The Burden Of Taxes
Allied Machine & Engineering Corp. in Dover, Ohio, is far in mileage and mission from the high technology companies in California's Silicon Valley and the Route 128 high-tech corridor around Boston, for which President Ronald Reagan created a research and development tax credit in 1981.
Indeed, the R&D tax credit, reauthorized by Congress in almost every year since then, was enacted as a benefit for companies that did not have large investments in plant and equipment eligible for depreciation allowances in tax returns.
“We are an industrial drill manufacturer,” says Steven Stokey, executive vice president of the family-owned business founded in 1941. “We're kind of that mom and apple pie company.” Nonetheless, an active research and development program is essential to competing globally, he says.
In 2004, Allied decided for the first time to look into the potential tax credit benefit. The company hired a tax consultant to guide it through the tax code maze to determine whether it was leaving money on the table by not maximizing its claim for its active R&D initiatives. Allied did this despite misgivings. As Stokey puts it, “You hire them, you comply and five years later the IRS comes in and audits you and says that is not entirely how you should have interpreted the law; here's what the real deduction should be.”
Allied decided to seek a credit for all the current and past years for which the company could state a claim related to its estimates of R&D expenses incurred to develop a portfolio of product initiatives, not a specific product. Wrong, the IRS said, disallowing estimates of R&D expenses. Many months and headaches later, Allied's owners, organized as a Subchapter S corporation—wherein taxable income from the business passes through to its individual owners' tax returns—settled with the IRS. Today, Stokey is not sure his company's legitimate attempt to “take advantage” fully of this one element of the tax code was worth the effort.
In late December, Congress and President Obama enacted a comprehensive tax bill that temporarily extended existing tax rates, exclusions and credits. But tax experts across the ideological spectrum say that, despite the emergency extensions, the nation's tax system is dangerously dysfunctional—retarding economic growth, wounding America's global competitiveness and failing at its primary task—to pay for government services. As Obama and Congress in the new year confront economic stagnation and mounting federal debt, they would do well to keep Allied Drill & Engineering and manufacturers like it in mind.
In the United States and Canada, industrial innovation and export expansion are central to economic growth. Tax policy can help. Canada, acknowledging that innovation historically took a back seat in its resource-based economy, has taken steps to improve the tax climate for its entrepreneurs. Innovation is a historical cornerstone in the United States, but capital intensive manufacturers, especially small and medium-sized manufacturers, have special reasons to be worried about the tax climate as they try to compete globally.
“We have to express our frustration at whether or not our government really wants manufacturing in the United States,” Stokey says.
In ranking nine “ease of doing business” factors that affect typical medium-sized companies in 183 nations, the annual World Bank study released last November found that the U.S. tax system was by far the most detrimental factor in overall U.S. business competitiveness; worse than in Canada, the United Kingdom, South Korea, Singapore and numerous other global competitors. The United States ranked fifth overall for its business climate. But its tax policies ranked it 62nd, tied with Uganda. All of America's major trade competitors, except Japan at 112 and China at 114, ranked higher on the tax climate favorability score.
Canada ranked 10th in the “paying taxes” category. The all-in tax rate as a percent of profits for a medium-size business in Canada was 29.2% in 2010, compared with 46.8% for a comparable company in the United States.
The U.S. top statutory tax rate on corporate income—35%—not only pushes business activity overseas, as competitors trim their corporate taxes. It also deepens the gap between the interests of giant multinational corporations and those of smaller companies that generate the majority of U.S. jobs.
In its 2009 annual report to shareholders, for example, General Electric Co. boasted, “Our consolidated income tax rate decreased from 2008 to 2009 primarily because of a reduction during 2009 of income in higher-taxed jurisdictions.” One element of GE's tax strategy: indefinitely reinvesting prior-year earnings outside the United States, a strategy largely unavailable to the core of American manufacturers.
“We manufacture everything in Ohio and sell it all over the world,” Stokey says. But the company hasn't established an off-shore tax haven. That means Allied and thousands of companies like it are exposed, more than GE, to the negative American tax regime.
The U.S. income tax will be 100 years old in 2013 (2017 in Canada). Few people will celebrate, because few people enjoy paying taxes. But the current tax climate is particularly difficult for small and medium-sized manufacturers for several reasons:
- Many U.S. manufacturers face a higher effective corporate tax rate than their competitors in Canada and elsewhere. This is true for traditional corporations, paying at the corporate income tax rate, and S corporations, many with shareholders who pay at the top individual tax rate. Most American trade competitors, except Japan, have lowered corporate tax rates in recent years.
