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Report: Close Corporate Tax Loopholes
Sunshine for California
Corporate tax avoidance leaves taxpaying households to pick up the tab for funding highways, schools, and other public structures. Much of the indirect costs of aggressive tax avoidance are also borne by investors who are unaware of these risky schemes. And everybody suffers when corporate profitability is determined by opportunities for tax evasion rather than efficiency or innovation.
Corporate tax avoidance is a rampant problem:
• In California 78 percent of corporations paid no more than the $800 minimum franchise tax in 2001. Worse, over half of profitable corporations paid no more than $800 minimum, including 46 corporations with over $1 billion in 2001 receipts.
• A study by the Multistate Tax Commission, a joint agency of state governments, estimates that by 2001 the growth of corporate tax sheltering accounted for $12.4 billion in lost annual revenue beyond what occurred during the 1980s. According to mid-range estimates, California corporate tax revenue was 19 percent lower than it should have been.
• The federal Government Accountability Office estimates that underreported corporate income taxes and employment taxes cost the federal government $84 billion in 2001. The GAO also reports that 33 percent of large U.S. corporations reported no tax liability in 1995, a percentage that rose to 45 percent by 2000.
• A study of 252 Fortune 500 companies between 2001 and 2003 found that they paid state taxes at only a third of the statutory rates and 71 of them paid no state taxes at all during at least one of these years.
Companies can practice a wide variety of tax-avoidance maneuvers, some of which are legal. Information about the use of particular tax schemes or basic information about whether corporations pay taxes remains hidden as corporate secrets.
Taxpayers pick up the tab when corporations avoid their taxes. The personal income tax is expected to provide 53.2 percent of revenues in the 2006-07 California state budget, up from 35.4 percent in 1980-81. Corporate tax receipts are meanwhile expected to provide 10.9 percent of General Fund revenues in 2006-07, down from 14.6 percent in 1980-81.
Corporations routinely report significantly lower incomes to California tax authorities than they do to their own shareholders; and they do so without any explanation for these differences. Corporations have a strong incentive to overstate their income to shareholders and to underreport income on their tax forms. The California Franchise Tax Board (FTB) calculates that corporations would contribute an additional $1 billion to $1.5 billion a year to the California state budget if they paid taxes on the income numbers that they tout to their shareholders. A Harvard study similarly found that for every $1 in income reported to the federal government for tax purposes in 1998, $1.63 was reported to shareholders.
Corporate tax secrecy obstructs good policy, sound investment, and market efficiency. Large nonprofit corporations must publicly disclose their detailed financial information. But for-profit corporations keep even their basic taxable income and the share they pay a secret. The lack of transparency leaves legislators in the dark, misleads investors, and distorts markets.
• Legislators are responsible for fine tuning tax laws, but they lack basic information about what corporations actually pay or how tax avoidance schemes reduce revenue.
• Investors cannot assess the financial health of corporations that aggressively avoid taxes, defer their tax liabilities, or inflate profit claims to shareholders. California could have been spared great pain if tax authorities had compared Enron’s reported $3.625 billion in profits reported to their shareholders between 1996 and 2000 to the $76 million reported to the IRS during this period. Studies show that the book-tax gap is a reliable predictor of tax evasion as well as poor future investment returns.
• Market performance suffers when corporate secrecy encourages tax evasion. Corporate tax avoidance skews the playing field toward economic activities that offer the most opportunity to avoid taxes rather than those that are most efficient or innovative. For instance, corporate tax evaders may pay lawyers and accountants large sums to create complex subleasing or debt-for-equity swaps that serve no productive purpose other than to reduce tax exposure.
Increased corporate tax transparency is a simple and effective solution. Requiring corporations to disclose and explain the gap between book and tax income would help reduce unlawful tax avoidance. Tax evasion thrives where its practices remain secret and reporting rules are inconsistent. Three kinds of reforms would promote transparency:
• Corporations should be required to explain discrepancies in the income numbers they report to tax authorities and their own shareholders. In response to concerns about tax evasion, in tax year 2004 the IRS began requiring corporations with assets over $10 million to file an additional form, the M-3, to reconcile differences between their reported income on financial and tax filings at the federal level. The Internal Revenue Service should make sure that all corporations are fully complying with the new requirement and enact penalties for non-compliance. In addition, California would benefit from a similar requirement at the state level, so that the Franchise Tax Board is equipped with the same detailed information to better target enforcement and minimize audits for law-abiding businesses.
• Public disclosure of how much corporations and large companies pay would make summary information accessible for journalists, watchdog groups, investors, analysts, and tax agencies. Corporate tax secrecy should not transcend the public’s right to know summary information about specific companies. Greater transparency would help ensure corporate accountability while promoting public confidence in government and elevating public debate about taxes and budgets.
• Reducing some differences in how book income and tax income are calculated would simplify tax compliance and reduce opportunities for tax evasion.
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