Skip to main content

Clean the Tax Code

If we taxed corporations on the profit they report to shareholders, they'd lose the incentive to buy billion-dollar tax breaks from Congress.

When hedge fund managers living in Greenwich, Conn., can pay a tax of only 15 percent on hundreds of millions of dollars of income — and even then, only when they deign to bring it into the United States from offshore accounts — something is wrong. But when Congress refuses to act to close that loophole, even after the press and the Congressional Budget Office have pointed out that closing it would offset the cost of eliminating the Alternative Minimum Tax on the middle class, something is really wrong.

Our tax system is broken and will remain so until we change the incentive systems that entice Congress to enact ever more tax subsidies for profitable corporations and wealthy individuals, while dumping the cost on our children. Those incentives will change dramatically once we begin taxing corporations on their reported profits, rather than the tax code's arcane calculations of taxable income.

In 1986, a bipartisan coalition in Congress managed to simplify our tax code and lower tax rates by eliminating numerous subsidies. Since then the tax code has gotten so complicated — and so full of huge subsidies for large firms and rich people — that it is more of an honor code than a tax code. Why? Because we have an auction system for tax subsidies.

Politicians fight to get on the House Ways and Means and Senate Finance committees not because they are intrigued by the complexity of the tax code but because the committees are the best fundraising platforms in Congress. And why shouldn't they be? It would be irrational for a businessman not to try to get tax subsidies by making campaign contributions or hiring lobbyists who will contribute. The return on such an investment almost always far outweighs any return he could get by investing in the market. Politicians vote for these tax subsidies not because they are corrupt (although some are) but because lobbyists, who bought access with campaign contributions, made a persuasive and usually unchallenged case for their tax subsidy.

This situation has been exacerbated during the Bush administration, which pushed for tax breaks for the very rich at the expense of the middle class, in the process taking a national budget surplus and turning it into the largest deficit our country has ever had.

Right now, the income disparity between the top one-tenth of 1 percent of earners and the middle class is higher after taxes than before. From 2003 to 2005, the increase in incomes of the top 1 percent of Americans exceeded the total income of the poorest 20 percent, according to the Congressional Budget Office. Yet, when the Organization for Economic Co-operation and Development tried to curb transfer-pricing abuses by making tax havens such as the Cayman Islands more transparent, the Bush administration opposed such action because of pressure from Republican campaign fundraisers — even though the move would have helped the small-business taxpayers who form a significant segment of Republican Party voters.

So why hasn't Congress responded to this tax-mugging of the middle class and small business, particularly now that Capitol Hill is run by Democrats? Part of the problem is that politicians, regardless of party, make decisions based on whether they will gain or lose votes at election time. If the public is not focused on an issue, most congressmen will vote to maximize campaign contributions, which they can then use to get more votes.

In almost every session of Congress, of course, there are a few votes that become issues so public and controversial that potential campaign contributions are not the deciding factor. Those issues are by and large created by the media. Taxation simply hasn’t been one of them.

So why haven't the media covered taxation and economics better? Part of the reason is simple: These issues are genuinely complicated. Most reporters I've dealt with through the years — even reporters at major news outlets — just don't have the knowledge to explain, for example, how companies use transfer-pricing to move their profits offshore, where they are not subject to U.S. taxation, in a way that the public can understand. This lack of expertise is no minor matter: Multinational corporations move profits offshore and evade U.S. taxes to the tune of $300 billion a year, according to estimates of the Senate Permanent Investigations Subcommittee, which has held extensive hearings on these issues. (An estimate of tax evasion, tax haven by tax haven, can be found in a series of articles by Martin Sullivan in Tax Notes).

Part of the reason for the underreporting of taxation issues seems also to involve the owners and managers of media companies that benefit from many of these tax subsidies and other government largesse (including free use of the airways); they don’t want to bite the hand that feeds them.

And part of the reason taxation stays under the radar is a sense of futility among journalists, a feeling that no matter what "reforms" are enacted, they'll be undone later.

