What I've learned: transparency, taxes, and the push for a better tax system.
Of course, it's more than just the cactus that ties with the theme. There is also the time of year. It's summer in the southwestern desert and that means the heat is on. And the heat is on for corporate America as well. This is, of course, nothing new. To many people, corporate America has long filled the bill as "the fellow behind the tree" in Russell Long's refrain, "Don't tax me, don't tax thee, tax the fellow behind the tree." Another version of Long's refrain ends with "tax the corporation across the sea," a formulation particularly appropriate today. In addition to being a deep tax pocket, that faceless fellow behind the tree is the all-purpose scapegoat.
The United States is not the only country in which corporations fall into disfavor from time to time. England's legislative response to the bursting of the South Sea bubble three centuries back, the Bubble Act of 1721, was a ban on the founding of joint-stock companies without a royal charter--a provision that slowed the development of British industry. More than a century passed before the Bubble Act was undone.
The heat is on for corporate America, and the question is how you, as officers of your companies, should respond. One view would be that the current climate is just another swing of the pendulum. It has swung back in the past. It will swing back again. Recall the anti-corporate sentiments of the late-1970s--if you're old enough to remember! If you believe the pendulum will soon swing back, then your goal is probably a minimal response. Change, of course, is costly. If you conclude the need for change is short term, then your best bet may be minimizing the cost.
There are a number of factors, however, that suggest the return swing of the pendulum will be a while in coming and that, when the pendulum swings, it may not move all that far. Indeed, aside from the institutional breakdowns fueling the wild swing of the '90s, I believe the return swings of the pendulum have been getting shorter with each passing cycle.
Meanwhile, the scandals of the past few years mean that the swing away from the '90s lionization of corporate America has been particularly strong. It will be sometime before the public forgets the bursting of the high-tech bubble, corporate accounting scandals, or lost retirement savings. Add to that stories of corporate inversions, assertions of "Benedict Arnold companies," outsourcing, government contract scandals, cover ups, sharp dealing at mutual fund companies, continuing coverage of the disparity between CEO and worker pay, and you have a recipe for something like road rage against corporate America.
At a conference a couple of months ago, a corporate products liability litigator described the danger of taking a case with a corporate defendant to trial before a jury because of the difficulty of seating a fair-minded jury. Recent events have triggered strong emotions, and it may be sometime before the emotions subside. Until they do, those emotions will affect the corporate landscape.
Other factors are at work shaping the corporate landscape. I'd like to talk about them, and the leadership role I believe corporate America must take if we are to advance to a system that better fosters America's global competitiveness. I put the factors shaping the corporate landscape in five categories: opacity, politics, the federal budget, global competition, and IRS competence.
First, opacity. We live in a world that grows increasingly complex, particularly when it comes to financial and economic interrelations. While the world grows more complex, the level of financial and economic literacy declines, with inadequate help from our educational institutions and little to no help from the media. Recent articles in USA Today (the country's most widely read newspaper) and The Economist (a British magazine) illustrate the problem with the U.S. media. Both featured front-page (cover in the case of The Economist) stories on trade. USA Today's article addressed people's opinions about trade and its adverse effects on the U.S. economy. It reported the opinions expressed as if they represented the facts. Real facts did not otherwise enter the story. The Economist, by contrast, ran a report on the facts regarding international trade, noting the disparity between the facts and American's opinions
While the world grows ever more complex, we layer unnecessary complexity on top of it. Case in point: the federal income tax, a system too complex for any one person to fully comprehend. That complexity must be considered in the context of the average American's tax literacy.
A few weeks ago I was in a coffee shop across the street from the Treasury Department. The customer in front of me ordered a cup of coffee, and the cashier told him the price was $5.87. Now this was not a gourmet coffee shop. The customer told her that was impossible because he had only gotten a cup of coffee. The cashier looked at the cash register, then turned back to him, and repeated that it was $5.87. When he protested that a cup of coffee cost less than $2.00, the cashier responded, "Well, there's tax."
