Yahoo Evaluating Cash-Rich Split Offs

The Wall Street Journal (sub. required) has reported that Yahoo Inc. is considering a disposition of its stakes in Alibaba and Yahoo Japan through cash-rich split offs. Yahoo owns a 43% stake in Alibaba, a Chinese search engine, and a 35% stake in Yahoo Japan.

The split-off transactions would make Yahoo a more attractive target for a subsequent acquisition by a private equity group or strategic investor (e.g., Microsoft). The market has speculated that Yahoo's complicated relationships with Alibaba and, to a lesser extent, Yahoo Japan, have discouraged potential suitors from offering a marriage proposal.

So what is a "split off" transaction? Why does the WSJ article describe the proposal as a "cash-rich split off" transaction? Can the tax lawyers save the day for Yahoo and its beleaguered long-term shareholders?

Spin Offs, Split Offs and Split Ups

Section 355 of the Internal Revenue Code governs "spin off" transactions, "split up" transactions and "split off" transactions.

• A "spin off" occurs when a distributing corporation (let's call it "Distributing") distributes the stock of a controlled subsidiary (let's call it "Controlled") pro rata to its shareholders. Following a spin-off transaction, the shareholders of Distributing also own stock of Controlled.
  
  
• A "split off" is similar to a "spin off," but with a twist. A "split off" occurs when Distributing redeems shares from one or more shareholders -- but not all shareholders -- in exchange for stock of Controlled. Following a split-off transaction, some of the historic shareholders of Distributing continue to own stock of Distributing. However, other historic shareholders own stock of Controlled. The latter group "trades" its interest in the overall Distributing business for a more direct interest in the Controlled business.
  
  
• In a "split up" transaction, Distributing engages in more than one business, for example, Business A and Business B. Distributing redeems stock from some shareholders in exchange for stock in a corporation that owns Business A. Distributing redeems stock from other shareholders in exchange for a stock in a corporation that owns Business B. Distributing is like the head of the Hydra. Following a split-up transaction, Distributing has disappeared, and its former shareholders go their own separate ways with stock in Corporation A (which owns Business A) and Corporation B (which owns Business B).
  

Yahoo's proposed dispositions of Alibaba and Yahoo Japan would be structured as "split off" transactions. As noted, Yahoo is a shareholder of Alibaba and Yahoo Japan. If the parties implement the "split off" proposal, Alibaba and Yahoo Japan would be the distributing corporations. Alibaba and Yahoo Japan would redeem their stock currently owned by Yahoo in exchange for stock in a controlled subsidiary. Following the transactions, Yahoo would cease to own any shares in Alibaba and Yahoo Japan. Instead, it would own stock in a corporation formerly owned and controlled by Alibaba and Yahoo Japan, respectively.

To qualify under Section 355, the split-off transactions contemplated by Yahoo must satisfy a number of technical conditions. If those conditions are satisfied, the split-off transactions would be non-taxable to the distributing corporations (Alibaba and Yahoo Japan) and to its shareholders (Yahoo itself). Section 355 thus permits a corporation to "shuffle" the form of its investment in a lower-tier corporation, without triggering income tax on any appreciation in the stock of such corporation.

Cash-Rich Split Offs

Now we're getting to the real action. Yahoo may be able to exchange its stock in Alibaba and Yahoo Japan for stock of a new corporation. But what does that accomplish? The market is already penalizing Yahoo for its unwieldy legal structure, which includes large but non-controlling stakes in Alibaba and Yahoo Japan. Would a split-off transaction address the market's concerns?

For Yahoo's shareholders, I have good news and bad news.

Good News

The good news is that Yahoo could effectively "monetize" its investments in Alibaba and Yahoo Japan through a cash-rich split off. By "monetize," I mean that Yahoo could convert its stock in Alibaba and Yahoo Japan into stock of new corporations whose principal assets are cash or other liquid securities. Although each of the new corporations must be engaged in a historic (five-year) trade or business after the split-off, up to two-thirds of its assets may be composed of cash or other liquid securities.

If the parties implement cash-rich split offs:

• Immediately before the split offs, Yahoo would own 43% of the stock of Alibaba and 35% of the stock of Yahoo Japan, respectively; and
  
  
• Immediately after the split offs, Yahoo would own 100% of stock of two new corporations. The first corporation would have a historic (five-year) trade or business formerly conducted by Alibaba, and a bucket of cash or other liquid securities. The second corporation would have a historic (five-year) trade or business formerly conducted by Yahoo Japan, and a bucket of cash or other liquid securities.
  
  
• Then Yahoo's shareholders and its pointed-headed tax lawyers would pop some champagne and haul out their dancing shoes. Well, maybe the shareholders would haul out their dancing shoes.
  

You might be curious whether Alibaba and Yahoo Japan could simply redeem Yahoo's shares for cash. Why does Yahoo need an army of pointed-headed tax lawyers to monetize its investments in Alibaba and Yahoo Japan? Alas, life is not so simple under current U.S. tax rules. The redemption transaction (exchange of stock for cash) would be taxable to Yahoo. Yahoo would incur U.S. tax expense and its after-tax cash proceeds would take a corresponding haircut. So bring on the tax lawyers!

Bad News

Now for the bad news. Unlike a corporation that owns 100% of a business, Yahoo owns a large, non-controlling stake in Alibaba and Yahoo Japan. Yahoo would require cooperation of the boards of directors of each company to implement a cash-rich split off transaction. Each board (including Yahoo's) would have a fiduciary duty to ensure a "value for value" exchange. It might be very difficult to negotiate a valuation that makes everybody happy. That said, if the tax savings to Yahoo were sufficiently material, Yahoo may be able to "share" some of that savings with Alibaba or Yahoo Japan to bridge any gaps in the numbers.

The parties would be required to navigate the various conditions of Section 355. For the most part, those should be manageable. The biggest hurdle would probably be Section 355(g), which was enacted in 2006 to diminish the appeal of cash-rich split offs. Section 355(g) limits the "investment assets" of a controlled corporation to two-thirds of the fair market value of all its assets. For such purposes, "investment assets" include cash and other liquid securities. To comply with the limitations of Section 355(g) any cash-rich split off would need to include material business assets of Alibaba and Yahoo Japan, respectively.

Finally, Alibaba and Yahoo Japan would need to "stuff" the controlled corporation with cash or liquid securities. Such an effort may require external financing, which may or may not be palatable to the directors of Alibaba and Yahoo Japan. The tax tail is not going to wag the dog unless the parties can round up financing to make the cash-rich split off work.

Repatriation?

Another hurdle for Yahoo would involve the repatriation of cash from its new subsidiary companies. Although I can only speculate on the transaction form, Yahoo is likely to own stock in a new foreign subsidiary following a split off from Alibaba or Yahoo Japan. As described above, the foreign subsidiary would have a historic (five-year) trade or business, and a large amount of cash and liquid securities.

If Yahoo repatriates the cash by causing its new subsidiary to pay a dividend, the dividend could be taxable to the U.S. group. Yahoo may or may not have sufficient foreign tax credits to offset the resulting U.S. tax liability. Any limits on repatriation may reduce the attractiveness of the split-off idea.

Alternatively, after the dust has settled on the split-off, Yahoo may be able to liquidate the foreign subsidiary and repatriate cash in the liquidation transaction. Such a liquidation would also be taxable to the extent of the foreign subsidiary's earnings and profits.

In either case, a portion of the distributing corporation's earnings and profits would be allocable to the controlled corporation immediately before the tax-free split off. Under the mechanical allocation rules, the new corporation may inherit a very small earnings pool from Alibaba or Yahoo Japan, respectively. If the earnings pool is small, a liquidation transaction may be a viable repatriation option for Yahoo. In any case, tax nerds and Yahoo shareholders will stay tuned for developments in the Yahoo story.

* * * * *

For more on cash-tax split offs, two articles by the ubiquitous Robert Willens are worth a read. See "Liberty Media and News Corp. Will Be Parting Ways," 114 Tax Notes 697 (Feb. 12, 2007), and "Can STI Efficiently 'Monetize' Its KO Stake," 120 Tax Notes 601 (Aug. 11, 2008). He even mentions Yahoo! in this interview (published Saturday, October 22).

Searching for the Elusive "Fair Share"

On Monday, David Logan of the Tax Foundation issued a report summarizing the individual income tax data from 2009. Highlights (or lowlights, depending on your perspective):

- Nationally, average effective income tax rates were at their lowest levels since the IRS began tracking them in 1986. The average tax rate for returns with a positive liability went from 12.24% in 2008 to 11.06% in 2009.

- Incomes reported by tax returns at the high end of the income spectrum fell from 2008 to 2009, as did their share of the nation's income and income taxes paid. In 2009, the top 1% of tax returns paid 36.7% of all federal individual income taxes and earned 16.9% of adjusted gross income (AGI), compared to 2008 when those figures were 38.0% and 20.0%, respectively.

- Each year from 2005 to 2007, the top 1%'s constantly growing share of income earned and taxes paid set a record. The 2008 reversal of this trend continued in 2009. In fact, the income share for the top 1% of tax returns was lower in 2009 than in 2000, largely due to differences in capital gains.

