax code. Examples include the differenttax treatment given to debt and equity and thedifferent rules imposed on corporations and thehalf dozen other types of businesses. Such incon-sistencies played a key role in the tax sheltersexploited by Enron and other firms. Worse, theyhave created large costs to the economy by dis-torting capital markets and channeling invest-ment into less productive uses. A cash-flow taxwould eliminate these distortions and put allbusinesses and investments on an equal footing.

This study discusses the most serious corpo-rate tax distortions and examines fundamentalreforms to fix them. One option examined is afull repeal of the corporate tax. Another option isreplacing the corporate income tax with a cash-flow tax. The study concludes that implement-ing a cash-flow business tax would build onPresident Bush’s tax cuts, help prevent futureEnron-style scandals, and permanently boost theeconomy.

Replacing the Scandal-PlaguedCorporate Income Tax with a Cash-Flow Tax

by Chris Edwards

_____________________________________________________________________________________________________

Chris Edwards is director of fiscal policy studies at the Cato Institute.

Executive Summary

No. 484 August 14, 2003

Introduction

The corporate income tax will raiseabout $150 billion in fiscal 2003, whichaccounts for about 8 percent of total federaltax revenues.1 Despite some popular percep-tions that large corporations are able toevade much of their tax liability, most largecorporations pay a huge amount of tax tothe federal government. Consider Wal-Mart.It paid $3.02 billion in current federalincome taxes in 2002 on pretax U.S. profitsof $9.52 billion.2 That works out to an effec-tive tax rate of 31.7 percent.

Of course, Wal-Mart and other corpora-tions do not actually bear the burden of thecorporate tax; they simply act as tax collectorsfor the government. The actual burden of cor-porate taxes falls on individuals as workers,consumers, and investors. The extent to whichthe burden falls on each group is subject tomuch debate with no clear answers.3 Supposethat Wal-Mart’s $3 billion tax in 2002 wasfully borne by its 1.1 million U.S. workers. Theeffect would be to reduce each worker’s annu-al wage by $2,727. But no matter which groupactually bears the burden, corporate incometaxes create the fiction that $150 billion of fed-eral spending is “free” because the cost is invis-ible to the general public.

The corporate income tax is generally con-sidered the most complex and distortionary ofall federal taxes. Jane Gravelle concludes thatthe “one fundamental aspect of the tax law thatappears to cause the greatest tax distortions isthe double tax on corporate income,” whichoccurs because corporate profits are taxed atboth the corporate and individual levels.4 Thatdistortion has caused concern since the begin-ning of the income tax, but the costs are risingin today’s competitive and globalized economy.The observations that Stanford economistsMyron Scholes and Mark Wolfson made in1991 are still true today:

The United States is out of sync withmost of the rest of the world in tax-ing corporate income so heavily rela-

tive to non-corporate income. Inmost other countries, corporateincome is taxed more favorably byallowing shareholders to take a taxcredit for corporate taxes they payindirectly as shareholders, by impos-ing low shareholder-level tax rates, orby imposing relatively low corporate-level tax rates.5

Scholes and Wolfson concluded that“unless the tax system is changed to makeU.S. corporations less tax disfavored relativeto partnerships, investment bankers andother organizational designers will continueto search for ways to gut the corporate tax.”6

That comment was prescient, given the sub-sequent aggressive tax avoidance efforts byEnron and other companies. The U.S. corpo-rate tax is not gutted yet, but policymakerslargely have themselves to blame for recentcorporate tax avoidance scandals. After all,policymakers have not responded to the real-ity that nearly every major industrial nationhas cut its statutory corporate tax rate tobelow the U.S. rate.7

The recent tax bill passed by Congressincluded shareholder tax cuts that are a firststep toward solving the corporate tax prob-lem. The Jobs and Growth Tax ReliefReconciliation Act of 2003 reduced the toptax rates on dividends and capital gains to 15percent.8 However, those tax cuts are set toexpire after 2008, and the tax bill did notaddress many serious distortions in the cor-porate income tax. For those reasons,Congress needs to pursue a major corporatetax overhaul or a full corporate tax repeal.Former treasury secretary Paul O’Neill’smusings about abolishing the corporateincome tax were not far-fetched, given thegrowing strain the tax is under in the com-petitive global economy.

That growing strain was highlighted in therecent 2,700-page report on EnronCorporation’s tax sheltering activities by thecongressional Joint Committee on Taxation.9

Enron is just one company, but it took a teamof JCT investigators a year to figure out how all

2

Policymakershave not respond-

ed to the realitythat nearly everymajor industrial

nation has cut itsstatutory corpo-

rate tax rate tobelow the U.S. rate.

its tax shelters worked. And the JCT was stillunable to determine how much tax Enronshould have paid between 1995 and 2001because the IRS needs to spend many morehours auditing those returns.10 The efforts ofthe JCT team were a mirror image of the hugeefforts of the experts at Enron, the accountingfirms, and investment banks that put Enron’stax shelters into place to begin with.

The brainpower spent on Enron’s taxes isa just a fraction of the vast brainpower spenton the 2.2 million corporate income taxreturns filed each year.11 Most of the 54,846pages of federal tax rules relate to businessincome taxes.12 The JCT concluded thatEnron “excelled at making complexity anally.”13 Although it was an ally to Enron, taxcomplexity is an enemy to productive busi-ness management and sound investmentdecisions. A typical large corporation spendstens of millions of dollars per year on taxplanning and paperwork. This paper drawson the numerous Enron tax shelter deals tohighlight the serious efficiency and complex-ity problems of the corporate income tax.

Enron-style tax sheltering has not been theonly type of corporate tax scandal in the news.Attention has also focused on the growingnumber of U.S. companies moving their placeof incorporation to low-tax jurisdictions, suchas Bermuda. U.S. firms can save taxes on theirforeign operations by creating a foreign parentcompany for their worldwide operations. At thesame time, there are growing incentives for for-eign companies to acquire U.S. companiesbecause the United States has a bad tax climatefor multinational headquarters.14

Those developments have prompted knee-jerk denunciations of corporate wrongdoingand a batch of ill-conceived Band-Aids fromCongress. But something more fundamentalthan a sudden decline in ethical standards orpatriotism in corporate boardrooms is goingon. The more fundamental issues include thehigh U.S. corporate tax rate, the uncompeti-tive and complex corporate tax rules, global-ization, and tax reforms by foreign govern-ments. In addition, Wall Street “financialinnovation is growing rapidly and the tax law

has not kept pace,” as the TreasuryDepartment noted in a major study of taxshelters in 1999.15 For example, the total valueof financial derivatives issued is estimated tohave jumped from $3 trillion in 1990 to $127trillion today.16 A recently decided case in theU.S. Tax Court involving Bank One’s use ofderivatives concluded an eight-year battle anda trial that produced a 3,500-page transcriptand 10,000 exhibits.17 Clearly, the complexmodern economy is creating unprecedentedpressure on the antiquated income tax system.

In the next section I examine how the cor-porate tax shelter issue has developed in recentyears and contrast legalistic and fundamentaleconomic solutions to the problem. Then I dis-cuss the three fundamental structural prob-lems with the U.S. corporate tax: the high statu-tory tax rate; the inherent complexity of anincome tax that relies on capital gains taxationand capitalization; and the gratuitous inconsis-tency that Congress has injected into theincome tax, such as the different rules for cor-porations and other types of businesses.

In the final part of the paper I consider tworeform options. First, I consider full corporatetax repeal. Second, I examine replacement ofthe corporate income tax with a low-rate busi-ness cash-flow tax. A cash-flow tax would elim-inate many current complexities (e.g., deprecia-tion) and distortions (e.g., debt favored overequity) that haunt the current tax code. Cash-flow taxation has been part of numerousreform plans over the years, including aBrookings Institution tax plan from the 1980sand then–house majority leader Dick Armey’sflat tax of the 1990s.18 I conclude that recentscandals and rising tax competition make thisan excellent time to repeal the corporate tax orreplace it with a business cash-flow tax.

Tax Shelters: Legalistic vs.Fundamental Economic

SolutionsEvery few years, the income tax generates

another cycle of tax avoidance scandals. Inthe 1970s and 1980s, the main focus was on

3

Although it wasan ally to Enron,tax complexity isan enemy to pro-ductive businessmanagement andsound investmentdecisions.

individual tax shelters. Wealthy taxpayerssheltered income in real estate deals, movieprojects, and exotic ventures such as jojobabean farming.19 The shelters involved strate-gies such as accelerating deductions, convert-ing ordinary income to capital gains, and useof limited partnerships. A series of tax laws inthe 1970s and 1980s mitigated those prob-lems by closing loopholes and substantiallycutting tax rates. The top individual incometax rate was cut from 70 percent to 50 per-cent in 1981, and then to 28 percent in1986.20 With that low rate, it made moresense for dentists, doctors, and other highearners to make sound investments ratherthan dodge the IRS with elaborate schemes.

In recent years, concern has shifted fromindividual to corporate tax avoidance. By mostaccounts, corporate tax avoidance has been onthe upswing, though there are no firm esti-mates of the magnitude of those activities.The upswing has been spurred by sophisticat-ed tax planning made possible by advancedcomputers and software, Wall Street financialinnovation, global competitive pressures, andthe high U.S. corporate tax rate. The first threefactors are realities that will only intensify inthe years ahead. But Congress can do some-thing about the high corporate tax rate, as dis-cussed in the next section.

Competitive pressures and financial innova-tions have also given rise to the manipulationsof financial statement earnings that have beenmuch in the news. Many corporate financialmanipulations have created the dual benefit oftax reduction and a reported earnings boost atthe same time. The rising gap between financialstatement income and income reported for taxpurposes seems to be caused by both tax avoid-ance efforts and efforts to inflate book earningsto please financial markets.

The increase in corporate tax avoidancehas been costly in time and money for bothcompanies and the government. Accountingand Wall Street firms have developed highlevels of expertise at combining disparateparts of the tax code to engineer tax savings.But that expertise costs money: tax shelterpromoters have been paid as much as $25

million for a deal sold to a single company.21

Enron paid $88 million for advice on 12 taxshelter deals between 1995 and 2001.22 Thesebusiness costs are mirrored by the addedcosts on government administrators andenforcers. For example, it can cost the gov-ernment $2 million just to litigate a single taxshelter case.23 The IRS, the Treasury, and thecourts are kept busy as each new tax shelter isdiscovered and then squelched throughstatutes, regulations, enforcement, and liti-gation. In 1999, the Treasury Departmentnoted that at least 30 new narrow provisionshad been added to the tax code in the previ-ous few years in response to particular abus-es.24 Those new rules in turn force taxpayersand their advisers to abide by growing lists ofanti-abuse statutes, reporting requirements,and disclosure rules.

Tax Code Ambiguity Makes LegalCrackdown Ineffective

One might think that these wastefulefforts could be reduced if corporations sim-ply stopped acting improperly. But there isusually no clear-cut right or wrong in theincome tax avoidance cat-and-mouse game.Most corporate tax disputes involve differentinterpretations of the rules, not straightfor-ward cheating.25 Indeed, taxpayers often wincourt cases when the IRS challenges them ontheir tax law interpretations. Some recentIRS wins against corporate tax shelters in theU.S. Tax Court were reversed by the FederalCourt of Appeals.26 Tax lawyers often cometo widely different conclusions when theyexamine the same facts in particular cases.Many issues are so gray that tax disputesbetween companies and the IRS can remainunsettled for 10 years or more.27 The IRS’sestimate of the correct tax liability across allcorporations can be tens of billions of dollarsdifferent from what U.S. corporations believeto be the correct amount owed.28

Given this level of legal uncertainty, com-panies have strong incentives to push the taxcode’s limits. After all, no taxpayer has anobligation to pay more than what is owed,and the government cannot tell taxpayers for

4

Tax shelter pro-moters have been

paid as much as$25 million for a

deal sold to a sin-gle company.

sure what an illegal tax shelter is. One tax lawprofessor noted that “virtually all tax shelterscomply with the literal language of a relevant(and perhaps the most relevant) statute,administrative ruling, or case.”29 With regardto Enron’s tax shelter activities, the then–JCTchief of staff Lindy Paull testified, “I don’tknow if you could call it illegal.”30 Thoughthey are not clearly illegal, Paull did thinkthat the IRS should challenge many Enron-style tax shelters.

The courts have followed various generalprinciples or doctrines to challenge tax shel-ters, such as “substance over form,” “businesspurpose,” and “economic substance.” Forexample, “substance over form” basicallymeans a taxpayer cannot simply label equityas debt and deduct dividends as if they wereinterest. That makes sense, but the TreasuryDepartment notes that the “substance overform doctrine is highly subjective and factdependent, and thus is uncertain.”31 The eco-nomic substance and business purpose doc-trines attempt to deny tax benefits for trans-actions that do not have a nontax businesspurpose. But ambiguity comes into playbecause it is not clear how broadly a “trans-action” should be defined or how much non-tax business purpose is needed for a transac-tion to pass muster.32

In speaking of anti–tax shelter legalapproaches, the 1999 Treasury Departmentreport noted that the “application of thesedoctrines to a particular set of facts is oftenuncertain.”33 Indeed, courts often come todifferent conclusions in seemingly similarcases. Nonetheless, the Treasury Departmentcreated its own list of the general characteris-tics that may identify an unjustified tax shel-ter. Those include transactions that lack eco-nomic substance, create inconsistenciesbetween tax and financial statement income,make use of nontaxable counterparties, aresold confidentially, have high or contingentfees, or involve widespread marketing effortsby the shelter creator.34

There is much debate regarding the bestway to crack down on tax shelters from alegal point of view. Some experts support

imposing more detailed rules; others supportstronger general standards. Some lawyersactually call for vague tax rules and largeamounts of IRS discretion to intimidatecompanies, but that seems to be hostile tothe rule of law and may inhibit legitimatebusiness activities.35 Numerous superficialanti-shelter ideas are currently being imple-mented. For example, the TreasuryDepartment recently issued regulations thatrequire that taxpayers and promoters ofdubious tax avoidance transactions registerthem with the IRS. In addition, there is amovement to ban accounting firms fromdoing tax work for their audit clients, espe-cially the marketing of tax reduction ideas.Obviously, such rules would not eliminatethe underlying economic incentives to avoidhigh taxes. Thus, large companies will proba-bly just do more tax planning in-house orpurchase shelters from nonaccounting firms.Ultimately, a large and sustained reductionin tax sheltering can be achieved by changingfundamental economic incentives, not byadding endless layers of new rules.

Fundamental Economic Solutions NeededThe development of detailed legal rules is

certainly necessary for any tax system. Butthe tax shelter discussion in the past fewyears has been far too much a conversationbetween lawyers, without any focus on eco-nomic solutions. The tax shelter discussionhas been about which legal doctrines shouldbe used to enforce bad laws, rather thanabout reforming the bad laws. The 1999Treasury Department study on tax sheltersidentified the many “discontinuities” in theincome tax as a key cause of shelters.

[Tax] shelters typically rely on sometype of discontinuity in the tax lawthat treats certain types or amountsof economic activity more favorablythan comparable types or amountsof activity.

These discontinuities can arise inthe basic structure of the Federalincome tax system or in specific provi-

5

The tax shelterdiscussion in thepast few years hasbeen far toomuch a conversa-tion betweenlawyers, withoutany focus on eco-nomic solutions.

sions of the Code and regulations. Thedevelopment of sophisticated financialinstruments, such as derivatives, hasfacilitated the exploitation of these taxlaw discontinuities.36

Yet the Treasury study spent only a fewparagraphs discussing fundamental reformsthat would remove those discontinuities andfocused instead on ways to better policethem. For example, the tax code favors debtover equity financing by allowing corpora-tions a deduction for interest payments butnot for dividend payments.37 That disconti-nuity has spurred companies to design com-plex financial structures that have many fea-tures of equity but are treated as debt for taxpurposes. If Congress eliminated suchinequities, tax authorities could save muchtime and effort now spent on policing the taxavoidance activities that have arisen inresponse. The American Bar Associationnoted that “parties to a tax-driven transac-tion should have an incentive to make certainthat the transaction is within the law.”38

However, it would be much better to reducetax-driven transactions altogether by creat-ing a more neutral tax code.

Unless basic economic incentives arechanged, narrow limitations on tax-drivenactivities may simply spawn new tax avoid-ance techniques.39 The Treasury Departmentreport notes that a vicious cycle is created as“legislative remedies themselves create thecomplexity that the next generation of taxshelters exploits, which leads to more com-plex responses, and so on.”40 For example,the private sector created new tax shelters inresponse to the repeal in 1986 of GeneralUtilities doctrine (which had allowed firmsto avoid capital gains tax on some transac-tions), the restrictions on foreign tax creditsin 1986, and the more recent implementa-tion of mark-to-market securities rules.41

Legalistic approaches to tax shelters usual-ly frame the issue as if Congress should impe-riously be able to impose any bad tax policy itwants on Americans without any considera-tion of the damage it may do. That attitude is

seen in the 1999 Treasury Department report,which states that tax shelters “breed disre-spect” for our “voluntary tax system.”42 Butsurely it is the compulsory, complex, andungainly tax system that breeds disrespect andgives rise to tax shelters. If we do not have atransparent and straightforward way of com-plying with the system, Congress is responsi-ble, not the taxpayers.

One trap that Congress repeatedly fallsinto is carving out narrow benefits targetedat special interests. Nontargeted taxpayerswill often find the new loopholes and exploitthem. A classic example was recently reportedby the New York Times.43 Decades ago,Congress carved out a tax exemption forsmall insurance companies—those with lessthan $350,000 in premiums—in order to helpfarmers and others get coverage. The Timesreports that a host of millionaires and non-insurance companies have seized the oppor-tunity to set up insurance company shellsthat do little actual insurance business.Those tax avoiders transfer billions of dollarsof assets to those shells in order to generatetax-free earnings—all legally.

As long as Congress perpetuates such dis-tortions in the tax code, legalistic solutionsto shelters will fail. Another dead end is thebelief that more money and more aggressiveenforcement by the 100,000-worker IRS willsolve the problem. The reality is that the IRSwill always be outgunned by highly paid taxexperts in the private sector.44 As Congressmakes the rules ever more complex, private-sector tax experts will have an even biggeradvantage. The government is already usingevery kind of legal tool in its arsenal—legisla-tive, regulatory, and judicial—to combat taxshelters.45 But the distortion-laden incometax is too complex for any bureaucracy toaccurately administer.

Instead, it is time that Congress pursued afundamental economic solution to the prob-lem. That means reducing the corporate taxrate and building the tax code on a neutraland transparent base to make administra-tion and compliance easier for taxpayers andthe government. Another advantage to a neu-

6

It is the compul-sory, complex,

and ungainly taxsystem that

breeds disrespectand gives rise to

tax shelters.

tral tax code is that it would reduce taxinequalities between companies. An impor-tant cause of aggressive corporate tax shelter-ing has been the pressure on executives toensure that their firms’ effective tax ratereported on financial statements is no higherthan competitors’ tax rates.46 As the TreasuryDepartment notes, effective tax rates are“viewed as a performance measure, separatefrom after-tax profits. That has put pressureon corporate financial officers to generatetax savings through shelters.”47 Thus, moreneutrality in the tax code would equalize taxrates between firms and reduce pressures topursue tax sheltering.

