by John Tamny, Toreador Research and Trading (Guest Contributor)
Taxes are always on the mind of the electorate, and while individual rates of taxation garner the greatest fraction of our attention, the way corporations are taxed is important too. A change in direction in this area could potentially free up a lot of capital, all the while reducing a great deal of waste.
By now most investors are familiar with the statistic showing that the U.S. rate of taxation, at 35%, is only exceeded by that in Japan among economically developed countries. Those who would like to see it lower argue that the high rate is reducing company formation stateside, so the clear answer is to reduce it.
No doubt the above is a worthy goal, but it brings to mind the old saying that "if you want the government out of your pockets, remove your hands from its pockets." To get to a lower corporate tax rate it would be essential to abolish the myriad corporate deductions that presently dictate a high headline rate.
In short, the ideal corporate tax would be a flat tax rate levied on gross receipts. All businesses would be equal before the IRS, and could be judged by investors solely on the basis of their economic prospects, as opposed to prospects that to varying degrees are distorted by the tax code.
Distortions. In the tax bill recently passed by Congress, businesses will enjoy some new tax write-offs, and the most notable one concerns expenditures on capital equipment. Businesses will be able to depreciate immediately 100% of new equipment in 2011, and 50% in 2012.
The problem with such a write-off is fairly obvious. As numerous Wainwright Economics publications have made plain over the years, government policies can't stimulate economic activity as much as they can reschedule it. Stimulus today realistically implies stagnancy down the road.
In this case, businesses have the incentive to bring forward capital expenditures into the current year and (less) into 2012, but logic tells us that will reduce similar expenditures that would otherwise have been made beyond 2012.
Worse than that, no reasonable business opportunity can attract capital based merely on its ability to simply spend it. Enterprises are in business to generate profits for shareholders; if tax policy invites activity meant to reduce taxable profits, economy-sapping distortions will surely be the result.
Google, for instance, was largely founded on cheap computer servers. Its profits weren't then, and aren't now, driven by capital expenditures as such, but by innovative concepts of the mind that have led to the creation of the most widely used search engine on the Internet.
In the case of Google, it's a clear distortion that a business reliant on heavy equipment expenditures can enjoy tax deductions that innovative companies largely reliant on intellectual capital cannot. Under our current system, the Googles of the U.S. - unless they can find non-economic activities that please Washington and the tax code - are taxed at relatively high rates so that equipment-heavy companies can enjoy a tax break.
Likewise, there's been talk for quite some time that to reduce unemployment, labor-intensive companies should enjoy tax write-offs to hire workers. This is once again mistaken thinking. No business in a truly capitalist world could attract capital based on a business plan that involves increasing its costs per unit of production.
But if the tax code reduces labor costs, businesses reliant on expensive human inputs benefit at the expense of other, less labor intensive companies. Be it human or equipment capital, tax policy that subsidizes the excessive purchase of either encourages waste. Sub-optimal allocation of the basic means of production means a less vibrant economic outlook.
Indeed, unless corporations have growth-related needs that would enhance profitability, tax policy should encourage the disgorgement of excess capital in the form of dividends. By that channel, what is always limited capital would then hook up with new, innovative concepts needful of funds necessary for development.
Tax policy that subsidizes the purchase of human and mechanical capital encourages businesses to consume, waste or retain funds that could be matched to higher economic uses if paid out to shareholders. When the tax deductions make economically viable what would otherwise not be, those that benefit have their operations distorted. That's not to mention the concepts that will never see the light of day at all thanks to capital retention and waste.
The simple truth is that economics is about scarcity. What's perhaps not discussed enough is how tax incentives that encourage the purchasing of capital inputs raise the cost of everything for all businesses, large and small.
If for instance FedEx chooses to buy new delivery trucks rather than maintain its existing fleet thanks to the former being tax efficient, there are necessarily fewer trucks for businesses more needful of them to grow. The artificial demand wrought by tax breaks must on the margin drive up their cost.
The end result is that smaller enterprises on the way up face higher equipment costs due to tax breaks for existing businesses. Thanks to the tax code, large companies, by virtue of being large, make the launch of a new business concept more costly.
Similarly, smaller businesses would face increased hiring costs if employee additions for existing companies were made tax deductible. Skilled human inputs in what is increasingly a knowledge economy are a precious commodity for businesses of all sizes. To put it simply, employee hiring that is encouraged by the tax code leads to a less economic and more wasteful allocation of human capital.
A lower, flatter, corporate tax. With a lower, flat tax on gross receipts, it becomes apparent quickly that a better allocation of capital would result. Companies would have less incentive to retain or waste capital. And originators of up and coming concepts would have greater access to funds more quickly released to shareholders.
Second, businesses made viable only by tax subsidies would quickly cease to exist in their present form, and rather than disappearing, their assets would instead be snapped up by better run, more economically realistic entities eager to pursue economically viable modes of expansion.
Third, tax compliance itself is costly. To monitor and maintain compliance, company resources must be diverted from productive use. While businesses would lose in the near term for deductions abolished, they would gain over the long term from a flatter, lower, more understandable structure; one that would enable them to reduce compliance costs.
Would a flat gross receipts tax kill investment? One argument made against abolishing tax breaks is that reduced profitability among the beneficiaries of deductions would decrease investment across the board. This fear seems overdone.
For one, if the tax code is what is propping up certain businesses, then it's a certainty that those harmed are not good stewards of capital to begin with. As always, we live in a capital constrained world, so it would be better to starve the businesses not viable under a tax system that doesn't play favorites.
Second, history is pretty clear that if a business concept is viable, there will be investment to fund it. Though oil exploration has historically been a "crapshoot" of sorts with profits from it distant, investment in what is a very uncertain pursuit has long existed in abundance. And pharmaceutical companies, despite the long odds that their health innovations will eventually reach the market in a profitable way, have always been able to attract significant investors seeking outsized gains. While potentially innovative companies would no longer enjoy deductions on equipment, labor and R&D, it's a fair bet that if their business models were sound that they would find willing capital markets.
Even better, a gross receipts tax presumes a much lower, flatter tax in return for lost deductions. Economically viable concepts that prove appealing to consumers would attract tax-conscious investors.
Conclusion. Governments cannot create economic growth. They can, however, divert, reschedule and distort growth through monetary and tax machinations that disfigure economic activity on the way to waste.
Governments can also play favorites with the tax system, doling out deductions to the companies that are equipment intensive, aggressive in their hiring, and that pursue concepts favorable to the powers-that-be. The end result is that tax breaks, rather than the simple drive for profit, to varying degrees drive and distory economic activity.
Worse, the companies that do the most with the least, meaning the very companies with the potential to attract the most growth-enhancing investment, are forced to pay higher tax rates in order to make viable more questionable uses of funds. And to the extent that taxes create incentives for non-economic expansion, the economy loses twice: first for wasteful economic activity being pursued by tax-favored businesses, and second for earnings being retained, rather than redistributed to investors so that they can become fresh capital flowing into new, innovative concepts.
The answer as always is for the government to simply get out of the way. If it must tax corporations, its taxation should be blind in the way that justice is. A flat gross receipts tax would make all corporations equal before the IRS. That would ensure the most economic allocation of capital on the way to rational, market-driven growth.
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.