Rip Me Off-- Please, A Guest Post by Chris M. Horwitz, PhD

Chris Horwitz is CEO of Electrogrip, which has manufactured equipment for the semiconductor industry for the past 25 years in Pittsburgh, PA. Electrogrip also makes precision large optical components; some of them for the new James Webb Space Telescope, which will be replacing NASA's Hubble Telescope in the near future. Last night was his guest guest post here at DWT. We are hoping there will be plenty more.

It seems so obvious-- reduce taxes on business and remove those awful tax loopholes that make taxes so complex, so that businesses can thrive. Don't business leaders know better than governments how best to spend those hard-earned profits? That's how the story goes and it's an easy one to believe. But it's not true. It's a financial engineer's dream but a manufacturing engineer's nightmare.

To see how reduced taxes are bad for business, imagine that your own household is a business and that you have choices for YOUR hard-earned cash; take a course to learn a new skill-- or buy a new TV set for the same amount of money. Governments tip the scales by giving tax benefits for education, making it cheaper for you to think ahead instead of giving in to quick gratification. Corporations also benefit from deductions and credits for long-term thinking. Examples are the Research and Development tax credit, and deductions for new buildings, computer gear and machine tools. So if the tax rate is high, and the deductions are well-targeted, firms will prefer to plough profits back into strengthening their business. This 'use it wisely or lose it' philosophy has guided tax policy for many decades.

We could invent other philosophies promoting lower taxes, and they could sound convincing. We've been hearing these during various political campaigns. So is there any evidence for either viewpoint? In 2005 a nonpartisan government advisory body, the Congressional Budget Office (CBO), published a comparative study of corporate taxes and their impacts. The graphs clearly show that three top exporters (The US, Germany, and Japan) all had the highest tax rates in the world, of about 40%.

Another graph in that same study showed a likely reason for these countries' export success: The highest tax-rate countries also had the highest corporate RE-investment rate in capital equipment. So the CEO's of those companies did a great job of hiding their income from the government, to avoid those high taxes. In the process they did their companies-- and their countries-- a world of good. Germany, the US and Japan were all top exporting nations so it's clear that high corporate tax rates had not been harmful. Does the Federal Government mind if corporations pay no tax due to re-investments? Corporate taxes lately have been only 10% of Federal revenue, down from 30% in 1953. So the major impact of high corporate tax rates would likely be raising company re-investment rates to higher levels than in other countries.

Now let's look at export performances of the four leading countries...Germany, Japan, China, and the US, taken from the CIA World Factbook (yes, some of the CIA's information is public). Their CIA export ranking is plotted below. You will notice that China has grown dramatically over the past twenty years. You will also notice that Germany and the US have been fighting it out for first place for much of that time, even though Germany's population is 1/4 that of the US. Japan has half the US population and half the ranking, so Japan is amazingly less efficient than Germany in terms of export prowess. China has a higher population than the US and one day it can be expected to dominate world trade. Notice however that Germany has maintained its pole position, except that now it is fighting it out with China for first place. With less than 1/10 of China's population! Japan has also maintained its approximate position. The US however is on a steep downward curve. Something changed in the US to cause such a drop, and I point to US tax policies which have moved to encourage reduced investment and reduced global performance.

The above graphs indicate that high corporate taxes are helpful for a country's continued re-investment in productive enterprises. But what are the limits on how high or low corporate taxes should be? We could imagine a 'perfect' world of killer 80% corporate tax rates, but where companies pay no tax because they plough almost all profits back into their company to further boost growth. A small and highly taxed amount would be accumulated in a 'rainy day' reserve fund. For such a well-run company, the corporate tax rate would be almost irrelevant. These high imaginary corporate tax rates would only matter to shareholders requiring dividends from those vanished profits, which would be heavily taxed both at the company and at the shareholder level. However shares also can rise in value. This capital appreciation boosts investor income, perhaps by more than could be got from dividends. In a world of high corporate taxes, investors would likely be advised to take no dividends and be satisfied with rising share values (which are currently are taxed at the really low capital gains tax rate). Therefore 'punishingly high' corporate tax rates would change how investors collect share income, but could be sustained, and would result in continued and strong company performance.