High Rate Exacerbates AllCorporate Tax ProblemsAfter the United States cut its corporate

tax rate from 46 percent to 34 percent in1986, other countries followed suit and taxrates tumbled across the industrial nationsof the Organization for Economic Coopera-tion and Development. Corporate tax ratecutting has continued in recent years, withthe average top rate in the OECD countriesfalling from 37.6 percent in 1996 to just 30.8percent by 2003.48 That compares to a 40 per-cent rate in the United States, including the35 percent federal rate and an average 5 per-cent state rate. The United States now has thesecond highest statutory corporate tax ratein the OECD next to Japan.49

More countries are realizing that high cor-porate tax rates discourage inflows of foreigninvestment and encourage domestic compa-nies to invest abroad. As world direct invest-ment flows soared from about $200 billionto $1.3 trillion during the 1990s, countriessought to attract their share of investmentsin automobile factories, computer chipplants, and other facilities.50 Extensive empir-ical research has concluded that tax rates areimportant in channeling cross-border invest-ments.51 As just one current example, theworld’s third largest memory chipmaker,Infineon Technologies, recently announced

that it may move its headquarters out ofGermany partly because of that country’shigh tax burden.52

Indeed, an important conclusion of pub-lic finance research is that in an open worldeconomy countries should reduce tax rateson capital income to zero.53 Higher tax ratesraise the required pretax return on invest-ments, which reduces a country’s capitalstock and wages. In that situation, it wouldbe more efficient for a country, and better forworkers, to tax wages directly. It is true thatthe zero tax rate conclusion depends on cer-tain qualifications, but it is efficient to taxhighly elastic items more lightly than otheritems. Corporate profits are highly elastic ormobile in today’s economy and thus shouldbe taxed very lightly in order to maximizeU.S. gross domestic product.

The mobility of the corporate tax base isillustrated by the number of U.S. companiesthat are “inverting,” or reincorporating inlow-tax foreign jurisdictions such asBermuda. By doing so, U.S. firms have foundthat they can reduce taxes paid to the U.S.government on their foreign operations. In atypical corporate inversion transaction, theU.S. firm places itself under a new foreignparent company formed in a lower-tax juris-diction. Such transactions generally have noreal effect on the company’s U.S. businessoperations; the company just pays less tax tothe U.S. government.

Many politicians and pundits have foundcorporate inversions to be scandalous, and anumber of bills have been introduced inCongress to stop them. Unfortunately, thoseefforts offer only a superficial response to theissues raised by inversions and do not tacklethe underlying uncompetitiveness of the U.S.corporate tax.54 It is certainly sad that venera-ble American businesses such as Stanley Worksand Ingersoll-Rand feel that the U.S. tax code isso bad that they must consider incorporatingabroad.55 The decisions to undertake suchtransactions are not taken lightly by U.S. com-panies because inversions need complex plan-ning and can involve large up-front tax costs.56

Thus, U.S. firms would not be pursuing inver-

7

The United Statesnow has the sec-ond higheststatutory corpo-rate tax rate inthe OECD next toJapan.

sions unless there was something seriouslywrong with the U.S. tax system.

This issue highlights the two-sided gamethat some politicians play with regard to thetax code. First, they attack the tax code’s inef-ficiency and complexity, and then they turnaround and attack the taxpayers who logical-ly try to take advantage of the tax mess thatthe government created. For example, in themid-1930s President Franklin Roosevelt andTreasury Secretary Henry Morgenthaulaunched a campaign to energize their con-stituents by attacking tax loopholes used bythe rich.57 The Treasury Department vilifiedfamous wealthy people as tax cheaters andintroduced a string of proposals to increasetaxes on the rich and big corporations.58 Yetin the previous few years, the governmenthad jacked up the top individual tax ratefrom 25 percent to 79 percent, thus encour-aging the rich to aggressively hunt for newtax shelters. Meanwhile, Roosevelt railedagainst income tax rules “so complex thateven Certified Public Accountants cannotinterpret them.”59

Today it is the same with the corporateincome tax. The high rate and the distortionswork hand in hand to give companies astrong incentive to pursue tax reductionschemes. The high corporate rate exacerbatesevery distortion in the income tax code, suchas the bias in favor of debt. Indeed, high taxrates increase the “deadweight losses” causedby such distortions more than proportional-ly as tax rates rise.60 Thus, even modest ratereductions can substantially increase the effi-ciency of the tax system. As marginal tax ratesfall, tax distortions become less importantand executives become less interested in tak-ing the risks and paying the high feesinvolved in tax shelter transactions.

In today’s global economy, it is not justthe absolute level of the corporate rate that isimportant but also the U.S. rate compared torates in other countries. For example, todaythere is much concern about “earnings strip-ing,” which occurs when parent firms andtheir affiliates use intercompany borrowingto shift profits from high-tax to low-tax

countries. The benefits of such transactionsdepend on the tax rates in the two countries.Thus as our trading partners have cut taxrates in recent years, it is not surprising thatthe U.S. corporate tax is feeling pressurefrom such tax avoidance techniques.

The United States needs to update its taxpolicies to keep pace with changes in the restof the world. Cutting the U.S. corporate ratefrom 35 percent to, say, 20 percent wouldincrease capital investment, reduce corporateactivities aimed at avoiding U.S. taxes, andencourage companies to restructure them-selves to move more of their global tax baseinto the United States.

Flaws Intrinsic to theCorporate Income Tax

The corporate income tax began in 1909masquerading as an “excise” tax.61 Ever sincethe Supreme Court had struck down theincome tax in 1895, attempts had been madeto work around the Court’s decision andsomehow apply taxes to an income base.62

The Corporation Tax Act of 1909 applied a 1percent tax on corporate net income, on thetheory that it was an excise on the “privilege”of organizing in the corporate form.63

Supporters of the tax took advantage of thepopulist anti-wealth and anti–big businessattitudes that had been gaining steam sincethe 1890s.64 Support for the corporate taxalso came from opponents of tariffs whowanted to find a substitute revenue source.65

The corporate income tax was seen as a firststep toward broader income taxation thatwould be adopted a few years later. After theadoption of the Sixteenth Amendment to theU.S. Constitution in 1913, the corporate taxwas rolled into the new income tax system.

Even before 1909, there was a history atthe state level of taxing corporations moreheavily than other types of businesses. Statecorporate taxes had been supported becausecorporations were seen as too powerful or asbeneficiaries of privileges conferred on themby the government. Politically, special taxes

8

The high corpo-rate rate exacer-

bates every distor-tion in the

income tax code.

on corporations made sense because theyallowed governments to hide funding foradditional spending out of sight of the vot-ers. But taxing corporations differently fromnoncorporate businesses never had a soundeconomic justification.

Congress compounded the mistake ofimposing a special tax on corporations byapplying the tax to the very troublesome baseof net income or profits. The tax base of netincome created substantial complexity fromthe beginning. Civil War administrators hadtrouble measuring income and capital gainsunder the income tax that lasted from 1861until 1872.66 Soon after the corporateincome tax was enacted in 1909, the tax basebegan creating confusion and inefficiency.The congressional Joint Committee onTaxation was created in 1926 to studyincome tax simplification and the complextax administration problems that hadalready arisen. By the 1930s, experts werelamenting all the fundamental income taxproblems that cause distortions and com-plexities today. A major report by theTreasury Department in 1934 noted withregard to the corporate income tax:

The irregularity of income, the taxa-tion of capital gains, the definitionof the time of “realization,” the han-dling of depreciation and apprecia-tion, the cash versus accrual methodof accounting, the holding and dis-tributing of corporation earnings inthe form of dividends, all raise seri-ous difficulties in the definition ofincome and administration of a netincome tax.67

Despite hundreds of statutory and regulato-ry changes to these provisions during subse-quent decades, all these problems persisttoday. A key problem is that the income taxsuperstructure has been built ever higher ona very problematic base. The problems beginwith the Haig-Simons income concept,which underpins the tax, named after econo-mists Robert Haig and Henry Simons writ-

ing in the 1920s and 1930s.68 In abstract,Haig-Simons income equals consumptionplus the rise in market value of net wealthduring a year. In practice, it includes all formsof labor compensation, including fringe ben-efits, and all sources of capital income, suchas interest, dividends, and capital gains.

A Haig-Simons tax would tax income verybroadly and would tax it on an accrual basis.Taxing on an accrual basis means taxingincome when earned, not when cash is actu-ally received. For example, individuals wouldbe taxed each year on all stock market gainswhether or not any stocks were sold. Also,individuals would be taxed on items such asthe buildup of wealth in their life insurancepolicies and the implicit rent received fromowning their homes.

It would be completely impractical to taxsuch a broad accrual income base.69 Forexample, many individuals would not haveany cash available to pay capital gains tax ifthey did not sell any stock. As a consequenceof the impracticality of full Haig-Simons tax-ation, the income tax system is a jumble of adhoc rules based on different theories and var-ious practical realities. David Bradford, a for-mer Treasury official and current Princetonprofessor, has examined the complexity ofincome taxation and concluded:

It is simply very difficult to designrules that can be administered byordinary human beings that will pro-vide an acceptable degree of approxi-mation to the accrual-income ideal.That is why the tax system requirescontinual patching—one year, taxstraddles; another year, self-con-structed assets; another year, install-ment sales; another year, discountbonds; and so on.70

Under the current income tax, corpora-tions generally capitalize long-lived assetsused for production. That means that suchassets may not be deducted when purchased,but their cost is deducted over time underrules for depreciation and amortization. In

9

Taxing corpora-tions differentlyfrom noncorpo-rate businessesnever had asound economicjustification.

addition, the income tax generally uses accru-al accounting, meaning that income is includ-ed in the tax base when earned, not when cashis received, and expenses are deducted whenincurred, not when cash is paid. Capitalizationand accrual accounting involve the creation ofmany artificial accounting constructs thatopen the doors to manipulation and distor-tion of the income tax.71 (By contrast, undercash-flow accounting businesses deduct allexpenses when paid and include income whenreceived.)

Capitalization and accrual accounting arealso the building blocks of financial state-ment income, based on generally acceptedaccounting principles (GAAP). Recent corpo-rate accounting scandals illustrate thatGAAP-based income suffers from largemanipulation problems, similar to the prob-lems faced by the current income tax. It isoccasionally suggested that income for taxpurposes be conformed to GAAP income as asimplification measure. However, recentaccounting scandals suggest that that wouldnot produce a less problematic tax base. Also,a tax base of GAAP income would retain theanti-investment bias of the current incometax. For example, it would still require depre-ciation of capital purchases rather thanimmediate deduction (“expensing”).72 Also,conforming tax to GAAP income may causecorporate executives’ tax considerations todistort their financial statements and upsetthe efficiency of financial markets.73

Net Cash Flow Is an Alternative Tax BaseAn alternative to income taxation based

on accrual accounting is consumption taxa-tion based on cash-flow accounting.74 Acash-flow tax would be imposed on net cashflow of businesses, not net income or profits.The most commonly proposed type of cash-flow tax (an “R-based” tax) would have a taxbase of receipts from the sale of goods andservices less current and capital expenses.Under an R (real) base, financial items suchas interest, dividends, and capital gainswould be disregarded—they would not beincluded in income or allowed as deduc-

tions.75 (Alternately, an R+F base, real plusfinancial, would include financial flows.)Under cash-flow accounting, businesseswould include receipts when cash is receivedand deduct the full costs of materials, inven-tories, equipment, and structures when theyare purchased.

Business cash-flow taxes have been dis-cussed in academic and policy circles foryears and have formed the basis of numerouslegislative proposals since at least the 1970s.(Going back further, Treasury SecretaryAndrew Mellon’s chief tax adviser in the1920s, Thomas Adams, suggested replacingthe income tax and its “incurable inconsis-tencies” with a consumption-based tax.)76 In1985, the Brookings Institution’s HenryAaron and Harvey Galper proposed an R+F-based cash-flow tax on businesses within acomprehensive tax plan.77 In 1981, theHoover Institution’s Robert Hall and AlvinRabushka introduced their “flat tax,” basedon an R-based business cash-flow tax.78

Interestingly, it was former senator DennisDeConcini of Arizona and former represen-tative Leon Panetta of California, bothDemocrats, who first introduced the Hall-Rabushka plan in Congress in 1982, illustrat-ing that tax reform was more of a bipartisanconcern in the 1980s than now.79 In the1990s, Dick Armey and Steve Forbes pro-posed Hall-Rabushka-style tax reform plans.

Economists from Aaron to Armey agreethat many basic income tax distortionswould be eliminated under a business cash-flow tax. Those distortions include the dif-ferent treatment of debt and equity, the dif-ferent treatment of corporate and noncorpo-rate businesses, the bias against saving, anddistortions caused by inflation.80 As timegoes by, the business cash-flow tax becomesmore appealing compared with the deepen-ing swamp of complexity and inefficiencyunder the corporate income tax.81

Income Taxation Is Sensitive to TimingTiming is everything under the income

tax, which relies on capitalization and accru-al accounting. The basic idea is to match

10

An alternative toincome taxationbased on accrual

accounting is con-sumption taxa-

tion based oncash-flow

accounting.

expenses against corresponding incomewhen earned. If cash is spent this year thatcreates benefits in future years, the expenseshould not be currently deducted. Instead,the cost must be capitalized and deductedlater. Alternatively, rules are needed to dealwith cash received this year that relates toeconomic activity in other years. Thus, in anygiven year under the income tax there arenumerous income and deduction items oncorporate tax returns that do not coincidewith flows of cash but are based on tax lawdefinitions determining the proper timing ofrecognition.

Examples of noncash tax return entriesare depreciation and amortization. Forexample, goodwill is created as an artificialasset under some corporate acquisitiontransactions. The acquiring company in anacquisition amortizes the goodwill asset(takes a noncash deduction) over the subse-quent 15 years. Such noncash items may onlybe rough measures of underlying economicreality. In addition, inflation throws awrench into the accurate matching ofincome and expenses since deductions slatedfor future years lose their value with infla-tion. As a result, the income tax code is rifewith distortions that are roadblocks to effi-cient investment and offer opportunities fortax avoidance transactions.

The Treasury Department notes that “it isextremely difficult, and perhaps impossible,to design a tax system that measures incomeperfectly . . . even if rules for the accurate mea-surement of income could be devised, suchrules could result in significant administra-tive and compliance burdens.”82 Capitalgains is a good example. In theory, broad-based income taxation would tax capitalgains on an accrual basis. But since that isnot feasible, the income tax falls back on tax-ing most, but not all, gains when realized.Recent tax shelters have exploited the factthat some gains are taxed on a realizationbasis and other gains, such as foreign curren-cy contracts, are taxed on a mark-to-market,or accrual, basis. That discontinuity has beenexploited by Wall Street experts who have

devised a variety of tax shelters.83 Apparently,firms subject to mark-to-market tax treat-ment are able to enter into mutually benefi-cial transactions with other taxpayers subjectto realization treatment to absorb their capi-tal gains.

Many tax avoidance techniques exploitthe income tax’s sensitivity to timing. Onetechnique is to take advantage of tax codeprovisions that accelerate income recogni-tion. Installment sale shelters and lease strips(both of which are now banned) used thatapproach. Those shelters worked by having acorporation set up a partnership with a non-taxpayer (such as a foreigner). A transactionwould be performed through the partner-ship that generated up-front income; thatincome would be mainly allocated to thenontaxpayer; then the partnership would bedissolved. Under the lease strip shelter, thepartnership would buy an item such as anairplane, lease it out under a prepaid lease,and then allocate the up-front money to thenontaxpayer.84 The partnership would thenbe dissolved, leaving the corporation with noincome to report but with annual deprecia-tion deductions to take on the airplane orother assets.

A number of Enron deals exploited vari-ous timing-sensitive income tax rules. Forexample, “commodity prepay” transactionswere used to reduce taxes. In one deal, Enronsought to generate income in order to useSection 29 tax credits before they expired.Those credits are special interest benefitsdesigned to encourage fuel production fromunconventional sources.85 Enron designedtransactions to enable it to receive up-frontpayments, so that it could use the tax credits,in exchange for later delivery of oil and gas.But no oil and gas were actually delivered,and the transaction was later reversed with acomplex flow of money after the tax benefitshad been realized.

Most such manipulations with regard tothe timing of income and expenses would beeliminated under a cash-flow tax. Incomewould be included in the tax base whenreceived. Deductions would be taken when

11

A number ofEnron dealsexploited varioustiming-sensitiveincome tax rules.

cash went out the door. That treatmentwould not only be more economically effi-cient, it would remove a great many taxavoidance opportunities that exist under thecurrent tax regime.

CapitalizationUnder the income tax, business costs for

assets that generate revenues in future yearsare typically not deducted at the time of pur-chase. Instead, such items as buildings,machines, and intangible assets are capital-ized and deducted over future years. Underincome tax theory, the purchase price ofbuildings and machines should be deducted,or depreciated, over time to match the loss ineconomic value of the asset. When intangibleassets are purchased, they are amortized overa specified period of time. Materials pur-chased for inventory and related inventoryexpenses face special rules to determine whendeductions should be taken.

There are two key problems with capital-ization: figuring out which assets need to becapitalized and figuring out the period overand method by which to take future deduc-tions. With regard to the first problem, anyasset that produces benefits in future yearsshould be capitalized, in income tax theory.But that principle becomes extremelyambiguous in practice. For example, the IRShas battled companies over whether manage-ment consultant expenses should be imme-diately deducted if they relate to long-termimprovements in a company’s productivity.Taxpayers say yes, but the IRS has held thatsuch expenses must be written off over futureyears. The tax code contains no consistencyon such rules. Advertising and research anddevelopment expenses are immediatelydeducted under current rules, yet they pro-duce benefits in future years. On the otherhand, the tax law requires capitalization ofnumerous expenses that taxpayers think ofas current expenses, such as interest costsrelated to inventory.

Capitalization is probably the greatestweakness of the corporate income tax.University of Chicago law professor David

Weisbach notes that capitalization is “unbe-lievably complex” and “extremely uncertain”for companies.86 In recent years, the IRS hasbeen aggressive in forcing companies to capi-talize all kinds of expenses that it unilaterallydetermines yield long-term benefits. Onerough estimate was that up to one-quarter ofIRS examination resources in some indus-tries are used for capitalization issues alone.87

Capitalization is a heavily litigated part of thetax code, with taxpayers winning about halfthe cases against the IRS.88 Weisbach notesthat the outcome of court cases is essentiallyrandom because of the ambiguity.89 TheSupreme Court has weighed in on the ambi-guity of capitalization: “If one really takesseriously the concept of a capital expenditureas anything that yields income, actual orimputed, beyond the period . . . in which theexpenditure is made, the result will be toforce the capitalization of virtually everybusiness expense.”90

The problems of capitalization are evidentin the tax rules for inventory. Businesses maynot simply deduct the costs of materials whenpurchased; rather, costs must be capitalizedand deducted later when products are sold. Arange of indirect costs related to inventories,such as interest, must also be capitalized.These rules are so complex that a top TreasuryDepartment official thinks that many compa-nies are simply guessing to get the correctinventory deduction on their tax returns.91

The 1986 tax act was supposed to “reform”the corporate tax by measuring income better,but with inventory accounting and otheritems the rules became more complex.