- In 2009, as in 2008, the top 1% no longer pays a larger percentage of total income tax than the bottom 95%. This trend was exacerbated by the aforementioned precipitous drop in AGI in 2009. During 2009, the bottom 95% (AGI under $154,643) paid 41.3% of the total collected, a larger share than the 36.7% paid by the top 1% (AGI over $343,947).

- The top-earning 5% of taxpayers (AGI equal to or greater than $154,643), however, still paid far more than the bottom 95%. The top 5% earned 31.7% of the nation's adjusted gross income, but paid approximately 58.7% of federal individual income taxes.

- Since 2001, the IRS has also been presenting data on a small subset of the top 1%, the top 0.1%. In 2009, this top 0.1% filed 137,982 tax returns, reporting 7.8% of all adjusted gross income earned and paying approximately 17.1% of the nation's federal individual income taxes. The average income for a tax return in the top 0.1% was $4.4 million in 2009, while the average amount of income tax paid was $1.07 million, indicating an average effective individual income tax rate of 24.3%.

- Overall, these data on high-income tax returns appear to confirm that the continued economic stagnation had the same diminishing effect on income inequality that most recessions have, and that it occurred for the same reason: a sharp decline in income at the high end. This appears to contradict reports based upon Census data suggesting the opposite that the recession increased income inequality.

Logan's report is particularly timely, in the midst of ongoing Occupy Wall Street protests. However, that's a post for another day, if the protesters keep plugging away despite the blizzard approaching the East Coast.

For today, the data inspire several questions. President Obama and his cheerleaders on the political left want to "spread the wealth" around. They believe that "millionaires and billionaires," defined as working professional married couples with $250,000 in taxable income, aren't contributing their "fair share" to the federal government.

Three questions for the political left:

[Q1] In 2009, the top 0.1% of taxpayers paid 17.1% of all individual income taxes, the top 1% of taxpayers paid 36.7% of all individual income taxes, and the top 5% of taxpayers paid 58.7% of all individual income taxes.

What percentage of individual income taxes should be paid by each sub-group to be considered their "fair share"? The answer should be a simple percentage, for example, 25% for the top 0.1%, 45% for the top 1% and 65% for the top 5% (numbers are illustrative only, not my view).

[Q2] If we increase taxes on the top 5% as you recommend in A1, will that solve the short-term or long-term budget gaps associated with current spending projections? Or will we also be required to increase taxes on the bottom 95% of taxpayers to solve the fiscal imbalance?

[Q3] Do you really believe that increasing taxes as set forth in A1 and A2 will address the wealth imbalance between the wealthiest 1% and the remaining 99%? Note that increased taxes on the bottom 99% or bottom 95% will decrease their ability to accumulate resources and "catch up" to the top 1%.

Tax bloggers on the political left, I look forward to seeing the answers to these straightforward questions.

Reid Reminder: Electoral Paradox

Last week, Senator Harry Reid (D-Nevada) reminded us why we need to "throw the bums out." During a debate over the teacher/first responder bill (S. 1723), Reid observed:

It's very clear that private-sector jobs have been doing just fine; it's the public-sector jobs where we've lost huge numbers, and that's what this legislation is all about.

Yes, he really said that. Reid went on the record and stated that the pace of job creation in the private sector is "just fine."

The last time I checked, we had a 9% headline unemployment rate, and a 16-20% effective unemployment rate. The 16-20% effective unemployment rate is an unofficial number which includes people who are too discouraged to continue seeking work. For Harry Reid, 9% headline unemployment and 16-20% effective unemployment is "just fine."

Reid's comments aren't particularly shocking. He makes airhead comments all the time. But that's no excuse. Why do we have such diminished expectations for our political leaders? We should not have to tolerate a Senate majority leader who projects such an air of incompetence. His own party should have demonstrated some common sense years ago and delegated Reid to the back benches. Let's prioritize leadership over seniority until we emerge from this period of economic malaise.

Reid apologists will argue that I'm taking his comments out of context. He was contrasting recent employment data in the private sector against similar data regarding state and local government employees. He was tilting at "obstructionist" Republicans who oppose more federal spending on state and local services. Blah blah blah. It was an airhead comment, and it projects an air of incompetence, regardless of political motivation.

I'm not just picking on the invertebrate* Harry Reid. Harry Reid is symbolic of a problem that has been festering on Capitol Hill for decades. It's not a problem with the Republican party or Democrat party; both parties share the blame for bad policies and incompetent leadership over the years. It's a structural problem baked into the U.S. electoral system itself. (*Credit to tax fashionista Lee Sheppard)

The problem is that our members of Congress are, for the most part, unaccountable for their actions as legislators. I won't digress far into PolySci 101. Suffice it to say that the deck is stacked in favor of incumbent legislators. Critically, incumbents can control or influence federal spending in their districts. Federal spending sometimes translates into permanent jobs (think military bases). Local constituents can sense where their bread is buttered, even if a given legislator is failing the country as a whole. Special interests trade campaign donations and elector muscle for direct or indirect legislative perks. Legislative districts are gerrymandered to maximize political support for one party or the other. The list goes on.

Because the deck is stacked in favor of incumbents, we get an Electoral Paradox. Depending on the poll, roughly 80 to 90 percent of Americans disapprove of Congress. Nearly 80 percent of the country believes that we're on the "wrong track." But paradoxically, local constituents continue to re-elect their incumbent members of Congress, cycle after cycle after cycle. Even in 2010, when the Tea Party energized a backlash against political incumbents from both parties, incumbents prevailed in an large majority of electoral contests. The American public is enormously disgruntled on a macro level, but doesn't hold incumbent legislators responsible on a micro level.

As a result of the Electoral Paradox, our nominal democracy has become a political oligarchy. We have a cadre of career politicians; men and women who are focused primarily on their individual re-election campaigns. Their secondary focus involves jockeying to create internal and external alliances and other legislative accoutrements (committee appointments, etc.) that support their primary focus on re-election. They are effectively neglecting the long-term interests of the country to pursue short-term agendas that "refresh" every two to six years.

We're emerging from a financial crisis that prompted the worst economic downturn since the Great Depression. The political class has attempted to pin the sole responsibility for the financial crisis on Wall Street. (To be fair, politicians on the left are more vocal advocates of this view. They also blame "de-regulation," despite the fact that the banking industry was highly regulated. But sheer volume of regulation is not the same as prudent and effective regulation.)

In reality, the financial crisis originated when the U.S. real estate bubble popped. The real estate bubble was fueled by government policies that distorted traditional lending practices. That problem was compounded by lax regulation of mortgage origination practices and feeble regulation of banks and other financial institutions. On both counts, legislators share culpability with Wall Street financial engineers. Politicians took the credit for a bubbly economy driven by the housing bubble. They scattered like cockroaches when the bubble popped and a vicious de-leveraging cycle ensued.

Congress has a responsibility to pilot the U.S. economy around financial crises. Individually and collectively, members of Congress failed to live up to that obligation. Political incumbents should acknowledge that they contributed to the financial crisis, accept responsibility, and pass the political reins to a new class of legislators. Instead, a majority of the political oligarchs have clung to power. Chuck Rangel, Henry Waxman, Barney Frank, and their senior colleagues on the political right, should not be able to look themselves in the mirror. The fact that they continue to influence legislation -- despite their abject failure as trustees of the American economy -- should make us all shudder. With some exceptions (e.g., Chris Dodd), these men and women have chosen to ride out their political careers in disgrace.

Bill Bradley on Tax Reform

This year marks the 25th anniversary of the Tax Reform Act of 1986. Whether you liked it, hated it, or come down in the middle, TRA 1986 was a monumental event in the history of U.S. tax policy.

To commemorate the anniversary, the editors of Tax Notes profiled several veterans of the 1986 tax reform effort this week. Nearly all of the interviews and personal recollections are worth a quick read. However, I wanted to spend a few minutes summarizing Meg Shreve's interview with Bill Bradley.

Bill Bradley is a former Senator (D-NJ) and Democratic presidential candidate. His popularity traces back to his career as a hall of fame basketball player with the New York Knicks. He was no intellectual slouch, attending Oxford as a Rhodes Scholar after a basketball career at Princeton.

Highlights from the interview:

[1] We need to define "tax reform."

Bradley emphasized that we can't do tax reform without defining tax reform. Do we close loopholes and use all the revenue from to lower rates? Or do we close loopholes and use only some of the revenue to lower rates (with some of the revenue dedicated to deficit reduction or new programs)? Alternatively, do we shift the paradigm by lowering income tax rates and offsetting the revenue shortfall with a consumption tax or some other source of revenue (e.g., a carbon tax)?

In 1986, political leaders defined tax reform as revenue-neutral loophole closers. Republicans wanted lower rates, and Democrats wanted fewer loopholes. In a sense, the stars were aligned to permit a political consensus. The Code was riddled with loopholes that were exploited by the highest earners, and top marginal tax rates were high. By eliminating loopholes, TRA 1986 increased taxes on the individuals and businesses that exploited the loopholes. The increased tax revenue was used to "pay for" lower tax rates across the board. The result was that "the top 5 percent paid a higher percent of the income tax revenue after tax reform than before tax reform even though the rate dropped from 50 to 28 percent."

