Skip to content

Jay Cost: Political Corruption Is Why Our Tax Code Is A Mess

SIGN UP FOR OUR NEWSLETTER

Editor’s Note: This is an excerpt from Jay Cost’s new book “A Republic No More: Big Government and the Rise of American Political Corruption,” which is available now at Amazon.com.

With a new, all-Republican Congress now seated for the first time since 2007, tax reform is once again a top issue. House Ways and Means Chairman Paul Ryan — the GOP’s most valuable legislator — has made it a priority.

Tax reform is long past due. Almost everybody agrees that United States’ corporate tax code is an embarrassment. Inefficient and unfair, it distorts the free flow of capital from its most useful destinations, and showers indefensible benefits upon politically connected businesses. Bipartisan reform that broadens the base by closing loopholes, coupled with an across-the-board lowering of rates, would benefit the nation enormously.

Unfortunately, near-universal consensus is not enough. In truth, tax reform is hotly opposed by important agents. First, there are the interest groups that lobby hard to get tax loopholes embedded in the law. Second, there are the professional politicians, especially in Congress, who abuse the taxing power to extract campaign contributions, public support, and cushy jobs for when they leave office. These agents worked hard to create our mess of a tax code; they will work twice as hard to keep it that way.

Thus, the main challenge for reformers is not so much ideological conflict, partisan gridlock, or public indifference. Rather, the impediment is best understood as political corruption — or politicians who put narrow factions of interest groups ahead of the public good. If tax reform is (finally) going to become a reality, reformers have to treat the problem accordingly.

****

Public support of private business has a very august pedigree in our nation. No less an eminence than Alexander Hamilton laid out the original case for why the federal government in particular should worry about economic development. In the Report on Manufactures (1791) Hamilton proposes lending public assistance to the search for private profit, in the belief that, over the long run, the benefits would accrue to society at large.

Today, both political parties essentially adhere to this view. Though the partisan rancor often generates a lot of heat, the main difference between them has more to do with emphases rather than first principles. Republicans prefer to expand programs like the Small Business Administration; Democrats like investments in green technology.

On paper, this often reads as noble and quite high-minded. Hamilton’s prose in the Report is the literary embodiment of earnestness, and the quadrennial platforms of the Republican and Democratic parties brim with confidence about all the great ways they can develop the economy.

However, in practice Hamiltonian economic stimulus lends itself to corruption. Our government can never quite live up to Hamilton’s ideal. It is simply not capable of selecting economic winners in a socially responsible manner.

And yet Uncle Sam continues to try, blithely assuming that he can do something that in fact he cannot. Nowadays this means that government support of business creates a wide-ranging, patchwork, and occasionally bizarre system of corruption. That is, under the guise of developing the economy in general, it has wasted untold billions of dollars funneling money to politically well-placed factions that offer a questionable return on the investment.

The tax code, through tax expenditures and leakage via aggressive tax sheltering, amounts to the largest kind of corporate payoff with the most far-reaching effects.

****

Corporate tax expenditures have been roughly constant, at least when measured as a share of GDP for the last thirty years. In 1985, they were nearly 2 percent of GDP; they fell to 1 percent in 1988 and have more or less remained there ever since. This is good news, but only in a modest sense. The Tax Reform Act (TRA) of 1986 eliminated only the most politically vulnerable expenditures. Many still remain—more than eighty according to the Government Accountability Office, at a total annual cost of about $150 billion in foregone revenue—and many are of dubious social value. A few of the minor expenditures are quite eye-popping for their absurdity:

  • The “Apple Loophole” allows U.S. multinationals to defer taxes on certain passive incomes like royalties earned by foreign subsidiaries. By creating subsidiaries in Ireland, the Netherlands, Luxembourg, and the Virgin Islands, Apple has used this to reduce its tax burden substantially.
  • In 2004, Congress allowed a complete write-off of the purchase price of a professional sports team in just fifteen years. This prompted one wag to joke, “Does a sports franchise depreciate in value?” Of course not. It is merely a payoff to franchise owners.
  • The Historic Preservation Tax Credit offered $27 million for investors to fund a microbrewery at an old Coca-Cola plant in St. Louis.
  • Hollywood can deduct up to $15 million to produce television episodes where 75 percent of the compensation is for work done in the United States.
  • Logging companies can deduct up to $10,000 in reforestation expenses per unit of property. This may not sound like much, but its estimated ten-year cost is $4.8 billion.

