Robert Iger, CEO of the Walt Disney Company (DIS), complained recently that the entertainment company’s income taxes are just too high. “It doesn’t mean that companies shouldn’t pay taxes, but I think the structure is off,” he said.
It would be easy to dismiss Iger’s words as just another self-serving gripe by an American CEO who doesn’t want to share in the burdens of supporting the United States of America, especially since he said nothing about reforms. That would be a mistake.
Corporate Tax’s Prosperity Mandate
Disney’s situation illuminates how America’s corporate income tax is failing to achieve any of its purposes, which are not limited to raising revenue.
One of the most important purposes of the corporate income tax, when Congress adopted the levy in 1909, was fostering prosperity. That may seem strange today when decades of anti-tax rhetoric have conditioned Americans to think of taxes as damaging to the economy—even as a form of legalized theft—instead of understanding, as the founders did and Congress did a century ago, that taxes are the foundation of our wealth and our liberties.
The original corporate income tax law encouraged economic growth and general prosperity by making sure risk-averse corporate owners and managers did not stuff profits into a mattress. The law imposed a penalty tax on excessive levels of liquid assets, a penalty levied on tens of thousands of mostly small or closely held businesses.
To avoid this penalty, companies earning robust profits need only pay dividends to owners, invest in new plant and equipment, or pay more to workers. That is, they had to put the money to work, not let it idle.
The key was that middle option—reinvesting profits to grow the business, which also meant creating more jobs in the 20th Century industrial economy.
Because investments in factories, machinery and lab equipment are tax-deductible, it means Uncle Sam shares in the cost of these investments. The higher the corporate tax rate, the smaller the after-tax cost of new investments; the lower the rate, the more owners bear the cost of reinvestment and the more likely they are to withdraw money for their personal pleasure.
How Corporate Taxes Work These Days
Today we see the result of policies that encourage withdrawal rather than reinvestment. Incomes at the top have exploded while 90% of Americans report an average income that, adjusted for inflation, is at the level of the mid 1960s. At the top, his-and-her jets—including a few personal jumbo jets—and multiple mansions abound.
The corporate income tax was also originally intended to create a level playing field with all profits taxed equally. As the old tax saying goes, Congress should tax the profits on chips without regard to whether they are microchips or potato chips.
That’s not how the corporate tax works these days, thanks to innumerable provisions that hardly anyone outside of tax specialists knows about, something Iger mentioned in passing. Disney’s taxes can illuminate what has gone wrong with the tax system in America.
Congress lets some big multinationals earn now, but pay their corporate income taxes by and by, under a single line added three decades ago to Section 531 of the Internal Revenue Code. This line encouraged companies to move their intellectual property offshore and to then pay royalties to their offshore subsidiaries, which converts taxable profits earned in the U.S. into tax-deductible expenses that that, once moved offshore, are taxed lightly or not at all.
In effect Congress loans these corporations the taxes they defer at zero interest. By investing the proceeds of these de facto government loans, the burden of the income tax is converted into a source of profit that grows and grows thanks to the magic of compound interest.
Taxpayers, who do not benefit from these zero interest loans, bear the cost of them. These untaxed profits are often invested in Treasury bonds. That means Congress not only extends zero interest loans to these lucky multinationals, it then taxes you to pay these companies to keep delaying payment of their taxes.
This system is not simple in practice. Think of it as a Rube Goldberg device.
The Zero-Interest AAPL Harvest
Apple (AAPL) is the champion mattress-stuffer with about $216 billion, most of it untaxed profits held in liquid assets offshore. Instead of being reinvested, which would create jobs at Apple or put money in the pockets of shareholders to invest or spend as they choose, the money passively gathers interest.
How does Apple escape the penalty tax on liquid assets far beyond what the law defines as the reasonable level needed to operate the business? That’s where that one line added to Section 531 comes in—what I call an “asterisk in tax law,” a single line that effectively exempted multinationals from the penalty tax provided they siphoned the profits out of the country and held them indefinitely in accounts with an offshore address.
Apple uses an arrangement based in Ireland to report most of its profits not in Dublin, but in a place called Nowhere. And, of course, since there is no government in Nowhere those profits are untaxed. Thanks to the legal asterisk, Apple’s cash hoard escapes the American penalty tax on excess liquid reserves.
What Apple does is legal. It is the very definition of a loophole, in this case one big enough to hold the equivalent of a dime on every dollar of profit American corporations earned last year. It’s also the economic equivalent of a roughly $76 billion loan from the federal government at zero interest, a form of welfare Congress never explicitly approved.
Apple’s loan is more than four and a half times the amount Congress authorized last year for Temporary Assistance to Needy Families, which helps only a small portion of the more than 6.7 million American households with children living in poverty.
Like Apple, Disney is a multinational, but my examination of its disclosure reports shows no indications it is playing this game. In recent years the company’s cash paid for American corporate income taxes has run close to the federal statutory tax rate of 35% of its profits.
Last year Disney reported worldwide pretax income of $13.9 billion and paid in cash corporate income taxes of $4.4 billion. That’s a cash paid rate of almost 32%.
Disney earned a tiny fraction of 1% of all corporate profits in America, but paid about 1.3% of all the corporate income taxes, my comparison of its financial statements to federal economic data shows.
By revenue, Disney ranked 53rd on the 2015 Fortune 500 list, paying more corporate income taxes in absolute terms and relative to its profits than a number of companies further up the list.
The reason Disney pays relatively high taxes is that it keeps its intellectual property in America, unlike the big drug companies, high tech companies and other companies that own theirs offshore, enabling them to report as tax-deductible expenses—paid to their offshore subsidiaries—profits earned in the U.S. (see America’s Missing $15 Billion in Corporate Taxes).
However, Disney is not using its profits to reinvest in America as much as to buy back stocks (see Walt Disney Stock: A Dividend Analysis). This is a practice Congress needs to limit, as I’ll explain in a future column, because of the damaging effects on economic growth and inequality. All the same, Iger is correct about taxes.
Congress: Listen to Disney
Congress can fix the federal tax code. We need basic reform of our corporate income tax—and cutting rates is not the way to go, in my view. We need a debate about the purposes of the corporate income tax, one that draws on what Congress debated in 1909, also the subject of a future column.
For now, the best thing Congress could do immediately is to heed Iger’s point that the system is ridiculously complex. It should close the loophole that lets some multinationals convert the black ink of profits into, for tax purposes, the red ink of costs and thus escape paying their full tax burden.
Repeal of what I call the asterisk provision in Section 531 of the tax code would help level the playing field and further reduce the federal budget deficit. Congress should include a waiver of the penalty tax for excess liquid assets, provided that the untaxed money offshore is returned within three years, is fully taxed and that the after-tax balance is used to pay dividends (not stock buybacks), to invest in new plant and equipment in the United States, or to pay bonuses to workers.
Doing that would not just put a smile on Mickey Mouse’s charming cartoon face, it would make for greater national prosperity.