Unfortunately, defining tax reform is more difficult today. Today's "loopholes" are tax expenditures that benefit tens of millions of middle-class taxpayers. Top marginal tax rates are lower today than in 1985. Even without the rancorous climate in Washington, it would be heavy lift for political leaders to adopt the 1986 definition of tax reform.

[2] We need a president that is "full square" behind tax reform and a Treasury Secretary with the gravitas to cut a deal.

Bradley recounted President Reagan's commitment to tax reform. Reagan "gave a couple of speeches," but delegated broad authority to former Treasury Secretary James Baker to cut a deal. Reagan "made it acceptable and led the charge." Baker ultimately brokered a tax reform deal with Bradley himself.

If Bradley is correct, we aren't going to see tax reform before 2013 or 2017. Meaningful tax reform is not a priority for President Obama. His priorities range from socialized health care and "spreading the wealth around" to green jobs and hybrid vehicles that will run 120 miles on a gallon of fuel. His Treasury Secretary, Timothy Geithner, is a bookish technocrat who has struggled to tread water due to economic conditions outside his control.

Bradley did not put a grade on Obama's efforts to drive tax reform. He suggests that Obama has been evasive for political reasons ("If the answer is 'we need to close loopholes to raise revenue and we don't touch rates' -- if that's what you mean, then say it.").

[3] Tax reform is too complicated for most people and will never be a "mainstream" issue. But political leaders need to articulate the principles guiding reform.

Bradley explains that the 1986 reforms were motivated by three simple principles. First, equal incomes should pay equal taxes. Second, the income tax should be progressive (those with higher incomes should pay more). Third, the market is more efficient at capital allocation than the Ways and Means Committee.

Team Obama has struggled to articulate clear, simple principles in respect to tax policy. Obama wants to increase taxes on "millionaires and billionaires," but defines millionaires as married working professionals with taxable income of $250,000. The income tax is steeply progressive, with the top 1% of taxpayers contributing 37% of income tax revenues. But he wants to "spread the wealth around" further, without defining what constitutes a "fair share." He has caught the "Buffett Bug," and become obsessed with the effective tax rates paid by the 400 top earning individual taxpayers. He sniffs at Bradley's quaint notion that the market is better at capital allocation than legislators and bureaucrats in Washington.

No wonder that individual Americans are confused and frustrated by the rhetoric around tax reform.

Solar Trade War: Collision Ahead

Back in August, before the Solyndra news broke, I discussed the bankruptcy filings of two U.S. solar manufacturers.

As I remarked in the August post:

The price of solar panels has fallen dramatically as China ramps low-cost manufacturing. That's good news for U.S. energy consumers and the environment, because the cost differential between solar power and power generation from fossil fuels is narrowing. If the trend continues, solar power will become a competitive alternative energy source without government subsidies.

Yesterday, the New York Times reported that seven of the surviving U.S. solar manufacturers have filed an anti-dumping case against the Chinese solar industry. The case seeks tariffs of more than 100% on the wholesale price of solar panel imports from China. Obviously, such an action would increase the cost of solar power development projects (by increasing the cost of solar panels). Higher-cost solar power projects would translate into higher costs for U.S. energy consumers (because the cost of renewable energy is "passed through" by utilities to consumers). Moreover, higher-cost solar panels would slow the transition in our energy infrastructure away from fossil fuels.

The result is a collision of political, economic and environmental priorities.

The U.S. solar manufacturers and many politicians will argue that this is about jobs. We need a strong manufacturing base and we have the capacity to lead the development of renewable energy technologies in the coming decades. As a leader in development, we should be able to exploit our technological advances by manufacturing solar panels "at home." If China really is dumping panels below cost to gain market share, we should enact tariffs to "level the playing field" so that U.S. manufacturers can compete with Chinese manufacturers.

All fair points; one might quibble with the details, but the broad principles hang together.

From an economic perspective, however, we might be better off permitting China to dump its solar panels on us below cost. Sure, that might cost us U.S. manufacturing jobs. But China's dumping policies would effectively be subsidizing U.S. solar development projects. To some extent, then, we'd simply be shifting jobs between industrial activities. We'd need less individuals fabricating and assembling solar panels. We'd need more individuals working on construction projects and, upon completion, operations and maintenance of solar facilities.

Big picture, why shouldn't we permit China to subsidize our solar development projects? By subsidizing our solar development, China would be reducing costs to U.S. energy consumers. Our businesses would be more competitive (due to lower energy costs), and individual consumers would have more disposable income. Let's say that a Middle Eastern country decided to "dump" oil into the U.S. market, reducing U.S. oil production and decreasing the number of U.S. oil drilling jobs. Would we view that as a negative development? Would the U.S. support an anti-dumping case against the Middle Eastern country to save American jobs? Or would the U.S. take the Middle Eastern energy subsidy and run with it?

Finally, how does the environment fit into this picture? Solar power is unequivocally "cleaner" than power generated from fossil fuels. Should environmental considerations "tip the balance" in a situation where economic and political objectives do not align? In this case, for example, does the threat of global warming and environmental catastrophe outweigh concerns about a few hundred (or few thousand) U.S. manufacturing jobs? Should we make the transition to a cleaner power generation footprint the highest priority? For politicians on the left and right, time to pick your poison. Which is the higher priority: protecting U.S. jobs; economic growth; or environmental protection?

$95 Million Pay Day

Several interesting developments this week converged to prompt this post.

- On Monday, our favorite tax fashionista, Lee Sheppard, published an article discussing the relationship between income tax rates and executive compensation. Sheppard argues that Reagan-era cuts to marginal income tax rates have fueled the dramatic inflation in pre-tax compensation payments to C-suite executives. See "News Analysis: Should We Adopt a Millionaire's Surtax?" 133 Tax Notes 307 (Oct. 17, 2011).

- Sheppard mines data compiled by Catherine Mulbrandon from a November 2010 report by Jon Bakija of Williams College, Adam Cole of the Treasury Department and Bradley Heim of Indiana University. The report analyzes the occupations of the top 1% on American taxpayers between 1979 and 2005.

- Sheppard focuses, in particular, on the profiles of the top 0.1% of American taxpayers. Catherine Mulbrandon presents a terrific graphic comparison of the top 1% and the top 0.1% on her website, Visualizing Economics.

- Catherine Rampell, an economics reporter at the New York Times, also discussed the report on Monday. Rampell's analysis contains some good tabular summaries of the underlying data. She gently tweaks the OWS protesters by noting that the large majority of taxpayers in the top 1% are not Wall Street financiers. They are doctors and lawyers and C-suite executives.

- Over the weekend, Kinder Morgan signed a deal to acquire El Paso Corp in a $38 billion transaction. If the transaction is completed, El Paso's current CEO will be eligible for an exit package worth $95 million. Perhaps he can purchase the Greek island of Santorini after closing the deal.

- Today, Paul Caron posted the following chart summarizing the percentage of income earned and income taxed paid across the tax brackets in 2009. Thanks to Peter Pappas for linking. (Note that the data compiled for the Bakija et al study dates to 2005, so the numbers aren't precisely apples to apples.) The average taxpayer in the top 1% earned a comfortable $343,000 in 2009. That's approximately 0.4% of the retirement package for El Paso's current CEO. The doctors and lawyers in the top 1% are no closer to the top 0.1% than the middle-class union members in the middle of the income distribution.


How does this all fit together?

Sheppard argues that American CEOs are "grotesquely overpaid," and I completely agree. According to Sheppard:

Chief executive pay has increased 500 percent in real terms since the 1981 act cut the top marginal rate to 50 percent. Average worker pay has not increased in real terms during the same period. The median chief executive of an S&P 500 company now takes home more than $9 million annually [versus $1 million in 1981, in inflation-adjusted dollars]. The average chief executive of a public company takes home $2.5 million. Research has calculated that executive pay is the equivalent of 10 percent of corporate earnings at the largest companies.

It really is outrageous. I'm a strong believer in free market economics, but executive compensation practices are symptomatic of market failure. No manager of an industrial/energy company deserves a $95 million retirement package. Bill Gates, Mark Zuckerberg ... different stories.

Consultants in the executive compensation space make a killing on "peer benchmarking." For a public company, the board of directors is responsible for hiring and compensating the CEO. Directors hire consultants to "benchmark" the compensation packages granted to CEOs at "peer" companies with somewhat comparable operations, capital structures, etc. The "benchmarking" studies are used to support ever-increasing compensation packages to CEOs. As Sheppard observes, "[n]o board wants to believe that its chief executive is merely average."

The net result is the ridiculous inflation in executive compensation that has occurred during the last 30 years. The benchmarking data contains a "one-way" bias, because boards never pay their executives less than the "average" CEO among the comps. If nobody is ever "below average," there is never a price mechanism to slow the price inflation for executive management. As CEO compensation increases, the consultants incorporate the increased compensation data into their benchmarking analyses. Year after year, the cost of an "above average" manager continues to inflate. The newest vintage of "above average" CEOs needs to be paid more than the last vintage of "above average" of CEOs.