Before you blame the school system in our nation's capital for that exchange, you should know that a former congressional leader's college-educated son equated his IRS refund check with having paid no income tax--to the dismay of his tax cut-favoring father. That is in contrast to the sibling of one of my former Treasury colleagues who knew she had paid tax and wanted the tax "returned" so she filed a tax "return." She was quite annoyed when the IRS declined to "return" her tax.
So now that we have taken the measure of our tax literacy, it should not surprise you to learn that the American public believes Robert McIntyre of Citizens for Tax Justice when he asserts that corporations are lying when they report one income figure to their shareholders and another to the IRS. Surely Robert McIntyre, whose organization purports to be brimming with tax expertise, must know that the Financial Accounting Standards Board (FASB i and Congress each write their own rules for calculating income and that the two sets of rules produce different results. Nonetheless, the complexity of the system, coupled with limited tax literacy, allow him to get away with statements he ought to know are false.
The OECD defines transparency in a tax system as certainty about what the tax rules are and equal application to all taxpayers--that is to say, the opposite of a system in which taxpayers negotiate their tax bills. In the United States, we have a tax system that fails the transparency test because the complexity obliterates certainty and the IRS can provide no assurance of equal application. The result is a growing public perception that the tax system is unfair. The past decade's tax legislation, which appeared destined to put "a tax credit in every pot," exacerbated the problem. It was so bad a few years ago that a Treasury economist designed the "tax credit for the taxpayer who didn't get a tax credit" in an effort to stave off further legislation.
The opacity of the system provides fertile ground for "think tanks"--and I use the term loosely--to publish all manner of absurd assertions and claim they are the product of "nonpartisan analysis." Even government agencies, most recently the General Accounting Office (GAO), have gotten into the act. The latest GAO report, which led to screaming headlines asserting that two-thirds of U.S. corporations paid no tax, was based on faulty assumptions and skewed analysis. The GAO, in my experience, does not ordinarily have an axe to grind, but it is an arm of Congress, and this study clearly served a political agenda. The opacity caused by the complexity of the corporate tax system provided the opening for all of the misstatements and misunderstanding the report generated.
Opacity also fuels public cynicism that "monied interests" control Washington. A recent USA Today graph illustrated an increase in the percentage of the public--to nearly 85 percent--who believe monied interests are in charge. Given the huffing and puffing in Washington, the perception is understandable, but after three years at Treasury, my observation is that the assertions of influence peddling (often fueled by the claims of the influence peddlers) are grossly overstated. If the FSC-ETI bill that passed the Senate is enacted into law, I may have to eat my words, but I think the reality is that Congress has difficulty moving anything that it cannot justify on policy grounds. That is not to say that the well-informed would always agree with the stated policy.
The perceptions of the influence of the monied interests are clearly fed by the media. Consider the news reports of contract overcharges by Halliburton. It seemed the media could not report anything about Halliburton without noting that Vice President Cheney had run the company. Indeed, the reporting could sometimes leave the less-than-careful reader with the impression that the Vice President was still running the company. It is not at all clear what the point was of the regular media association of Halliburton and Cheney, but the effect on the public was to cement cynicism about the influence of monied interests in Washington.
My own experience is to the contrary. Government officials bend over backwards to avoid even the appearance of a conflict, sometimes to the detriment of the taxpaying public. Nevertheless, the claims of influence are clearly perceived as reality by the public. That, I believe, is unhealthy for the country in general and corporate America in particular. It breeds more resentment that the system is unfair and provides an excuse for resignation: A mistaken belief that the system is stacked against the ordinary guy.
The second factor is politics. Much has been written about the growing polarization of the electorate. Whether it caused the polarization or merely mirrors it, the same may be said of the legislative process. The result is that we focus on the minutia about which we disagree to the neglect of the broad principles on which there is fundamental agreement. Suddenly issues for which there was bipartisan support become opportunities for partisan bickering and accusations. The result is legislative gridlock on important legislation. Consider, for example, the several near-death experiences of what became the 2002 economic stimulus bill.
