Sunday, October 28, 2007

Wal-Mart's tax minimization efforts demonstrate flaws in tax system

Why the current income tax structures, for both corporations and individuals at both the federal and state levels, need an overhaul:

In May 2001, Wal-Mart Stores Inc. issued an appeal to big accounting firms: Find us creative new ways to cut our state tax bills.

Ernst & Young LLP swung into action. Senior tax experts at the big accounting firm swapped ideas via email and in a series of meetings. At least one gathering, according to an internal Ernst & Young calendar, took place in Wal-Mart's headquarters in the "Tax Shelter Room."

Ernst doesn't specialize in cost accounting. Wal-Mart isn't calling on one of the big four to help it realize efficiency gains in its distribution process. The mass retailer wants to shuffle around income classifications, set up LPs and LLCs, and find ways to allocate depreciation and amortization schedules in states to maximize the paper expense as early as possible:

State income-tax rates for corporations average about 6.9%, and come on top of a federal statutory rate of 35%. Tax rates vary from state to state, and some states have no corporate tax at all on certain income. That provides ample opportunity for so-called tax arbitrage, in which companies allocate expenses and revenues between states in order to minimize taxes owed. That practice has been going on for decades. Some such strategies are perfectly legal. The government considers others to be abusive.

States are looking to go after Wal-Mart for trying to minimize its real tax expense (which, interestingly, means the retailer is trying to hard to maximize its reported operational expenses):

Ernst & Young's contributions to Wal-Mart's state-tax minimization project are outlined in a raft of documents filed in recent months in North Carolina state court, where the state's attorney general is challenging a Wal-Mart tax-cutting structure involving real-estate investment trusts. The material, which includes company emails and memos, provides a rare window into accountants' role in generating tax-reduction ideas at one major company.
Corporations have what amounts to an almost inexhaustable out here, however. They argue it's merely an attempt to raise capital through better business management. And the effect, presuming legality, is to do just that.

If state government regulators discover a novel tax reducing scheme, they are hard-pressed to bring successful charges against the purveyor, as they tend to run into the ex post facto trap. The WSJ article offers reports on candid commentary from an Ernst executive in his discussions with Wal-Mart:

"We don't think there is much the state taxing authorities can do to mitigate these savings to Wal-Mart, however some states might attempt something if they had advance notification," he wrote. "We think the best course of action is to keep the project relatively quiet....there just seems to be too many opportunities for it to get out to the press or financial community and we all know they are difficult to control, particularly when we are dealing with a client as well-known as Wal-Mart."

So hand-wringing occurs. State (and in the case of high-profile national cases like the Enron collapse, federal) legislatures then pass legislation to address these specific tax reducing tactics.

Federally, that adds to Title 26 of the USC, and the 17,000 page beast grows even longer. There are endless opportunities for sharp accountants to find new schemes in that labyrinth. Often that involves taking certain financial operations to other countries (something Ireland has benefited enormously from), or selling assets to foreign investors and then paying those investors (who do nothing with the assets) to 'rent' the same assets, at a pre-tax cost to the company that is slightly higher than what it would have been in retaining ownership (so the investor comes out ahead) but that is more than made up for in tax bill reductions for the company doing the selling and subsequent renting. On net, this means the domestic company makes an inefficient decision and sends money overseas, neither of which benefit the US economy.

But accounting firms are moving increasingly in the direction of this sort of tax minimization work, not only for firms but also for affluent individuals. With double-digit annual growth in the number of US millionaires, and a similarly rapid rise in the number of 'super rich', and the proliferation of low-cost tax software, the H&R Block variety of routine tax preparation is becoming a thing of the past for tax professionals.

Parenthetically, there are three major accounting 'branches': Managerial (or 'cost'--this actually involves working toward bettering business operations by cutting out duplication and streamlining production processes), financial (putting out, complying with, and reviewing corporate earnings reports), and tax. Managerial is growing steadily along with the economy at large. It is mostly done by companies in-house, and is where many accountants migrate to after working on the financial side (although this has seen lots of growth due to Sarbox regulations) for one of the big four. Tax, meanwhile, has become more specialized.

