A Taxing Business: Understanding America’s Corporate Tax System



  • U.S. companies pay the highest corporate tax rates in the world, but the payments account for a small fraction of the country's GDP
  • American companies have been avoiding taxes on $958 billion in overseas earnings
  • Under one proposed solution, public companies would be taxed on market capitalization rather than income

General Electric’s motto is “imagination at work.” But in 2011, GE became an icon for imagination of a different sort: creative ways of dodging corporate income taxes. The New York Times reported America’s sixth-largest company paid zero U.S. taxes in 2010, despite domestic profits of $5.1 billion. 

On closer look, the charge doesn’t hold up, says John Robinson, professor of accounting at the McCombs School of Business. But he acknowledges it’s easy for observers to get confused. “Most citizens don’t understand the corporate income tax,” he says. “Politicians don’t make it any easier.”

What misleads GE’s critics, says Robinson, is that the company reports one set of numbers to the IRS and a different set to investors, a practice common to most public companies. “What a corporation actually pays in taxes in cash,” he says, “is not the same as what accrues on an income statement.”

A firm’s tax return records what it actually pays Uncle Sam. Its financial statements, in contrast, reflect how much it sets aside to pay future taxes. That number is easy to manipulate. In fact, executives have incentives to low-ball it, says Robinson, because the less they reserve for taxes, the higher earnings they can report. “My suspicion,” he says, “is that executives care a lot about it because they’re rewarded based on after-tax income.”

GE’s 2010 annual report lists $3.2 billion in “current tax benefits.” That makes it look like the firm got a huge refund. In reality, it’s partly accounting changes, which reduced GE’s tax reserves, and partly losses it expects in its financial services arm. The company says it paid income taxes in 2010, but won’t disclose the amount.

More Trouble Than It’s Worth?

Such accounting gymnastics are one reason the corporate income tax is perhaps the least popular levy among some tax and finance faculty at the University of Texas at Austin. Another reason is the large amount of trouble it takes to collect a small amount of bucks.

By one measure, U.S. companies pay the highest corporate tax rates in the industrialized world: 39.2 percent, versus an average of 25.4 percent among the 34 countries in the Organization for Economic Cooperation and Development.

But by other measures, they pay some of the lowest amounts. In 2009, corporate taxes were 1.7 percent of America’s gross domestic product, compared to an OECD average of 2.8 percent. The tax contributes a scant 8 percent of Uncle Sam’s revenues.

“I don’t think it’s an effective way to collect money,” says Sandy Leeds, senior lecturer in finance at McCombs. “It’s a small percentage, and we’re spending a lot to avoid it.”

Collecting on Foreign Earnings

In fact, American companies have been avoiding taxes on $958 billion in overseas earnings, according to the Congressional Research Service. That’s because firms can postpone taxes on foreign earnings, as long as the earnings stay offshore — that is, until foreign subsidiaries pay them to the parent companies, as dividends. Subsidiaries can keep earnings offshore indefinitely, by expanding or buying other companies.

“It’s almost like exempting them from U.S. taxes,” says Robert Peroni, professor at the School of Law. “It encourages U.S. companies to shift investment abroad.” (See accounting professor Lillian Mills’ research on the potential effectiveness of tax “repatriation holidays.”)

With so many strikes against the corporate income tax, you might think reform would be a sure political bet — especially when both major parties are calling for it. President Barack Obama has proposed trimming the top rate to 28 percent, while a House Republican plan would lower it to 25 percent.

But the two parties are far apart in other respects. Obama wants to start taxing all foreign earnings of U.S. multinationals, while Republicans would exempt most such earnings altogether — even when companies finally bring them home. (For more information, watch Lingo: Foreign Tax Credit.)

Corporations also have conflicting interests, notes Robinson. In 2004, many of them lobbied against cutting the top rate. The reason: Like GE, they had tax benefits on their books — such as operating losses from past years, which they could use to reduce future taxes. If the tax rate went down, so would the value of those tax benefits. Predicts Robinson, “You’ll see a replay if they try to lower the corporate tax again.”

Proposed Changes 

Rather than simply reducing rates, Robinson would like to see a more fundamental change in the corporate tax: Integrate it with the individual income tax. That would end so-called “double taxation,” in which the same earnings are taxed twice — once at the corporate level, and again when stockholders receive them as dividends.

“We’re the only advanced country in the world that still has double taxation of corporate profits,” he notes. “Most other countries have integrated the corporate tax with the individual tax.”

He suggests several possible ways to integrate them. One method would be to tax only the portion of corporate earnings that’s not paid out in dividends. Another would be to give shareholders credits for the taxes their companies pay. That system is widely used in Europe, where corporate tax rates tend to be lower and individual rates higher than in the U.S.

At the School of Law, professor Calvin Johnson suggests a different sort of fundamental change: Instead of taxing public companies on income, tax them on market capitalization. He suggests charging 0.8 percent on the total value of a firm’s publicly traded stock and bonds. Private companies would remain under the current system.

Unlike taxable income, he says, a firm can’t use accounting tricks to manipulate its stock price. GE’s combined debt and equity were worth $821 billion at the end of 2010. Under his proposal, that would have yielded a tax bill of $6.5 billion.

“We are free to take a ride on the wisdom of the stock market,” says Johnson. “GE can zero out their taxable income. But they don’t want to zero out their market capitalization. They want their shareholders.”

Some critics would like to junk the corporate income tax altogether, but that wouldn’t be practical, says Robinson. “If you go to that extreme, people will game the system. Say I’m a sole proprietorship. I find out that if I incorporate, I’d have no income tax. So I’d incorporate myself.”

The legislative goal, says Peroni, should be a simpler system that slices the tax rate but closes most loopholes, leaving less room for creative accounting. “Having U.S. corporations deal with needless complexity is a waste of the resources they have to spend on tax planning,” he says. “We don’t want a system where the only way to get to a reasonable effective rate of taxation is taking advantage of a lot of gimmicks.”


Faculty in this Article

Calvin H. Johnson

Andrews & Kurth Centennial Professor School of Law, University of Texas at Austin

Calvin H. Johnson has been a member of the University of Texas Law School faculty since 1981. His research is currently focused around the...

John Robinson

Professor of Accounting McCombs School of Business, The University of Texas at Austin

John R. Robinson is the C. Aubrey Smith Professor in Accounting, in the Department of Accounting. He has taught at the University since 1985. John...

Lillian Mills

Professor, Department of Accounting

Lillian Mills received her BA from the the University of Florida and her Ph.D. from the University of Michigan. Her research interests include...

Robert J. Peroni

The Fondren Foundation Centennial Chair for Faculty Excellence School of Law, The University of Texas at Austin

Professor Peroni joined the faculty in 2003, and his primary areas of teaching and scholarship are federal income taxation, international taxation...

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

Leave a comment

We want to hear from you! To keep discussions on-topic and constructive, comments are moderated for relevance and for abusive or profane language.
Login or register to post comments