Ironically, CEO pay seems to be the one area where business organizations seek to maximize their costs. Imagine how long a business would last if it committed to paying "above average prices" for the various inputs into its products or services. Competitive markets reward innovative enterprise that can satisfy consumer demand while lowering costs of production. I understand that CEOs play a critical strategic role within their respective businesses. They're distinguishable from commoditized widgets. Nonetheless, corporate boards are consistently failing their shareholders by acquiescing to current executive compensation trends.

(Boards have other incentives to inflate CEO pay. Frequently, CEOs install or support directors who are themselves CEOs of other public companies. This creates an obvious conflict of interest. A CEO of Company A that wears a "director hat" for Company B is more likely to support an outrageous compensation package for the CEO of Company B, because he or she knows that the compensation package will become part of the benchmarking data supporting his or her compensation as CEO of Company A.)

Sheppard discusses various options to curb the inflation of executive compensation, including surtaxes and new brackets for the highest-paid taxpayers. I don't believe that taxes created the problem, so I don't believe that taxes will solve the problem. Instead, corporate boards should adopt guidelines on the relationship between CEO compensation and the median compensation of an employee within the organization. It could be a simple formula: CEO pay for a given period may not exceed 10x or 20x of the median employee pay. It could be more complicated, with performance metrics and clawbacks. No matter how you slice it, corporate boards should begin chipping away at the market failures that are inflating CEO pay.

Government Spending: 2x Inflation

On Friday, I discussed Steve Shay's recent insights on fundamental tax reform. Today, I want to circle back to some interesting numbers in Shay's article.

Shay notes that federal on-budget expenditures have grown from $807 billion (18.3 percent of GDP) in 1986 to $2.9 trillion (20 percent of GDP) in 2010. Tax expenditures were approximately $1 trillion in 2010. Thus, the sum of on-budget and "off-budget" spending in 2010 was approximately $3.9 trillion.

According to a report by the Tax Policy Center, tax expenditures were approximately $362 billion in 1985. (I can't quickly locate the numbers from 1986, which were excluded from the Tax Policy Center report.) The sum of on-budget and "off-budget" spending in 1985/1986 was approximately $1.2 trillion.

Adjusting for inflation, $1.2 trillion in 1986 dollars is $2.4 trillion in 2010 dollars. Had federal spending kept pace with inflation, the federal budget would have grown by approximately 100% between 1986 and 2010. Instead, the federal budget grew by more than 200%.

I don't have time to poke around the state data, but I'd be surprised if state expenditures grew materially slow than federal expenditures between 1986 and 2010.

Here is the question for the advocates of big government. During the past 25 years, federal spending has outpaced inflation by more than a 2 to 1 ratio. Are we all better off today as a result? Are the "most vulnerable" Americans and the middle class doing better today than their counterparts in 1986? Has the binge of federal spending increased the quality of life of the vast majority of Americans? Has the growth of federal spending increased standards of living commensurate with the resources tapped to fuel the spending?

If the answer is "yes," then how do you explain 9% unemployment? How do you explain the tea party movement and and nationwide Occupy Wall Street protests? How do you explain the frustration over the inter-generational burden that debt-fueled government spending will place on our children and grandchildren (and their children and grandchildren)? How do you explain the general public dissatisfaction with our political and business leaders?

If the answer is "no," then how do you justify demands for increased government spending? Can government spend more money to "cure" problems that are correlated with increased government spending? Government spending has increased at a 2 to 1 ratio compared to inflation over the past 25 years. Would we all be better off had spending increased at a 3 to 1 ratio? A 5 to 1 ratio? How much faster does government have to grow before before it becomes obvious to everyone that government expansion blunts the vibrancy of the private sector?

Ironically, the expansion of government spending has tracked the rising inequality of income and wealth distribution that so agitates the political left. The left does not seem to realize that bigger government creates more opportunity for business and individuals to capture economic premiums by exploiting the "regulatory state." How does a regulatory or tax attorney justify an hourly billing rate of $1,500 ($3 million/year at 2,000 hours/year)? Because he or she helps businesses and individuals navigate the regulatory state. How does a CEO justify compensation of $5 million or $10 million per year? Because he or she pays the regulatory and tax attorneys $3 million per year simply to navigate the regulatory state!

Steve Shay on Tax Reform

Earlier this week, Steve Shay published an article in Tax Notes with his observations on fundamental tax reform. See "Jobs, Deficit Reduction, Revenues, and Fundamental Tax Reform," 133 Tax Notes 213 (Oct. 10, 2011).

I always pay attention to articles written by Shay and Edward Kleinbard. Both are seasoned tax professionals with experience in private practice, government and academia. Shay practiced with Ropes & Gray for 20 years before jumping to Treasury in 2009. He served for two years as Deputy Assistant Secretary for International Tax Affairs. Kleinbard practiced at Cleary Gottlieb for 30 years before serving as Chief of Staff of the Joint Committee from 2007-2009. After grinding away as tax attorneys for decades, and then bashing their heads against DC gridlock for a couple years, Shay and Kleinbard both sought refuge in the ivory tower. Shay teaches and writes from Harvard Law School; Kleinbard from the USC Law School.

As tax attorneys who represented a wide range of domestic and multinational businesses in private practice, Shay and Kleinbard bring thoughtful voices to the dialogue over U.S. tax reform. Politics aside, we need more contributions to the tax policy debate from experienced practitioners who have a more balanced view of the relationship between the private and public sectors. We get way too much loaded rhetoric from business lobbyists and "career academics" on the political left.

A few highlights from Shay's article:

[1] Shay urges policymakers (presumably aiming towards the political right) not to take revenue increases off the table while considering tax reform options. Shay does not advocate "millionaire surcharges" or the "Buffett Rule," whatever his personal view on those proposals. Shay primarily focuses on tax expenditures, and the opportunity to increase revenues "by eliminating tax expenditures and rationalizing the income tax base, as part of an overall plan to restore a sustainable fiscal policy." He's basically following along a trail blazed by Kleinbard, among others.

[2] In Shay's view, fundamental tax reform "should make the income tax code a fairer and more efficient instrument suitable for the economy of today and the future."

The objective of fundamental tax reform should be a more comprehensive income tax base that is simpler and fairer and does not make losers of domestic manufacturers and winners of video game companies with offshore intangibles.

Funny how that theme keeps surfacing in discussions of fundamental tax reform. I outline the problem of "multinational princes" and "domestic paupers" in this post (discussing a tax reform proposal by Bill Parks).

[3] Shay gently scolds President Obama for his class warfare rhetoric:

[The President] has acknowledged a need for new revenues, but limiting shared sacrifice to those with incomes of $250,000 and above is inconsistent with rationalizing many wasteful tax expenditures that benefit middle-income earners as well as the very wealthy. In exchange for job-creating stimulus, Democrats should be open to sharing sacrifice more broadly, but without sacrificing a fair distribution of overall tax burden.

Shay doesn't define a "fair distribution of the overall tax burden," but he implies that "shared sacrifice" should include tax increases on all Americans. The top 1% of taxpayers currently shoulder 37% of the total income tax burden. If deemed "fair," policymakers could aim to keep that number constant, while increasing overall revenues from the tax system. By definition, such an effort would require an increased "contribution" by the bottom 99% of taxpayers.

[4] Shay bluntly scolds Team Obama for its lack of leadership on tax reform. But let's face it, this administration has other priorities. President Obama focused on socializing health insurance during the worst economic crisis since the Great Depression. Now he's focused on his 2012 re-election despite a widespread economic malaise and 9% unemployment rate. I'd wager my $100 that Team Obama will not lead us to the Promised Land of Fundamental Tax Reform.

Get Serious about Jobs Creation

As I've previously discussed, President Obama launched his 2012 campaign by proposing a $447 billion stimulus proposal, the "American Jobs Act." He may not be able to bring the unemployment rate below 9%, but his main priority is to shift blame for the sticky unemployment rate to "obstructionist" Republicans. If he can't persuade Congress to "spread the wealth around," maybe he can persuade voters to "spread the blame around" and vote Team Obama.

The new stimulus proposal is heavy on payroll tax cuts ($240 billion total) and unemployment benefits ($62 billion). It also includes $140 billion in funding for state teachers ($30 billion) and first-responders ($5 billion), school modernization ($30 billion), road construction ($50 billion), an infrastructure bank ($10 billion) and neighborhood stabilization ($15 billion).

When talking about the ways to tackle the unemployment crisis, Obama loves to pull out the "infrastructure" card. If you took him at face value, you'd think the federal government could allocate funds to "infrastructure," load the funds into an enormous Jobs Vending Machine, and order up a few hundred thousand jobs over the next 12 months. Please deposit $1 billion and punch A1 for jobs in Alabama, A2 for jobs in Alaska, A3 for jobs in Arizona...

Unfortunately, infrastructure spending does not occur with the snap of a president's fingers. Major infrastructure projects involve years of lead time and millions of dollars in up-front costs. Project managers cannot get "shovels in the ground" until they have surmounted an exhaustive list of hurdles. To name a few: developing budgets and time lines; arranging engineering studies; procuring licenses, easements, land rights; procuring other state and local permits; environmental reviews; obtaining RFPs from prime contractors and/or subcontractors; resolving potential litigation and environmental remediation; navigating state, local and federal labor regulations; arranging committed financing; and paying legal and consulting fees for each step forward in the regulatory labyrinth.