Of course, legislative gridlock is not all bad. Congress has a tendency to overreact. That may be because it has to work itself into a lather before it can actually enact legislation. When it does, it often goes overboard. Consider Sarbanes-Oxley, for example. Many--perhaps most--of the provisions of Sarbanes-Oxley represent sound corporate governance. But did we really need Congress to codify sound corporate governance practices? Or add penalties for non-compliance?
It may interest you to know that legislative overreaction is about as old as legislatures. If you haven't read The Company by John Micklethwait and Adrian Wooldridge, I encourage you to do so. You'll find numerous accounts of legislative cures far worse than the diseases that spawned them.
The point for corporate America, I believe, is that dealing with our own problems is far preferable to leaving them to Congress to clean up for us because of the risk of overreaction and the unavoidability of unintended consequences. Not to mention the fact that we really shouldn't need an act of Congress to remind us of the difference between right and wrong or to compel us to adopt best practices.
Two other points on politics: We have had total transparency in the regulatory process for around three decades courtesy of Tax Analysts' Freedom of Information Act suits against the IRS and the Treasury Department. Transparency in the legislative process is a more recent development, but the future is likely to bring us even more transparency in that arena. Because of the opacity of the tax system, however, you should not expect the news reporting made possible by transparency to produce an accurate picture. That may help you or it may hurt you.
It is very difficult to get Congress to pay enough attention to an issue for it to result in enacted legislation unless it has sizzle and sound bite. Sound bites seldom go hand in hand with sound policy. Perhaps that means those who are advancing good policy just need to hire better writers. But don't count on it. We need a system that functions on the basis of thoughtful analysis, not sizzling seven-second sound bites.
Third factor: the federal budget. OMB projected a deficit of $521 billion for this fiscal year. Of course, OMB resolved at the end of 2002 never again to overestimate capital gains receipts. Consequently, its receipts projection differs from the Treasury Department's projection because OMB arbitrarily adjusted Treasury's projection because we simply do not know how many unused capital losses remain following the collapse of the stock market in 2000 and 2001. The most recent data suggest the deficit will come in south of $450 billion, but that is still a large number.
Both President Bush and Senator Kerry have promised to cut the deficit in half in five years. President Bush has proposed doing so with loophole closers and reduced spending; Senator Kerry with increased taxes, loophole closers, and some reduced spending. Either way, it is a tall order. Taking national security, defense, and entitlements off the table leaves little room for cutting. Raising taxes only on 2004's definition of "rich" leaves very few taxpayers to soak.
To that must be added the Congressional proclivity to "save" revenue by enacting tax cuts for temporary periods. That leaves an increasing number of popular tax cuts--from the R&E credit to low income taxpayer AMT relief--subject, in effect, to annual appropriation. The complexity caused by allowing tax provisions to expire is atrocious, and the annual tax "cuts" piling up exceed over $1 trillion during the next 10 years.
We must also add to that the need to do something with the individual AMT. Since repeal would cost around a trillion dollars, unless it is coupled with a rejiggering of the regular income tax, repeal does not seem like a realistic possibility. A complicating factor is that the AMT contributes to the progressivity of the tax system. Consequently, progressivity advocates are likely to demand that a rejiggering of the income tax collect more from the taxpayers defined as "rich."
Large as the expiring provisions and the individual AMT may seem, grappling with them is a short-term budget issue, and our short-term budget issues are insignificant compared with the longer term issues of the unadjusted growth in Social Security and Medicare expenditures.
So other than the expiring R&E credit, you may blithely assume that none of this has anything to do with corporate America. Right? Not so fast. That GAO study may have been flawed and the think tanks may be publishing nonsense, but corporate tax receipts' shrinking as a share of total federal receipts remains a reality. To be sure, many factors have contributed to the decline--the rise in use of pass through entities, increased use of debt, stock options--but they do not explain the entire decline, and the opacity of the system defies attempts both to explain the readily identified contributors and to understand the rest.
A year ago, many federal budget analysts were surprised and dismayed by the dramatic fall-off in corporate tax receipts in 2002. Even for those experts who had been ardent backers of the economic stimulus bill in 2002 and were fully aware of the numbers the revenue estimators had hung on its provisions, the result--a decline in corporate receipts--had somehow not sunk in. Even reminders that a decline in corporate tax receipts was what was intended by the economic stimulus bill did not completely allay the discomfort.