The second key problem with capitaliza-tion is determining the time period over andmethod by which each asset should be deduct-ed over future years. In income tax theory,depreciation deductions should match anasset’s obsolescence over time. But every assetis different, and new types of assets are beinginvented all the time. Rough approximationsare used to place assets in categories thatdetermine the length of the period for deduc-tions and which formula to use in calculatingdeductions.92 For example, cars, farm build-

12

Capitalization isprobably the

greatest weaknessof the corporate

income tax.

ings, racehorses, shrubbery, and tugboats mayall have different depreciation time periodsand other rules. For newer technologies, theasset classification system is long out of date,resulting in incorrect treatment of such itemsas computers.93 But even up-to-date deprecia-tion schedules would be wrong because ofinflation distortions.

Depreciation plays an important role inmany tax shelters, including a number ofEnron deals. A basic shelter strategy is to arti-ficially raise the basis of an asset to increasefuture depreciation deductions. (“Basis” isgenerally the original cost less accumulateddepreciation. For example, a machine thatwas purchased for $100 and had $40 depreci-ation taken against it would have a basis of$60.) That strategy was used in 1997 inEnron’s Teresa tax shelter, which involved asynthetic lease, which is a lease treated differ-ently for tax purposes and financial state-ments.94 Enron and an investment bank setup a partnership to which Enron contributedits Houston North office building and otherassets, as well as preferred shares of an affili-ate. In the early years of the deal, Enron paidadditional tax from receipt of dividends, butthat cost would be outweighed by addeddepreciation deductions in later years. Taxbenefits were gained by shifting $1 billion inbasis from a nondepreciable asset (the pre-ferred shares) to depreciable assets includingthe office building.

The partnership tax rules combined withthe shifting of basis from nondepreciable todepreciable assets was also the key to otherEnron tax shelters.95 Enron shelters Tammy1 and Tammy 2 involved shifting about $2billion in basis to the Enron South officebuilding and other assets. Again, tax benefitswere gained by increasing future deprecia-tion deductions.96 (Ultimately, those dealswere not completed as planned because ofthe subsequent Enron meltdown.)

A business cash-flow tax would eliminatecapitalization and all related concepts suchas depreciation. Basis could not be shiftedfrom some assets to others as in the Enrondeals because asset basis is always zero under

a cash-flow tax. Businesses would include thefull price of asset sales in taxable receipts andwould deduct the full cost when purchased.All business purchases would be treated thesame way and immediately deducted.Partnerships would be taxed the same asother business entities so there would be noadvantages in shifting assets to them.Expensing would create tax neutrality acrossall types of assets. Inflation would not distortmarginal tax rates under a cash-flow tax as itdoes under the income tax. The rules under acash-flow tax would be simple and durableover the long term.

Capital GainsCapital gains taxation has caused com-

plexity and distortion throughout the histo-ry of the income tax. As early as 1944, aTreasury Department report noted that “thetreatment of capital gains has long been asource of controversy in federal taxation.”97

Under consumption-based taxes, such as acash-flow tax, capital gains taxation woulddisappear. But under the income tax,Congress cannot seem to find a stable andefficient treatment for capital gains: it repeat-edly changes the rates, exclusion amounts,holding periods, and treatment of losses.Capital gains taxation gets more complex asCongress adds more rules whenever newfinancial products are developed. For exam-ple, complex “constructive sale” rules wereadded in 1997 to prevent investors fromusing short selling to lock in gains withoutpaying tax. But the new rules prompted pri-vate-sector development of other techniquesto allow investors to accomplish the samething, such as strategies using puts and calls.

While Congress has made capital gainstaxation more complex than it needs to be—for example, by imposing multiple tax rates—most of the complexity is intrinsic. For exam-ple, practicality dictates than most gains betaxed on a realization basis, yet that treat-ment “stimulates an almost infinite varietyof tax planning.”98 Since gains are taxedwhen assets are sold, taxpayers need to opti-mally plan, matching their gains with losses.

13

Capital gains tax-ation has causedcomplexity anddistortionthroughout thehistory of theincome tax.

That planning has prompted the govern-ment to create a large apparatus of rules topolice realization strategies.

One example of intrinsic capital gainscomplexity for businesses is the difficulty indrawing distinct lines between assets sold asa part of regular sales, which are taxed asordinary income, and assets sold by investorsfor speculation, which are taxed as capitalgains.99 For industries such as real estate, thisclassification of receipts as ordinary or capi-tal gains is a continuing area of complexityand conflict.

For corporations, net capital gains aretaxed at the regular corporate rate, generally35 percent.100 Capital losses may be deductedonly against capital gains, not ordinaryincome. Net capital losses may be carriedback three years or forward five years. Thesebasic rules necessitate large amounts of taxplanning. Companies have an incentive toavoid realizing gains unless they have lossesavailable. Also, they generally prefer incometo be characterized as capital gains not ordi-nary income, and losses to be characterizedas ordinary losses not capital losses, becauseof the limitations on capital losses.101 Inaddition, the international tax rules provideincentives to characterize income or gains asforeign-source, but deductions or losses asU.S.-source.

Corporations pay capital gains taxes onsales of capital assets, such as shares of othercorporations. But gains on the sale of depre-ciable assets involve other rules. Sales of per-sonal property, such as machinery, are taxedpartly as capital gains and partly as ordinaryincome. The overall taxable amount is thedifference between the sales price and basis,which is generally the original cost less accu-mulated depreciation. That amount is taxedas ordinary income to the extent of previousdepreciation allowances (depreciation is“recaptured”). Sales of real property, such asbuildings, are also taxed partly as ordinaryincome and partly as capital gains, but differ-ent rules apply.

In a nutshell, the corporate capital gainsrules are complex and compel substantial tax

minimization planning. In addition, theycreate distortions, such as “locking in” cor-porate investments in other companies. Thatoccurs because built-in gains face corporatetaxation when shares are sold. Thus, compa-nies may avoid selling shares and be stuckholding old investments with low returns orbe unable to reallocate their capital whenbusiness conditions change.

A key goal of German corporate taxreforms put in place in 2002 was eliminationof this lock-in effect. In an effort to improvethe economy’s competitiveness, Germany cutits federal corporate tax rate to 25 percentand eliminated the corporate capital gainstax on sales of other firms’ stock.102

Incestuous cross-holdings between Germancompanies are thought to have sapped thedynamism from the economy. Capital gainstaxes stood in the way of needed divestituresand corporate restructuring. The tax reformwas designed to allow corporations tounwind their unproductive investmentswithout a tax penalty. The Netherlands hasalso gained a competitive edge by having nocorporate capital gains tax on sales of share-holdings. As a result, the Netherlands is afavored location for holding companies andmultinational headquarters.103

By contrast, the United States dissuadesefficient business reorganizations by taxingcorporate capital gains at a high rate. To giveone example of the size of the lock-in effect,consider SunTrust and Coca-Cola. SunTrustowns roughly $2 billion in Coca-Cola com-pany shares, which it has held since 1919. IfSunTrust wanted to unload those shares, itwould face corporate capital gains taxes ofroughly $700 million at the 35 percent cor-porate tax rate.104

Not surprisingly, the high corporate capi-tal gains tax has caused U.S. corporations todevise elaborate strategies to avoid it.Corporations have developed techniques toeffectively divest holdings in other firmswhile retaining legal ownership and deferringcapital gains tax until later years.105 Forexample, Times Mirror wanted to unload itsholding of Netscape Communications with-

14

Germany cut itsfederal corporatetax rate to 25 per-

cent and eliminat-ed the corporatecapital gains tax.

out paying the corporate capital gains tax in1996.106 With help from Wall Street, TimesMirror designed and issued “PEPS,” whichallowed it to put off until later years capitalgains taxes on the sale, to get cash up front,to push Netscape risk onto PEPS holders,and to receive an interest deduction for itsPEPS payments.107

Deals to avoid corporate capital gainstaxes come in many flavors. Tax Notes colum-nist Lee Shepard wrote sarcastically a fewyears ago: “It has finally happened. WallStreet has run out of macho acronyms forsecurities that purport to be debt. We alreadyhave LYONS and TIGRS and CATS andPRIDES and ELKS. We have securities withmeaningless names, like MIPS and DECSand PEPS. And now we have PHONES.”108

PHONEs are financial derivatives that givecompanies the benefit of selling their hold-ings without actually selling stock and incur-ring capital gains tax. PHONES were used afew years ago by Comcast when it unloadedits AT&T holdings and by Tribune Companyto unload its AOL holdings. Such large stocksales could generate a huge tax at the 35 per-cent rate; thus companies have big incentivesto devise complex strategies, such asPHONES, to avoid the tax.

A number of tax avoidance strategiesinvolve companies buying assets with built-inlosses that can be used to offset other income.One strategy popular in the late 1990sinvolved companies putting profitable activi-ties into their foreign subsidiaries and thenacquiring losses from foreigners to offset theirprofits.109 For example, a foreign entity mighthave a built-in loss stemming from owning afinancial security worth $10 million that hadbeen bought for $50 million. A subsidiary of aU.S. company could devise a strategy to buythe security for, say, $11 million, and acquirethe asset’s high basis and thus built-in loss.Using various provisions of the tax code, thesubsidiary could sell the security and take a$40 million ordinary loss and use it to offsetother income.

Enron built a number of tax sheltersaround the capital gain and loss rules.

Enron’s tax shelter deal Tanya aimed to gen-erate capital losses that it could use to offsetgains it had created in other activities.110 In1995 Enron had a large gain from the sale ofEnron Oil and Gas. Arthur Andersen cameup with a transaction that moved assets andliabilities to an Enron subsidiary, EnronManagement Inc. Then Enron sold its hold-ing in the subsidiary to create a capital loss of$188 million for Enron to use to offset gainsfrom other activities. The deal also managedto create duplicate tax deductions in lateryears. Project Valor was similar, creating a$235 million capital loss for Enron that itused to offset gains from further sales ofholdings in Enron Oil and Gas in 1996.111

Steele and Cochise were deals in whichEnron acquired built-in losses from anothercompany in order to offset some of itsincome. The Steele tax scheme involved set-ting up a new entity, ECT Partners, and thentransferring assets with built-in losses fromBankers Trust to the entity. The assetsinvolved were REMIC residual interests,which are particularly suited to such deals.112

The assets had a basis of $234 million and amarket value of only $8 million. Since ECTPartners was part of Enron in its consolidat-ed tax return, Enron was able to use the loss-es to reduce taxable income by $112 millionbetween 1997 and 2001.113

This deal and others generate tax benefitsby moving “tax attributes,” such as built-inlosses, net operating losses, and credits, fromthe firms that generate them to other firmsthat can better use them. Income tax rules tryto limit the transfer of tax attributes, and IRSpolicing is required to challenge deals wherethere seems to be no nontax purpose to suchtransfers.114 But how much nontax purposeis needed to pass IRS inspection is ambigu-ous. In these Enron deals, the nontax pur-pose was to increase financial statementincome that came about from the reductionin taxes—a clearly circular logic. Nonetheless,in these shelters and others, prestigious lawand accounting firms signed off on the deals,usually charging a fat fee for writing opinionletters.115

15

The high corpo-rate capital gainstax has causedU.S. corporationsto devise elabo-rate strategies toavoid it.

Another tax shelter incentive created bycapital gains taxation is to increase assetbasis before a sale in order to reduce taxablegain. Enron used this strategy with theTomas deal, which involved increasing thebasis of a portfolio of assets it wanted to dis-pose of, including leased airplanes and railcars. The deal eliminated $270 million of tax-able gain on the disposition of thoseassets.116 Enron set up a partnership withBankers Trust in 1998, to which it trans-ferred assets that had high market value butlow basis (i.e., the assets had been nearly fullydepreciated). Once the partnership held theassets, it used various transactions and taxprovisions to shift basis from stock it held tothese depreciable assets. The deal was able toincrease the assets’ basis enough to reduceEnron’s taxable income by $270 million.Later Enron liquidated its interest in thepartnership. The partnership and BankersTrust were able to sell the high-basis assetswithout gain. As in other deals, use of thepartnership structure was crucial. Enronpaid Bankers Trust $13 million for the deal.

These tax shelters illustrate the extensiveincentives and opportunities that capitalgains taxation creates for corporate tax plan-ning and avoidance. Under a business cash-flow tax, capital gains taxation would beeliminated. Businesses would generally notcollect “tax attributes,” such as built-in loss-es, that could be traded to other companiesin tax avoidance schemes. Asset basis wouldnot be a variable to manipulate up or downto create gain or loss. Businesses would sim-ply include the market price of asset sales intaxable revenue and symmetrically expenseassets when purchased. That would create anenormous simplification of business taxplanning, close many tax shelters, and reducethe need for government rules and enforce-ment efforts.

Mergers and AcquisitionsThe tax law controlling the world of cor-

porate reorganizations—mergers, acquisi-tions, and other transactions—is a messyinteraction of the income tax rules for capital

gains, depreciation, interest deductions, netoperating losses, goodwill, and other items.Many tax experts echo Cleveland StateUniversity professor Deborah Geier’s viewson this area of tax law:

The current state of the law regard-ing corporate reorganizations isincomprehensible. The law in thisarea is not the result of a grand,coherent scheme but rather is theend result of a long accumulation ofcases, statutory amendments, andIRS ruling positions, the sum total ofwhich is a system that is staggeringin its complexity and unpredictabili-ty. Moreover, the system exactsextremely high and inefficient trans-actions costs, as deals must be struc-tured in ways that make sense onlyto the tax lawyers.117

Tax law stifles economic growth if itstands in the way of flexible business restruc-turing. Indeed, as noted in a study of therecent German corporate tax reforms, “Thefreedom to buy, sell, and refocus and reallo-cate assets in response to changing economicforces is potentially one of the most criticalfeatures of competitive market econo-mies.”118 Conglomerates may find that theyneed to refocus on their core mission andspin off some divisions. Growing firms maywant to acquire weaker firms to build greatereconomies of scale. Industries facing foreigncompetition may need to restructure to sur-vive. Tax rules should not be a hurdle tothose transactions.

Tax rules should also not encouragetransactions that make no economic sense.For example, the more favorable treatment ofdebt than equity may encourage firms topursue ill-advised debt-heavy acquisitions.There was much concern in the 1980s thatthe preferential tax treatment of debt washelping fuel the leveraged buyout spree,which was financed by high-yield, or junk,bonds. For example, part of the game plan ofthe famous 1989 RJR-Nabisco buyout was to

16

The tax law con-trolling the worldof corporate reor-

ganizations is amessy interactionof the income tax

rules for capitalgains, deprecia-

tion, interestdeductions, net

operating losses,goodwill, and

other items.

wipe out the company’s taxable income foryears to come with interest deductions froma huge high-yield bond issue.119

Although buyouts are often a big plus forimproving corporate management, the taxcode should not be setting the parameters inthe market for corporate control. But as taxlaws change, so do the incentives for mergersand acquisitions (M&As). The 1981 tax actencouraged M&As, but then the 1986 tax actreversed course and discouraged them. Onechange in 1986 was the repeal of the GeneralUtilities doctrine, which had allowed firms toavoid capital gains tax on certain distribu-tions of assets to shareholders. That changecaused firms to innovate and find new waysto avoid capital gains on appreciated proper-ty they held.120

The complexity of the tax rules on corpo-rate reorganizations spurs companies to cre-ate elaborate strategies for tax avoidance.Those strategies provide great fodder foranti-business cynics in the media. TheWashington Post’s Allan Sloan makes it seem asif every business reorganization he reviews isrobbing Uncle Sam blind. Some of his col-umn headlines have been “GM Finds a Holein the Tax Code Big Enough to Drive BillionsThrough” and “Northrop Grumman DealScores a Direct Hit on Taxes.”121 But the crit-ics rarely consider whether there is some-thing fundamentally wrong with a tax sys-tem that turns nearly every M&A into a sup-posed scandal.

The problems that create M&A scandalsand complexity are rooted in the basic struc-ture of the income tax. A brief overview ofM&A tax rules illustrates the importance oftwo key income tax problems—capital gainstaxation and capitalization.122 Shareholdersof companies being bought (target firms)may be paid either in cash or in shares of theacquiring firm. A tax-free transaction gener-ally occurs when the target’s shareholdersreceive shares. In these deals, target share-holders do not pay capital gains taxes in thetransaction. (They will pay capital gains taxeslater when they sell their shares.) By contrast,under taxable transactions the target firm

shareholders receive cash and may face cur-rent capital gains taxes. Deals are sometimespartially stock and partially cash, in whichcase target shareholders may pay some taxes.

Different transaction structures (called A,B, C, etc.) provide rules for different amountsof stock and cash, different classes of shares,and other specifics. For example, Allan Sloancriticized General Motors in 2001 for a dealthat used multiple classes of shares to getaround capital gains taxes on the sale ofGM’s Hughes Electronics to Echostar.123

With this deal, GM was apparently able to getaround restrictive new rules put in place in1997. In turn, the 1997 rules had been put inplace to prevent transactions of a type withwhich GM had been able to avoid taxes in aprior deal. What is Sloan’s solution to theseendless tax avoidance games? He does nothave one.

Another key tax issue for M&As is howmuch depreciation will companies be able todeduct on target assets after reorganization.Under some types of transactions, particular-ly taxable ones, the basis of the target’s assetsis stepped up to market value. If a targetfirm’s assets have a market value higher thantheir current tax basis, the assets will beworth more to another company, which willbe able to take larger depreciation deduc-tions than the current owner. That fact cre-ates incentives for acquisitions.

All in all, the tax rules for corporate reor-ganizations are “immensely complicated,”notes tax guide publisher CCH.124 WhileSloan criticizes firms for navigating the taxrules to the best of their ability, considerwhat one judge said in an M&A tax case. A1999 Tax Court case involved an energy com-pany acquisition that seemed to be tax drivenbecause the acquiring firm would gain $84million of the target firm’s losses. The courtended up siding with the taxpayer and con-cluded, “In the complexity of today’s busi-ness and tax jungle, a corporate presidentwho does not obtain tax advice before anacquisition or merger or substantial dollartransaction ought to be fired.”125

Most of the tax rules for business reorga-

17

There is some-thing fundamen-tally wrong witha tax system thatturns nearly everyM&A into a sup-posed scandal.

nization would be swept away under a busi-ness cash-flow tax. Indeed, a study on taxreform by the American Institute of CertifiedPublic Accountants concluded that “thenotoriously complex rules surrounding cor-porate distributions, liquidations, and reor-ganizations would become almost entirelyobsolete” under a business cash-flow taxsuch as the Hall-Rabushka flat tax.126

Generally, business reorganizations thatinvolve an exchange of shares—the purchaseof stock of one firm by another—would notbe taxable events.127 However, sales of assetsfor cash between businesses would be taxableevents. The market value of assets would beincluded in the seller’s tax base, which pro-vides symmetrical treatment to the expens-ing of asset purchases. The concept of “basis”that is behind capital gains and depreciationunder the income tax would disappear undera cash-flow tax.128 There would be no step upin asset basis during restructuring, no futurestreams of depreciation or goodwill deduc-tions to consider, and no distinctionsbetween debt and equity for financing.American businesses could merge, split up,spin off, and reorganize any way that was effi-cient without the tax distortions that plaguebusiness restructuring today.

