Corporate Taxes and Apple: The Flaw Is in the Law

Last week it was the turn of Apple’s (NASDAQ:AAPL) Chief Executive Tim Cook to sit in the Congressional hot seat. With lights blazing and cameras rolling, a bipartisan lineup of Senators grilled him about the relatively small amount of tax the company pays on its substantial corporate profits. According to a New York Times account of the hearing, Republican John McCain characterized Apple “as among America’s largest tax avoiders.” Democrat Carl Levin complained about the use of “ghost companies” to hide profits overseas.

Cook replied that Apple pays “all the taxes we owe — every single dollar.” He could have added that as Chief Executive, it is his fiduciary duty to look after the interest of his shareholders. He could go to jail if he passed up entirely legal methods of protecting their profits from the IRS. So don’t beat up on Apple. The flaw is in the law.

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What exactly are the flaws in the corporate tax law?

The first is that the “corporate tax” is not really a tax on corporations. Yes, corporations can “pay” taxes in the sense that the check that goes to the IRS is printed with the corporate logo, but they can’t bear the economic burden of taxes, because they are not people. The entire burden of the tax ultimately falls on the corporation’s stakeholders — its shareholders, executives, workers, customers, suppliers and others.

Unfortunately, we don’t really know exactly which of these stakeholders bear what share of that burden. Economists used to assume that all or most of the burden of corporate taxes fell on shareholders. For a corporation operating a closed economy, that may have been a good assumption. However, when corporations operate in a global market, they are able to shift much of the tax burden to employees, up to 70 percent, by some estimates. That number may not be exactly right, but the shift is substantial. (For a more detailed discussion of the incidence of the corporate tax, see this earlier post.)

The second flaw with the U.S. corporate tax is that its marginal rates are too high and its loopholes are too many. At 35 percent, the top U.S. corporate tax rate is the highest in the world. No wonder companies try to avoid it. There are plenty of legal ways to do so: Hold profits overseas rather than bringing them home. License intellectual property on advantageous terms to subsidiaries located in low-tax jurisdictions. Take advantage of numerous other preferences, like accelerated depreciation of equipment. Eric Toder of the Tax Policy Center estimates that eliminating corporate tax preferences could potentially save $506 billion over five years. With fewer loopholes, we could cut the marginal tax rate to about 25 percent with no loss of revenue, he says.

To his credit, President Obama recommended doing just that in his recent budget message. Too bad he hasn’t said a word about it since.

The third flaw in the tax is the double taxation of corporate income. The corporate tax hits profits once, when a company earns them, and again, when it distributes them to shareholders. Congress has responded to the problem of double taxation with preferential personal income tax rates on capital gains and dividends, but as I discussed in another earlier post, that is the wrong approach.

What should be done? As an interim measure, by all means, close loopholes in the corporate tax and use the extra revenue to cut its marginal rate. (By the way, Cook says he endorses this idea, even if the result would increase Apple’s taxes.) The top rate could be cut even further if personal income from dividends and capital gains were taxed at the full personal income tax rate. If we reduced the U.S. corporate tax rate even to the OECD average of about 25 percent, there would be less incentive for companies like Apple to park so much of their profits in foreign subsidiaries.

An even better solution would be to eliminate the corporate tax altogether. For all of the economic distortions it causes, it doesn’t really bring in much. It now accounts for only 9 percent of total federal tax revenue, down from a post-World War II high of 30 percent. The government could recoup part of the revenue by taxing capital gains and dividends as ordinary income on personal income tax returns. It could make up the rest by closing other loopholes in the personal income tax, or by introducing new, broadly based taxes like a VAT or a carbon tax. (I will write more about those in future posts.)

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Meanwhile, it is comforting to note that at least one Senator did get something right at this week’s hearing. “Instead of bullying Apple executives,” said Senator Rand Paul, “we should have brought in a giant mirror to look at the reflection of Congress. If you want to assign blame, look in the mirror and see who created this mess.”

Ed Dolan is Wall St. Cheat Sheet’s in-house economics professor. He is the author of an acclaimed series of textbooks Introduction to Economics and Ed Dolan’s Econ Blog.

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