- In their proposal to cut the corporate income tax rate to stay globally competitive, the Obama administration and its deficit-study commission, headed by Erskine Bowles and Alan Simpson, pushed to make the cut revenue-neutral by broadening the business tax base. In particular, the administration, in its 2011 budget proposal, proposed barring last in, first out (LIFO) inventory accounting to compute taxable business income—a move that falls most heavily on manufacturers and distributors.
- Small and medium-sized manufacturers have less access to sophisticated debt-finance strategies, including so-called junk bonds and exotic debt/ equity hybrid instruments, used by larger companies to finance operations. Interest on debt obligations is tax-deductible, but returns on equity investments are not. Moreover, smaller companies have less access to capital infusions from tax-exempt pension funds and endowments, leaving their equity more exposed to capital gains taxes and Chapter S income taxes.
- Manufacturers based in nations that finance government services with value-added taxes (VATs) on businesses and consumers, a popular way to tax consumption instead of income, often enjoy a tax advantage over U.S.-based manufacturers in global trade.
Because of their relatively small size, most manufacturing businesses pay a greater portion of their revenues as tax compliance costs than large companies. The economies of scale in tax and regulatory compliance costs are rarely addressed in tax policy debates.
Small manufacturers, which typically operate in highly competitive markets with low after-tax profit margins, could make a major contribution to the upcoming debate on fiscal policy. Permanent tax cuts for such companies, research shows, could yield more substantial economic growth than tax cuts for wealthy individuals.
In the late 1970s, economist Arthur Laffer and conservative politicians promoted the Laffer Curve, which demonstrated, in theory, that cutting tax rates may increase tax revenues for the government. At that time, the top tax rates were 70% for individuals and 46% for corporations.
“Business investment and business economic activity is much more sensitive to tax rate changes in the current range [of tax rates] than are individual decisions to work or not work relative to the personal income tax,” says Jeremy Leonard, a Montreal-based economic consultant to the Manufacturers Alliance/MAPI, based in Arlington, Virginia.
Yet, like the tax experts, managers in the U.S. manufacturing sector are not optimistic about the prospects for political attention to their particular tax situation.
“We all understand that tax policy needs to provide for investment, and the aluminum industry needs investment,” says Thomas Brackmann, president of Nichols Aluminum Co. in Davenport, Iowa. “But the chance of having a clear policy emerge out of Congress is problematic.”
“I think tax reform is really urgent because we know we're in a slow recovery; and you can get almost 1% a year [worth of economic growth] out of fundamental tax reform,” says Kevin Hassett, a senior fellow and director of economic policy studies at the American Enterprise Institute in Washington, D.C. “If you think we're going to have a [bad] decade, then the way to not lose the decade is to have fundamental tax reform.”
Hassett suspects a reduction in the maximum U.S. corporate income tax from 35% can be achieved in a few years. But he is less optimistic about comprehensive reform of the way businesses are taxed.
“We're more than likely headed for a crisis,” says tax law professor Daniel Shaviro, a left-leaning tax expert and professor at New York University School of Law. “I don't see tax reform as an urgent issue [in Congress].” In his 2009 book, “Decoding the U.S. Corporate Tax,” Shaviro says U.S. business tax policy is built on pillars of sand: “It resembles a ramshackle mansion erected by multiple builders whose work was crudely joined together once the pieces were almost complete.”
Washington watcher Michael Williams, managing director of public policy in the Americas for Credit Suisse Securities, agrees. “For the next two years I think that gridlock is going to reign,” he told the annual economic forecast conference of the Metals Service Center Institute last fall. “There will be a tremendous amount of political posturing, and some good ideas will be left at the side of the road.”
Statutory Tax Rates on Business
Among major industrialized nations, the top combined U.S. corporate tax rate (federal and state) rate, at 39.3%, is second only to Japan, at 39.5%. Cutting corporate tax rates has been the trend among U.S. trading partners in recent years, while the U.S. rate has remained stable.
Nonetheless, the urge on Capitol Hill to cut the top U.S. corporate tax rate is muted in part by the fact that major multinational companies have numerous ways of avoiding it. Indeed, collections of corporate taxes from traditional corporations, known as C corporations, have been declining since World War II, both as a share of federal tax revenue and as a share of GDP.
In 1946, corporations paid 30% of total federal taxes. In 2009, the rate was 6.6%. The decline reflects a gradual reduction of corporate tax rates, a tightening of pretax profit margins as global competition increases and the ability of multinational corporations to choose not to pay the U.S. corporate tax.