The ugly truth is that local, state and federal regulatory hurdles significantly delay the infrastructure development process. When it comes to federal spending on infrastructure, President Obama talks a good game, but hasn't backed that up with meaningful legislative or regulatory proposals to accelerate investment in public or private infrastructure. A $10 billion "infrastructure bank" is a silly drop in the bucket. Moreover, banks and other financial institutions have plenty of capital. We don't need a new government bank to fund infrastructure development.

So how can President Obama get serious about jobs creation?

First, scrap the $447 billion stimulus proposal. It's another round of political gamesmanship that distracts from the problem at hand. In the real world, we're suffering from a slow-burning unemployment crisis. President Obama and his advisers should have trouble sleeping at night, because the unemployment crisis has largely unfolded on their watch. They should wake up every morning and get worked up into a slather over fresh ideas to improve the conditions for investment, development and job creation.

Second, the crux of my proposal. The Obama administration should use its platform to blast the following message to the private sector:

Private sector businesses and developers, we want to help you accelerate the development of your capital-intensive projects.

We will be shifting all resources necessary from other administrative functions into development-support functions until we have measurably decreased the unemployment rate.

Our goal is to accelerate $250 billion [or $500 billion, stretching for the biggest number realistically possible] in capital spending into the next two years.

You bring us a credible development plan for a project involving capital investment of $250 million or more. We will twist arms and use all executive powers available to ensure that your project is "shovel ready" no later than year end 2012. We will provide federal overrides of state and local red tape, relax environmental regulations for projects that do not pose an imminent danger to human life, and mediate settlements with litigants who seek to delay the start of construction.

We acknowledge that jobs creation is driven by private investment and private enterprise. Government regulation and frivolous litigation has been an impediment to jobs creation for too long. For now, we need to address the unemployment crisis. We can revisit the overall regulatory environment after we put millions of Americans back to work.

Here's the interesting thing. Although I've been noodling on this idea for some time, someone within the administration shares my perspective. The administration recently announced that it would "fast track" 14 infrastructure projects to accelerate jobs creation. My question for administration officials is: why limit this to 14 public infrastructure projects? You have just conceded that red tape delays public infrastructure development and jobs creation. Why not extend the "fast track" principle to private development projects (infrastructure, technology capex, industrial capex, utility capex, etc.)? Sure, it's a tacit admission that liberal regulatory objectives can impede economic growth. But we're in the middle of a crisis, so let's deal with the political blowback at a later date.

Do I think that President Obama is ready to get serious about jobs creation? All evidence suggests that he is not. So I'm not holding my breath, but I'd love to be wrong on this one.

Talk is Cheap

The "Occupy Wall Street" protests are a major topic of conversation these days. Thus far, I haven't been able to discern a specific "cause" motivating the protests.

Some protesters are unhappy about "corporate greed," whatever that means. Some protesters believe that the government is not sufficiently focused on "creating" jobs for grad students. Some protesters want more subsidies for green energy. Some protesters want to do yoga in the streets. Some protesters are just unhappy with authority, like the guy who decided to express his outrage by defecating on a police car. Some protesters -- the college-age types -- are along for the ride, enjoying the privileges of youth, parental support, and the spontaneity that accompanies minimal responsibility. Ahhhh ... to be 20 years old with no bills, no kids, no pets, no mortgage payments.

The political left is struggling to articulate a credible narrative for OWS. Linda Beale linked to an editorial by Paul Krugman. Krugman believes that OWS represents a mass uprising against Wall Street oligarchs who bulked up their personal fortunes at taxpayer expense while triggering the Great Recession. But that's Krugman's gripe, with no connection to anything I've heard trickling up from the protesters themselves.

I've never understood why people invest so much time and effort into protests. In law school, I lived across from a Planned Parenthood center. Every weekend, from dusk until dawn, anti-abortion protesters with billboards and hand-outs marched the street, seeking to discourage young women from entering the center to discuss contraception and abortion.

The anti-abortion protesters were exercising a Constitutional right to express their moral convictions in public. However, it always struck me as a complete waste of time. Why not use the hours spent protesting to counsel at-risk teenagers? Or to help nurture foster children or other troubled children from unfit homes? Or to volunteer in a hospital to nurture babies whose mothers were addicted to drugs or alcohol? If you are opposed to contraception and abortion, and thus favor more children in unstable home environments, why not focus your time and energy to improve the lives of existing children who lack stability, guidance and love? And then, when all children are healthy and happy, living in stable and nurturing environments, get back to protesting against Planned Parenthood?

I have the same reaction to the OWS protesters. They got their message into the media. They are exercising a Constitutional right to express their outrage over the failures of our political and business leaders. But why are they devoting so much time to empty rallies? What is shouting whining, stomping and defecating going to accomplish, besides draining local security budgets? Isn't this the same crowd that protests "cuts" to "services" for "the most vulnerable Americans"? Shouldn't the able-bodied college and grad students be volunteering their time in public schools and after-school organizations? Or helping out underprivileged children as Big Brothers and Sisters? Or assisting non-profit organizations that provide meals to seniors and other individuals with limited mobility? Or cleaning up public parks? Any of us can think of hundreds of organizations that would welcome a small army of enthusiastic volunteers with open arms.

But talk is cheap, as the saying goes. Volunteering for a non-profit organization, or a run-down public school, or a foster home, or a senior center, requires people to commit time and effort. It's a drain, physically and emotionally. Let's face it, that doesn't sound nearly as appealing as a "spontaneous" street rave, fueled by Twitter and Facebook, to stomp around and shout about the Great Unfairness of the world. If you can't join Dumbledore's Army, perhaps the hippest substitute is Krugman's Army. But the hipsters aren't making a difference, and Dumbledore probably wouldn't be impressed.

So I'll keep half an eye on the protesters, to see if they develop a coherent message before the winter hits. Meanwhile, my respect goes out to individuals like Larry Powell, whose actions speak louder than their words.

Moe Money, Moe Problems

In today's Wall Street Journal, Randy Noonan offers a portrait of an American success story, Moe the Millionaire.

Moe is an insurance salesman with a minority equity interest in his employer, a mid-size insurance business organized as a C corporation for tax purposes. Moe is retirement age (around age 65, having worked in the insurance business for 40 years). His ending salary, including bonus, was $200,000. In the year he retired, Moe tagged along with a sale of the insurance business, selling his minority interest at an $850,000 gain.

Moe's net worth in the year before retirement was:

Cash in bank: $100,000. Investment in business to be sold: $950,000 [cost basis $100,000]. Value of Moe's home: $450,000 [cost basis $95,000]. Total assets: $1,500,000.*

* Noonan posits that Moe would receive $75,000 in annual pension benefits from the insurance company's defined benefit pension plan, but does not include the "value" of the pension benefit in the calculation of Moe's net worth in the year before retirement.

The year of his retirement, Moe recognized $1,050,000 in total income: $200,000 in salary and bonus; and $850,000 in capital gain from the sale of his interest in the insurance business. Noonan inquires:

Is Moe the "millionaire" that Obama wants to tax? Is it "fair" that his once-in-a-lifetime capital gain of $850,000 be taxed at top tax-bracket rates? Even assuming that the current 15% capital-gain rate would be raised to only 25% for this one-time millionaire (so that his tax rate would not be less than those "middle class" taxpayers), the tax would still be $212,500, more in tax than Moe ever made in salary and bonus in any one year.

A few observations:

[1] Big picture, Noonan is framing the correct issues. The political left believes that we should increase taxes on the "wealthy." The left sometimes defines the "wealthy" as "millionaires and billionaires" (the Buffett view). President Obama takes it further, consistently defining the "wealthy" as married couples earning $250,000 and single individuals earning $200,000 in a year.

I'm unaware of any data that suggests a high proportion of married couples earnings $250,000 (or individuals earning $200,000) are "millionaires and billionaires." I'm sure that Obama would concede that an individual's taxable income during a given year is not a proxy for his or her "wealth." And an individual's "wealth" is not necessarily reflected in his or her taxable income during a given year. I will explore this basic theme in a later post (or posts).

[2] Back to Moe the Millionaire. I believe that Noonan was mistaken in assuming a 25% tax rate on the $850,000 capital gain. President Obama wants to tax a millionaire's entire income at a 30% or higher federal effective tax rate. Tack on another 5% to reflect state income taxes, and the tax leakage on $1,050,000 in income is around $368,000. In other words, Moe would bring home around $683,000 after the payment of taxes on his retirement-year income.

When the dust settles, Moe is still a millionaire, but not by much. His liquid assets of $783,000, if invested conservatively, might yield around $40,000 annually before taxes. Almost everyone on both sides of the political would agree that this is a modest pre-tax income, even if the recipient is a "millionaire" on paper.

From a tax perspective, the main "problem" here is the lack of income averaging. Arguably, Moe should not be penalized for an extraordinary one-time gain. I'm sympathetic to Moe's plight, but I'm hesitant to endorse income averaging because I favor tax reform that will streamline -- not further complicate -- the tax code.

