How corporate America learned to dodge billions in income taxes.

How corporate America learned to dodge billions in income taxes.

How corporate America learned to dodge billions in income taxes.

Moneybox
Commentary about business and finance.
Feb. 14 2003 4:15 PM

Higher Profits, Lower Taxes

It's not just Enron that's been dodging corporate income taxes. The rest of the Fortune 500 has been duping the IRS, too.

The latest Enron outrage appeared in yesterday's three-volume, 2,700-page congressional report on the corrupt energy trading company. Congress found that while Enron reported billions of dollars of profits to shareholders in the years before it imploded, it paid no federal income taxes between 1996 and 1999 and just $63 million in 2000 and 2001.

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Enron was certainly an outlier in tax avoidance, but it reflects a broader trend. For all big businesses whine about high federal corporate income taxes, they don't pay very much of them.

Back in 1977, according to a paper by Harvard Business School's Mihir Desai, the corporate income tax provided nearly 20 percent of the government's on-budget revenues (i.e., excluding taxes paid into the so-called Social Security trust fund). But in 2001, it accounted for just 10.2 percent of on-budget revenues. If you calculate corporate income taxes as a percentage of all federal revenues—including Social Security taxes—corporations contribute even less to the national fisc. In 1997, corporate income taxes provided about 12 percent of total revenues—$188.67 billion out of $1.578 trillion. But that contribution fell to 10.1 percent in 1999 and to 8 percent in fiscal 2002, when corporations paid just $148 billion in income taxes. In other words, between 1997 and 2002, corporate income taxes fell 21 percent in real terms, and their contribution to overall revenues fell 33 percent. (The data is drawn from the highly useful Treasury Monthly Statement.) (Corporations also contribute to the national balance sheet by paying a portion of payroll taxes.)

Of course, tax receipts should decline if corporate profits fall, as they have in recent years. But as Desai notes, "The recent decline, beginning in 1996, is puzzling given the coincident economic expansion."

The culprit turns out to be a growing divergence, beginning in the mid-'90s, between book income (the profits companies report to shareholders) and tax income (the profits they report to the Internal Revenue Service). In 1993, at firms with more than $250 million in assets—which pay the overwhelming majority of corporate income taxes—the two figures were rather close. Such companies claimed $1.12 in book income for every dollar in tax income. But Desai shows that the ratio rose in each of the following five years so that by 1998 large companies were reporting $1.63 in book income for each dollar of tax income. That year, in fact, tax income fell 10.8 percent while book income rose 0.8 percent. In dollar terms, the gap between the two figures rose from $37 billion in 1993 to $172 billion in 1996 to $247 billion in 1998.

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Why would book income and tax income differ at all? Well, wrinkles in the tax code allow corporations to count depreciation and foreign source income differently in the two measures. Another culprit is options. Companies deduct from their taxable income the difference between the strike price of an option and the market price of the stock at the time of exercise but don't necessarily deduct it from the book income they report to shareholders. So in the late '90s, when insiders cashed out big-time, the rampant options exercise lowered taxable income. According to Desai, from 1996 to 2000, the proceeds from option exercises in the largest companies amounted to more than one-quarter of operating cash flow. These actions didn't necessarily drain tax revenues from the government. For when individuals exercised options, they owed personal income taxes on the gains they realized. However, if executives then move to shelter hundreds of millions of dollars of this option income from taxes, as Sprint Chairman William Esrey is reported to have done, it's another story.

But that's not the whole story. According to Desai, in 1998, "more than half of the difference between tax and book income—approximately $154.4 billion or 33.7 percent of tax income—cannot be accounted for by these factors." He concludes that the increasing use of tax shelters by large companies in the late '90s could explain much of this gap.

Indeed, a chart in yesterday's New York Times suggests that, while most large firms aren't avoiding taxes to the obscene degree Enron did, they're certainly taking evasive action. In 1999, companies with $250 million in assets or more had a real tax rate of 20.3 percent—sharply lower than the 35 percent statutory rate. Smaller companies, those with between $25 million and $100 million in assets, paid federal income taxes at about a 36 percent rate.

What do these numbers show? It could be that the government is not so greedy when it comes to large corporations. More likely is that the sort of tax avoidance that Enron elevated to an art has become part of the package of tools that companies use to manage their earnings. And the bigger you are, the more likely you are to evade aggressively—hiring accounting firms, lobbyists, and lawyers; setting up subsidiaries in the Cayman Islands; etc.

Congress may have enough resources to investigate one Enron that is slyly ducking its income taxes, but it certainly doesn't have enough to investigate a whole Fortune 500 that is doing the same.