Many smaller companies have escaped the corporate tax, as well, although not the top tax rate of 35%. An important factor in declining corporate income tax revenue was the Tax Reform Act of 1986, introduced by President Reagan. Congress imposed a new maximum tax rate on individuals of 28% (starting in 1988), down
from 50%, and 34% for top-earning C corporations, down from 46%. For the first time, the top individual tax rate was less than the maximum rate on corporations.
Afterward, many small and medium-sized companies shifted their business charters to the S corporation form, meaning that their company's pre-tax income would pass through to the
shareholders' individual tax returns. S corp companies are limited to 100 shareholders. S corp tax receipts are not counted by the Treasury Department as corporate tax revenues, but rather as individual tax revenues.
“Once the rates flipped, there was no reason why anyone in their right mind would want to be in the C corp form, unless you had to be because you wanted to access capital markets,” says Peter Merrill, a principal in the Washington-based national tax services office of PwC. “We're at rate parity now, but if you do distribute dividends [as a C corp] you have the double tax.”
The S corp phenomenon means that the owners of many U.S. manufacturing companies are far more interested in personal tax rates than corporate tax rates. The National Association of Manufacturers estimates that about 73% of U.S. manufacturing companies are organized as S corps or other entities taxed at the individual rate. The Treasury Department calculated that S corp and other flow-through revenue businesses accounted for 30% of all business taxes paid.
It's not surprising, therefore, that S corp entrepreneurs were a critical factor in the debate over extending the so-called Bush tax cuts on highincome individuals.
The Business Tax Base
The business income tax burden is a function of tax rates and the tax base, the source of income against which the rate is applied. The idea of broadening the business tax base by eliminating deductions, credits and other preferences has percolated in Congress for years, under Republican and Democratic administrations.
In 2007, for example, the George W. Bush administration proposed several steps to “improve the competitiveness of the U.S. business tax system for the 21st Century.” Among them was “broadening the tax base by eliminating all special provisions.” The largest three tax preferences for elimination were the 3% Section 199 deduction for U.S.-based manufacturing (known as the U.S. production activities deduction); the R&D tax credit, also known as the research and experimentation (R&E) tax credit; and accelerated depreciation and expensing of capital investments.
The Bush Treasury Department estimated that killing these tax preferences and others used by business, including corporate charitable gift deductions and an exclusion of interest on life insurance savings, would yield $1.3 trillion over 10 years and enable the government to cut the corporate tax rate (and corresponding individual tax rate for S corps) to 28%.
Propagating the “pillars of sand” image of the U.S. tax system, President Bush instigated the Section 199 domestic production deduction just three years earlier in the 2004 American Jobs Creation Act. The Obama administration has proposed repeal of Section 199 for U.S. oil and gas companies, prompting howls of protest from energy companies.
“A corporate rate cut would probably have a fairly uniform impact across companies but the (base-broadening) offsets to pay for it are often concentrated, so it does create winners and losers,” says Merrill. “That's why revenue-neutral tax reform is very challenging. The losers tend to complain a lot more loudly than the winners cheer.”
Overall, economic consultant Leonard says, “The holes in the tax base disproportionately benefit manufacturers, which in the practical competitive sense is a good thing, because it keeps their effective tax rate lower, but from an economic perspective it makes the tax system less efficient.”
In particular, the use of last in, first out accounting, a practice not employed by most U.S. trading partners, is a significant and symbolic tax preference for manufacturing “that has helped keep the effective tax rates lower than companies in other sectors,” Leonard says.
“LIFO makes much more sense because it's more reflective of current market conditions,” says William Hickey, president of Lapham-Hickey Steel in Chicago. “What we see in these massive swings in prices in steel in the last few years is that LIFO has been beneficial in truly reflecting the marketplace. It gives you a much better balance.”
Debt vs. Equity Financing
Nobel Prize-winning economist Merton Miller often equated financing a business with slicing a pizza. No matter how many slices, representing various forms of debt and equity, the size of the pizza (the value of the company) is the same, he reasoned. Moreover, the business has to make enough money to cover its overall cost of capital, whether equity or debt.
Still, for decades, the U.S. tax code has favored companies that finance their activities with debt. That's because interest paid for bank loans, commercial paper, notes and bonds is tax deductible as a business expense. But the returns to stockholders necessary to attract equity finance are not deductible and may be subject to double taxation when investors receive stock dividends and capital gains on the sale of shares.
To illustrate the extreme case of debt vs. equity financing, the Treasury Department has estimated that a hypothetical investment financed strictly by debt would result in a negative marginal tax rate (in effect, a tax refund) of 2.2%, while the same investment financed only by equity would carry a marginal tax rate of 39.7%.