A disproportionate chunk of tax schemes involve the state of Delaware. Like Ireland in Europe, or the UAE internationally, the otherwise obscure First State (when was the last time you heard of anything, Senators excepted, happening in Delaware?) has the most corporately-friendly and developed body of tax policies in the country. The article offers a typical example:
Under Texas law at the time, a limited partner from out of state was exempt from Texas's corporate franchise tax. As a result, scores of companies, including Wal-Mart, reorganized their Texas operations into limited partnerships. The general partner, which was subject to state taxation, was typically a subsidiary based in Texas. But the limited partner, often owning as much as 99.9% of the entity, would be based in Delaware or another tax-friendly state. The result: up to 99.9% of the profits of the Texas operation would flow to that out-of-state limited partner, making that income tax-free.
Wal-Mart's revenue is primarily generated in the US, so it is more focused on state tax restructuring than most companies are. But why shouldn't our federal tax structure be set up to do what Delaware has done, albeit on an international stage?

A consumption tax in place of the federal income tax strikes me as the best way to do this. Such a change would create a magnet for manufacturing and encourage MNCs who started in the US to bring their headquarters back home.

It has other positives. The economic benefit employers see in utilizing illegal immigrant labor gets a major boost from those illegals often not paying federal income taxes, meaning their wages can nominally be 20% less than those of the native working class and still have the same real purchasing power, so the native guy is at an inherent disadvantage. The FairTax, in creating a monthly rebate for all citizens based on family size, turns this around entirely. With $200 coming in at the end of the month, and facing no disadvantage in having to pay income taxes that illegal workers are not subject to, the working class native now has the advantage at the starting gate.

More than $350 billion in revenue is 'lost' by the federal government through the overreporting of deductions, and the underreporting and undercollection of income. That's more than twice the size of this year's federal government deficit. A consumption tax will not eliminate cheating, but it has an enormous built-in advantage over the income tax--it always takes two parties instead of sometimes just one to filch.

There are lots of ways I can fudge numbers on my tax return without any way of being caught short of a detailed audit (which happens to less than 1% of individuals, and that small fraction is disproportionately comprised of people who are members of partnerships, S Corps, and LLCs).

But if the tax is only levied at the point of sale, the buyer can help detect avoidance (as he can now for in the collection of state sales taxes). There is little incentive for him to say anything about it, though, since he stands to benefit directly from that avoidance. However, if there is some incentivizing reward for him in anonymously reporting avoidance to authorities, it does provide some added level of potential detection (turning conspirators against one another in illicit drug sales using a similar reward strategy seems to me a worthy idea to consider as well).

Adam Smith's four maxims of an optimal tax code--equity (progressive, corporations with lots of cash can hire firms to find ways around paying), certainty (if you do your own taxes, you struggle with uncertainty every April, awaiting that letter from the IRS saying you owe more than you thought you did), convenience (advice from the tax accountant: Keep records of everything!), and efficiency (corporations spending money to pay sharp accountants to make business decisions based not on total utility but on tax efficiency)--do not describe the federal income tax in the least.

A consumption tax, in contrast, fulfills all of them. Regarding equity, you pay when you have the wherewithal to do so--that is, when you're making the purchase. You cannot go into debt for tax bills you're unable to pay. Everybody (including immigrants and foreign travelers) pays in.

In terms of certainty, it's simple. If it's a new item or a service, it is subject to the consumption tax. If it is a used item, it is not.

Perhaps its biggest advantage is in convenience. Imagine not having some percentage of each paycheck being diverted to various tax lines. You pay your taxes when you buy groceries and go to the movies. That's it. You never have to think about it.

As for efficiency, the annual cost of compliance (including the loss of potentially productive time) is north of $200 billion, according to the Tax Foundation. A national consumption tax would require only an augmentation of the current systems already in place to ensure sales taxes are collected. Further, while an income tax punishes people for making money and encourages them to spend it (small wonder our national savings rate hovers around zero), a consumption tax does just the opposite--it encourages people to create wealth and discourages them from squandering it.