Gratuitous Flaws in theCorporate Income Tax

On top of the intrinsic problems ofincome taxation, such as capitalization andcapital gains taxation, are the gratuitousflaws added by Congress. Corporate andnoncorporate businesses are taxed different-ly. Earnings paid out as dividends face taxa-tion at both the corporate and individual lev-els, but interest does not. Retained earningsface double taxation insofar as they generatecapital gains, but they are favorably treatedcompared to dividends. The corporateincome tax imposes different marginal taxrates on different types of capital investment.All those factors result in investment beingmisallocated—investment is reduced, too lit-

tle investment flows through corporate busi-nesses, too much debt is used in financialstructures, and corporate profits are retainedrather than paid out.

How much do such corporate tax distor-tions cost? Jane Gravelle summarized theextensive research on the issue and conclud-ed that corporate income tax distortionsprobably cost more than is collected in cor-porate tax revenue.129 Thus, the corporate taxwill impose a direct cost of about $150 bil-lion this year in tax liability, and distortions(or deadweight losses) will cost Americans anadditional $150 billion or so.130 Note that thecost at the margin is greater than implied inthis 1-to-1 ratio. In other words, a cut in thecorporate rate that reduced revenues by $20billion would save the private sector muchmore than $20 billion in deadweight loss-es.131 In addition, corporate tax distortionsare rising over time as a result of the increas-ing openness in the world economy andgreater capital mobility.

These figures summarize the costs thatcan be measured in formal economic models.In addition, the corporate tax creates othercosts that are harder to measure. For exam-ple, the bias toward debt probably causesincreased bankruptcy, but the destabilizingeffects of bankruptcies are difficult to put adollar value on. Also, complexity and fre-quent changes in the tax law waste a greatdeal of executives’ time and energy on taxavoidance and business restructuring. It ishard to estimate how much higher GDPmight be if executives focused instead on cre-ating better products.

The following sections summarize someof the major distortions of the corporateincome tax that are unwarranted under anytax system.

Multiple Business StructuresThe largest business enterprises in the

United States are organized as “subchapterC” corporations and are subject to the corpo-rate income tax. The corporate income taxforms a second layer of tax on investmentreturns in addition to individual income

18

The corporate taxwill impose adirect cost of

about $150 billionthis year, and dis-tortions will cost

Americans anadditional $150

billion or so.

taxes. Noncorporate businesses face just asingle layer of income taxation. As a result,the overall marginal effective tax rate on cor-porate income is about twice that on thenoncorporate sector.132 Thus, “despite thecritical role played by corporations as a vehi-cle for economic growth, the United Statestax law often perversely penalizes the corpo-rate form of organization,” concluded theTreasury Department’s major 1992 study ontax reform.133 As a result, fewer businessestake advantage of the benefits of the corpo-rate structure, such as limited liability, ease ofownership transfer, access to public capitalmarkets, and rapid growth potential.

The list of competitors to C corporationsincludes sole proprietorships, partnerships,subchapter S corporations, limited liabilitycorporations (LLCs), limited liability part-nerships (LLPs), real estate investment trusts(REITS), regulated investment companies(RICs), real estate mortgage investment con-duits (REMICs), and financial asset securiti-zation investment trusts (FASITs). Each ofthese structures avoids the double taxationof earnings, but each is subject to an array ofspecial tax code rules. As a result, entrepre-neurs and investors must consider theunique limitations of each structure whenstarting, expanding, or investing in a busi-ness.134 One simple example is that S corpo-rations can only issue a single class of stockand can have no more than 75 shareholders.

The pros and cons of the various businesstax rules have resulted in different businessstructures being popular in different indus-tries. Also, the complex rules have resulted ina multiplicity of business lobbyists inWashington, each looking for narrowchanges in the rules for particular businesses.Often, American businesses do not speakwith one voice because the tax code hascarved them up into multiple constituencies.

As the tax rules affecting each businessstructure have changed, industry has evolvedto fit the incentives created by Washington.For example, changes in the top tax rate forindividuals relative to corporations affect theattractiveness of the corporate form. After

the Tax Reform Act of 1986 cut the top indi-vidual rate to below the corporate rate, therewas strong growth in the number of S corpo-rations, whose owners are taxed at individualrates.135 Further liberalization in S corpora-tion rules has caused the number of suchcompanies to grow from 0.7 million in 1985to 1.6 million in 1990 and to more than 2.7million today.136 Also, federal and state lawchanges created rapid growth in LLCs in the1990s.137 In general, alternatives to C corpo-rations have grown in popularity during thepast decade or two. Indeed, some observersthink that C corporations may whither awayfrom “self-help integration” as the rules forother business types are liberalized. Thatdoes seem to be the case for small and midsizedfirms, and it is a positive trend. But it wouldbe much more efficient if Congress took thelead and directly eliminated the double layerof taxation on C corporations.

The existence of different business struc-tures creates tax planning opportunities forbusinesses since the same activity can beundertaken in different ways with differenttax results. Tax shelters used by Enron andothers have made extensive use of alternativebusiness structures to conceal debt, changethe form of financial flows, and confuse taxauthorities and investors. In particular, theinteraction of the partnership and corpora-tion rules seems to be a key focus of many taxavoidance efforts. The idea behind partner-ships is that income, gains, and losses are nottaxed at the partnership level but passedthrough to individual partners on the basisof the parameters in the partnership agree-ment. One basic tax sheltering idea is for acorporation to set up a partnership with atax-exempt entity and to then allocate thetax-exempt partner most of the income,while the corporation is allocated the lossesto offset other income it may have.

The “partnership rules often act as chemi-cal plants creating artificial tax losses and dis-tilling them out to U.S. corporations . . . thevariations on the idea are infinite.”138 We sawthis with Enron. Partnership rules were usedin a number of its tax shelters, including

19

The overall mar-ginal effective taxrate on corporateincome is abouttwice that on thenoncorporatesector.

Tomas and Condor, often with the goal ofmoving assets between entities to engineerincreases in asset basis. If deals can be struc-tured to increase asset basis, taxes can be cuteither by reducing capital gains on sales orgenerating higher depreciation deductions.139

The problem is not that the tax code haspartnership rules. Rules for partnerships andother structures are in the tax code to relievethe double taxation that faces C corpora-tions. Partnerships allow corporations toenter into deals with other companies with-out an additional layer of tax acting as a hur-dle. The underlying problem is that the gov-ernment has imposed a double tax on C cor-porations to begin with, creating an incentivefor the nation’s biggest businesses to contin-ually hunt for tax relief.

Partnerships were not the only businessstructure used in Enron tax shelters. TheApache deal used a FASIT, a business struc-ture created by Congress in 1996.140 FASITsare similar to REMICs, which were created byCongress in 1986. They are both flow-through, or nontaxable, vehicles used in thesecuritization of debt. REMICs are mainlyused to securitize mortgage debt, whereasFASITS hold a broader array of debt, such asautomobile loans. One indication of howcomplex the tax code has become is that onetax guide on the Federal Income Taxation ofSecuritization Transactions covers REMICs,FASITS, and similar investments and spans1,309 pages!141 Despite the length, theauthors claim it is written in “plain English”and is not just for specialists, which makesone wonder how long the specialist versionwould be.

In Enron’s Apache deal, a FASIT structurewas used to get around some punitive partsof the tax code, including the subpart F ruleson inclusion of foreign income.142 Using aforeign subsidiary, Enron created a financialstructure that allowed it to deduct bothinterest and principal payments to a foreignlender. Enron was able to avoid the subpart Frules that would usually require some of thedeal’s income to be included in taxableincome. The deal provided Enron with inter-

est deductions of $242 million in 1999 and2000, yet a big circular flow eventually sentthe money back to Enron. A FASIT was a cru-cial middleman in the Apache deal, designedto stand between the Enron foreign sub-sidiary and U.S. Enron.143

Enron used other types of business struc-tures as middlemen in tax shelters. A REMICwas used in Steele and a REMIC and a REITwere used in the Cochise deal.144 A particularform of REIT, a “liquidating REIT,” wasexploited by a number of companies as onepopular tax shelter in the 1990s.145 ButCongress did not create special interest busi-ness structures such as FASITS, REMICS,and REITs for companies such as Enron toexploit. Nonetheless, since Congress createdthem, financial engineers have swooped in tohelp every company extract what tax benefitsit can from Congress’s narrow tax provisions.

The alternative is to establish a singleform of business organization across allindustries and every type of business big orsmall. Indeed, that is one of the principles ofa business cash-flow tax, such as the Hall-Rabushka flat tax. It would treat all businessactivity equally and eliminate special formsof business organization. However, the flattax would not tax income twice because itwould tax only labor income to individualsand only capital income to businesses. Thus,it would integrate individual and businesstaxation so that income from all types ofbusiness activity would be taxed only once.Princeton’s David Bradford notes that such“uniform treatment of all businesses,whether corporate or in other form, auto-matically deals with a vast array of complexissues that are intractable under presentlaw.”146 There would be no need for specialpass-through entities such as REITS becauseall income would be taxed only once.Marginal investments would produce thesame after-tax return no matter which type ofbusiness undertook them.

In addition, a single type of businessstructure would eliminate the ability of largecompanies to structure fancy deals that aretough for tax authorities and investors to fig-

20

A business cash-flow tax would

treat all businessactivity equally

and eliminate spe-cial forms of busi-ness organization.

ure out. Investors would not have to hunt forsuspicious “special purpose entities” onfinancial statements, which use the rules forpartnerships, LLCs, and other entities.Companies would not be able to arbitragethe tax rules on different structures. Taxplanning for new investments would be abreeze, and all businesses would compete ona level playing field.

Double Taxation of Corporate EquityA Treasury Department report said:

“Double taxation of corporate profits is theprincipal problem raised in connection withthe corporation income tax. At the presenttime corporate profits are taxed first to thecorporations, then again to the stockholderswhen they are distributed as dividends.”147

That assessment was not from the BushTreasury but from Roy Blough, director oftax research at the Treasury Department in1944. The double taxation of dividends was along-festering problem that Congress hasjust taken the first step to fix in this year’s taxbill with the reduction of dividend and capi-tal gains tax rates.

Corporate earnings distributed as divi-dends face both the 35 percent corporateincome tax and the individual income tax,which had a top rate of 38.6 percent beforereductions in this year’s tax law. The Jobs andGrowth Tax Relief Reconciliation Act of2003 reduced the maximum individual rateon dividends to 15 percent through 2008.148

Earnings retained in the corporation alsoface double taxation. Retentions generallyincrease a corporation’s share price, thusimposing a capital gains tax on individualswhen the stock is sold. In contrast to divi-dends and retained earnings, interest isdeductible to the corporation and thus onlytaxable at the individual level. JGTRRAreduced the maximum individual tax rate oncapital gains to 15 percent until 2008.

The 1944 Treasury Department reportsuggested some of the same dividend taxreforms that were considered this year,including a corporate deduction, an individ-ual exclusion, and an individual credit.149 In

the 1980s, the Reagan Treasury proposed a50 percent corporate dividend deduction aspart of a major tax reform plan.150 Morerecently, the Treasury Department’s 1992report on tax reform discussed various meth-ods of corporate integration to eliminate thedouble taxation problem.151 That report’srecommendations were the basis of the cur-rent President Bush’s proposal for an indi-vidual dividend exclusion. The Bush planwould have allowed individuals to excludefrom tax dividends on which corporate taxeshad already been paid and provide share-holders capital gains relief on corporate earn-ings retained.152

This year’s dividend tax reduction is notan untried or risky scheme. Indeed, nearly allmajor industrial countries have partly orfully alleviated the double taxation of divi-dends. Currently, 28 of 30 countries in theOECD, including the United States with thisyear’s tax cut, have adopted one or moremethods of dividend tax relief.153 OnlyIreland and Switzerland do not relieve dou-ble taxation, but Ireland and Switzerlandhave substantially lower corporate tax ratesthan does the United States.

The economic distortions created by thecurrent tax bias against corporate equity arebriefly reviewed here. These distortions werereduced, but not eliminated, by JGTRRA. Asdiscussed below, a cash-flow business taxwould fully eliminate all these distortions. Acash-flow tax would equalize the treatmentof debt and equity and remove the biasagainst dividend payouts. A cash-flow taxwould create neutrality in corporate financialand investment decisions.154

Increased Cost of Capital. High dividendtaxes add to the income tax code’s generalbias against savings and investment.Dividend taxes raise the cost of capital, whichis the minimum pretax rate of return thatfirms must earn to proceed with a new proj-ect. Income taxes on individuals and corpo-rations place a wedge between the after-taxreturn enjoyed by individual savers and thegross return on corporate investment thattheir money finances. The tax wedge pushes

21

This year’s divi-dend tax reduc-tion is not anuntried or riskyscheme. Indeed,nearly all majorindustrial coun-tries have partlyor fully alleviatedthe double taxa-tion of dividends.

up the cost of capital and reduces the num-ber of profitable business investments.Reduced business investment means reducedoutput and reduced family incomes in thelong run.

Nonetheless, there are differences of opin-ion among economists as to exactly how div-idend taxes affect the cost of capital and mar-ginal investment decisions.155 The traditionalview contends that the dividend tax burdenfalls heavily on marginal investment andthus creates large economic distortions. Thenew view, which was developed a couple ofdecades ago, contends that most firmsfinance marginal investments throughretained earnings or debt, and thus dividendtaxation does not have a large marginalinvestment effect (retained earnings facedouble taxation as well, but less so than divi-dends). Differences in these two positionsaffect policy views regarding the effects ofdividend taxes on stock market valuation,dividend payout, and other items. Empiricalstudies lean toward favoring the traditionalview.156 In a recent analysis of the administra-tion’s dividend proposal, the CongressionalBudget Office assumed an effect midwaybetween those two views.157 However, there isgeneral agreement that the cost of capital forinvestment financed by new share issues isincreased by dividend taxation. As a result,heavy dividend taxation certainly hurts new,growing companies that may not have sub-stantial retained earnings to harness forgrowth and need to tap equity markets.

Excessive Debt. When corporations borrowmoney to finance investment they are able todeduct interest payments and reduce theirtax liability. By contrast, when new invest-ment is financed by equity, dividend pay-ments cannot be deducted. That means thata corporation needs to earn $1.54 pretax inorder to pay $1 in dividends but needs toearn just $1 to pay $1 in interest. As a result,the tax system favors debt, and U.S. corpo-rate structures have become overleveraged.158

There are varying empirical estimates of theextent of this distortion. A 1999 study byRoger Gordon and Young Lee found that a

10 percentage point reduction in the corpo-rate tax rate would reduce the share of assetsfinanced with debt by about 4 percentagepoints.159 The authors conclude that this is alarge distortion, given that the share of assetsfinanced by debt has been about 19 percenthistorically.

Numerous studies have examined whycorporate debt levels are not even higher,given the big tax advantage of debt. The rea-son appears to be that there are substantialnontax costs to overleveraging. The marginalcost of debt rises with increases in debt load,which curtails debt issuance. This occursbecause added debt increases the risk offinancial difficulty and bankruptcy and thusaffects credit ratings. Excessive debt can alsorestrict management flexibility, which maybe suboptimal. Finally, there are nontaxadvantages to equity financing that offsetequity’s tax disadvantage.

Taxation is just one factor that affects cor-porate financial structure, but it is an impor-tant factor. To the extent that taxes distortcorporate decisions, the costs can be large,given that corporations are the dominantbusiness organization in the country. If taxrules favor excessive debt, the entire economymay be destabilized as more corporations arepushed into bankruptcy during recessions.As profits turn to losses during recessions,dividends can be suspended, but interest pay-ments must be paid. Since equity provides acushion against the ups and downs of thebusiness cycle, penalizing it is a poor policychoice.

Excessive Retained Earnings. When a corpo-ration earns a profit, it has the choice ofretaining earnings or paying them out as div-idends. Prior to the 2003 tax cut, dividendsfaced ordinary tax rates of up to 38.6 percentwhen paid out to individuals. The 2003 taxlaw dropped the top dividend rate to 15 per-cent through 2008. When earnings areretained, they also generate a layer of individ-ual taxation when they push up the shareprice and create a capital gain. The 2003 lawimposed a maximum capital gains tax rate of15 percent, but gains are taxed only when

22

Heavy dividendtaxation certainlyhurts new, grow-

ing companiesthat may not have

substantialretained earnings

to harness forgrowth.

realized. The effect of this deferral of tax is tofurther reduce the effective tax rate. Thus,retained earnings face a lower tax rate thanearnings paid out as dividends, thus creatinga bias toward earnings retention. However,this bias was reduced by the 2003 tax law.

The precise effects of dividend taxation onearnings payout has been subject to dozensof studies over the years but with few con-crete results.160 The traditional and new viewsof dividend taxation provide different per-spectives on dividend incentives. But it isclear that there has been a downward trendin dividend payments by U.S. corporations.Between 1925 and 2002, the average dividendpayout as a share of corporate earnings was55 percent.161 Today, the payout ratio hoversaround 30 percent. One study found that theshare of corporations paying dividends hasfallen from about 90 percent in the 1950s toabout 20 percent today.162 Newer firms, inparticular, avoid paying dividends. One rea-son is that corporations are paying out earn-ings in the form of share repurchases, whichavoid the individual dividend tax (but dogenerate capital gains tax). Repurchases haveaccelerated since the mid-1980s.163 Anotherfactor to consider is that a substantial shareof dividends is paid to nontaxable entities,such as pension funds.