[3] Despite framing the correct issues, Noonan's hypothetical contains a couple of flaws. The first relates to his assumed savings balance upon retirement. Noonan stipulates that Moe earns $200,000 in salary and bonus after 40 years in the insurance business. Let's assume his salary increased no slower than the rate of inflation between year 1 and 40. He purchased a modest home for $95,000 decades ago, and had a $100,000 bank account the year before retirement.

Moe must have suffered from a drug or shopping addiction, because he should have had more than $100,000 in a bank account upon retirement. Noonan stipulates that Moe made "regular but modest" charitable contributions at church (deductible for tax purposes). Moe would have paid taxes at an effective tax rate around 20% (perhaps 25% including state income taxes). During the decade before retirement, with a six-figure income, 20% effective tax rate, "modest" charitable donations and negligible housing costs, Moe's savings account should have increased substantially.

Moe's net wealth is foundational to Noonan's analysis, so Noonan should have been more careful with his assumptions about Moe's spending and savings profile.

[4] Noonan also fumbles with respect to Moe's pension benefits. According to Noonan, the insurance company's defined benefit plan will provide Moe with $75,000 annually. Noonan characterizes $75,000 as "enough to live on but only just."

We know that Moe lives in a relatively affordable community, because his home value in the year of retirement is $450,000. Moe owns his home outright, so has relatively low costs associated with outright home ownership (maintenance and property taxes). He's retired, so he won't have commuting expenses and a number of other expenses associated with life as a working stiff. He's presumably eligible for Medicare and Social Security. All in all, $75,000 in annual pension benefits should provide a comfortable existence for our retired friend.

Morever, the pension benefits reflect a substantial "asset" that we should not disregard in computing Moe's net wealth. However, in fairness, the political left disregards the value of defined benefit pensions when focusing on "income as a proxy of wealth." So I can't be too critical in this instance.

[5] Enough tax for a Friday post. Noonan's portrait of an American success story was almost certainly moe-tivated by a success story from the 1990s. Let's kick it to Notorious B.I.G:

Dude, Who Moved My Deductions?

They didn't cover this in Corporate Tax 101:

The federal government has found a new weapon in its war on marijuana — the tax man.

A San Francisco Bay area medical marijuana dispensary that promotes itself as the world's largest has been hit with a $2.4 million tax bill following an audit by the Internal Revenue Service, the dispensary founder said Tuesday.

The back taxes, penalties and interest levied against Harborside Health Center came after the IRS examined its returns for 2007 and 2008 and determined a 1982 tax code prohibiting cost deductions for businesses that traffic in illegal drugs applies to the dispensary.

Harborside is a spa-like fixture on Oakland's waterfront with 94,114 registered customers and 84 full-time employees that offers an average of 30 varieties of medical marijuana every day and has $22 million in annual sales.

One nice thing about life as a tax professional. You learn something new every day. I had no idea that someone had developed 30 varieties of medical marijuana. Does the development work qualify for R&D tax credits? Are they keeping the R&D work in the United States? Or outsourcing to a 16-year old with a second-grade education, earning pennies a day to get stoned in some foreign country?

Paul Caron at TaxProf Blog added some additional color on the pending IRS controversy.

I just keep imagining Jeff Spicoli's reaction to an aggressive IRS audit. (Parental warning: PG-13 content) Classic.

Are All Taxes Created Equal?

On Friday, I discussed a Citizens for Tax Justice report advocating for the Buffett Rule. I'm officially done wasting time on the Buffett Rule itself. Today I'll discuss a collateral issue raised by the CTJ report.

[1] CTJ argues that any comparison of effective tax rates paid by individuals must include payroll taxes. Some critics of the Buffett Rule have solely focused on income taxes paid by individuals in various tax brackets. I haven't studied the issue in enough detail to draw a firm conclusion. However, the CTJ argument would be considerably weaker if payroll taxes were excluded from the math.

Are payroll taxes equivalent to other income taxes? Where do we draw the line between taxes that should be included in the computation of effective tax rates, and taxes that should not?

Payroll taxes primarily fund Social Security and Medicare payments. Social Security and Medicare are "social insurance" programs. An individual's payments into Social Security and Medicare resemble insurance premiums (albeit mandatory insurance). Most notably, an individual's Social Security benefits during retirement depend on the amount of "premiums" paid during his or her working career. The "premiums" are pooled into trust structures; the trusts "invest" net cash inflows into Treasuries; and the trusts will redeem the Treasuries to cover net cash outflows.

If payroll taxes are (effectively) insurance premiums, then they should be excluded from the effective tax rate computations. The fact that government "collects" the social insurance premiums does not transmute them into the equivalent of income taxes. Ultimately, social insurance results in a direct payment to an individual beneficiary. Social insurance premiums which support direct payments to individuals are not comparable to income tax revenue that fund other government operations. Sure, we all derive some indirect benefit from government expenditures on defense and transportation and agriculture. But there seems to be a qualitative difference between payroll and income taxes that justify excluding the former when computing the effective tax rates paid by different income groups.

Note that Social Security and Medicare may be "insolvent" under current projections, meaning that government receives an "F" for its stewardship of the social insurance programs. We might have solvent programs if we handed the keys over to actuaries and sent the politicians home. However, an insolvent social insurance program is still social insurance.

[2] All that said, the political right generally discusses payroll taxes as if they are income taxes borne by the employee or self-employed individual. They certainly "feel" like taxes to me. If the right presses that argument, then I agree with CTJ that payroll taxes should be included in the effective tax rate computation. Let's compare apples to apples, not apples to oranges.

[3] Some economists theorize that labor bears a portion of -- and perhaps all of -- the corporate income tax. Two interesting observations.

First, under CTJ's methodology, the effective tax rates paid by all taxpayers would increase if we assume that employees bear a portion of the corporate income tax. I'm not sure how the burden would be shared among low-, middle- and high-income employees. Food for academic thought.

Second, if the theory is correct, it dismantles the argument underlying the 15% tax rate for qualified dividends and capital gains. If labor, and not capital, bears the burden of corporate income taxes, then the owners of capital should not receive preferential tax treatment upon a corporation's distribution of previously-taxed earnings. I'll wait patiently for a counter from the Wall Street Journal editorial board.

[4] Back to CTJ's premise that payroll taxes should be included in effective tax rate computations, because they are economically borne by employees (not employers). As discussed above, payroll taxes are equivalent to social insurance premiums. If we include social insurance premiums in the effective tax rate computation, how about other amounts paid by an employer for the benefit of employees?

For example, many employers offer generous health insurance benefits for employees on a pre-tax basis. Absent the tax preference and historical legacy of U.S. health care, employers would increase wage income to employees, and employees would use the increased wages to purchase individual health insurance policies. Like social insurance premiums (payroll taxes), employees bear the economic burden of employer-sponsored health insurance premiums.

Obamacare mandates that all individuals must obtain health insurance or pay a penalty. Should the payment of health insurance premiums be viewed as a "tax" for the same reason that social insurance premiums are viewed as a "tax"? Does the fact that a federally-mandated insurance program is administered privately really matter? Wouldn't that be a triumph of form over substance? If we include health insurance premiums in the effective tax rate computation, middle-class effective tax rates would skyrocket, and effective tax rates for higher-income taxpayers would also increase dramatically. However, the political left might not be enthusiastic to highlight this fact in public debate.

CTJ for Mega-Billionaires!

I was hoping to end my discussion of the Buffett Rule with this post last Friday. However, no rest for the weary. On Tuesday, an organization named "Citizens for Tax Justice" entered the fray. CTJ published a report advocating for the Buffett Rule.

I've been critical of CTJ in the past. On June 1, CTJ published a report "analyzing" the financial statements of 12 "illustrative" U.S. corporations. I believe that the purported "analysis" contained material inaccuracies and omissions. I sent a letter to Tax Notes suggesting that CTJ's report was borderline unethical (131 Tax Notes 1199 (June 13, 2011)). I was concerned that unsophisticated readers would take CTJ's misleading "analysis" at face value. As expected, the political left feigned outrage over CTJ's dubious conclusions.

The latest report from CTJ has its weaknesses, but raises some interesting questions. Unlike the June report, CTJ's advocacy of the Buffett Rule doesn't taint the organization's credibility. Five observations:

Distortions

[1] Mega-billionaire Warren Buffett hasn't released his tax returns, so this is speculative. CTJ states that Buffett has long criticized the "loopholes" in the tax code that allow him to pay a lower effective tax rate (at 17.4%) than his middle-class secretary (at 30%). A "loophole" is defined as "an ambiguity in a system, such as a law or security, which can be used to circumvent or otherwise avoid the intent, implied or explicitly stated, of the system."

The tax code is filled with loopholes (as defined), but it is unlikely that Buffett is exploiting one. More likely, he simply derives a large proportion of his annual income from qualified dividends and capital gains. Qualified dividends are taxed at a 15% rate, because the distributing corporation was previously taxed on its earnings at a 35% rate. The same principle applies to capital gains from the disposition of stock in a corporation with accumulated earnings. The tax preference reflects an explicit Congressional judgment to blunt the "double taxation dilemma" associated with the taxation of C corporations and their owners. It is no more a "loophole" than any number of tax preferences that are widely available to virtually all taxpayers.