Finance professor Aswath Damodaran of the Stern School of Business at New York University, using data on 7,036 publicly traded companies by industry group, calculates that the average debt-to-capital ratio is 33.3%. The ratios range widely among industry groups: 23.5% for steel companies, 75.3% for financial service companies; 31.8% for machinery manufacturers; 7.5% for semiconductor manufacturers; and 60.7% for auto and truck manufacturers.
These figures do not reflect the capital structure of non-listed businesses that have less access to global stock and bond markets. Nor do they reflect unwillingness of banks to lend in recent years or an IRS ruling in 2008 that complicated the ability of S corporation shareholders to lend money to their businesses.
Heavy reliance on debt magnifies the riskiness of any business. But in recent years, exotic financial instruments that offer the tax advantages of debt have emerged on Wall Street. The chief innovation, available to publicly traded companies, has been high-yield debt securities, also known as junk bonds. Other instruments, including “monthly income preferred securities,” have been designed to be treated as debt for federal income tax purposes but equity for financial accounting purposes, notes tax attorney David Hariton at Sullivan & Cromwell in New York.
Consider two historically prominent Ohio manufacturers: privately held Allied Machine & Engineering Corp. in Dover, Ohio, and publicly held Cooper Industries plc, founded 55 miles to the west in Mount Vernon in 1833.
About the time Allied was attempting to garner a tax break through the R&D credit, Cooper had bigger plans. In 2002, Cooper changed its place of incorporation from Ohio to Bermuda, which has no income tax.
“This change will enhance Cooper's strategic flexibility and our reduced global tax position will significantly increase cash flow—enabling us to further strengthen our balance sheet and better position us to pursue worldwide growth opportunities,” H. John Riley Jr., Cooper's CEO at the time, told shareholders.
Cooper still pays the U.S. corporate rate on American operations. But as a result of the move, its consolidated tax rate from global operations dropped to 23.1% in 2002 from 32.1% in 2001. (In 2009, the company transferred its corporate seat to Ireland, where the statutory tax rate on operating businesses is 12.5%. Its U.S. headquarters is in Houston, Texas.)
At family-owned Allied, on the other hand, “we wave the flag, and we believe in our country,” Stokey says. “The more neutral publicly held companies that simply look at the tax environment around the world and make common-sense business decisions are a better measure of how good or bad our tax policy is, because they simply look at the numbers and then move.”
U.S. manufacturers like Allied, with no inclinations or abilities to shift taxable income offshore, face tax disadvantages not only against their U.S. multinational competitors but also against non-U.S. competition. That's because most U.S. trading partners have adopted a consumption-based, value-added tax (VAT).
When a product manufactured in a VAT country is exported, the tax is forgiven or rebated to the seller, making the export product cheaper than a comparable product sold in the country. But when a product from a non-VAT country, such as the United States, is imported to a VAT country, the tax is imposed on the buyer. With no VAT of its own, the United States cannot respond in kind without running afoul of World Trade Organization free-trade agreements. Economists argue that on a macroeconomic basis, these border adjustments cancel each other out as currency exchange rates change to reflect them. But border adjustments sting, nonetheless.
For example, the VAT in Germany is about 20%. “Since there is no value-added tax in the United States, when you put a $30,000 Ford we make on the south side of Chicago on a boat and ship it to Germany, you have to pay a $6,000 import tax. Border adjustments [under a VAT regime] subsidize exports and penalize imports” in the VAT country, says Hickey, who is among the most active and knowledgeable critics of government policy among metals industry executives.
You can't blame Dan Watson, comptroller at Darcor Casters and Wheels in Toronto, for scratching his head when the subject of taxes comes up. His company pays an accounting firm to prepare income tax filings for its two corporate entities in Canada and the United States, $7,500 for the Canadian return and $2,500 for the U.S. filings. But the U.S. company, incorporated in Delaware, has been dormant for many years.
“Although there is no activity in the company, we have to file federal returns and returns for Pennsylvania, Tennessee and California,” Watson says.
The cost and headaches of tax compliance frequently prompt similar horror stories by businesses around the world. Canada has attempted to reduce tax compliance costs by offering many companies the opportunity to file a single return for national and provincial taxes. “We file one corporate tax return to the federal government, and they administer the portion that is applicable to provinces,” says Watson. “This obviously is simpler than the U.S.”
Research studies compiled by the U.S. Government Accountability Office in 2005 estimated that direct tax compliance costs range from 1% to 1.5% of U.S. GDP per year, which grew at an annual rate of about 2% late in 2010. Indirect costs to economic efficiency—the extent to which taxpayers shift toward less efficient economic behavior to avoid taxes—are nearly impossible to quantify but are “likely to be large,” the GAO reported.