Thus perhaps corporate tax rates have been kept as low as they are to permit dividend payments to make more sense for those with a shorter time frame for investment. Another possible argument for low corporate tax rates, which sounds really good on the surface, is the preference a high tax rate may give towards debt (which is damaging in the long term) rather than issuing more preferable share equity. Debt interest payments are deductible from profits, but dividends are not, so companies could take on tax-deductible debt. This may seem more attractive than issuing shares and having to pay dividends which are not tax-deductible. Corporate debt over a period of reducing corporate tax rates is shown below, from a 1990 publication "Taxation, Corporate Capital Structure, and Financial Distress", by Mark Gertler and R. Glenn Hubbard, from the National Bureau of Economic Research. Interestingly, this shows that as corporate tax rates fell, the level of corporate debt rose in relation to shareholder capital. This counter-intuitive observation, while hard to explain on the basis of tax rates alone, has the benefit of being true. So lower tax rates seem to encourage, or at least do not inhibit, high corporate debt.

So what is bad with high debt levels? It turns out that debt is less sustainable than shareholder equity through economic boost and downturn cycles, since debt service is typically fixed, while dividends can be stopped in hard times. High debt level levels are a harbinger of bankruptcies, as described in the above Gertler and Hubbard publication. So there seems to be no strong argument for lowering corporate tax rates. Hubbard was an adviser to Mitt Romney in his 2012 presidential run, and now advocates for his financial firm clients, and also for low tax rates, but his publication's evidence is clear.

Here's another argument for low corporate tax rates. Folks talk about competition between countries, and that tax rates should be harmonized between competitors so that low rates in one country don't steal companies from other, more highly-taxed countries. However there's little evidence that globalization of production is determined by relative tax rates - especially since taxes can be reduced so easily through re-investment and royalty payments, and since infrastructure plays such a large part in the success of an enterprise. If taxes were all that mattered, manufacturing would all move to Africa or Antarctica! The above first graph from the CBO provides further evidence that low tax rates don't correlate with competitive industry.

So what WOULD happen with low corporate tax rates? We know that high tax rates encourage re-investment, and that high tax rates do not induce a higher and damaging level of company debt. On the other hand, a low tax rate would permit CEOs to more easily favor their personal desires for a large bonus in preference to investment in their company. So we would expect damage from reduced company re-investment, likely a higher debt load, and higher CEO bonuses, but that's not the end of the story! If corporate tax rates become lower than personal tax rates, high net worth individuals would gain yet another way to lower their personal tax rates; they could convert their assets into a corporation and enjoy those new low tax rates. As a bonus, their assets would gain a corporate life of their own and escape estate taxes as well. Have you heard anyone advocating bringing corporate tax rates down to zero? Now you know what's behind that idea. So low corporate tax rates would help some folks, but not productive companies, nor the country as a whole.

There's one more nasty little trick left in the box, because there's another way that a company could reduce its tax to zero, and which is encouraged by a low capital gains tax. A company could be bought out by 'investors' who force it to borrow so much money that interest payments on the loan wipe out its profits. The investors pay themselves enormous 'advisory fees', paid for by that loan, and would pay income tax at their low corporate or personal rate. If by chance the company manages to do well, the company can be taken public or sold to others. The resulting additional income is classed as capital gains, so is taxed currently at an even lower rate than the personal rate. Meantime that company, with its heavy debt burden, during a general economic downturn will be more likely to go bankrupt. Mitt Romney pioneered this method at Bain Capital and gained himself hundreds of millions of dollars. In his 2012 campaign, Mitt Romney also advocated bringing the capital gains tax down to zero. Such a move would further reward financial engineering, at the expense of manufacturing engineering. If capital gains were taxed at the personal or corporate tax rate, such financial tricks would not be so profitable.

The next time you hear the mantra "lower the tax burden, reduce the deductions, bring capital gains tax to zero", you now know what that means; give over the economy to those who don't want to invest in the future, but are perfectly happy to rip off what is already there. Unhappily the reductions in US corporate taxes over the past 20 years have accelerated this unfortunate trend. Our politicians know better, but perhaps they believe that no-one has been watching them, and have been happy to accept campaign help from those that have benefitted from our overall downward slide.