14 comments:

Hal De Fencelaus said...

When I read the quote "federal statutory rate" above, I saw "federal statutory rape" instead. That would be more accurate of course, referring to tax rates.

nc mortgages said...

everytime walmart moves into a neighborhood...the values always go down!

Anonymous said...

That would be more accurate of course, referring to tax rates.
---------------------------------

Wait till you see Canada...

Ian said...

Taxing business is just a hidden tax to the consumer. Getting onboard the FairTax movement to support bills HR 25 / S 1025 to replace the income tax system with the FairTax consumption tax is what is needed.

Congress will not pass this bill without a major citizen uprising. To date, 72 members of the House and Senate, combined, endorse and co-sponsor these bills.

While many who are invested in the current income tax system seek to demagog the well-researched FairTax plan, FairTax's theoretical underpinnings have been professionally reviewed, and its acceptance in the professional / academic community continues to grow.

Renown economist Laurence Kotlikoff believes that failure to enact the FairTax - choosing instead to try to "flatten" what he deems to be a non-flattenable income tax system - will eventuate into an irrevocable economic meltdown, because of the hidden aspects of the current system that make political accountability impossible. Tom Frey, of the DiVinci Institute, foresees the coming collapse of the income tax system.

Here is why the FairTax MUST replace the income tax. It's:

• SIMPLE, easy to understand
• EFFICIENT, inexpensive to comply with and doesn't cause less-than-optimal business decisions for tax minimization purposes
• FAIR, loophole free and everyone pays their share
• LOW TAX RATE, achieved by broad base with no exclusions
• PREDICTABLE, doesn't change, so financial planning is possible
• UNINTRUSIVE, doesn't intrude into our personal affairs or limit our liberty
• VISIBLE, not hidden from the public in tax-inflated prices or otherwise
• PRODUCTIVE, rewards, rather than penalizes, work and productivity


Its benefits are as follows:

For INDIVIDUALS:
• No more tax on income - make as much as you wish
• You receive your full paycheck - no more deductions
• You pay the tax when you buy "at retail" - not "used"
• No more double taxation (e.g. like on current Capital Gains)
• Reduction of "pre-FairTaxed" retail prices by 20%-30%
• Adding back 29.9% FairTax maintains current price levels
• FairTax would constitute 23% portion of new prices
• Every household receives a monthly check, or "pre-bate"
• "Prebate" is "advance payback" for taxes payable on monthly consumption to poverty level
• FairTax's "prebate" ensures progressivity, poverty protection
• Finally, citizens are knowledgeable of what their tax IS
• Elimination of "parasitic" Income Tax industry
• NO MORE IRS. NO MORE FILING OF TAX RETURNS by individuals
• Those possessing illicit forms of income will ALSO pay the FairTax
• Households have more disposable income to purchase goods
• Savings is bolstered with reduction of interest rates


For BUSINESSES:
• Corporate income and payroll taxes revoked under FairTax
• Business compensated for collecting tax at "cash register"
• No more tax-related lawyers, lobbyists on company payrolls
• No more embedded (hidden) income/payroll taxes in prices
• Reduced costs. Competition - not tax policy - drives prices
• Off-shore "tax haven" headquarters can now return to U.S
• No more "favors" from politicians at expense of taxpayers
• Resources go to R&D and study of competition - not taxes
• Marketplace distortions eliminated for fair competition
• US exports increase their share of foreign markets


For the COUNTRY:
• 7% - 13% economic growth projected in the first year of the FairTax
• Jobs return to the U.S.
• Foreign corporations "set up shop" in the U.S.
• Tax system trends are corrected to "enlarge the pie"
• Larger economic "pie," means thinner tax rate "slices"
• Initial 23% portion of price is pressured downward as "pie" increases
• No more "closed door" tax deals by politicians and business
• FairTax sets new global standard. Other countries will follow


It's well past time to scrap the tax code and pay for government the way that America's working men and women are paid - when something is sold.

(Permission is granted to reproduce in whole or part. - Ian)

undergroundman said...

