The Bane of Corporate Existence: The Corporate Income Tax

The NY attorney general has subpoenaed a dozen private equity firms-including Bain Capital-over their use of a certain tax strategy.  The political motivations here are pretty obvious, so I will leave that as an exercise for the class.  I want to focus on one statement in the article that speaks volumes about the US tax code:

The tax strategy — which is viewed as perfectly legal by some tax experts, aggressive by others and potentially illegal by some — came to light last month when hundreds of pages of Bain’s internal financial documents were made available online.

So different tax experts look at the same strategy and their conclusions run the gamut from “A-OK” (“not risky or even aggressive” in the words of one) to “pushing it” to “lock-’em-up.”

A perfect testament to the dysfunctional arbitrariness of the tax code.  An invitation to spend large amounts on tax advice and tax planning-which is a waste of real resources.  A source of uncertainty and risk that interferes with business planning and distorts resource allocation.  And crucially, a source of discretion for government authorities that they can use to reward favored companies and punish disfavored ones.

Note that the authorities can use the tax code to dragoon those it has targeted even if the likelihood of a successful prosecution is small.  The costs of tax litigation can be immense, and the risks greater.  And there is a profound asymmetry between the government and the targeted company.  If the government loses, no big deal.  Yeah,the prosecutor loses face,  but s/he usually has a way to minimize that.  If the company loses, however, the costs-in dollars and cents, and possible imprisonment-can be very large.  (Note that tax prosecution of political enemies is a favorite tactic in Putin’s Russia, cf. Khodorkovsky.  There’s a reason for that.  It is a very powerful cudgel-or knout, if you will.  It would be naive to think this a uniquely Russian phenomenon.)

The economic case for corporate taxation and capital taxation is dubious even when you abstract from the realities of the tax code. When those byzantine, Kafkaesque realities are considered, it is pretty clear that the deadweight costs of the system are large and that it should be scrapped, or thoroughly overhauled.  Unfortunately, that will never happen because (a) there is a widespread belief that “corporations” should pay taxes as a matter of fairness (a view ironically pushed by those who go ballistic at the notion that corporations are persons on certain legal dimensions), and (b) the tax code got the way it did for political economy reasons, i.e., there are those who benefit from this byzantine provision or that, or who have a competitive advantage in exploiting the complexity of the tax code.

I think it was Milton Friedman that pointed out that tax reform occurs when politicians figure they’ve given out all of the tax breaks they can, they take them away in a tax simplification effort so they can sell the favors again in the future.

The AG’s action gets attention only because of the Romney connection: and arguably, the Romney connection is the only reason for the AG’s action.  But it should get attention for a completely different reason: it demonstrates how arbitrary and subject to abuse the tax system is.

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