CTJ may not be happy with the result, but they should tone down the misleading rhetoric.

[2] CTJ claims that Buffett's effective tax rate (17.4%) is "typical" of taxpayers with $10 million or more of income. CTJ's claim is inconsistent with the data on page 3 of its report. Based on those numbers, the "average" taxpayer with $10 million or more of income pays an effective tax rate of approximately 24.6%.

Again, words are important. Buffett is not "typical" of uber-wealthy individuals. The data suggests that the $10 million club is comprised of two groups. One group recognizes a large proportion of its income from qualified dividends and capital gains, taxable at the 15% rate described above. The other group recognizes a large proportion of its income as ordinary income (wage income or other income for services (athletes, celebrities) or short-term capital gains (hedge fund managers)).

CTJ wants the first group (the investors) to pay tax at rates comparable to the second group (the athlete/celebrity/hedge fund VIPs).

Consensus and Questions

[3] I agree with CTJ on a fundamental principle. I believe that all income should be taxed at the same tax rates.

I suspect we disagree on the next principle. I believe that we should lower income tax rates for corporations and individuals (with the decrease in revenue offset, in part, by an increase in tax rates applicable to capital gains). My two principles work in tandem. The decrease in the top marginal corporate income tax rate would undermine much of the rationale for the 15% tax rate (as described above).

[4] CTJ compares an individual taxpayer with $60,000 in wage income and an individual taxpayer with $60,000 in qualified dividends and capital gains. The former pays an effective tax rate of approximately 30% (including employer and employee payroll taxes; more on that in my next post). The latter pays an effective tax rate of 4%. I would lower the tax rate applicable to the wage earner, offset in part by higher taxes on the investor. Does this increase the overall "fairness" of the tax system in CTJ's view?

[5] On a similar note, CTJ states that "it’s downright unfair when millionaire investors pay effective tax rates far lower than those of most middle-income people." (To get there, note that CTJ is including payroll taxes in the computation of effective tax rates for middle-income taxpayers.) But isn't it unfair when middle-income investors (the individual with $60,000 in investment income above) pay effective tax rates far lower than those of middle-income wage earners? And isn't it unfair when gazillionaires pay effective tax rates far higher than other gazillionaires?

The "fairness" point highlights why the proposed Buffett Rule is a class warfare strategy, as discussed here and here. CTJ compares the tax rates paid by millionaires to the tax rates paid by the middle class. I'm concerned about the disparate treatment of wage earners and small business owners relative to the investor class. I'm concerned about efficiency and fairness, but I don't need class warfare rhetoric to articulate the concern. We don't need a "Buffett Rule" to accomplish fundamental tax reform. We simply need legislators who are willing to prioritize and compromise.

Prioritize and Compromise

On Monday, Michael Durst elaborated on a previous tax reform proposal (see Durst, "An Employment, Equity, and Competitiveness Tax Act," Tax Notes, Sept. 26, 2011; discussing Durst, "Radical Centrism and the Corporate Income Tax," Tax Notes, Sept. 5, 2011).

Durst describes his proposal as "a two-pronged, radically centrist tax package" with two key elements:

1. A reduction in the corporate tax rate to 15 percent, along with elimination of opportunities to shift income to tax havens and other significant corporate base broadeners. The goal would be to increase U.S. job creation, both through the effects of the lower rate and by eliminating current tax haven techniques that encourage job creation outside instead of within the United States.

2. A reform of the individual income tax that would make the tax more progressive, primarily by increases in rates applying to the highest-income taxpayers. Maximum rates nevertheless would remain low by historical standards....

I don't agree with Durst's entire reform proposal, but I agree with Durst that legislators need to prioritize and compromise. Our tax system is a ramshackle structure decomposing from within, and I'd love to strip it down to the studs and begin renovation. However, if we have to renovate incrementally, I'd start with corporate tax reform.

Our corporate tax rate is uncompetitive by international standards. Capital is mobile and ruthlessly unpatriotic. As such, it migrates to the highest after-tax return opportunities. The uncompetitive U.S. tax rate discourages capital allocation to U.S. businesses by decreasing after-tax returns to investors. This has a pernicious ripple effect that hits the capital-intensive manufacturing industry particularly hard. Less capital means a higher cost of capital. A higher cost of capital means higher input costs. Higher input costs mean higher-cost products and services. Higher-cost products and services are less competitive in domestic and international markets (and more expensive for domestic consumers).

Compounding matters, the U.S. transfer pricing regime is porous, favoring multinational enterprises that can migrate intangibles offshore over U.S. businesses with tangible assets, operations and employees in the United States. The deck is effectively stacked against U.S. businesses relative to their multinational and international competitors.

A growing consensus of tax professionals, academics and economists has acknowledged the need to reform the corporate tax system by lowering rates. Hopefully, that message will begin to resonate with legislators, who are struggling to cope with our lapsed economic hegemony. Although I don't expect a "grass roots" movement for corporate tax reform, I hope that the most zealous advocates of high corporate tax rates achieve irrelevance.

Meanwhile, there is no free lunch. Although corporate tax reform is a priority, we can't escape the fact that government obligations will continue to swell as the Baby Boom generation enters retirement. Realistically, we'll need to offset a decrease in corporate tax revenues with another source of revenues. Legislators should consider a VAT, and they should consider progressive increases in average tax rates as a trade-off for corporate income tax reform.

In particular, a reduction in the corporate tax rate could be partially offset by eliminating the tax preference for certain investment income. Corporate earnings are taxed at a 35% top marginal rate, and the 15% rate applicable to qualified dividends and long-term capital gains reduces the overall tax burden on the underlying business income. By lowering the corporate tax rate, legislators would undermine the conceptual justification for the 15% rate.

The existing political climate is depressing to those of us who don't extract power or lobbying money from gridlock. Tax reform seems virtually impossible before 2012. However, we don't need a "Buffett Rule" to jump start the process. Corporate tax reform is possible if legislators would simply prioritize and compromise. A reduction in corporate tax rates, offset by taxing investment income at the same rates as ordinary income, could be an important step towards fundamental tax reform.

Stay tuned for more details on my own corporate tax reform proposal.

Surprising C Corps

Today in Tax Notes, Martin Sullivan contributed an interesting article on "small business" C corporations (see "The Small Business Love-Hate Relationship With Corporate Tax").

Sullivan's article mines data in a new study prepared by a group of economists at the Treasury Department. The data indicate that nearly 900,000 small business employers filed tax returns as C corporations in 2007. The thresholds for a "small business employer": gross receipts or total income of less than $10 million; and wage or salary deductions of more than $10,000.

At first blush, the numbers sound pretty crazy. The income of a C corporation is subject to double taxation. Under the "double-taxation dilemma," a C corporation pays tax on its income (the first tax, up to a 35% marginal rate). Then its owners pay tax on dividend payments from the C corporation (the second tax, at a 15% rate for qualified dividends). Including state income taxes, a shareholder of a C corporation may suffer a 55-60% tax expense on income of the underlying business.

For small business owners, the "double-taxation dilemma" is essentially voluntary. And many individual owners of small businesses have elected out. Income earned by "pass-through" entities (e.g., S corporations and partnerships) is subject to a single level of tax. Unlike a C corporation, a pass-through entity does not itself pay tax. Instead, its owners report their share of income from the underlying business, and pay tax on that income (a single tax, up to a 35% marginal rate in 2011).

Sullivan's article explores why small business owners may elect into the "double-taxation dilemma" and operate their businesses through C corporations. Sullivan demonstrates that, "[u]nder the right conditions, a C corporation can be a nice little tax shelter for a small business. That helps explain why so many small businesses remain C corporations when they have the option of becoming LLCs or S corporations."

I follow Sullivan's conclusion. However, I'd guess that many of these C corporations owe their "existence" to bad tax advice or tax illiteracy (i.e., no tax advice). In the M&A context, I've seen numerous instances where a small business owner inadvertently grows a business under a C corporation "wrapper." They come to regret that planning (or lack of planning) when they decide to sell the business. (Due to the "double-taxation dilemma," in most instances, a purchaser will pay more for a "pass-through" entity than a C corporation.) Moreover, most "small" business owners are focused on their small businesses and are resource constrained with no "budget" for tax planning. To this point, Sullivan lists some of the pitfalls for a small business owner seeking to exploit a C corporation tax shelter.

Sullivan's article is worth a read for tax nerds. It encouraged me to jot down some corporate tax reform ideas that have been rattling around in my head. More to come in a subsequent post.

All Sizzle, No Steak

Ask a Wall Street financial expert to name the most high-profile resident of Nebraska. They'll probably answer Warren Buffett, the legendary investor and "Oracle of Omaha." Now ask a Nebraska farmer. They'll probably answer Tom Osborne, the legendary football coach of the Nebraska Cornhuskers.

In Nebraska, Cornhusker football is a quasi-religious experience. When the 'Huskers play at home, their stadium becomes the third-largest city in the state (behind Lincoln and Omaha, Buffett's home city). While the 'Husker fans take their teams seriously, they don't converge on Lincoln solely for the football. With college football, comes serious tailgating. And with serious tailgating, comes grilled meat for the inner caveman.