Congress is going to be looking for additional revenues, and the faceless fellow behind the tree will be an attractive target. Raising taxes on individual taxpayers is politically unpopular, to put it mildly. And we have removed so many taxpayers from the tax rolls entirely--more than 50 million individuals and families pay no income tax--that it becomes very difficult to raise sufficient revenues on the individual side without broadening the tax base. How do we broaden the tax base? Any takers for removing the mortgage interest deduction? How about taxing employer-provided health insurance? Individual base-broadening has never been popular either.
Turning to the fourth factor: global competition. I would argue that the global marketplace and our national interest in successfully competing there ought to inform all of what we do as a country. We want to preserve our high standard of living and that means continuing to lead the global competition.
The reason we have led the global competition for so many years is--are you ready for this?--the strength of corporate America, especially the much-maligned multinational corporation. Our multinational corporations have made us the world's largest exporter, creating jobs for millions of Americans.
Among the public, however, with the aid of the media, corporate America is pitted against the workers of America. We have to counter those views. The reality is American workers succeed because the companies they work for succeed; they cannot succeed without one another.
Since it is a global competition, we need to consider what other countries are offering businesses locating there.
What's on the list?
* Lower tax rates on corporate income for starters. Even alter last years dividend tax cut, we rank number 1 on the OECD list for taxes on corporate income.
* Higher R&D incentives. A recent study put the United States--not dead last--no, but second from the bottom. Another recent study observed the linkage between the location of R&D facilities and manufacturing operations. Given that, it seems obvious that we ought to make the credit permanent. Yet we labor with a complicated, uncertain, and quaintly-designed credit that expires at junctures curiously close to strategic elections.
The R&D credit is the best jobs credit we've got. More than 75 percent of R&D credit dollars represent the wages of U.S. workers. R&D is about our future. Innovation results in new products, fattens profit margins, and yields our high standard of living. It is time we quit the political intramurals. There's a global competition out there.
* Some countries offer territorial tax systems. None have a subpart F as onerous as ours. What that means for companies headquartered elsewhere is the ability to deploy and redeploy capital without a potential tax penalty, with greater certainty about tax costs and an enhanced ability to benefit from lower foreign tax rates.
* They also offer no American tort lawyers, no Sarbox (so far), and no state attorneys general whose ticket to the governor's mansion is punched with headlines on how they are beating up the corporate world.
* Countries just entering the global marketplace offer a workforce that is lean, hungry, and increasingly well-educated. I have a newly-minted political science graduate at home. They, by contrast, are turning out graduates in math, science, and engineering. (Nothing against liberal arts degrees. They should be quite effective in preparing IRS protests.) Increasing education spending is not the solution, though a helping hand at the college level continues to be important. Mostly, we need to raise our expectations of students and parents. It does not matter what we spend on education if kids won't get off the couch and into the study gym. And they must be studying subjects too many are currently avoiding--like math, science, and engineering.
The final factor is IRS competence. You have all spent enough time with the IRS to know how it functions. I knew the IRS's limitations before I got to Treasury, but I still found distressing our inability to answer basic questions. For example, what is the scope of the tax shelter problem? Is it really huge or merely hype? Where is the tax shelter problem most serious? Is it large companies, mid-size companies, or individuals? We could not answer those questions. With respect to where the most serious problem resides, anecdotal information (including the information the IRS was beginning to accumulate) suggested the noncompliant class was individuals, but corporations are the target preferred by Congress and the media. Without more solid information pointing elsewhere, you should expect them to stick to the corporate target.
The lack of information impedes the IRS's ability to properly redirect its resource allocation. I don't know whether you've all been enraptured by rupture or whether your rapture has been ruptured, but things clearly have to change. Three years ago, the IRS's Large and Mid Size Business Division (LMSB) was spending 25 percent of its time on capitalization issues . pursuing timing changes while permanent losses slipped through undetected. Another large chunk of time went to the R&E credit. The R&E credit at least involved a permanent item, but the resources devoted to the issue were out of proportion to the problem.