A 20% consumption tax, which is what the FairTax calls for, would drive much of the economy underground and into the black market. It's ironic that libertarian-esque people are sometimes confused enough to agree with this system, or maybe it's a deliberate thrust towards anarchy.

The truth is that it would divert money towards criminals, and in the process many other people would be hurt.

undergroundman said...

Emailing further comments to myself...

Audacious Epigone said...

UC,

Are you arguing that state sales taxes have higher avoidance rates than state income taxes? That is patently false.

Regarding the underground economy, more than $400 billion is 'hidden' from the federal income tax system. Provide a carrot for those who (anonymously) report sellers who violate, and the problem is well on its way to being taken care of. Skimping on sales taxes is more difficult than is skimping on income taxes.

undergroundman said...

Show me a state sales tax in the range of 20%. The carrot would have to be significant.

By the way, why not do a value-added tax? Why hurt the retailers disproportionately?

I suspect ignorance explains why those who favor a FairTax don't advocate a value-added tax

Audacious Epigone said...

UC,

State income taxes, with rates averaging between 3%-6% have higher avoidance rates than state sales taxes of 3%-6%. Perhaps this would flip as both get into the double-digits, but I see no reason to assume that will be the case.

Regarding the VAT: I like it more than an income tax. But VAT compliance is more difficult to assure than end-product sales taxes are, and I like how a sales tax favors creation over consumption more than VAT does (even with an end-product export exemption). I also worry about exemptions and how convulted they might become. But I don't dislike the VAT idea.

In either case, I'm arguing for system replacement, not supplementation.

Ian said...

The flat tax is really a VAT. Here is a substantive rebuke of FairTax naysayer, Bruce Bartlett, who's been dissing the FairTax (in sloppy, biased manner) at such venues as OpinionJournal.com, WSJ, and The New Republic Online.

(Paraphrased) Reply by Dan R Mastromarco (LL.M., Taxation, Georgetown, principal in the Argus Group, adjunct professor at the University of Maryland, International Management Program, and research consultant to Americans for Fair Taxation - FairTax.org) to:

"A National Sales Tax Doesn’t Add Up" by Bruce Bartlett, December 29, 1999

Many engaged in true tax reform find Bartlett-type attacks exasperating, if not embarrassing. I'd like to convey perspective of both flat taxers and sales taxers who believe that such attacks are counterproductive, but first provide some political history by which to frame said perspectives.

For years Conservatives have posited that a VAT is bad policy (when liberals were discussing it), fearing it would become additional to an income tax (it was called a "money machine"). Circa 1980, conservative intellectuals touted Hall-Rabushka "subtraction method"[ H-R ] VAT which taxed business value added at the business side and labor value added at the labor side. Unlike European VATs (identical in scope), H-R became favorite of Dick Armey and Steve Forbes. It eliminated steeply progressive tax rates and tax on savings. Because of the prior VAT criticisms, H-R was packaged as the "flat tax" and is sold as an income tax to this day, rather than the VAT that its DNA characterizes it as being.

Some conservative commentators have called for the repeal of the 16th Amendment and for the adoption of the flat tax, (despite the fact that it is styled as a direct tax and could not be adopted with such repeal). Mr. Bartlett has called the national sales tax [ie, the FairTax] a VAT (which it isn't), castigated VATs as evil, and has said that sales taxes have become VATs in Europe (which they didn't). In the next breath, he "throws his arms around" the flat tax (which is a VAT). He quotes Bill Gale that the [FairTax] would have to be imposed at 60 percent, but glaringly fails to recognize that if the two bases are the same, he would have to impose that rate for the flat tax to be revenue neutral. In truth, all economists know that the two plans differ NOT in economic effect or base, but in administration.

An income tax taxes savings and investment multiple times. Both flat tax and FairTax are neutral as to savings and investment, tax income only once, and are both consumption taxes. Both are single rate taxes, have nearly the same base, and would improve the U.S. standard of living. Neither redistributes wealth.