The World Bank study estimates that a typical company employing 60 individuals in Canada spends 131 hours a year in tax compliance efforts, compared with 187 hours in the United States. Still, compliance complaints rarely enter into government policy discussions of tax reform in the United States.
“People have adapted to the complexity,” says PwC's Merrill. “The cost of compliance weighs much more heavily on small business than big business. There are tremendous economies of scale in tax compliance. But if you offer a taxpayer the choice, increase your taxes and dramatically simplify your tax return, or reduce your tax burden 2% and increase the complexity, 99% of tax payers would say I'll eat the complexity. I want the lower tax. You don't really have anyone at the table who's arguing for simplicity.”
For most manufacturers, the cost of complying with environmental regulations exceeds the cost of tax compliance, says the 2005 study by the U.S. Small Business Administration. At manufacturing companies employing 20 to 499 workers, the annual cost per employee of environmental regulations was estimated at $4,970; the per-employee cost of tax compliance was $1,030. Economies of scale drove per-employee compliance costs at manufacturers down for companies with 500 employees or more—$3,391 for environmental rules and $767 for taxes.
The Way Forward
Given the importance of manufacturing and exports to the economic futures of the United States and Canada, tax-based disincentives for manufacturing growth seem like logical objectives in tax debates in Washington and Ottawa. But they aren't, for several reasons.
In Canada, progressive taxation of business has been a popular political theme for years, making business executives reluctant to tamper with their good fortune by seeking more tax relief and others convinced that it's time to halt or reverse the business tax reform process in favor of social needs.
“For the last 10 years there has been a consensus in both major parties that lower corporate tax rates are a good thing because it allows companies to produce more and create more jobs,” says Montreal-based economic consultant Leonard. A major thrust of Canadian business interests is renewing or enacting tax incentives to spur industrial innovation.
“Our investment rates in [information technology] are much lower on a per-capita or percent of GDP in the manufacturing sector,” says Leonard. “That's a perennial problem in Canada.”
Canadian Manufacturers and Exporters, a business group, urges an extension of temporary investment write-offs enacted during the recent recession and a reformulation of the nation's scientific research and experimental tax credit to be refundable tax credits, rather than a credit against taxes owed. “Our issue, as for other struggling manufacturers, in the last two years has been cash flow,” says Darcor's Watson. “You need the cash flow to pay for these investments or available credit from the banks. If you do not have the cash flow or banks that are willing to lend for capital investments, you cannot do it.”
In the United States, manufacturing companies that seek a more rational, globally competitive tax system for business face at least two obstacles in Washington.
First, the idea that lowering the manufacturing tax burden to stimulate growth that leads to greater tax revenues, in line with the Laffer Curve, is a hard sell. The current White House, like those before it, wants to repeal tax preferences for business as a new source of revenue. Administration officials have in their favor the widely accepted view that broadening the tax base by trimming preferences is sound economic and fiscal policy.
Second, the political pressure to focus on reductions in government could be a roadblock to tax reform. Any effort to shift the U.S. tax system from income-based taxes to consumption-based taxes could falter because VAT is too efficient for some. “But the argument from the right against it is that it's actually too efficient a revenue raiser, a money machine, that will eliminate pressure against Leviathan,” Merrill says. “The argument from the left is that it's regressive.”
Many Republicans adopt the view of the late President Ronald Reagan, who noted in 1985 that a VAT is imposed at each stage in a product's manufacturer as well as a retail counter. “A value-added tax actually gives a government a chance to blindfold people and grow in stature and size,” Reagan said. “It's hidden in the price of a product.”
Other tax reforms are on the table that might help Allied Machine & Engineering Corp. and other manufacturers.
The December tax bill permits 100% of qualified business investments made between Sept. 8, 2010, and Jan. 1, 2012, to be written off as expenses called “bonus depreciation.” In addition, 50% of investments put into service after Dec. 31, 2011, and before Jan. 1, 2013, would receive immediate expensing. The R&D tax credit, which had expired at the end of 2009, was extended to 2010 and 2011. Obama's proposals to make the R&D tax credit permanent, simpler and more generous were not enacted.
In this vein, the U.S. Tax Court, in a case concerning Union Carbide Corp., ruled last year for the first time that the R&D tax credit might apply to R&D costs associated with upgrading manufacturing processes at a company rather than just R&D costs associated with making a discreet product for sale.
The tax court and White House proposals are being eyed by manufacturers as possible steps toward removing pointless distinctions in the tax code and moving toward greater innovation in U.S. manufacturing. Manufacturers in Canada are hoping for a similar outcome.