While dividends are down, they are notout. In 2000, $142 billion of taxable divi-dends was reported on tax returns.164

Economists have asked why corporations paydividends at all, given the heavy tax penalty.The answer is that there are important non-tax benefits to dividends. Dividends helpreduce the “principal-agent” problem causedby the separation of ownership and controlin large corporations. Retained earningsallow corporate executives to more easilymake imprudent investment decisions andfund wasteful projects. If high dividend taxescause excessive earnings retention, executivesbecome the default investment managers forshareholders by making decisions thatshould be made by individual investors.Higher dividends reduce the discretionarycash that executives can pour into pet proj-

ects. Forcing executives to go to the marketto raise money provides an added check ontheir investment strategies. The bias in favorof retentions has also put undue emphasison stock option compensation, which maylead executives to overemphasize short-termfinancial results

Dividends signal to shareholders that a cor-poration is earning solid profits and makinggood decisions. Dividends help investors accu-rately judge the financial health of companiesbecause they are paid in hard cash and cannotbe fudged or manipulated, as financial state-ment earnings can be. Financial markets arethought to reward firms that generate risingdividend payouts.165 As Jeremy Siegel notes,before today’s regulatory agencies were created,dividends were the old-fashioned—but proba-bly superior—way to ensure that earnings weresolid.166 Indeed, nearly all corporate earningswere regularly paid out as dividends during the19th century.167

The upshot is that dividends make goodsense from a corporate governance perspec-tive, and high dividend taxes stand in the wayof this important investor protection. Theproblems caused by the tax bias against divi-dends have been recognized for decades. Forexample, the issue was discussed in the 1930swhen the Revenue Act of 1936 imposed an“undistributed profits tax” on retained earn-ings to encourage a higher payout. ATreasury Department staff report from 1937foreshadowed today’s debates about corpo-rate management:

The earnings of a corporation belongto its stockholders; and stockholdersare entitled to exercise a choice . . .with respect to the disposition ofthose earnings. [Tax changes] thatencourage corporate managementsto obtain the consent of their stock-holders for capital expansion, and togive stockholders—the real owners ofthe corporation—a greater controlover the dispositions of their earn-ings, this effect is altogether desirable.It has often been remarked that cor-

23

Since equity pro-vides a cushionagainst the upsand downs of thebusiness cycle,penalizing it is apoor policychoice.

porate managements are far moreprudent in the use of capital fundsobtained through formal financingwith the aid of investment bankersthan in the use of capital funds aris-ing out of reinvested earnings.168

The 1930s undistributed profits tax was abad solution to the problem and was short-lived, but it is interesting that the corporategovernance problems of the income tax werenoticed right from the beginning. As dis-cussed below, replacement of the corporateincome tax with a cash-flow tax would elimi-nate those problems by creating neutrality incorporate financial and investment decisions.

Wasteful Financial Engineering. The tax advan-tage of debt has spurred corporations to designcomplex transactions that are treated as debtfor tax purposes but as equity for financialstatements.169 In turn, financial innovationshave forced Congress and the TreasuryDepartment to add more and more tax rules topolice the debt-equity distinction. Disputesbetween taxpayers and the government onsecurities that have both debt and equity char-acteristics have gone on for years.170

Corporations have long sought securitiesthat combined the tax advantage of debt andthe financial statement advantage of equity.171

In the 1980s, debt tax preference apparentlyhelped fuel the binge in leveraged buyoutsfinanced by high-yield bonds. In a 1990 study,Lawrence Summers and his coauthors com-plained about debt securities that were “equityin drag.” These securities helped fuel leveragedbuyouts such as the RJR-Nabisco deal andallowed companies to cut or wipe out their tax-able income with interest deductions.172

In the 1990s, Enron and other companiesdiscovered hybrid securities called monthlyincome preferred securities (MIPS,), which fitwithin a broader category of “tiered preferredsecurities.”173 Under one deal, Enron set up asubsidiary, Enron Capital LLC, in the Turksand Caicos in 1993.174 This “special purposeentity,” or SPE, issued $214 million of pre-ferred shares, then lent the money to Enronto be paid back over 50 years. Enron began

deducting interest payments to the SPE onits tax return. But on its financial statements,Enron counted the transaction as equitycalled “preferred stock in subsidiary compa-nies.” Therefore, Enron reduced its taxes butwas able to avoid increasing its financialstatement debt, which might have hurt itscredit rating.

MIPS highlight the use of noncorporatebusiness structures in tax shelters. Enronused an LLC in this deal as an SPE to trans-form the character of the deal’s financialflows. Partnerships and trusts can also playthe role of middleman in a tax shelter. ForEnron, the SPE was not part of its consoli-dated tax return; thus it could deduct inter-est paid to it. But the SPE was part of its con-solidated financial statement.175 During the1990s, the use of hybrid securities such asMIPS exploded. By 2002, a total of $180 bil-lion of tiered preferred securities was out-standing, with Enron accounting for about$800 million of the total.176

While many commentators find MIPS andtiered preferred securities very dubious, othertax experts have argued that they are reason-able from a tax and a financial accounting per-spective.177 They argue that Enron’s financialstatement disclosures on these hybrids weresufficient and that credit rating agenciesshould have been able to figure them out.178

Either way, a legal battle over these hybridsraged between taxpayers and the TreasuryDepartment throughout the 1990s.179 All inall, such hybrids have surely cost hundreds ofmillions of dollars in lawyer and accountantfees—pure waste from the perspective of thebroader economy. The JCT notes that withMIPS Enron was pursuing self-help corporateintegration, or finding a way to get around thedouble taxation of corporate equity.180 Thatcut the cost of capital for Enron, but it wouldbe better to cut out all the game playing andtreat all companies the same by real integra-tion under major tax reform.

MIPS are not the only type of tax shelterthat preys on the debt-equity distinction.There were also “step-down preferreds,”which, like MIPS used a noncorporate mid-

24

The tax advantageof debt has

spurred corpora-tions to design

complex transac-tions that are

treated as debt fortax purposes but

as equity forfinancial

statements.

dleman structure.181 In this shelter, a U.S.corporation would set up and fund a realREIT in an agreement with a nontaxpayer,such as a foreigner, an American Indian tribe,or a company with losses. The REIT lends thecorporation money, which the corporationpays back over time and deducts interest. TheREIT is a flow-through entity and uses inter-est received to generate an income stream tothe nontaxpayer. The effect is to allow thecorporation to reduce taxes from an interestdeduction with no offsetting taxable incomereported elsewhere.

The government has typically used narrowBand-Aids to close these sorts of tax shelters.Yet Glenn Hubbard and William Gentry note,“As financial markets become even moresophisticated, the line between debt and equityfor tax purposes is likely to be tested moreoften.”182 As long as tax distinctions, such asdebt versus equity and corporate versus non-corporate, remain, companies will have incen-tives to keep pushing against the legal defini-tions. It makes more sense to end the gameplaying and create a lasting economic solutionwith fundamental tax reform.

Marginal Tax Rate DistortionsThe federal income tax imposes different

marginal effective tax rates on different eco-nomic activities. (Effective tax rates take intoaccount statutory tax rates plus such items asdepreciation deductions and tax credits.) Thesetax rate differences cause investment to be mis-allocated across industries and across types ofcapital equipment. Industries produce toomuch or too little, and they use the wrong com-bination of inputs to produce it. Research hasfound that intersectoral and interasset distor-tions create large deadweight losses, or ineffi-ciency costs, under the current income tax.

The Tax Reform Act of 1986 narrowed therange of marginal effective tax rates acrossthe economy, but it did so by broadly push-ing up tax rates. To provide one example,Gravelle found that before TRA86 the taxrate on a corporate investment in electrictransmission equipment was 21 percent, butthe rate on communications equipment was

just 4 percent.183 After TRA86, those tax ratesjumped to 36 percent and 22 percent, respec-tively. Thus after TRA86, corporate invest-ment was subject to higher tax rates, andthere are still substantial tax rate differencesbetween assets and industries. Similarly, in a2002 study Treasury economist JamesMackie estimated effective tax rates acrossindustries and types of assets and found fair-ly substantial differences.184

A key factor causing marginal tax rates todiverge across different economic activities isdepreciation. Even if broad-based income taxa-tion—which mandates use of depreciationinstead of expensing—made economic sense, itis very difficult to design depreciation sched-ules that accurately track the true depreciationrates of thousands of different assets in theeconomy. A much better idea is to expense allcapital investment, as under a business cash-flow tax. That would eliminate investment dis-tortions as it equalized marginal tax rates acrossindustries and different types of assets.

Tax Rules on International InvestmentThe tax rules on international investment

are perhaps the most complex part of the cor-porate income tax. Most large U.S corpora-tions have dozens, sometimes hundreds, offoreign branches and subsidiaries, and theymust do a great deal of planning to minimizetheir global tax burden. A key source of com-plexity is the application of the corporate taxto the worldwide income of U.S. companies.For example, a U.S. company that owns a win-ery in France or an oil rig in Iraq must reportthat foreign income on its U.S. tax return.

An alternative method, used by about halfof the major industrial nations, is the “terri-torial” approach, under which active foreignbusiness income is generally not taxed.185

Business cash-flow tax proposals, such as theHall-Rabushka flat tax, generally adopt theterritorial approach. Territorial business tax-ation would allow for a much simplified setof international tax rules.

Simplification is badly needed.186 Forexample, profits earned abroad by majority-owned subsidiaries are generally not taxed

25

A key factor caus-ing marginal taxrates to divergeacross differenteconomic activi-ties is deprecia-tion.

until repatriated—taxation is deferred. Butthere are overlapping sets of anti-deferralrules that do tax certain types of foreignincome as soon as it is earned. On top ofthose rules, a complex system of foreign taxcredits provides relief from taxation whenincome is taxed in both the United Statesand a foreign country. But foreign tax creditsare subject to complicated limitations. Forexample, firms may average out incomeearned in high-tax and low-tax countries inorder to maximize their tax credits. But thetax code limits such cross-crediting by divid-ing up foreign income in nine different cate-gories, or “baskets,” that cannot be blended.

The U.S. international tax rules have beenwidely criticized for complexity, uncompeti-tiveness, and “stimulating a host of tax-moti-vated financial transactions,” as GlennHubbard and James Hines put it.187 Businessgroups, the American Bar Association, andthe American Institute of Certified PublicAccountants have repeatedly called forreform.188 For companies, the internationaltax rules create a very complex tax-planningclimate. For example, a California computercompany must perform extensive tax calcula-tions and projections of its U.S. tax situationbefore deciding where in Europe, if any-where, to build a new facility.

Enron provides interesting illustrations ofthe problems with the international tax rules.Enron was particularly concerned with its sit-uation vis-à-vis the foreign tax credit, the rulesthat allocate interest deductions betweendomestic and foreign income, and the tax dis-incentive to repatriating earnings fromabroad. The JCT’s Enron report found that“the company faced the possibility of signifi-cant double taxation of its foreign sourceincome. This potential for unmitigated dou-ble taxation was of paramount concern inEnron’s international tax planning and signif-icantly influenced the structures of Enron’sinternational operations and transactions.”189

Enron’s aggressive global expansion strat-egy was one source of its tax problems. As thefirm expanded abroad by buying powerplants and other assets, the U.S. rules threat-

ened it with double taxation. One strategy itused to deal with the problem was to avoidrepatriating its foreign earnings. “In Enron’scase, the U.S. international tax rules (particu-larly the interest expense allocation rules)combined with the relevant financialaccounting standards, created a significantincentive for the company not to repatriateforeign earnings to the United States,” theJCT concluded.190 The tax disincentive torepatriate foreign earnings is a negative forthe U.S. economy since it may reduce domes-tic investment or cause a smaller dividendpayout to U.S. shareholders.

Some pundits zeroed in on Enron’s use ofhundreds of foreign affiliates as proof of taxevasion activity. But the JCT found insteadthat “prudent tax planning typically requiresa U.S. based multinational enterprise to use acombination of many different entities inmany different jurisdictions, even if theenterprise’s tax planning goals are limited to. . . generally unobjectionable ones.”191 Enronhad 1,300 foreign entities in its structure,although only about 250 were used for ongo-ing business. An important reason for theexistence of so many affiliates was Enron’sinability to use foreign tax credits, which gavethe company strong incentives to defer taxon foreign earnings through use of compli-cated affiliate structures.192 Tax planning fora foreign project often requires creating acomplex tier of foreign entities to minimizethe risk of excess U.S. taxation.

The JCT also found that media reports farovercounted the number of Enron affiliates inlow-tax Caribbean nations. It noted that com-panies that have affiliates in places that do nothave corporate income taxes, such as theCayman Islands, are not necessarily illegally orunethically avoiding taxes.193 Overall, Enron’sinternational tax planning did not particular-ly push the legal limits. Instead, it simply tookpart in the usual grossly complex tax planningthat most large U.S. corporations deal withunder the U.S. worldwide tax system. Forinvestors, the fact that tax rules encouragesuch complex business structures is an imped-iment to transparency and accurate assess-

26

The tax disincen-tive to repatriateforeign earningsis a negative for

the U.S. economysince it may

reduce domesticinvestment or

cause a smallerdividend payout

to U.S. shareholders.

ments of firms’ financial health.The complexity of the international tax

rules makes fertile ground for tax shelters, andit makes government enforcement more diffi-cult. Congress makes it worse by greedilysqueezing as much tax as it can out of foreignincome under the pretense of closing tax shel-ters. But that greediness can backfire. Forexample, the 1999 Treasury Department taxshelter report noted: “The 1986 Act included acomplex set of restrictions on the use of for-eign tax credits. Attempts to avoid theserestrictions seem to be at the heart of certaintypes of tax shelters. . . . Efforts by Congress torein in specific tax shelters often make theCode more complex, creating a vicious cycle.The legislative remedies themselves create thecomplexity that the next generation of taxshelters exploits.”194

The vicious cycle of international tax com-plexity can be ended by fundamental taxreform. A territorial cash-flow tax wouldgreatly simplify business planning by elimi-nating most international tax rules.195 Therewould be no need for foreign tax credits andnumerous other parts of the internationaltax apparatus. A territorial tax would allowU.S. businesses to compete in foreign mar-kets without the burdens imposed by theU.S. tax code. The United States wouldbecome an excellent location for multina-tional corporate headquarters because for-eign affiliates could repatriate their profitsfree of U.S. tax.196 The current disincentivefor repatriation—a key tax-planning factorfor Enron—would be eliminated. Finally, cap-ital expensing under a consumption-basedcash-flow tax would create strong incentivesfor domestic and foreign companies to locateinvestment in the United States.

Employee Compensation—$1 MillionWage Limit

Recent corporate scandals have highlight-ed distortions in the income tax relating toemployee compensation and pensions. Somedistortions are deeply rooted, such as thegeneral practice of taxing saving more heavi-ly than consumption and then selectively

relieving taxes on pensions and other politi-cally favored types of saving. Other distor-tions stem from narrow special interest pro-visions that Congress has placed in the taxcode.

One narrow and problematic provision isthe arbitrary $1 million limit on tax deduc-tions for non-performance-based compensa-tion. The tax law denies businesses a deduc-tion for executive wages of more than $1 mil-lion but allows tax deductions for stockoption compensation above that limit. Thisprovision was added in 1993 in an attempt tomicromanage corporate compensation poli-cy. But the micromanaging has backfired.The limit seems to have caused the rapidgrowth of stock option compensation in the1990s, which many observers now complaincauses corporate governance problems.

A traditional argument in favor of stockoptions was that they helped align the inter-ests of shareholders and corporate executivesby encouraging executives to earn higherprofits. Therefore, stock options appeared tobe a solution to the “principal-agent” prob-lem and promote good management. Butmore recently, analysts have criticized stockoptions for promoting irresponsible effortsby executives to pump up share prices forpersonal gain without creating solid long-term growth. Stock options may also dis-courage executives from paying out divi-dends because retained earnings help pushup stock prices. It appears that the combina-tion of excessive stock option compensationcaused by the $1 million cap and the doubletaxation of dividends has caused executivesto excessively retain earnings and overem-phasize short-term financial results.

Another concern has been that, sincestock option compensation may be deductedon corporate tax returns, firms such asEnron have reduced their tax liability exces-sively.197 It is true that stock options have cre-ated large corporate tax deductions, but thattax treatment seems to be correct. Whenfirms take a tax deduction at the point ofstock option exercise, individuals take amatching income inclusion taxed at ordinary

27

A territorial cash-flow tax wouldgreatly simplifybusiness plan-ning by eliminat-ing most interna-tional tax rules.

rates (for nonqualified options). Thus, thetreatment is parallel to the treatment ofwages, and one estimate found that the indi-vidual inclusion may raise more federal rev-enue than the deduction loses.198 Therefore,if Congress is concerned about stock options,it should not focus on the tax treatment ofoptions. Rather, it should remove artificialincentives that encourage overuse of stockoptions, particularly the $1 million cap onwage compensation.

Employee Stock Ownership PlansMicromanaging employee compensation

through the tax laws has backfired in otherareas as well. In the wake of the Enron scandal,it is clear that the tax rules that encourageworkers to invest in their own company aremisguided. Current tax rules encourage anondiversified savings strategy, which was evi-dent when many Enron workers lost their sav-ings that had been invested in Enron stock.Similar losses of employee wealth occurredwhen the finances of Global Crossing andWorldCom collapsed. Enron workers held anaverage of 62 percent of their 401(k) portfoliosin company stock.199 The average share ofcompany stock in all defined-contributionplans is about 19 to 39 percent. Even thatshare is higher than prudent.200

Jane Gravelle examined compensationissues that have arisen in the wake of theEnron scandal.201 She finds particular faultwith the “juicy” tax benefits given to employ-ee stock ownership plans (ESOPs). ESOPs aredefined-contribution plans in which employ-ee accounts are invested primarily in a com-pany’s own stock. Enron’s ESOP was used toprovide matches of its stock in workers’401(k) plans in a structure called a KSOP.Gravelle’s study drives home the perversity ofthe current income tax, which simultaneous-ly encourages worker ownership of companystock through ESOPs and KSOPs and dis-courages it under other rules.

ESOPs represent classic congressionalmicromanaging gone bad. ESOPs receivedspecial tax breaks in 1974 and added further“juicy” benefits in later years, including sub-

stantial new breaks in the 2001 tax law.202

ESOPs illustrate how special tax breaks cre-ate an entrenched interest that pushesCongress for more special benefits. ESOPshave gained support from those wanting tocreate a kind of worker capitalism withemployee-owned companies. Superficially,that might sound like a good idea, but it hasbackfired. Worker ownership does not seemto work very well. Consider bankrupt UnitedAirlines. It is a prominent employer-owedfirm and its “ESOP was a disaster,” accordingto one industry expert.203

Another distortion is the widespread useof the ESOP as a financial tool to ward offhostile takeovers and protect incumbent cor-porate managers, as occurred withPolaroid.204 ESOPs interfere with the “mar-ket for corporate control,” which is crucial toany economy dominated by large corpora-tions. Corporate executives may not alwaysact in the best interests of shareholders. Theymay line their own pockets or make badinvestment choices. For those reasons, it isimportant that shareholders have tools tocombat these problems and oust bad execu-tives. ESOPs stand in the way of such share-holder empowerment by making it more dif-ficult to launch an outside takeover.

Time to Retire Employer-Tied PensionsA broader compensation issue raised by

the Enron scandal is whether retirement sav-ings should be tied to employers at all. Thereare nontax reasons for companies to sponsorpension plans, such as encouraging employ-ee loyalty. But employer-tied pensions seemto be mainly an artifact of tax code distor-tions because saving in employer-tied plans,including defined-benefit (DB) and defined-contribution (DC) plans, is taxed more light-ly than regular private savings. Congressneeds to rethink employer-tied savingsbecause it has created large risks, complexi-ties, and administrative costs for workers andemployers. Individually based saving vehiclesare better suited to today’s mobile anddiverse workforce because workers usuallyhold many jobs during a career.

28

Congress shouldnot focus on thetax treatment of

options. Rather, itshould removeartificial incen-

tives that encour-age overuse ofstock options,

particularly the$1 million cap

on wage compensation.

