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February 7, 1992
"Big Flaw: Corporate Debt is a Tax Advantage"
San Jose Mercury News

By Timothy Taylor
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WHY ARE the relatively popular taxes in decline? When most people are asked about the taxes they would least hate to see increased, taxes on corporations and on items like alcohol and cigarettes usually head the list.

But the corporate income tax has slipped, falling from 4 to 5 percent of gross national product in the 1950s to less than 2 percent today. The Tax Reform Act of 1986 did force corporations to pay a bit more, as is shown by an upward tick on the accompanying chart. Excise taxes -- that is, the taxes on products like cigarettes, alcohol and gasoline -- have slipped dramatically as well, from nearly 3 percent of GNP in the 1950s to less than 1 percent of GNP now.

In 1950, corporate and excise taxes combined raised 46 percent of total federal revenue. In 1992, they will raise only 13 percent. With the federal government in desperate need of ways to reduce the budget deficit, numbers like these should command attention.

While any tax increase hurts, at least excise taxes have the virtue of imposing costs on individuals whose behavior is imposing costs on society. For example, alcohol leads to about 19,000 fatal auto accidents involving drunken driving each year; 370,000 people undergo treatment for alcoholism per year; there are many other alcohol-related injuries and illnesses.

Yet the federal taxes on alcohol will collect only $8 billion next year, surely far less than the social costs created by alcohol use and abuse. Raising the price of alcoholic beverages by 10 percent would lead to a drop in demand of about 7 percent, according to evidence collected by the Congressional Budget Office.

A similar argument can be made for higher taxes on tobacco or on gasoline. A million new cases of lung cancer were diagnosed in 1990, and hundreds of thousands of deaths every year are attributed to tobacco use. Burning gasoline pollutes the air, creating smog and perhaps even a greenhouse effect.

Yet the federal tax on tobacco will raise only $5 billion in 1992, and the gasoline tax will raise only $12 billion, again far less than the costs society is bearing from consumption of these products.

Using a tax to raise the price of cigarettes by 10 percent would lead to about a 5 percent decline in consumption, and more among younger smokers who aren't yet hooked. Raising the price of gasoline by 10 percent would reduce the amount consumed by about 2 percent in the short run, and perhaps 8 percent in the long run.

Excise taxes aren't always politically popular, in part because they do pressure people to change their behavior. On the other hand, the corporate income (or profits) tax is primarily popular largely because many refuse to believe that people, individual consumers, actually pay it.

But corporations are just collections of people, and their tax bill either comes out of what is paid to workers, executives or shareholders, or forces the company to charge more to consumers. Somehow, somewhere, some person pays every dollar of corporate tax. Economic studies have generally found that relatively wealthy shareholders do end up paying the corporate income tax, rather than executives, or the average worker or consumer.

But the fact that shareholders pay much of the corporate tax points out a gaping flaw in the way the tax is designed, a flaw that bears heavy responsibility for the explosion of corporate borrowing and takeovers during the 1980s.

The problem is that interest payments are treated as an expense by the tax code, while profits that are paid to shareholders or reinvested are taxed. As a result, a company can reduce its profit -- and thus its tax bill -- by taking on a lot of debt and paying a lot of interest. Many of the corporate takeovers and buyouts of the 1980s used borrowed money to buy stock, thus benefiting from the tax advantages of debt.

Now that the recession has arrived, though, many heavily indebted corporations are discovering that debts have a problem of inflexibility. When a heavily indebted company can't make its interest payments, it goes belly-up. In fact, the entire economy suffers when indebted companies seek to avoid default on their loans by cutting back on investment and laying off workers. If many of those companies had avoided so much debt, and instead stayed responsible to shareholders, they could have cut back on dividends in these hard times and stayed in business.

The Department of the Treasury has just released a report that analyzes the corporate tax code's bias toward debt, and proposes solutions. One prototype, called the Comprehensive Business Income Tax, would remove the tax-motivated incentives to take on heavy debt, without costing the government any revenue. Even if the government wasn't running a $400 billion budget deficit in 1992, raising excise taxes on alcohol, tobacco and gasoline makes some sense. But under the current tax code, raising taxes on corporations just provides a greater incentive for them to take on more debt. The priority for corporate taxation should not be raising revenue, but reforming the system.

Sunday: The Deficit

Chart shows corporate income taxes and excise taxes as percentages of the gross national product. (Fever chart)

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