The IRS's Small Business/Self Employed Division (SBSE) had comparable resource allocation issues. Let me give you one example. SBSE put a lot of resources into use of the cash method of accounting. Obviously, when we adopt accounting method rules, we expect them to be followed. It is clearly the IRS's job to see that the rules are followed. But when the IRS forces one plumber to use the accrual method by asserting that his plumbing supplies are inventory and does nothing about the plumber down the street who is part of the underground economy and does not even file a return, the result is bound to be a loss of respect for the tax system.
Another area where information is lacking is how best to foster compliance. One might expect--I certainly did--that the IRS and Treasury Department would have considerable knowledge in this area. When we tried to determine what would be the most effective tax shelter strategy in 2001, however, we learned the knowledge was centered on the effects of altering the economics of the risk/reward ratio. In other words, increasing penalty rates. The likelihood of detection, application of the penalties, and making the penalties stick were not even part of the equation. Perhaps that is a limitation of economics. We focus on what can be readily measured. The effect of an increased penalty can be measured, while the other factors are much more difficult to gauge.
Research in other areas of the law, however, confirms that penalties that are too draconian are ineffective because they are not enforced. Courts and juries decline to apply them. There is also research tying a positive view of the IRS with increased compliance, which influenced former Commissioner Rossotti's drive to improve IRS customer service.
Looking statistically at what has occurred over the last couple of decades in the tax system, one might conclude that the driving principle has been to audit fewer and fewer taxpayers, but to really whack those who are audited. Some of the research in other disciplines and my personal observation lead me to a contrary conclusion. Research suggests the biggest factor in why people comply with the law is the perception that the law is fair and fairly enforced. That suggests the need to ensure everyone pays the tax they owe. Penalties should be imposed where the penalties apply, but we should be far less interested in enforcing penalties than in collecting the taxes due. It is important to remember that, given resource constraints, every dollar spent on enforcing penalties is a dollar that cannot be spent collecting the taxes due from other taxpayers.
Right now, much is being made of the deterrent value of making examples of a few high profile cases. I am concerned the "E" word--enforcement--is being way overused. We are in danger of forgetting that our goal is compliance and that enforcement is no more than one of our tools for achieving it. Emphasizing (or overemphasizing) enforcement may be good for the livelihood of certain tax professionals, but that does not mean it is good for the tax system.
The IRS's difficulties are compounded by regular legislative intervention and congressional micro-management. Congress dictates extra procedures and then expresses dismay when the procedures slow the process. It extends the statute of limitations on collection and then is shocked to find the IRS's receivables inventory growing as the number of open years grows. Congress specifically appropriates resources to pursue earned income tax credit (EITC) noncompliance and then professes anger with the IRS for spending resources on low income taxpayer audits. All the micro-management tends to result in hard-and-fast rules that can be extremely counterproductive. For example, one taxpayer reported $15,000 in income, claimed the EITC, and had several million dollars in unreported offshore income. She turned herself in during one of the IRS's voluntary disclosure initiatives. Had the IRS found her after commencing an audit, she would have been classified as a low income taxpayer and been added to the statistics indicating the IRS was allocating too many resources to low income taxpayers. Willie Sutton may have robbed banks because that's where the money is, but devoting audit resources solely to the taxpayers where the money is represents a questionable basis for allocating audit resources. It means the largest taxpayers in the country--corporate America--will always be audited, regardless of compliance history, and the others can operate with nary a concern about being discovered or second-guessed.
Corporate America has a vested interest in a more effective tax administrator.
What's the Prescription for Change?
In the face of strong anti-corporate sentiment, complicated by an opaque system, an increasingly political legislative process, a federal budget deficit, a less than fully functional tax administrator, and growing global competition, should you just sit back and wait for the pendulum to swing back? I don't think so. It's a risky course and one that may well mean squandered opportunities. Corporate America spends too much time on defense and reacting. It is time to go on offense. So what should you do? Two things:
* Take the lead in building a better system.
* Promote the good you do and the good corporate America represents.