But there are some simple tax solutions that may be possible to enact because of a looming economic crisis: We seem to be headed into a serious recession, and people feel more and more economically insecure as housing prices plummet and leading financial institutions require bailouts. This insecurity and the growing federal deficit may get major media organizations to focus attention on them and force Congress to move on tax and economic issues.

But Congress won't move in the right direction unless the media focus the public's attention on realistic options.

Right now, almost every special interest tries to buy a tax subsidy, and politicians have every incentive to grant subsidies. But we could change the frame of reference: We could eliminate the pressure for businesses to seek tax subsidies by simply imposing a flat tax on the profits that corporations report to their shareholders and the Securities and Exchange Commission. Clearly, these SEC figures are a more accurate reflection of corporate profit than those fantastical numbers reported to the IRS under the current, subsidy- and loophole-filled system.

And SEC reports will be relatively immune to manipulation. Corporate managers will likely continue to report accurate profit figures; after all, their compensation is dependent on their corporations' profits. Also, there is the Sarbanes-Oxley Act of 2002, which holds chief executive officers criminally liable for filing false financial reports.

Basing taxes on SEC profit reporting would eliminate a host of complex tax accounting issues, including unpoliceable transfer-pricing abuses. For example, Microsoft saved itself more than $300 million in taxes by simply opening an "office" in an Irish solicitor's office, transferring patents to that "office" and then deducting royalties paid to that "office" from its otherwise taxable U.S. income. If multinational corporations were treated as one unit taxed on its reported profit, we would have a far more accurate picture of their actual worldwide income, and intracorporate transfer-pricing abuses would be eliminated. This would also allow corporate tax rates to be lowered and let domestic corporations, which have to pay taxes, compete more effectively against multinational corporations, which don't. Corporations not under SEC jurisdiction could be required to use the generally accepted accounting principles known as GAAP, which are designed to accurately reflect profitability.

By basing taxation on realistic corporate profits (rather than the tax code's unrealistic taxable-income calculation), we would strike a blow for ethical government, eliminating the incentives for sophisticated and expensive lobbying operations and for massive campaign contributions to congressional tax-writing committee members in a single legislative stroke.

Such a move would also be good business, encouraging corporations to act in an economically rational manner rather than tailoring their activities to the availability of tax subsidies. The government could still encourage particular business activities through direct financial incentives not linked to the tax code. But it would need to publicly appropriate money for these incentives every year, unlike the case with tax subsidies, which, once adopted, last long after any justification for them exists.

Making the federal tax system fairer will require other changes. We need to simplify individual taxes and lower rates. We need Congress to answer the question: What is the justification for taxing income from investments at a lower rate than income from labor? We need to stop treating Greenwich, Conn., as part of a foreign country where resident hedge fund managers can avoid taxes by claiming their funds are "located" in the Cayman Islands. And we need to give the IRS the resources it needs to catch tax cheats. The cutbacks in enforcement resources started under President Reagan have cost the American public literally hundreds of billions of dollars in evaded taxes.

Above all, though, we need to improve the news media's tax and economic expertise and coverage so the public understands the issues that so profoundly affect their — and their children's — well-being.

Although some journalists and some media organizations have occasionally focused attention on egregious tax loopholes, there is only one entity that consistently has focused on attempts to hijack the tax code: Tax Analysts, a nonprofit publisher that reports in great detail on taxation and has, according to several senior Capitol Hill aides, saved taxpayers literally billions of dollars by exposing unjustifiable tax subsidies.

Many of Tax Analysts' reports can be read for free on its Web site, and it is dedicated to helping other journalists report on these issues. But not enough journalists take advantage of the help, and the site doesn't have the audience of the nation's major newspapers, magazines and television networks. (By way of full disclosure, I am chairman of the board of Tax Analysts.)

We must realize that the primary goal of our tax system should be to raise the revenue needed to run our government, not to promote special interests, no matter how noble any one interest may seem at the time. We need to simplify the code and lower rates by eliminating tax subsidies, en masse. But without much more active coverage from the major media, we are doomed to a future of multimillion- and billion-dollar tax breaks, auctioned to the highest bidder.

Who probably won't be you.

Sign up for our free e-newsletter.

Are you on Facebook? Become our fan.

Follow us on Twitter.

Add our news to your site.