During a 'Husker tailgating party, when the charcoal starts glowing, fans break out the brats and burgers and steaks. Nebraskans want their steaks fresh, juicy and big, with an anonymous American beer on the side. They're looking for the steak in steak, not the sizzle.

On Monday, September 19, President Obama announced five principles of tax reform (part of his plan for economic growth and deficit reduction). As I discussed in my last post, the fifth principle is "observe the Buffett rule." The Buffett Rule says that people making more than $1 million a year should not pay a smaller share of their income in taxes than middle-class families pay.

The rule is all sizzle, no steak. That's ironic, given its namesake. Then again, mega-billionaire Buffett would probably be more comfortable at an Obama fundraising event than a 'Husker tailgating party.

Sizzle, Drizzle, Fizzle

The Buffett Rule attracted immediate criticism. For tax professionals and economists familiar with tax data, the premise of the Buffett Rule didn't pass a "smell test." It just didn't seem like a widespread problem that should become a central plank of tax reform. Gene Sperling conceded as much this week on a White House blog post "clarifying" the Buffett Rule.

The $100 Million Man

For several years, Buffett has claimed that he pays a lower effective (or average) tax rate than his secretary, who earned $60,000 in 2007. Buffett claimed that he paid tax at a 17.7% average rate (for example, $1.77 million in tax on $10 million in income). He claimed that his secretary paid tax at a 30% average rate ($18,000 of tax on $60,000 in income).

The numbers recited by Buffett never made sense to me. I understand why an uber-wealthy individual taxpayer might pay a low effective tax rate. More on that below. I don't understand how a secretary earning $60,000 could get stuck with tax at a 30% rate. As discussed in the next section, it seems unlikely (impossible?) that Buffett's secretary pays tax at a 30% average tax rate.

Why can an uber-wealthy individual taxpayer pay a low effective tax rate? Seems kind of unfair, right? Under current law, qualified dividends and long-term capital gains are subject to tax at a 15% rate. The 15% tax rate is intended to reduce the double-taxation dilemma that occurs when a corporation distributes its previously-taxed earnings to its shareholders. If a high proportion of an individual's taxable income is derived from dividends or capital gains, that individual's effective tax rate gets "averaged" down towards 15%.

In fact, under current tax rules, a mega-millionaire could earn millions from tax-exempt bond investments, and pay an effective tax rate of zero! Imagine a successful Internet entrepreneur cashed out at the top of the bubble in 1999, paid taxes on his fabulous gains, and rolled $100 million of cash into tax-exempt bonds yielding 5%. His tax-exempt bonds would generate annual cash income of $5 million. However, the income from the bonds is exempt from federal income tax. Zero tax on $5 million in income results in a 0% effective federal income tax rate. That's a lower rate than Buffett, his secretary, and the other 99.99% of us endure.

Of course, Congress didn't exempt state and municipal bond income from taxation as a favor to our $100 Million Man. The exemption for interest paid on tax-exempt bonds represents a subsidy to state and local governments. The federal tax subsidy reduces the cost of financing by permitting state and local governments to issue debt at lower yields. The subsidy reflects a policy choice, and arguably a "bad" policy choice that encourages undisciplined spending by state and local governments.

Note that Congress could increase the 0% effective tax rate applicable to our $100 Million Man by eliminating the tax subsidy for states and municipalities. Eliminating the tax subsidy would increase borrowing costs and decrease the funds available for other state and local objectives. Maybe that's better policy in the long run. But the political left assaults common sense when it demagogues "millionaires and billionaires" who benefit from structural policy decisions (like the tax subsidy for state and municipal bonds). Our $100 Million Man isn't "gaming" the system to achieve a 0% effective tax rate. He's simply playing by the rules of the game that Congress put on the table.

Numbers Don't Lie

Let's get back to Buffett and his secretary. Buffett has complained that he pays a higher effective tax rate (at 17.7%) than his secretary (at 30%). President Obama has seized Buffett's complaint and incorporated it into his "principles" that should guide "fundamental tax reform."

Because the President has made Buffett's complaint a prime-time issue, it raises three questions. Is the complaint accurate, i.e., does Buffett really pay a lower effective tax rate than his secretary? Is the problem widespread based on existing tax data? And is Buffett's concern fundamental to our long-term fiscal solvency and economic competitiveness?

No, no, and no.

[1] Buffett's claim does not seem accurate, much less possible, based on prevailing tax rates. Of course, we don't have complete facts on Buffett's secretary. Is he or she married? Does he or she have children? If married, what kind of earnings does his or her spouse bring to the table? The list could go on for 10 paragraphs.

Having been deprived of the actual facts by Buffett and Obama, I plugged some assumptions into a tax calculator. I assume that Secretary reports $60,000 in taxable income, claims the standard deduction ($5,700), a single exemption ($3,700), and takes advantage of the reduced Social Security tax rate in 2011 (4.2%). On my assumptions, Secretary is in the 25% tax bracket, but pays income tax at a 17.3% average rate. (For another cut at the exercise, see this hypothetical from Peter Pappas.)

We'll never know if Buffett was exaggerating the numbers, confused about the fact that marginal tax rates exceed average tax rates, or had special knowledge about his secretary's tax position (e.g., secretary is married to a spouse with a $200,000 income). However, it seems highly unlikely that Buffett's claim was accurate. So the fifth "principle" guiding Obama's tax reform platform is based on exaggeration, confusion, or some combination of the two.

[2] The "problem" identified by Buffett (based on exaggeration or confusion) is inconsistent with the existing tax data, as discussed here and here.

The nearby table is copied and pasted from the Wall Street Journal article. Although the mega-billionaire Buffett (at 17.7%) may pay a lower effective tax rate than an average working professional married couple with taxable income of $250,000 (at 19.6%), that is not the case for the average "millionaire or billionaire." Both the average millionaire (at 23.3%) and the average working professional married couple (at 19.6%) pay significantly higher effective tax rates than the average middle-class secretary (at 8.9%, assuming taxable income in the $50,000 to $100,000 range).

[3] Finally, the "problem" identified by Buffett (based on exaggeration or confusion) is not fundamental to our long-term fiscal solvency or economic competitiveness, as I discussed in my last blog post.

White House Spin Fizzles

In light of the numbers, the Obama administration went into spin mode. Gene Sperling posted this defense of the "Buffett Rule" on the White House blog last week. Sperling clarified several of the questions that jumped to my mind when I heard about the proposal. Ironically, however, Sperling's attempt to rebut criticism of the proposal confirmed that the "principle" is a class-warfare tactic that will distract from actual tax reform.

So what did Sperling say?

[1] The Buffett Rule will only potentially apply to those with taxable income over $1 million -- approximately 0.3% of American taxpayers. We're off to a shaky start. I thought this was supposed to be a "fundamental" principle of tax reform. And it only potentially applies to 0.3% of taxpayers?

[2] Even among that 0.3% of American taxpayers, it affects only those within that group that pay low tax rates:

In fact, many — if not most — of the few true small business owners making over $1 million already pay ordinary income tax rates (and not the preferential rates) and thus would not be impacted at all by the Buffett Rule.

Okay, so the Administration believes that "many" but not "most" taxpayers reporting more than $1 million in taxable income pay tax at ordinary income rates (35% in 2011). That seems consistent with the data (see table above; the average tax rate paid by taxpayers in this group was 23.3%). However, now we're talking perhaps 0.1% or 0.2% of American taxpayers under the microscope.

[3] The Buffett Rule is not about "all taxpayers." It is about those taxpayers who are able to pay at lower tax rates than middle-class families:

Take IRS data on the taxes paid by the 400 highest-income households in 2008, all making over $110 million per year and making an average of $271 million per year. Some of those 400 taxpayers do pay their fair share, but according to that data, one-third of this group pays less than 15 percent of their income in taxes and 85 percent pays less than 30 percent.

Now, we're getting somewhere. It appears that the Administration is obsessed with roughly 133 taxpayers (one-third of 400). Because 133 taxpayers recognize a disproportionate amount of income from qualified dividends and capital gains (see above), the Buffett Rule has become a central plank of tax reform? Excuse me while I read the White House blog again, because I must be missing the joke.

[4] Sperling then launches into a series of hypotheticals where he, perhaps channeling Buffett, confuses marginal tax rates for average tax rates.

Conclusion

I'm pretty much sick of Warren Buffett and his bumbling foray into tax policy. Team Obama has taken an alleged "problem" involving 100-200 uber-wealthy taxpayers, and begun marketing the "solution" as fundamental tax reform. The emphasis on average tax rates might be a good class warfare tactic, but it misses the critical question. The critical question is: how much of the total income tax burden should we impose on the top 0.1% of taxpayers (or top 0.3%, or 1%, and so on). Perhaps we'll look at the numbers and conclude that they're paying their "fair share." Perhaps we'll conclude that they're not. A focus on "average tax rates" simply distracts from the question.

Meanwhile, the Nebraska Cornhuskers are 3-0 going into a game against Wyoming. Break out the steak, and leave the sizzle to Team Obama.