Tax breaks like this make for good headlines when one wants to write about the absurdity of the tax code. Still, they are not the main drivers of the corporate tax expenditure budget. The most expensive, far and away, is accelerated depreciation. It accounts for more than 40 percent of all corporate tax expenditures. Businesses are allowed to deduct the cost of machinery, software, buildings, and more at a rate much faster than they actually lose their value. Thus, it amounts to a subsidy for businesses, particularly capital-intensive ones. A review of extant scholarly studies conducted by the Congressional Research Service concludes that bonus depreciation “in general is a relatively ineffective tool for stimulating the economy.”

Accounting for about 20 percent of corporate tax expenditures is the foreign income exclusion. Foreign income is subject to U.S. income tax when it is repatriated through payment of dividends to the parent corporation, minus a credit for taxes paid overseas. In some sense, this is necessary to create a fair tax base—corporations should not have to be taxed twice (once by the United States, once by a foreign government)—but this has become the backbone for expansive schemes to avoid any and all taxation.

Accounting for about 5 percent of total corporate tax expenditures is a research tax credit. In theory this may be a good idea, but research is an ambiguous concept in the tax code. Creative accountants have helped corporations take advantage of this, for instance by redesigning food wrappers and calling the effort research.

Finally, accounting for 3 percent of corporate tax expenditures is the active financing loophole, often called the “GE Loophole.” This allows corporations to defer taxes on some financial income that was really earned in the United States, but was shifted overseas. It is called the GE Loophole because GE’s financing arm, GE Capital, makes such heavy use of it.

One study from the Tax Foundation concludes that of the estimated $150 billion spent on corporate expenditures in 2014, about $45 billion was properly corporate welfare, or subsidies to corporations. The rest was spent to make the code more neutral toward different types of income.

But the trouble does not end there. In fact, the GE and Apple Loopholes point to a much bigger problem in the tax code, which the conventional understanding of tax expenditures only captures to a limited extent. That is, multinational firms can move profits around overseas to avoid paying federal taxes. In theory, corporations should not have to pay taxes on income earned overseas; they should pay it to the foreign government under which it was generated. Yet multinational companies use a whole host of artifices and tax shelters to shift domestic profits overseas. Meanwhile, it is virtually impossible for the federal government, with its existing tax laws and enforcement assets, at any rate, to assess how much is actually owed.

This problem is often called leakage, and it could cost up to another $150 billion in lost tax revenue per year. By most accounts, it has gotten worse over the last twenty years. In particular, there has been a marked increase in corporate tax sheltering practices. Multinational corporations create shelters that span the globe, often housing money in countries like the Cayman Islands that are actively seeking tax refugees.  A recent study found that a handful of tiny countries book profits from U.S. subsidiaries that dwarf their GDP. Profits booked in Bermuda amounted to 1,643 percent of its GDP; in the Cayman Islands, 1,600 percent; in the Virgin Islands, 1,102 percent; in the Bahamas, 123 percent; in Luxembourg, 106 percent; and in Ireland, 42 percent. Moreover, a 2011 investigation by the Senate Committee on Homeland Security and Governmental Affairs found that roughly half of the more than $500 billion in corporate earnings housed overseas was in fact invested in domestic financial institutions.

****

Tax experts have been complaining about this kind of spending for nearly a century. As early as the 1920s, they were warning about various forms of leakage in the tax code. There were similar complaints in the 1940s, ’50s, ’60s, and ’70s, with various, unsuccessful attempts to reform the code. Today, just a quarter century after the TRA, experts are saying once again that the tax code needs to be rationalized.

So, if the tax code is an unfair, inefficient, and socially harmful mess that almost every disinterested expert has despised for nearly a century, why has it not been substantially reformed? The answer is the same reason so many of the policies that we have studied persist: political corruption. In fact, tax expenditures are a way to tinker with the tax code to favor factions in society: the government sets broad-based rates that it largely leaves unchanged over the decades, then sets up exceptions for well-placed interest groups. This is more important to our government than creating a fair, efficient tax code.