For employers, the administration of bothDB and DC plans is complex and costly.Traditional DB plans provide employers an up-front deduction for contributions, with taxespaid later by workers when they receive benefits.DC plans, such as 401(k)s, also receive up-frontdeductions and individuals are taxed later ontheir retirement withdrawals. The problem isthat “the federal laws and regulations govern-ing employer-provided retirement benefits arerecognized as among the most complex sets ofrules applicable to any area of the tax law,”notes the JCT.205 For example, “nondiscrimina-tion rules” require that pension plans passnumerous formulaic tests that compare cover-age of highly paid workers with coverage ofother workers in an attempt to spread pensioncoverage more broadly.

The rules for employer-based pensionshave gotten so complex that many firms havedropped plans altogether. In particular, theshare of workers in DB plans has fallen sub-stantially in recent years. The complexity andhigh cost of employer plans has causedCongress to respond by creating new simpli-fied employee plans, such as SIMPLEs. Butthe proliferation of new plans itself adds tothe complexity of the overall tax system.

One of the costs of DB plans is the highlevel of government policing that they entail.Workers face the risk that promised benefitsmay not be there for them if their companygoes bankrupt or tries to cheat them. Inresponse, in 1974 the government created thePension Benefit Guaranty Corporation, afederal bureaucracy designed to regulate pen-sion plans and provide pension insurance bybailing out workers if DB plans are short ofmoney or go bankrupt. But now the PBGC isitself in financial distress; it recently reportedan $11.4 billion loss, the largest in its histo-ry.206 Nationwide, pension plans covered bythe PBGC are underfunded by about $300billion, a problem for which governmentexperts have not yet found a solution.207

Despite the presence of the PBGC, work-ers are still open to uncertainty and possiblelosses from DB plans. A recent example wasthe bankruptcy of US Airways. The airline

has a $2 billion shortfall in its pension plan,which it is hoping to impose on otherAmericans through a PBGC bailout.208 Evenwith a bailout, some airline workers will getshortchanged because the PBGC places lim-its on the pension amounts that retiredworkers can receive. Similar pension reduc-tions occurred a decade ago when a numberof airlines went bankrupt.

The bottom line is that workers cannotcount on the current employer-governmentretirement system to deliver future benefits tothem with certainty. PBGC’s recent bailouts ofsteel industry pension plans also illustratehow one industry’s excessive costs can getpushed onto workers elsewhere under the cur-rent system. More than $6 billion in pensioncosts at Bethlehem Steel and other steel firmshave been covered by PBGC in the last yearand a half, at the expense of workers in otherindustries who will face higher premiums.209

Individually based savings do not need thecomplex apparatus of the employer-based sys-tem and would give workers more security andcontrol over their finances. In addition, anindividually based system would be moreequitable because the current system of DBand DC plans covers only about half of allworkers. All Americans would have greatersaving opportunities if Congress removed thedouble taxation of savings across the board.One model to aim for is the Hall-Rabushkaflat tax, which would end individual taxationof interest, dividends, and capital gains (butwould tax capital income at the business level).Note that under the flat tax businesses wouldstill deduct pension plan contributions, andbenefits would be taxable to individuals. Butemployer-based pensions would be de-empha-sized because the tax hurdles to all regular sav-ings would be eliminated.

The Jobs and Growth Tax Relief Reconcili-ation Act of 2003 took a step in this direction byreducing the maximum tax rates on dividendsand capital gains to 15 percent (and reducingthe rate to 5 percent for lower-income individu-als). Next, Congress should consider the Bushadministration’s plan for “lifetime savingsaccounts” (LSAs), which would work like

29

Workers cannotcount on the current employ-er-governmentretirement system to deliverfuture benefits to them with certainty.

expanded and improved Roth IRAs. LSAswould allow all individuals to make after-taxcontributions of up to $7,500 per year, withwithdrawals for any purpose not subject totaxes or penalties. Such accounts would greatlysimplify saving for most families and encourageAmericans to build a stronger financial basefree of the many shortcomings of employer-tiedsavings vehicles.

Policy Options

Repeal the Corporate Income TaxThe corporate income tax has survived for

more than 90 years despite having little sup-port in economic theory.210 Indeed, mosteconomists agree that the cost of the corpo-rate income tax in terms of distortions creat-ed is very high.211 Conservative economistshave tended to favor a consumption-basedtax system, which has no place for a corpo-rate tax on net income. Liberal economistshave tended to favor the Haig-Simons idealof broad-based income taxation, but thatideal does not require a corporate income taxeither. The Haig-Simons approach could beimplemented by imposing a broad tax oncapital income at the individual level. In his1977 classic, Blueprints for Basic Tax Reform,David Bradford sketched out both a con-sumption tax and a broad-based income taxmodel for fundamental reform, and neitherincluded a tax on corporations.212

With no compelling economic rationale,then–treasury secretary Paul O’Neill and oth-ers have suggested repealing the corporateincome tax. But there are some administra-tive and political hurdles to corporate taxrepeal. The politics are easy to understand.Corporations provide a concentrated pool ofcash that government can tap to fill its cof-fers—governments tax corporations “becausethat is where the money is.” Trillions of dol-lars of revenue flow through U.S. corpora-tions each year, providing an irresistible tar-get for politicians. Indeed, the country adopt-ed the corporate income tax in 1909, notbecause of any economic principle, but main-

ly because of the anti–big business politicalatmosphere at the time.

Corporations are an easy target becausethey do not vote, and corporate taxes areinvisible to individuals. Corporate taxes getpassed along to consumers, workers, andinvestors, but those individuals do not direct-ly observe the burden that falls on them.213

Tax invisibility is beneficial to politicians, butit creates a basic dishonesty in democraticgovernment. It denies individuals the abilityto make informed and efficient choices sincegovernment spending appears to be partly“free.” If $150 billion of corporate taxes isinvisible, citizens will likely support a largegovernment.

Of course, the ability to fuel a bigger gov-ernment by invisible corporate taxation isappealing to some on the political left. None-theless, some liberal economists have support-ed corporate tax repeal as part of an overall taxreform package. One problem they see is thatthe corporate tax does not allow the fine-tun-ing of income redistribution that they favor.Recipients of corporate income include bothlow-income retirees and high-income inves-tors, but they will both be hit by the same 35percent corporate tax rate.214 Thus, someadvocates of progressive taxation might sup-port corporate tax repeal with the substitutionof more individual taxation of capital income(but that is still an inferior option to movingto a consumption-based system).215

Aside from politics, there are some admin-istrative hurdles to consider in repealing thecorporate tax. The corporate income tax issupported as a backstop to individual taxa-tion of capital income. Corporations areessentially withholding agents for capitalincome that flows through to individuals.Under the Haig-Simons ideal, businesseswould not need to be taxed if all capitalincome were taxed on an accrual basis at theindividual level. But that is extremely imprac-tical (in addition to being bad economic pol-icy). Instead, the current income tax systemsettled on using corporations as “pre-collec-tors” of income taxes. That structure pre-vents individuals from accumulating income

30

Congress shouldconsider the Bush

administration’splan for

“lifetime savingsaccounts,” whichwould work like

expanded andimproved Roth

IRAs.

within corporations tax-free, which wouldviolate accrual income tax theory. Also, cor-porations are used to prevent evasion sincethey generate information about dividendsand interest paid out.

However, there would be no need for acorporate-level tax under some proposals forconsumption-based tax reform. “Savings-exempt” or “consumed-income” tax propos-als would apply a comprehensive tax at theindividual level without need for a business-level tax. One model is the saving-deferredcash-flow tax proposal developed by NormanTure at the Institute for Research on theEconomics of Taxation.216 This proposalwould replace the individual and corporateincome taxes with a flat rate individual taxon a base of income less net savings.Individuals would defer tax on savings bydeducting savings (and debt repayments)from taxable income but would include with-drawals from savings (and borrowing) intheir tax base. The result would be that busi-ness earnings would be taxed at the individ-ual level when not reinvested by individuals.A similar proposal is the model cash-flowconsumption tax included in Bradford’s1977 Blueprints for Basic Tax Reform. TheBlueprints model would eliminate the corpo-rate-level tax and allow individuals a choiceof two treatments for savings.217 Savings inqualified accounts would be deducted upfront with withdrawals taxed later, like regu-lar IRAs. Alternately, savings could be madefrom after-tax earnings with the returnsreceived tax-free, like Roth IRAs.

Corporate tax repeal would involve sometricky issues with regard to internationalinvestment. As one public finance scholarnotes, “One reason most countries tax corpo-rate profits is because most countries tax cor-porate profits.”218 Cross-border investmentsby multinational corporations have causedtax systems to become entangled with oneanother. For example, corporate tax repealcould result in the federal government ced-ing tax revenue to foreign governmentsbecause, if the United States did not tax theU.S. profits of foreign companies, other

countries would have an incentive to do so.Suppose a Japanese car company earns $100million in its U.S. subsidiary and pays $35million in U.S. corporate tax. When the com-pany filed its Japanese corporate tax return, itwould receive a foreign tax credit, which isdesigned to prevent taxation of the sameincome in both countries. But if the UnitedStates repealed its corporate tax, Japan’sworldwide system would still tax the U.S.profits, but no tax credit would be provided.The end result might be that the car compa-ny paid tax on $100 million of U.S. profits tothe Japanese government but paid no tax tothe U.S. government.

However, a number of factors would miti-gate that possible problem. The Japanesegovernment might face pressure to reducetaxes on Japanese firms’ U.S. profits so as notto put those firms at a competitive disadvan-tage in the U.S. market. The firms would beat a disadvantage to firms headquartered incountries that have “territorial” tax systems,which would not tax U.S.-source profits.219

One step the United States could take withcorporate tax repeal would be to place a with-holding tax on profits when paid to parentcompanies of foreign firms. That would gen-erate revenues to the U.S. government andwould not necessarily impose higher overalltaxes on companies operating here since theywould get a credit for the withholding tax ontheir home-country tax return.

Federal corporate tax repeal may have a pre-cursor at the state level. The share of state tax rev-enues coming from corporate income taxes hasfallen from more than 9 percent to about 6 per-cent in the past two decades.220 State-level taxcompetition has been intense as mobile corpora-tions organize their activities to minimize theirstate tax payments. States have responded withcuts and various tax base changes.221 State cor-porate tax competition has also led to tax com-plexity and litigation as companies spanningnumerous states have had to fight each state taxauthority over the proper amount owed. As aresult, a growing number of economists are sup-porting state corporate tax repeal because the taxis highly inefficient and collects little revenue.

31

There would beno need for a cor-porate-level taxunder some pro-posals for con-sumption-basedtax reform.

The liberal contributing editor of State Tax Notes,David Brunori, came out for state corporate taxrepeal last year because the state tax “consumesan inordinate amount of intellectual firepowerand economic resources in terms of planning,compliance, and administration.”222

Similar pressures and inefficiencies aregrowing under the federal corporate incometax as international tax competition increas-es. Revenues from the corporate income taxhave fallen from more than 30 percent of fed-eral revenues in the early 1950s to just 8 per-cent today.223 As a highly inefficient tax thatcollects only a small fraction of federal rev-enue, the corporate income tax is a high pri-ority tax for Congress to repeal.

Replace the Corporate Income Tax with aBusiness Cash-Flow Tax

If a corporate-level tax is retained, reformsshould focus on reducing the rate and creat-ing a transparent and uniform base to maxi-mize efficiency and minimize tax sheltering.One idea is to retain an income tax but elim-inate some of the inconsistencies. For exam-ple, the corporate tax could be “integrated”with the individual tax to reduce the dispari-ties between debt and equity and betweencorporate and noncorporate businesses. In1992, the Treasury Department issued amajor study on corporate tax reform optionsthat included various integration proposalsto eliminate the double taxation of corporateequity.224 One proposal was to exempt divi-dends from individual taxation, which alsoformed the basis of President Bush’s divi-dend proposal this year.

A more ambitious proposal in the 1992report was for a comprehensive businessincome tax (CBIT). The idea behind the CBITwas to tax capital income only once—at thebusiness level. Neither dividends nor interestwould be deductible by businesses. But indi-vidual taxes on interest, dividends, and capi-tal gains would be repealed. All businesses(corporate and noncorporate) would betaxed under the same rules. The CBIT wouldequalize taxes on corporate and noncorpo-rate businesses, equalize taxes on interest and

dividends, eliminate the lock-in distortion ofcapital gains, and remove the bias againstdividend payouts.

Although such a tax reform would be far-reaching, key distortions would remain. TheCBIT would retain core problems of income-based taxation, particularly capitalization,inflation-caused distortions, and a biasagainst savings and investment. Thoseremaining distortions could be eliminated byreplacing the corporate tax with a cash-flowtax. That would be like taking the CBITreforms and adding capital expensing (ratherthan depreciation) and cash accounting(rather than accrual accounting).

Substituting a cash-flow tax for the corpo-rate income tax has been discussed by econo-mists for years. Fundamental reform alongthese lines would “dramatically reduce theincentives for tax planning,” concluded GlennHubbard and William Gentry.225 A cash-flowtax would “make it easy to write rules thathold to a minimum tax distortions in finan-cial and business affairs,” concluded DavidBradford.226 Recent scandals and the growinguncompetitiveness of the current corporatetax make now an excellent time for Congressto take a fresh look at a cash-flow tax.

A cash-flow tax would be imposed on netcash flows of businesses, not net income. Netcash flow is calculated as the receipts fromthe sale of goods and services less current andcapital expenses. Financial flows such asinterest income and interest expense wouldbe disregarded.227 Accrual accounting underthe income tax would be replaced with sim-pler cash accounting. Businesses wouldinclude receipts when cash is received anddeduct materials, inventories, equipment,and structures when purchased. The cost ofboth a $1 pencil and $10 million machinewould be deducted immediately.

Various proposals for cash-flow taxes havediffered with regard to whether employeecompensation would be deductible. If com-pensation deductions were disallowed, thetax would be a value-added tax (VAT). Such atax would capture the value added by bothlabor and capital at the business level. The

32

Recent scandalsand the growing

uncompetitive-ness of the cur-

rent corporate taxmake now an

excellent time forCongress to takea fresh look at a

cash-flow tax.

broad base of a VAT would need only a lowtax rate to raise the same amount of revenueas the current corporate tax. For example, an11 percent VAT formed part of the “USA” taxproposal of former senators Nunn andDomenici.228 A recent estimate suggests thata VAT would need a rate of between 5 and 7percent to replace the revenue generated bythe corporate income tax.229

However, that raises a key problem with aVAT—it would be a money machine for thegovernment because the tax base is so broad.While the rate might start out low, each rateincrease would sound modest yet would raisea huge amount of fresh government revenue.That problem would be exacerbated becauseVATs, like all business-level taxes, could behidden from the view of individuals, thustempting politicians to continue raising therate over time. Since individuals ultimatelybear all tax burdens, taxes should be visible tothem so they can best judge how big the gov-ernment ought to be. As a general rule, taxreforms should keep the bulk of tax collec-tions at the individual level to promote visi-bility and frugality in government.

The flat tax proposed by Robert Hall andAlvin Rabushka of the Hoover Institution isstructured to reap the efficiency benefits of acash-flow business tax while keeping thebulk of taxes visible and payable by individu-als.230 Versions of the Hall-Rabushka planwere proposed by former house majorityleader Dick Armey and by former presiden-tial candidate Steve Forbes. Under the Hall-Rabushka plan, individuals would be taxedon wages and pension benefits at a flat 19percent, with large basic exemptions provid-ed. Individuals would not be taxed on inter-est, dividends, or capital gains. Businesseswould pay a 19 percent tax on receipts fromsales of goods and services less wages andpurchases of materials, equipment, build-ings, and other expenses.231 Businesses woulddisregard interest, dividends, and capitalgains. For example, interest would not bedeductible, nor would it be taxable. Thisexclusion of financial flows means that theflat tax has a real, or “R base,” as did the

Treasury’s CBIT.232 (Alternately, a cash-flowtax could have an R+F base—real plus finan-cial—where firms take into account all flowsof cash, other than to their own shareholders,when calculating their tax base).233

The flat tax business structure would besimilar to the CBIT except businesses wouldexpense capital purchases rather than depre-ciate them. It is that difference that makesthe CBIT an “income tax” and the Hall-Rabushka tax a “consumption-based tax.”Consider the basic economic formulation:income = consumption + investment. Giventhat, a tax on income with a full deductionfor investment is said to be a consumption-based tax. Some observers conclude fromthis that a cash-flow tax would not tax busi-ness profits or capital income at all. That isnot correct; the issue is more tricky.

It turns out that business expensingexempts only the “normal” risk-free rate ofreturn (also called the return to waiting) butfully taxes “above-normal” returns (alsocalled “economic rents” or “inframarginalreturns”).234 The normal risk-free rate ofreturn is usually measured by the Treasurybill interest rate. “Above-normal” returns areprofits made through monopoly profits,unexpected windfalls, and other unique fac-tors. Because it is thought that above-normalreturns account for most of total businessprofits, a cash-flow tax with expensing wouldcontinue to tax most business profits.235

However, while a cash-flow tax would con-tinue to tax most business profits, it would doso much more efficiently. That is because mar-ginal investments yielding the normal returnwould not be taxed. In present value terms, theup-front tax benefit of expensing fully offsetsfuture tax payments on normal returns. As aresult, the tax would not distort marginalinvestment choices, thus spurring greater cap-ital formation.236 Investment decisions wouldnot be distorted by inflation, depreciation, orother factors that affect marginal effective taxrates under the income tax.

Economists generally agree that a businesscash-flow tax would be simpler and more effi-cient than the corporate income tax. However,

33

A cash-flow taxwould beimposed on netcash flows ofbusinesses—receipts from thesale of goods andservices less cur-rent and capitalexpenses.

there are various implementation concernsthat would need to be ironed out with theadoption of a cash-flow business tax:

• A cash-flow tax would close a hugearray of tax shelters, but it may open afew new ones. One point of trouble fora cash-flow tax with an R-base is theseparation of financial from nonfinan-cial flows, which would create a sourceof tax avoidance opportunities. Forexample, businesses would try to char-acterize normal sales receipts as inter-est in order to exclude them from taxa-tion. Some tax lawyers have exploredmore complex financial strategies thatmight develop to exploit the sharpdivide between financial and nonfi-nancial.237 One solution would be toadopt an R+F base cash-flow tax,rather than the R-base tax of the Hall-Rabushka model.238

• A number of tax avoidance problemsunder the current tax system wouldcontinue to be problems under somecash-flow taxes. An example is transferpricing by multinational corporations.That refers to the shifting of profitsfrom high-tax to low-tax countriesusing the prices of goods, services, andintangibles traded between corpora-tions and their subsidiaries. Transferpricing would continue to be a prob-lem under a Hall-Rabushka cash-flowtax, although it would be eliminatedunder cash-flow taxes that are “borderadjustable.”239

Note that tax reform is designed tocut marginal tax rates, which in itselfwould reduce tax avoidance. For exam-ple, the Hall-Rabushka flat tax wouldhave a broad tax base and no tax cred-its, thus allowing for lower rates thancurrently. For example, an analysis ofall nonfinancial corporations for theperiod 1998 to 1992 found that theHall-Rabushka tax at 19 percent wouldhave raised about the same revenue asthe current corporate income tax.240

With a rate only about half of the cur-rent 35 percent corporate rate, theincentive to engage in all forms of taxavoidance, such as transfer pricing,would be greatly reduced.

