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Corporate Income Taxes:

Trends and Forecasts

Presentation to the President’s Advisory Panel on Federal Tax Reform

March 8, 2005

Douglas A. ShackelfordUniversity of North Carolina and NBER

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Overview Look back

Corporate income taxes are in a long decline Why have they declined?

International competition Alternative organizational forms More effective tax planning

Tax shelters Mobility of income

Look forward Feasibility of the corporate income tax in an

information economy

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Corporate Income Tax as a Percentage of Federal Revenue and GDP

Source: Office Management and Budget, Fiscal Year 2005 Budget, as reported by the Tax Policy Center.

0.0

5.0

10.0

15.0

20.0

25.0

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35.0

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45.0

1934

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1959

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1974

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1984

1989

1994

1999

2004

% o

f R

even

ue

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% o

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DP

Revenue GDP

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Why Have Corporate Taxes Declined? International competition has eroded

corporate taxes as a revenue source Lower rates at home and abroad Smaller base—e.g., accelerated/bonus

depreciation, R&D deductions and credits Other organizational forms (e.g., S corp)

The corporate income tax is a special levy on companies that access capital through the public equity markets

Other techniques to undo two levels of tax More effective tax planning

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International Competitiveness: Reducing Corporate Tax Rates

Source: Gravelle, J. “The Corporate Tax: Where Has it Been and Where is it Going?” National Tax Journal 57 No. 4 (December, 2004): 903:922.

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35

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45

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65

Tax

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e %

Statutory Marginal

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S Corporations: Eroding the Corporate Tax Base

2004-2010, projected. Source: IRS Statistics of Income.

Number of Returns Filed (in Thousands)

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1,000

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5,000

1980

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C-corp S-corp

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Business Net Income by Type of Entity

Source: Drew Lyon, PriceWaterhouseCoopers, Presentation at the 6th Annual Tax Council Policy Institute

Symposium, February 11, 2005. Underlying data from IRS statistics of Income.

0

100

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700

1991 1992 1993 1994 1995 1995 1997 1998 1999 2000 2001

C corps, excl. RICs and REITsS CorporationsPartnerships, excl. LLCsLLCsAll Passthroughs

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Other Ways to Eliminate Double Taxation Year-end bonuses in privately-held firms Debt shifts business profits to the lender’s

tax return since interest is deductible Employee stock options

Total deductions from stock option exercises were 10% of total pretax income for the 100 largest U.S. companies in 2000. However, total deductions exceeded total pretax income for the Nasdaq 100. (Graham, Lang, and Shackelford, Journal of Finance, 2004)

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More Effective Tax Planning:Book-Tax Gap The gap between accounting earnings and

corporate taxable income widened during the late 1990s e.g., Desai (2002) finds $155 billion of

unexplained book-tax gap in 1998 Perhaps book is overstated

Earnings pressure may have led to inflated, fictional earnings in the late 1990s

Corporate Tax Shelters

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How about Book-Tax Conformity? Argument given for conformity: If

companies are overstating book profits and understating taxable income, then require them to report the same figure to shareholders and the taxing authority and you fix two problems.

Not a good idea Conformity ignores the critically important role

that accounting information plays in the markets.

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Corporate Tax Shelters Legal noncompliance

Meet the letter, but not the spirit of the law Reduce taxable income but not book

income Little public data so estimates of their

magnitude are difficult Leasing transactions estimated to cost $4

billion for one year (Joint Committee on Taxation, 2004)

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Shelters Today Market has cooled

Recession reduced demand Bad publicity IRS has become more aggressive Big 4 withdrew partly because shelters

threaten to undermine the profitable Sarbanes-Oxley audit work.

Market could revive Booming economy—high profits, high taxes Recent IRS defeats embolden taxpayers Big 4 spin off their tax practices

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Income Mobility The tax system relies on information from

the historical cost accounting system The accounting system is struggling to

measure income where the primary assets are intangibles.

As a result, taxable income is becoming increasingly difficult to measure.

These measurement problems provide opportunities for tax planners and raise doubts about the long-term viability of income taxes

Problems increase with globalization

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Old Days Factors of production

Largely immobile—heavy industry Bricks and Mortar Large unskilled/skilled labor force Production of goods

Income Primarily sales less production costs Biggest accounting questions—inventory,

depreciation

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Today Factors of production

Highly mobile--intellectual Intangibles and highly technical Small, highly educated labor force Service-oriented

Income Affected mostly by people and intangibles Biggest accounting questions—realized and

unrealized intangibles What is a brand name worth? Where does a telephone call take place?

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Is an Income Tax Feasible in the Future? A tax system built on income can only last

as long as we can define income with some precision.

A tax system depends on market frictions that make it difficult to undo the tax. In old days you could not easily dismantle the plant. Today you can move profits around the globe with transfer prices or a plane ticket.

Is it feasible to think that income can be a basis for tax measures in the future?

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Tax Planners Need Differences in Tax Rates Tax the Same Income Differently

At Different Times E.g., current tax holiday on repatriated cash

In Different Places U.S. vs. foreign-source

In Different Organizational Forms Flow-through entities, tax-exempt organizations, pensions

Depending on the Savings Vehicle Stock held in an 401(k) vs a mutual fund vs personal

account

Tax Similar Income Differently E.g., new lower rates on U.S. manufacturing