While some have even suggested that hey are the same plans under different names, the flat tax taxes value added at each stage in the production process, but the FairTax prefers to tax it when it is added up at the end and eliminate the need to make everyone a taxpayer and collector.

Substantive commonalities between the flat tax and FairTax doesn't mean that there are NO key political and policy distinctions that could be exploited in pitting one against the other. If FairTax supporters wanted to retaliate in response to the Bartlett-type critique, they would have much material with which to honestly do so:

• The flat tax will make small firms and farmers pay the tax even if they have no profit
• The flat tax is opposed by many small business groups
• The flat taxers implicitly support big government by disguising even more of the overall tax burden as the current law
• The flat tax has been kicking around for nearly 20 years
• The flat tax makes everyone a taxpayer and collector, while the FairTax exempts 115 million filers [2000 figure] from ever having to deal with the IRS
• The flat tax is regressive, but the FairTax would enable everyone to keep his full paycheck.
• The flat tax has not only stalled, it has lost public and Congressional support.
• The FairTax is instantly understood, while even some proponents of the flat tax don’t understand it
• There are no transition rules developed for the flat tax and they would be very difficult to craft
• The flat tax taxes exports and relieves imports from tax
• The flat tax confuses tax reform with temporary tax reduction and makes both twice as hard
• The flat tax retains the entire income tax apparatus which erodes as quickly as you can say, “tax bill”


FairTaxers could advance these truthful points without resorting to bigotry associated with a cultic religious organization. However, for the most part, FairTax supporters have chosen not to attack the flat tax, but rather accentuate the commonalities between the plans - despite the above-noted differences. The reason is that, in the battle for tax reform, the real enemy is our current system.

Income tax advocates look down upon the articles of Bruce Bartlett with smug chortling, as Bruce is doing their work for them. The IRS and the liberals who want an income tax to ensure (1) taxes can be raised without the American people knowing it, and (2) wealth can be redistributed from the middle class to the poor, do not even need to fight us - we're killing ourselves!

Perhaps Mr. Bartlett believes that the flat tax will help elect Republicans, effect tax reform, and provide tax cuts; however, the real effect of his criticism is to divide conservatives, to delay serious national consideration of tax reform, and to fertilize the roots of the income tax.

( Source - Pass it along, permission granted, in whole or part. - Ian)

undergroundman said...

Hmm. I'm starting to like the idea of the "FairTax", actually. I'm dreading tax season, and amount of time and money wasted on taxes is ridiculous. I'm willing to try it and see what happens as far as the black market -- although I still predict that the black market will boom and much of the normal economy will go underground.

However, the flat tax does hit the final retailers hard and everyone else not so hard. But then again, the final retailers will probably pass some of that burden on to their suppliers.

The constant change that sales taxes lead to also bothers me...I like living in Oregon, where there's no sales tax.

Audacious Epigone said...

Ian,

Thanks for that. I'm with Mastromarco in that I see the flat tax as a replacement of the current income tax structure in a positive light, but like the idea of a consumption tax better, for many reasons touched on in my response to the same article written by Bartlett.

UM,

You do some trading as well. If your first ever sell came in '07, you'll dread it even more than last year. Be sure not to go with the default of FIFO on shares of an equity you've bought up on at different periods of time. You can specify which shares are being sold.

I agree that there will be underground activity. It will, by and large, shift from the labor side of things to the consumption side of things. But it'll be easier to expose, and on net I foresee less total evasion, based on what happens at the state level (admittedly at smaller tax rates for both methods of collection).

Ian said...

Thanks, but trading-wise, I've gone largely dormant while I focus my personal time more sacrificially toward helping investors get connected to FairTax idea.

Yes, your Bartlett reponse was great.

Just to clarify above, Mastromarco favors FairTax consumption tax ("flat tax" being what Bartlett supports).

Audacious Epigone said...

Ian,

Right, I realize Bartlett opposes the FairTax and supports the Flat Tax. But his slopiness aside, a flat tax would be a welcome change.

The trading reference was for Undergroundman, who talks about stocks from time to time on his blog.

Keep fighting the good fight.