There is renewed interest in comparing U.S. corporate statutory tax rates to effective tax rates. U.S.-based multinationals have been complaining about the U.S. having the highest corporate tax rate (35 percent) among OECD member countries and plead that any comprehensive tax reform package undertaken by Congress includes lowering the corporate rate. Others correctly point out the effective tax rate on corporate income is substantially lower due to business tax credits, such as the research and development credit, being applied and reducing taxable income. Those opposing any reduction in the statutory rate point to the effective rate being substantially less and that U.S. corporations donaEUR(TM)t deserve a break.
Many holding this position were ecstatic earlier this month when the General Accounting Office (GAO) publically released its report, aEURoeEffective Tax Rates Can Differ Significantly from the Statutory Rate,aEUR? first provided to Senate requesters in May. Why? Because of the headline-grabbing finding that the U.S. corporate average effective tax rate was just 12.6 percent in 2010. The phrase caveat emptor comes to mind when using this report to make that claim. Most other previous reputable studies showed that the effective U.S. corporate tax rate is somewhere between 25 and 29 percent. While itaEUR(TM)s probably not fair to assert that the report compares apples and oranges, it is accurate to say it compares oranges to tangerines.
There are a number of factors supporting the above contention. The explanations can be a bit tedious, but IaEUR(TM)ll do my best. First, the period chosen for the analysis was 2008-2010. That might seem reasonable since it uses the most recent detailed data. However, because that period contains the most severe economic contraction since the Great Depression, many distortions are introduced, such as many firms reporting losses. The GAO concluded it could minimize this effect by including only profitable companies in its calculations. The problem is that many profitable firms in 2010 were absorbing losses from earlier years. These so-called loss carry forwards from 2008 and 2009 cut tax liabilities in 2010, reducing the reported effective rates in the GAO analysis.
Second, Congress passed several temporary depreciation rules at the request of President Obama in an effort to stimulate economic activity. Effectively this enabled companies to deduct the entire amount of their new investments in the current year rather than spread them out over their useful economic lives under normal depreciation rules. Additionally, many firms strengthened their pension plans in 2010, because by most accounting standard measures they were deemed underfunded. By allocating income to pension plans, firms appropriately took tax deductions. Combined, these items substantially reduced tax liabilities in 2010.
A third compounding element was the fact that the GAO used income from corporate financial statements in its calculations, while it based taxes-paid figures on consolidated tax filings from the IRS. These firms are large, complex, multidimensional entities, making it difficult to have consistent bases of comparison for where income is earned and taxes appropriately paid. The accounting in financial statements will tend to produce larger income estimates than under the tax liabilities from IRS calculations. In other words, the measure of income in the denominator appears much greater than that of the taxes paid calculation from the numerator, driving down the effective tax rate. For example, the GAO report stated that financial statements of the firms showed they earned a total of $1.443 trillion from U.S. and foreign subsidiaries, but reported taxable income based upon the tax code under IRS rules of just $863 billion for profitable corporations in 2010, a difference of $580 billion, or 40 percent.
Another flaw in the GAO analysis is that they are comparing total profits of U.S.-based multinationals with total U.S. corporate income taxes paid or relative to corporate income taxes paid on a global basis. However, multinationals donaEUR(TM)t owe taxes on their worldwide profits, just on profits earned in the U.S. plus income remitted from foreign entities less the credit for foreign taxes already paid. Incorporating the foreign tax credit, the ratio of U.S. federal income taxes paid and foreign tax credits to taxable income in 2009 (the latest year for detailed data from the IRS) was around 33 percent. This is a more applicable measure of the effective tax rate.
When you go through the calculations from the May GAO report, it leaves you wondering why most of their choices on measurement lent themselves to reducing the effective tax rate estimates. Furthermore, for competitiveness purposes, I would argue that the average effective tax rate isnaEUR(TM)t the proper measure. Effective marginal tax ratesaEUR"the incremental tax burden from additional income attributable to an incremental dollar of investmentaEUR"are a much better measure, and the U.S. is in an unfavorable international position. Unfortunately, the GAO report raises more questions than it answers. If authorities at the GAO are mystified by the labyrinth U.S. tax code, it cries out for a comprehensive overhaul.