• Businesses with net operating lossescreate a challenge for any tax system.241

In theory, losses should be refundableto create fair and symmetrical treat-ment between profit and loss firmsand between firms with fluctuatingand stable profit patterns. The currentincome tax allows losses to be carriedbackward 2 years and forward 20 yearsto offset profits, but without interest.Limita-tions on losses invite tax avoid-ance efforts because businesses will tryto move losses to profit-making firms.A related issue is whether affiliatedentities should file as consolidatedunits. Conso-lidation is advantageoussince it allows business units to offsetprofits and losses. To deal with theseissues, the Hall-Rabushka plan wouldallow unlimited carryforward of losseswith interest.242 That favorable treat-ment would reduce tax avoidanceefforts and retain strong incentives forcapital investment by companies withlosses.

• Financial businesses, such as banksand insurance companies, wouldrequire special rules under any taxreform plan, just as they do under thecurrent income tax. Special ruleswould be needed under an R-basedcash-flow tax because it does notinclude financial flows, such as inter-est, in the tax base. One solutionwould be to simply exclude financialbusinesses under a new consumption-based tax system, as is the case undermost state retail sales taxes and for-eign VATs.243 Another option wouldbe to tax financial businesses on anR+F cash-flow tax basis.244

• A tax reform challenge will be to createtransition rules to move from the oldtax system to the new one.245 A key issue

34

While a cash-flowtax would contin-

ue to tax mostbusiness profits,

it would do somuch more efficiently.

is treatment of the existing tax basis inassets (that portion of the asset’s costnot yet recovered by depreciationdeductions). Trillions of dollars ofmachines and buildings would be onlypartially written off at the time ofswitching to a new tax system. Notallowing the remaining deductions onthis old capital would impose large loss-es on owners. On the other hand, allow-ing full and immediate deduction forbasis in old assets would involve a largeshort-term government revenue loss.Ultimately, creating some middle-ground rules for basis and other transi-tion items is essential to generating sup-port for reform.246 Transition relief is ahurdle, but given that a new tax systemmight last even longer than the currentone has lasted, it is worth the trouble.

Conclusion

The flawed structure of the corporateincome tax is a key driver of inefficient andwasteful business activities. The income taxdistorts corporate investment and financialchoices, and its complexity and inconsistencystimulate an aggressive pursuit of elaboratetax shelters.

Three fundamental flaws of the corporateincome tax would be addressed by the adop-tion of a low-rate cash-flow tax. First, a lowercorporate tax rate would reduce wasteful tax-sheltering activities, mitigate the economicdistortions caused by business taxation, andrespond to the rising global competitionfaced by U.S. businesses.

Second, a business cash-flow tax wouldeliminate key flaws intrinsic to the incometax, particularly capitalization and capitalgains taxation. These features of the incometax create complexities and distortions thatseem to get worse over time. Enron and othercompanies zeroed in on these weaknessesand exploited them with elaborate tax shel-ters. A business cash-flow tax would elimi-nate capital gains taxation and would substi-

tute expensing for capitalization to createsimple and efficient treatment of businesscapital investment.

Third, the great number of gratuitousinconsistencies in the corporate income taxwould be reduced or eliminated under acash-flow tax. All businesses would be treatedequally, the tax treatment of corporatefinancing would be neutral between debt andequity, and there would be little incentive orability of companies to create complex trans-actions to avoid tax.

Today’s combination of corporate man-agement problems and rising global compet-itive pressures makes this an excellent time tofundamentally rethink U.S. business taxa-tion. A cash-flow tax holds out hope of dra-matically reducing the complexity, distor-tions, and scandals that mark the currentcorporate tax system.

NotesStephen Entin and Dan Mastromarco providedhelpful comments. Of course, all errors are thoseof the author.

1. Congressional Budget Office, “An Analysis ofthe President’s Budgetary Proposals for FY2004,”March 2003, p. 36.

2. Wal-Mart Stores Inc., Form 10-K as filed withthe Securities and Exchange Commission. The“current” income tax expense reported on finan-cial statements often differs, sometimes substan-tially, from actual liability reported on the 1120tax return filed with the Internal Revenue Service.Wal-Mart’s federal tax rate on U.S. income was28.7 percent in 2001 and 34.7 percent in 2000.

3. Estimates of incidence differ depending onsuch factors as the length of the time period con-sidered and the international openness of the econ-omy. A good survey is John Whalley, “TheIncidence of the Corporate Tax Revisited,”Canadian Department of Finance, TechnicalCommittee Working Paper no. 97-7, October 1997.

4. Jane Gravelle, The Economic Effects of TaxingCapital Income (Cambridge, Mass.: MIT Press,1994), p. 245.

5. Myron Scholes and Mark Wolfson, “The Roleof Tax Rules in the Recent Restructuring of U.S.Corporations,” in Tax Policy and the Economy 5

35

Today’s combina-tion of corporatemanagementproblems and ris-ing global com-petitive pressuresmakes this anexcellent time tofundamentallyrethink U.S. busi-ness taxation.

(Cambridge, Mass.: National Bureau of EconomicResearch and MIT Press, 1991), p. 2.

6. Ibid., p. 24.

7. KPMG, “Corporate Tax Rate Survey,” January2003, www.us.kpmg.com/microsite/Global_Tax/TaxFacts.

8. For a description, see Joint Committee onTaxation (JCT), “Summary of ConferenceAgreement on H.R. 2, the Jobs and Growth TaxRelief Reconciliation Act of 2003,” JCS-54-03,May 22, 2003.

9. JCT, “Report of Investigation of EnronCorporation and Related Entities RegardingFederal Tax and Compensation Issues, and PolicyRecommendations,” vol. 1, “Report,” JCS-3-03,February 2003.

10. Ibid., p. 6.

11. Internal Revenue Service, Statistics of IncomeBulletin (Washington: IRS, Summer 2002), Table13. This is the total number of corporate returns,excluding S corporation returns.

12. This is the 2003 page count for the CCH“Standard Federal Tax Reporter,” which includesthe tax code, tax regulations, and various IRS rul-ings. See www.cch.com/wbot2003. For the busi-ness share of the burden, see Scott Moody, “TheCost of Complying with the U.S. Federal IncomeTax,” Tax Foundation, November 2000.

13. JCT, “Report of Investigation of EnronCorporation,” p. 16.

14. For example, the decision to headquarter Daimler-Chrysler in Germany as opposed to the United Stateswas apparently partly motivated by tax considerations.See discussion in Chris Edwards and Veronique deRugy, “International Tax Competition: A 21st-Century Restraint on Government,” Cato PolicyAnalysis no. 431, April 12, 2002.

15. U.S. Department of the Treasury (U.S.Treasury), “The Problem of Corporate TaxShelters: Discussion, Analysis, and LegislativeProposals,” July 1999, pp. 17, 27, 30.

16. John Berry, “Divided on Derivatives,” WashingtonPost, March 6, 2003, p. E1.

17. Glenn R. Simpson, “Derivatives Traders, IRSMay Be Near a Truce,” Wall Street Journal, June 10,2003, p. C1.

18. See Henry Aaron and Harvey Galper, AssessingTax Reform (Washington: Brookings Institution,1985). Aaron and Galper propose an “R+F-based”

cash-flow tax.

19. U.S. Treasury, “The Problem of CorporateTax Shelters,” pp. 19, 55, 58.

20. The 50 percent rate enacted in 1981 was effec-tive for 1982. The 28 percent rate enacted in 1986was effective for 1988.

21. U.S. Treasury, “The Problem of Corporate TaxShelters,” pp. vi, 23.

22. JCT, “Report of Investigation of EnronCorporation,” p. 107.

23. U.S. Treasury, “The Problem of CorporateTax Shelters,” p. v.

24. Ibid., p. iv.

25. For example, in comparing differences inamounts perceived as owed by the IRS and largecorporations, the General Accounting Office(GAO) found that “the difference is substantialand, in large part, attributable to ambiguity andcomplexity in tax law.” GAO, “Reducing the TaxGap,” GAO/GGD-95-157, June 1995, p. 4

26. See a summary in Steven Toscher and CharlesRettig, “A Once in a Lifetime Opportunity: TheTax Shelter Controversy Continues,” 2002,www.taxlitigator.com.

27. GAO, p. 4.

28. For example, in 1992 the IRS estimated thatafter audit large corporations owed $142 billionin taxes, but corporations themselves figured theyowed just $118 billion. See Ibid.

29. Joseph Bankman, “Bankman Examines theNew Market in Corporate Tax Shelters,” TaxNotes, June 21, 1999, p. 1775.

30. Quoted in Peter Behr, “Enron Skirted Taxesvia Executive Pay Plan,” Washington Post, February14, 2003, p. E1.

31. U.S. Treasury, “The Problem of Corporate TaxShelters,” p. 48.

32. Bankman, pp. 1778, 1787.

33. U.S. Treasury, “The Problem of CorporateTax Shelters,” p. 46.

34. Ibid., p. v.

35. See related comments of Lester Ezrati of theTax Executives Institute, Statement before theU.S. Senate Committee on Finance hearing on“The Clinton Administration’s Proposals relating

36

to Corporate Tax Shelters,” April 27, 1999.

36. U.S. Treasury, “The Problem of CorporateTax Shelters,” pp. 6, 9.

37. The recently passed tax law, which reducedindividual tax rates on dividend income, will part-ly solve this problem.

38. Cited in U.S. Treasury, “The Problem ofCorporate Tax Shelters,” p. xiv.

39. Ezrati.

40. U.S. Treasury, “The Problem of CorporateTax Shelters,” p. 30.

41. Ibid., pp. 30, 26, 16.

42. Ibid., p. iv.

43. David Cay Johnston, “Help for Bad Times NowHelps Rich,” New York Times, April 1, 2003, p. C1.

44. Bankman notes that many attorneys believethe IRS is currently far outgunned on corporateshelters. Bankman, p. 1786.

45. For a good summary of corporate tax shelter-ing, see ibid.

46. U.S. Treasury, “The Problem of CorporateTax Shelters,” pp. 7, 14.

47. Ibid., p. 28.

48. KPMG.

49. Ibid.

50. For a discussion of cross-border investment,see Edwards and de Rugy.

51. See James Hines, ed., International Taxation andMultinational Activity (Chicago: University ofChicago Press, 2001). See also James Hines,“Lessons from Behavioral Responses toInternational Taxation,” National Tax Journal, June1999, p. 305.

52. Hans Nagl, “Infineon CEO Mulls MovingHQ, Plans Job Cuts,” Reuters, April 29, 2003.

53. For a brief survey of the issue, see Eric Engen andKevin Hassett, “Does the U.S. Corporate Tax Have aFuture?” Tax Notes, 30th Anniversary Edition, 2002.

54. For a discussion, see Veronique de Rugy,“Runaway Corporations: Political Band-Aids vs.Long-Term Solutions,” Cato Tax & BudgetBulletin no. 9, July 2002.

55. Ingersoll-Rand reincorporated in Bermuda in2001. Stanley Works ultimately backed down onits plan to reincorporate abroad.

56. U.S. Treasury, “Corporate Inversion Transactions:Tax Policy Implications,” May 2002, p. 21.

57. Joseph Thorndike, “Civilization at a Discount:The Morality of Tax Avoidance,” Tax Notes, April29, 2002. See also W. Elliot Brownlee, FederalTaxation in America: A Short History (Cambridge:Cambridge University Press, 1996), pp. 72–82.

58. Ibid.

59. Joseph Thorndike, “Historical Perspective:Wartime Tax Legislation and the Politics ofPolicymaking,” Tax History Project at Tax Analysts,2002, p. 5, www.taxhistory.org/Articles/ wartaxes.htm.

60. Michael Boskin, “A Framework for the TaxReform Debate,” in Frontiers of Tax Reform, ed.Michael Boskin (Stanford: Hoover InstitutionPress, 1996), p. 14. See also Gravelle, The EconomicEffects of Taxing Capital Income, p. 30.

61. For a summary of the early law, see Roy G.Blakey, “The Federal Income Tax,” U.S. Treasury,September 20, 1934, sec. I, www.taxhistory.org.

62. The income tax law of 1894 was struck downin Pollock v. Farmers’ Loan and Trust Company, 157US 429 (1895).

63. It is often stated that the corporate businessform exists only because of government “privileges.”But that view has been challenged. For example, seeNorman Barry, “The Theory of the Corporation,”Ideas on Liberty 53, no. 3 (March 2003).

64. Brownlee, pp. 36–46.

65. Carolyn Webber and Aaron Wildavsky, A Historyof Taxation and Expenditure in the Western World (NewYork: Simon and Schuster, 1986), p. 420.

66. Blakey, sec. I.

67. Ibid., sec. VIII.

68. For further discussion, see Art Hall, “TheConcept of Income Revisited: An Investigation intothe Double Taxation of Saving,” Tax Foundation,February 1997.

69. For a further discussion, see Chris Edwards,“Simplifying Federal Taxes: The Advantages ofConsumption-Based Taxation,” Cato InstitutePolicy Analysis no. 416, October 17, 2001.

70. David Bradford, Untangling the Income Tax

37

(Cambridge, Mass.: Harvard University Press,1999), p. 313.

71. For a discussion of the basic problems withincome taxation, see ibid. See also DavidBradford, Blueprints for Basic Tax Reform, 2d ed.(Arlington, Va.: Tax Analysts, 1984), p. 22.

72. Note that the measure of net income for taxand GAAP can be quite different. For example,depreciation for tax purposes is generally acceler-ated compared to GAAP depreciation.

73. Calvin Johnson, “Using GAAP Instead of TaxAccounting Is a Bad Idea,” Tax Notes, April 19, 1999.Johnson calls GAAP accounting “a pretty sick puppy.”

74. For a discussion of cash-flow vs. income taxes,see Jack Mintz and Jesus Seade, “Cash Flow orIncome? The Choice of Base for CompanyTaxation,” World Bank Observer, July 1991, p. 180.

75. Most cash-flow tax proposals have an “Rbase” as they consider just real, not financial,transactions. An R+F cash-flow tax base has beenconsidered for the taxation of financial institu-tions under a consumption-based tax.

76. Brownlee, p. 64.

77. Aaron and Galper. The authors called their plana “cash flow income tax.” The plan would combinea personal consumed-income tax, a business cash-flow tax, and taxation of estates and gifts.

78. Robert Hall and Alvin Rabushka, The Flat Tax, 2ded. (Stanford, Calif.: Hoover Institution Press, 1995).

79. Ibid., p. 47. For another good discussion ofcash-flow business taxation from the 1980s, seeMervyn King, “The Cash Flow Corporate IncomeTax,” National Bureau of Economic Research(NBER) Working Paper no. 1993, August 1986.

80. These distortions are discussed in Aaron andGalper.

81. There has also been substantial interestabroad in cash-flow business taxation. For exam-ple, the New Zealand Treasury has produced anumber of studies on the issue. A good recentstudy is Peter Wilson, “An Analysis of a Cash FlowTax for Small Business,” New Zealand Treasury,Working Paper no. 02/27, December 2002.

82. U.S. Treasury, “The Problem of CorporateTax Shelters,” p. 113.

83. Ibid., p. 16.

84. Bankman, p. 1780.

85. JCT, “Report of Investigation of EnronCorporation,” p. 346.

86. David Weisbach, Comments at the “InvitationalConference on Tax Law Simplifi-cation,” sponsoredby the American Bar Association, the AmericanInstitute of CPAs, and the Tax Executives Institute,Washington, December 4, 2001.

87. Ibid.

88. IRS National Taxpayer Advocate, “FY2002Annual Report to Congress,” December 2002, pp.288, 290. The IRS’s aggressive position grew out ofthe 1992 INDOPCO case. See also LawrenceLokken, “Capitalization: Complexity in Simplicity,”Tax Notes, May 28, 2001.

89. Weisbach, Comments

90. Quoted in JCT, Study of the Overall State of theFederal Tax System and Recommendations forSimplification (Washington: Government PrintingOffice, April 2001), JCS-3-01, vol. II, p. 324.

91. Pamela Olson, Comments concerning taxcode section 263A at the “Invitational Conferenceon Tax Law Simplification.”

92. Under the Tax Reform Act of 1986, business-es depreciate tangible property under theModified Accelerated Cost Recovery System(MACRS), sec. 168 of the tax code, which deter-mines recovery periods, placed-in-service rules,and depreciation methods.

93. Tom Neubig and Stephen Rhody, “21st CenturyDistortions from 1950s Depreciation Class Lives,”Tax Notes, May 29, 2000. They note that the currentclassification system is partly based on guidelinesfrom a 1959 Treasury study.

94. JCT, “Report of Investigation of EnronCorporation,” pp. 165, 173, 174.

95. Ibid., p. 181.

96. Ibid., pp. 221, 234.

97. Roy Blough, “Postwar Tax Structure—CapitalGains Tax,” staff memo, U.S. Treasury, Division of TaxResearch, December 5, 1944, www.taxhis tory.org.

98. The New York State Bar Association, cited inU.S. Treasury, “The Problem of Corporate TaxShelters,” p. 10.

99. JCT, Study of the Overall State of the Federal TaxSystem, vol. II, p. 37.

100. For a discussion, see JCT, “Tax Treatment of

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Capital Gains and Losses,” JCS-4-97, March 12,1997, p. 7. Prior to 1986, the corporate capital gainsrate was generally less than the ordinary rate.

101. U.S. Treasury, “The Problem of CorporateTax Shelters,” p. 36.

102. Mark Lang, Edwards Maydew, and DouglasShackelford, “Bringing Down the Other BerlinWall: Germany’s Repeal of the Corporate CapitalGains Tax,” Paper presented at NBER PublicEconomics Program Meeting, April 6, 2001, p. 11.In the reform, Germany also eliminated its divi-dend imputation system and went to a 50 percentdividend exclusion for individuals.

103. Sven-Olof Lodin, “The Competitiveness of EUTax Systems,” International Bureau of FiscalDocumentation, European Taxation, May 2001, p. 169.

104. Lang, Maydew, and Shackelford, p. 10. Theauthors’ example was recalculated at today’sshare price.

105. Ibid., p. 6.

106. E. S. Browning, “Hybrid Stock Issue Skirts Tax,Securities Laws,” Tax Notes, April 8, 1996, p. 223.

107. “PEPS” stands for premium equity partici-pating securities.

108. Lee Sheppard, “Rethinking DECS, and New Waysto Carve Out Debt,” Tax Notes, April 19, 1999, p. 347.

109. Bankman, p. 1777. This is a very brief sketchof Bankman’s “High-Basis Low-Value” example.

110. JCT, “Report of Investigation of EnronCorporation,” pp. 118, 128.

111. Ibid., p. 124.

112. Ibid., p. 146.

113. Ibid., p. 136.

114. Ibid., p. 159.

115. For example, see ibid., p. 142.

116. Ibid., pp. 189, 201.

117. Deborah Geier, “A Proposal for Taxing CorporateReorganizations,” Tax Notes, February 10, 1997, p. 801.

118. Lang, Maydew, and Shackelford, p. 1.

119. Jeremy Bulow, Lawrence Summers, and VictoriaSummers, “Distinguishing Debt from Equity in theJunk Bond Era,” in Debt, Taxes, and CorporateRestructuring, ed. John Shoven and Joel Waldfogel

(Washington: Brookings Institution, 1990), p. 135.