The principal culprit here is Congress. The legislature can choose to delegate responsibility to the bureaucracy, and has often done so on other matters, but it has retained primary authority over the income tax code because it is so politically useful. It is a noticeable and direct way to funnel money to preferred interest groups, which realize immediately that they have received a bounty and can easily credit Congress for securing it.

Moreover, the balance of pressures placed upon Congress is uniquely tilted toward favoritism. In the field of industrial regulation, for example, there is often a battle between environmental groups and industry groups. This is far from a guarantee that the public interest will prevail, but the competition is at least helpful for that purpose. There is really no such competition over taxes. When Congress elects to give an industry a special tax break, who really loses? The public at large, but in such an indirect and imperceptible way that nobody really notices, which means there are no interest groups that emerge to oppose the payoff. There are public-spirited groups that fight for tax reform—think tanks like the Heritage Foundation on the right and Citizens for Tax Justice on the left—but they are seriously out-matched.

To see how influence peddling works in practice, consider the fight over the Economic Recovery Tax Act of 1981. Campaigning in 1980, Ronald Reagan advocated lower income tax rates for all payers, believing that this would help producers create more and investors better direct capital to productive ends. Business-specific corporate tax expenditures (or loopholes) were not at the top of his list; however they were a major priority for corporate America. It organized aggressively during this period to expand the investment tax credit created during the Kennedy years and also to speed up (already accelerated) depreciation. The famed Carlton Group, formed in 1978, was a loose collection of lobbyists that included the business community’s heaviest hitters. It met every Tuesday morning at the Sheraton-Carlton Hotel in Washington to plot strategy on how to enact its 10-5-3 proposal, which would reduce the timeframe of depreciation to ten years for buildings, five years for equipment, and three years for vehicles.

Reagan quickly found himself embracing new corporate tax expenditures. The reason was that congressional Democrats, led by House Ways and Means Committee Chairman Dan Rostenkowski, were drafting an alternative tax plan that did not reduce rates as much as Reagan wanted; rather, it was extremely favorable to businesses with its tax expenditure policies. Reagan had no choice but to counter the offers made by House Democrats, and soon both sides were locked in a bidding war for industry support. Eventually, congressional Democrats, belying their claims of populism against Reagan’s elitism, actually offered full expensing for business equipment. As Boston University political scientist Cathie Martin puts it: “Corporate tax benefits … became the medium of exchange for buying legislative support … [S]pecial interests played an extremely prominent role and more concessions were made than usual.”

Thirty-five years later, precious little has changed. Today, members of Ways and Means are thoroughly lobbied and showered with generous campaign cash. As of July 20, 2014, in the 2013–2014 election cycle, for instance, the average Ways and Means Committee member had already received $1.3 million in contributions from political action committees and individuals, more than any other average member on the other committees. This money does not go to waste. A team of researchers led by Matthew D. Hill of the University of Mississippi recently took a look at the influence of lobbying on corporate tax bills. They find “corporate tax lobbyers exhibit lower effective tax rates and greater book-tax differences.” In other words, these corporations are not wasting their money.

Money is but one piece of the puzzle. In 2014, House Ways and Means Committee Chairman Dave Camp released a tax reform proposal that was not expected to go anywhere during the 113th Congress, and yet it drew heavy attention from tax lobbyists. Similarly, a battle in 2014 to extend various business tax expenditures (like the GE Loophole) drew what one think tank calls an “army” of lobbyists. On the extender bill alone, 1,359 lobbyists attempted to contact members of Congress or their staff 12,378 times; 58 percent of these lobbyists had previously worked somewhere in the government.

****

This may just be “the way things work,” but it is not the way things are supposed to work. The Framers designed our government to place the public interest ahead of private, parochial concerns. When government behaves to the contrary, it is acting corruptly. The fact that we are inured to this misbehavior is merely an indicator that our tax code has been corrupt for a very long time.

So yes, reforms are overdue, but reformer cannot underestimate the challenge that they face. The divide is not primarily ideological. After all, the left and right came together for tax reform in 1986. Rather, the point of conflict is between the advocates of special interests and the rest of us. This is a fight, frankly, that the special interests usually win.


Comment count on this article reflects comments made on Breitbart.com and Facebook. Visit Breitbart's Facebook Page.