The late Treasury Secretary William Simon said, "The United States should have a tax system which looks like someone designed it on purpose." You've learned how to play the angles for your companies, but you also know how irrational the system is and the investment distortions it creates. In addition to the irrationality of the system, the differences between book and tax income and the lack of transparency they bring are a potentially dangerous virus.
In the 1890s, one house of the Indiana legislature attempted to enact a simpler definition of [PI] (pi). It seems that multiplying by 3.1416 ... was too complicated, so the legislature concluded they should round it to 3.20 to simplify the math. Fortunately, the other house of the Indiana legislature saved the state from this folly. Warren Buffett has used that story as a metaphor for congressional efforts to prevent FASB from requiring the deduction of stock option expenses. It is a pretty good metaphor for a lot of congressional efforts to define taxable income. Congress can deny a deduction but that does not mean it is not an expense. It can include or exclude items of income or alter a value, but that will neither reduce the item to cash nor alter or eliminate the real value. Not that FASB always gets it right in the determination of book income, but at least it has the discipline of the financial markets to keep it within bounds.
The differences between book and tax income have given rise to a whole host of economists--in academia and at think tanks--who devote time to analyzing your corporate financial statements and IRS Statistics of Income data to determine whether your companies have paid tax, how much tax and why, how that compares with your competitors, and how it compares with other industries. They publish articles and hold conferences on what they have learned, what they cannot determine, and what it all means. What they cannot determine is a source of much conjecture and often a greater source of intrigue that what they can demonstrate.
Intrigue is not healthy. During my tenure at the Treasury Department, we made two attempts to increase transparency: the required tax return disclosure of book/tax differences and the proposed revision of Schedule M-1. I know the required disclosure has increased your workload, but believe the transparency flowing from the disclosures and Schedule M-1 changes will reduce your risk if successfully implemented.
I can't tell you, however, that the increased transparency will be more than band-aids on the system. Neither can I tell you how long the band-aids will hold.
There are a number of reasons to dump income as our corporate tax base. It produces a highly volatile source of receipts. Given the disparate treatment of economically similar instruments and transactions, such as the differing treatment of debt and equity, the tax base is manipulable. Current differences between book and tax breed cynicism about the fairness of the tax system. If we keep income as a base, we ought to look seriously at conforming book and tax, but it may be time to consider an alternate base.
The confluence of events suggests change is coming. Corporate America--and that means you as officers of your company--should be leading the effort. You should be leading the effort because it is the right thing to do. But, more than that, you should lead the effort because if you don't, you may be run over.
You can be proud to be part of corporate America and proud of what corporate America has accomplished. I mentioned Micklethwait and Wooldridge's book, The Company. It tells a wonderful story of the contributions of the limited liability entity to global prosperity. One section in particular notes the things that business leaders have contributed, not because legislatures compelled them, but because they chose to do so.
Creating pensions for their employees. Congress didn't require that. Contributing to their communities. Congress didn't make them do that either. Exporting ethical business practices and transparent markets. Truth be told, Congress may have had a hand in that one, but the point is that American companies have led the way in bringing the ethical business practices they employ everyday in the United States to other companies and to countries around the globe to the benefit of the citizens of all of those countries. What you should understand is that the positive far outweighs the negative. Nevertheless, you are being hammered constantly by negative anecdotes. You need to trumpet the good you do because the media won't and the public needs some perspective.
Corporate America's legacy is leadership, best practices, and doing the right thing. In the best tradition of your corporate predecessors, you should seize the initiative.
PAMELA F. OLSON is former Assistant Secretary of the Treasury for Tax Policy, and is currently a partner in the Washington office of Skadden, Arps, Slate, Meagher & Flom LLP. A long-time speaker at TEI conferences and seminars, Ms. Olson is a graduate of the University of Minnesota with B.A., M.B.A., and J.D. degrees. She is a recipient of Tax Executives Institute's Distinguished Service Award. This article is adapted from her remarks to TEI's May 12-15, 2004, conference entitled "Managing the Tax Department in the Age of Transparency: An Interactive Conference."
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|Author:||Olson, Pamela F.|
|Date:||May 1, 2004|
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