120. U.S. Treasury, “The Problem of CorporateTax Shelters,” pp. 26, 31.

121. Allan Sloan, “GM Finds a Hole in the Tax CodeBig Enough to Drive Billions Through,” WashingtonPost, January 28, 1997, p. C3; and Allan Sloan,“Northrop Grumman Deal Scores a Direct Hit onTaxes,” Washington Post, February 27, 1996, p. C3.

122. For an overview, see Patrick Gaughan,Mergers, Acquisitions, and Corporate Restructurings, 3ded. (New York: John Wiley & Sons, 2002). See alsoMerle Erickson, “The Effect of Taxes on theStructure of Corporate Acquisitions,” Journal ofAccounting Research 36 (Autumn 1998): 279–98.

123. Allan Sloan, “GM Follows Zero-PercentFinancing with a Zero-Tax Sale of DirecTV,”Washington Post, November 6, 2001, p. E3. Sloandescribes a “reverse Morris Trust” deal.

124. Gary Maydew, Small Business Taxation, 2d ed.(Chicago: CCH, 1997).

125. The case was Plains Petroleum Co. and Subsidiaries v.Commissioner, T.C. Memo 1999-241 (1999), cited inVivian Hoard, “Corporate Tax Shelters: Is EveryGeneration Doomed to Repeat History?” Tax Practice& Procedure, June–July 2000, p. 24.

126. Martin Sullivan, “Flat Taxes andConsumption Taxes: A Guide to the Debate,”American Institute of Certified Public Account-ants, December 1995, pp. 7, 99. For a discussionof M&A issues under a flat tax, see DavidWeisbach, “Ironing Out the Flat Tax,” John M.Olin Law & Economics Working Paper no. 79,University of Chicago, August 1999, pp. 36-44.

127. For a further description of rules that mightapply under a cash-flow business tax, see AllianceUSA, “USA Tax System,” January 24, 1995, pp.275–84. This tax reform group was chaired byPaul O’Neill and Robert Lutz.

128. However, determining the best treatment ofcurrent law asset basis during transition to a newtax system is a difficult problem. For a discussionof transition issues, see Ibid., p. 55.

129. Gravelle, The Economic Effects of Taxing CapitalIncome, p. 90.

130. For a summary of the many estimates of theefficiency costs of the corporate income tax, seeJohn Whalley, “Efficiency Considerations inBusiness Tax Reform,” Canadian Department ofFinance, Technical Committee, October 1997.

131. Ibid., p. 13.

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132. Gravelle, The Economic Effects of Taxing CapitalIncome, p. 52. “Effective” tax rates take intoaccount statutory rates and other tax items suchas depreciation deductions.

133. U.S. Treasury, Integration of the Individual andCorporate Tax Systems: Taxing Business Income Once(Washington: Government Printing Office,January 1992), p. v.

134. For a discussion, see John Lee, “Choice ofSmall Business Tax Entity: Facts and Fictions,”Tax Notes, April 17, 2000, p. 417.

135. Scholes and Wolfson, p. 5.

136. IRS, “SOI Bulletin,” Spring 2002, p. 297.

137. The Treasury’s “check-the-box” regulationsin 1996 simplified the tax classification of LLCsand generally allowed most non-publicly tradedentities to avoid the corporate income tax. SeeJCT, “Report of Investigation of EnronCorporation,” p. 368.

138. Calvin Johnson, “Corporate Tax Shelters,1997 and 1998,” Tax Notes, September 28, 1998, p.1603.

139. JCT, “Report of Investigation of EnronCorporation,” p. 181.

140. Ibid., p. 244.

141. James M. Peaslee and David Z. Nirenberg,Federal Income Taxation of Securitization Transactions,3d ed. (New Hope, Pa.: Frank J. Fabozzi Associ-ates, 2001), www.securitizationtax.com.

142. JCT, “Report of Investigation of EnronCorporation,” p. 255.

143. Ibid., p. 244.

144. Ibid., p. 115.

145. U.S. Treasury, “The Problem of CorporateTax Shelters,” pp. 4, 135.

146. David Bradford, “An Uncluttered Income Tax:The Next Reform Agenda,” John M. Olin ProgramDiscussion Paper no. 20, Princeton University, July1988.

147. Blough.

148. Note that about half of corporate dividendsdo not face double taxation because they go totax-exempt entities such as pension funds.

149. Blough.

150. This was the “Treasury I” proposal. SeeBradford, Untangling the Income Tax, p. 291. Theoriginal proposal was contained in U.S. Treasury,Tax Reform for Fairness, Growth, and Simplicity(Washington: Government Printing Office, 1984).

151. U.S. Treasury, Integration of the Individual andCorporate Tax Systems.

152. U.S. Treasury, “General Explanations of theAdministration’s Fiscal Year 2004 RevenueProposals,” February 2003.

153. Chris Edwards, “Dividend Taxes: U.S. Hasthe Second-Highest Rate,” Cato Tax & BudgetBulletin no. 12, January 2003. Based on data fromthe Organization for Economic Cooperation andDevelopment.

154. For a discussion, see Mervyn King, “TheCash Flow Corporate Income Tax,” NBERWorking Paper no. 1993, August 1986, pp. 14–21.

155. See Hans-Werner Sinn, Taxation and the Cost ofCapital: The Old View, the New View, and AnotherView, Tax Policy and the Economy 5 (Cambridge,Mass.: NBER and MIT Press, 1991), p. 25. See alsoU.S. Treasury, Integration of the Individual andCorporate Tax Systems, p. 116.

156. For a summary of studies, see GeorgeZodrow, “On the Traditional and New Views ofDividend Taxation,” National Tax Journal 44(December 1991): 497.

157. Congressional Budget Office, p. 23.

158. For a discussion, see U.S. Treasury, Integration ofthe Individual and Corporate Tax Systems, pp. 3–14, 115.

159. Roger Gordon and Young Lee, “Do Taxes AffectDebt Policy? Evidence from U.S. Corporate TaxReturn Data,” NBER Working Paper no. 7433,December 1999.

160. For a survey, see Franklin Allen and RoniMichaely, “Payout Policy,” Wharton FinancialInstitutions Center, April 2002, http://fic.wharton.upenn.edu/fic/papers/01/0121.pdf.

161. Ken Brown, “Will Stock Dividends Get BackTheir Respect?” Wall Street Journal, December 10,2002. Based on Ibbotson Associates’ data.

162. Allen and Michaely, Figure 2, pp. 8, 134.

163. Ibid., p. 116.

164. William Gale, “About Half of DividendPayments Do Not Face Double Taxation,” Tax Notes,November 11, 2002, p. 839. Gale notes that $62 bil-

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lion of payments was interest payments from mutu-al funds that the IRS records as dividends.

165. Allen and Michaely, pp. 10, 117.

166. Jeremy Siegel, “The Dividend Deficit,” WallStreet Journal, February 2, 2002, p. A20.

167. Brown.

168. George Haas, “Rationale of the Undistri-buted Profits Tax,” staff memo, U.S. Treasury,Division of Tax Research, March 17–18, 1937,www.taxhistory.org.

169. William Gentry and R. Glenn Hubbard,“Fundamental Tax Reform and CorporateFinancial Policy,” NBER Working Paper no. 6433,February 1998.

170. JCT, “Report of Investigation of EnronCorporation,” p. 327.

171. John Reid, “MIPS Besieged—Solutions inSearch of a Problem,” Tax Notes, December 1,1997, p. 1057.

172. Jeremy Bulow, Lawrence Summers, andVictoria Summers, “Distinguishing Debt fromEquity in the Junk Bond Era,” in Debt, Taxes, andCorporate Restructuring, ed. John Shoven and JoelWaldfogel (Washington: Brookings Institution,1990), p. 135.

173. MIPS were the Goldman Sachs version ofthis financial structure, while TOPRS wereMerrill Lynch’s version. See Reid, p. 1057.

174. John McKinnon and Greg Hitt, “DoublePlay: How Treasury Lost in Battle to Quash aDubious Security,” Wall Street Journal, February24, 2002, p. A1.

175. JCT, “Report of Investigation of EnronCorporation,” p. 314.

176. McKinnon and Hitt, p. A1. See also JCT, “Reportof Investigation of Enron Corporation,” p. 313.

177. For a defense of MIPS, see Edward Kleinbard,“Lee Sheppard’s Misguided Attacks on MIPS,”Tax Notes, June 8, 1998, p. 1365.

178. Ibid.

179. McKinnon and Hitt, p. A1.

180. JCT, “Report of Investigation of EnronCorporation,” p. 332.

181. See Bankman. See also Lee Sheppard,“Treasury Steps on Step-Down Preferred,” Tax

Notes, March 3, 1997, p. 1102.

182. Gentry and Hubbard, “Fundamental TaxReform and Corporate Financial Policy,” p. 18.

183. Gravelle, The Economic Effects of Taxing CapitalIncome, p. 55.

184. James B. Mackie III, “Unfinished Business ofthe 1986 Tax Reform Act: An Effective Tax RateAnalysis of Current Issues in the Taxation ofCapital Income,” National Tax Journal 60, no. 2(June 2002): 293.

185. Carl Dubert and Peter Merrill, Taxation of U.S.Corporations Doing Business Abroad: U.S. Rules andCompetitiveness Issues (Morristown, N.J.: FinancialExecutives Research Foundation and Pricewater-houseCoopers, 2001), Table 10-2.

186. For a summary of U.S. rules, see ibid. See alsoNational Foreign Trade Council, The NFTCForeign Income Project: International Tax Policy for the21st Century (Washington: NFTC, 1999), part 1.

187. Glenn Hubbard and James Hines, “ComingHome to America: Dividend Repatriations by U.S.Multinationals,” NBER Working Paper no. 2931,April 1989.

188. For example, see American Bar Association,“Tax Simplification Recommendations,” February2001. See also National Foreign Trade Council.

189. JCT, “Report of Investigation of EnronCorporation,” p. 370.

190. Ibid., p. 371.

191. Ibid., p. 373.

192. Ibid., p. 377.

193. Ibid., p. 375.

194. U.S. Treasury, “The Problem of CorporateTax Shelters,” p. 30.

195. For a further discussion, see Edwards and deRugy.

196. For a discussion, see National Foreign TradeCouncil.

197. Albert Crenshaw, “At Enron, the CompensationKept Paying,” Washington Post, February 16, 2003,p. H2.

198. John Graham, Mark Lang, and DouglasShackelford, “Employee Stock Options, CorporateTaxes, and Debt Policy,” NBER Working Paper no.9289, October 2002, p. 32.

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199. Jane Gravelle, “The Enron Debacle: Lessonsfor Tax Policy,” Urban-Brookings Tax PolicyInstitute, Discussion Paper no. 6, February 2003.

200. Ibid., p. 3.

201. Ibid., p. 2.

202 Ibid., p. 21.

203. Keith Alexander, “Ruling May End EmployeeControl of United Airlines,” Washington Post,March 5, 2003, p. E4.

204. Gravelle, “The Enron Debacle,” p. 9.

205. JCT, Study on the Overall State of the Federal TaxSystem, vol. II, pp. 149, 150, 197, 198.

206. Albert Crenshaw, “U.S. Pension Agency Goes$11 Billion in Red,” Washington Post, January 31,2003, p. E1.

207. Albert Crenshaw, “Deficit Grows at AgencyThat Backs Pensions,” Washington Post, May 1,2003, p. E2.

208. Kirstin Downey, “Pilot Pensions Off Course,”Washington Post, March 7, 2003, p. E4.

209. Details of the steel industry bailout are atPension Benefit Guaranty Corporation, “PBGCto Protect Pensions of 95,000 at Bethlehem Steel,”December 16, 2002, www.pbgc.gov/news/press_releases.

210. A number of economic justifications havebeen given for a corporate tax, but they do notseem to be crucially important. For example, itmay be efficient in theory to correct certain exter-nalities through corporate taxes. For a discussion,see Richard Bird, “Why Tax Corporations?”Canadian Department of Finance, TechnicalCommittee Working Paper no. 96-2, December1996, p. 4.

211. For example, Bird notes that the high distor-tions are “sufficiently persuasive to convince mosteconomists that there is little, if anything, to besaid for corporation taxes.” Ibid., p. 1. However,Bird concludes that there are reasons for retentionof the corporate tax, at least within an income taxsystem in a smaller economy such as Canada’s.

212. Bradford, Blueprints for Basic Tax Reform, p. 4.

213. Despite endless debate, economists do notagree on which group bears the burden of the cor-porate income tax. Probably, it changes over timeand falls variously on consumers, workers, orinvestors depending on the openness of the econ-omy and market conditions in various industries.

214. The federal corporate rate is not preciselyflat. Indeed, it has rates of 15, 25, 34, and 35 per-cent, but the large bulk of business activity occursin the top two brackets that apply to companieswith taxable income of more than $75,000 and$10 million, respectively.

215. My view is that proportional taxation is bothfairer and more efficient than progressive taxa-tion; thus one of the few virtues of the currentcorporate tax is its essentially flat rate. Also, noteagain that the actual burdens of capital incometaxation may fall on individuals other than thestockholders who mail tax payments to the IRS.

216. See Stephen Entin, “The Inflow-OutflowTax—A Savings-Deferred Neutral Tax System,”Institute for Research on the Economics ofTaxation, undated, www.iret.org. Another versionof a savings-exempt tax is the individual portionof the USA tax introduced in 1995 by SenatorsNunn and Domenici.

217. Bradford, Blueprints for Basic Tax Reform, p. 13.

218. Bird, p. 7.

219. Note that even under worldwide systems,foreign active business profits are usually nottaxed until repatriated.

220. David Hoffman, “State Tax Collections andRates,” Tax Foundation, February 2002.

221. Kirk Stark, “The Quiet Revolution in U.S.Subnational Corporate Income Taxation,” State TaxNotes, March 4, 2002. The author discusses the appor-tionment formulas that determine the corporate taxbase, and he advocates corporate income tax repeal.

222. David Brunori, “Stop Taxing CorporateIncome,” Tax Notes, June 25, 2002.

223. Budget of the United States Government, FiscalYear 2004, Historical Tables (Washington:Government Printing Office, February 2003).

224. U.S. Treasury, Integration of the Individual andCorporate Tax Systems. See also discussion inGentry and Hubbard, “Fundamental Tax Reformand Corporate Financial Policy.”

225. Ibid., p. 30.

226. Bradford, Untangling the Income Tax, p. 314.

227. Most cash-flow tax proposals have an “R” taxbase. Alternatively, a cash-flow tax could have an“R+F” base, which would be calculated using bothreal and financial income and expense amounts.

228. The proposal included a subtraction-method

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VAT, which differs from the credit invoice VATs thatare common in Europe. For a discussion of these twotypes of VATs, see Sullivan.

229. Engen and Hassett, p. 29.

230. Hall and Rabushka.

231. Business expenses that would not bedeductible under the Armey plan include interest,dividends, nonpension fringe benefits, employer’sshare of payroll taxes, and bad debts.

232. The terminology of cash-flow taxes, R-base(real) or R+F (real + financial), follows from theBritish government’s Meade Commission reporton tax reform in 1978.

233. For a discussion, see Bradford, Untangling theIncome Tax, p. 119.

234. William Gentry and R. Glenn Hubbard,“Distributional Implications of Introducing a Broad-Based Consumption Tax,” NBER Working Paper no.5832, November 1996. Gentry and Hubbard definethis issue precisely by breaking down capital incomeinto four parts: (1) the opportunity cost of capital orthe return to waiting, (2) the return to risk taking, (3)inframarginal returns or economic profit, and (4) real-izations differing from expectation or unexpectedwindfalls. The income tax taxes all four components. Aconsumption-based tax taxes only the last three com-ponents. See also Gentry and Hubbard, “Fundamen-tal Tax Reform and Corporate Financial Policy,” p. 8.

235. See discussion in David Bradford, Taxation,Wealth, and Saving (Cambridge, Mass.: MIT Press,2000), pp. 91–93.

236. Jack Mintz and Jesus Seade, “Cash Flow orIncome? The Choice of Base for CompanyTaxation,” World Bank Observer, July 1991, p. 180.See also see Mervyn King, “The Cash FlowCorporate Income Tax,” NBER Working Paperno. 1993, August 1986, pp. 14–21.

237. For a discussion of some possible administrativeproblems with the flat tax, see Weisbach, “Ironing Outthe Flat Tax.” See also Parthasarathi Shome andChristian Schutte, “Cash-Flow Tax,” in Tax PolicyHandbook, ed. Parthasarathi Shome (Washington:International Monetary Fund, 1995), p. 172. See alsoGentry and Hubbard, “Fundamental Tax Reform andCorporate Financial Policy,” p. 29.

238. Charles McLure and George Zodrow, “A Hybrid

Approach to the Direct Taxation of Consumption,”in Frontiers of Tax Reform, p. 76. The authors proposea hybrid tax that would tax individuals under theHall-Rabushka-style individual tax but businessesunder an R+F cash-flow basis.

239. A border-adjustable tax would exemptexports from U.S. taxation and symmetricallydeny a deduction for imported inputs. The USAtax is a border-adjustable cash-flow tax. By con-trast, the Hall-Rabushka tax is “origin based” andwould tax income on exported goods but allow adeduction for imported inputs.

240. Price Waterhouse LLP, Economic PolicyConsulting Services, “Tax Liability of NonfinancialCorporations under the USA and Flat Taxes: AnIndustry Analysis,” June 29, 1995. I adjusted thestudy’s 17 percent results up to the 19 percent ratespecified under the Hall-Rabushka plan.

241. These issues have been around since thebeginning of the income tax. For a discussionfrom the 1930s, see Blakey, sec. VIII.

242. For a discussion, see Weisbach, “Ironing Outthe Flat Tax,” p. 36.

243. See Harry Grubert and James Mackie, “AnUnnecessary Complication: Must Financial ServicesBe Taxed under a Consumption Tax?” U.S. Treasury,January 30, 1996. Note that countries with VATs oftenimpose a separate type of tax on financial institutions.

244. See Peter Merrill and Chris Edwards, “Cash-Flow Taxation of Financial Services,” National TaxJournal, September 1996. See also Peter Merrilland Harold Adrion, “Treatment of FinancialServices under Consumption-Based TaxSystems,” Tax Notes, September 18, 1995. Notethat Armey’s flat tax legislation recognized theneed for special rules for “financial intermedia-tion services” but did not specify any details.

245. Melbert Schwarz, Peter Merrill, and ChrisEdwards, “Transitional Issues in Fundamental TaxReform: A Financial Accounting Perspective,” in TaxPolicy and the Economy 12 (Cambridge, Mass.: NBERand MIT Press, 1998). Also see David Bradford,“Fundamental Issues in Consumption Taxation,”American Enterprise Institute, 1996.

246. The Nunn-Domenici USA cash-flow tax plandid include detailed transition rules. Generally,the plan allowed for the amortization of remain-ing asset basis over a period of years.

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