The High Cost of High Tax Rates

THE HIGH COST OF HIGH TAX RATES From The Morgan Guaranty Survey~ November 1962 IN A POPULAR NOVEL of a decade ago, Executive Suite~ the two most unattractive characters were both experts at figuring the "tax angle" in any business situation. By portraying them so unsympathetically, the book reflected the impatience which the public has come to feel, not so much toward the "tax expert" as toward the taxing system that by the enormity of its appetite and the com plexity of its workings has created a place, indeed a need, for him. Taxes in the United States-especially the high rates of federal income tax on corporations and on individuals of middle or higher income levels-have distorted busi ness practice, twisted incentive into strange shapes where they have not killed it completely, and diverted brain hours beyond tally into the fascinating but economically sterile art of avoidance. (Avoidance is not to be con fused with evasion, the term applied by the authorities to the· nonpayment of taxes· actually due.) It is only logical for individuals and companies to plan their activities so as to avoid taxes by all available law ful means, just as a traveler lays out his route to avoid 85 86 THE MORGAN GUARANTY SURVEY torn-up roads and traffic bottlenecks. There is no case moral, legal, or otherwise-against tax avoidance. There is a strong case, both in economics and in national in terest, against a structure of taxes so punitive in some of its effects that taxpayers feel it more desirable to minimize taxes than to maximize earnings. At that point, the nation's methods of raising revenue are well into the area of diminishing returns. The tax dollar saved-valu able as it is to the individual or company-is not a dollar earned so far as the total growth of the economy is con cerned.

Taxmanship, a term sometimes applied to avoidance in its more intricate forms, might be called the active response to today's crushing tax burdens. It involves waste and irrationalities that may be as great a drag on growth as is the passive response of avoiding taxes by choosing not to earn to full capacity. The toll in man power alone is impressive. The number of full-time tax specialists in the U. S. is estimated to be near 100,000 mostly lawyers and accountants. This figure does not in clude the thousands of employees and executives of busi ness firms who devote all or part of their working time to tax matters. Since government must have revenues, and compliance with tax laws of any kind will involve bookkeeping and other administration, some drain of human resources in the process is inevitable. But the de gree to which present taxation forces the defensive de ployment of time and talent represents a deplorable waste.

One business commentator has remarked that the tax THE HIGH COST OF HIGH TAX RATES 87 collector sits in invisible attendance at every meeting of a corporation's board of directors. He had in mind the preoccupation with tax consequences that dominates so many business decisions. Illustrative is the prevalent concept of two kinds of dollar-before-tax and after-tax. To this type of thinking, minor savings in costs may not seem worth the pain and effort when it is pointed out that they are well worth only 48 cents of the dollar. Con versely, expenditures look much less formidable when it is recalled that 52 per cent of the amount would be taken by federal income tax if the company decided against the expense. The habit of half-price thinking has colored the whole conduct of business. True, the results have not been en tirely unwholesome. Corporate philanthropy, which if properly administered, benefits society and ultimately the company itself as well, unquestionably has rec:eived a stimulus from the steep level of the corporate income tax rate (contributions that meet Internal Revenue Service requirements are deductible). In fact, the whole structure of gift-supported activities in welfare, educa tion, and related fields has become so related to the high tax rates on corporate and upper-bracket personal in come that some agencies dependent on voluntary dona tion are studying ways to meet the fund-raising prob ..

lems that a meaningful reduction in rates might pose. Other manifestations of the after-tax approach to the corporate dollar are less appealing. It is possible to con jecture, for example, that postwar cost increases in the U. S. would have been less sharp-and the present com88 THE MORGAN GUARANTY SURVEY petitive position of American products in world markets consequently stronger-if industry's wage negotiators and salary administrators had not been operating in the knowledge that about half the cost of increases granted would go to taxes if it didn't go to payroll expense. The Problems of Raisin.g Pay In the upper salary ranges, where personal income tax rates approach the point of total takeover, the prob lem of how to award a raise when deserved has led corporations into the paths of innovation that are valid in intention but in practice have proved subject to abuse. Among devices adopted are employment contracts providing for deferred compensation, usually to be paid after the individual has ended active work with the com pany, and plans by which specified individuals receive options to buy company stock over some future period at a price set in advance. The first method spreads in come over a longer period and thus usually makes it taxable at somewhat lower rates. The second can pro duce capital gains, taxable at lower rates than ordinary income, if the stock is bought and then sold after the required waiting period at a price higher than was paid for it. Both are legitimate devices, but excesses in their use have drawn wide criticism.

In an effort to shield compensation from the bite of high tax rates, some companies have been liberal in their policies toward business expenses, letting selected per sonnel enjoy unusual perquisites in the course-or, someTHE HIGH COST OF HIGH TAX RATES 89 times, merely in the name-of furthering the interests of the enterprise. In its crudest form, this is usually known as "the old expense account dodge." Aside from out right cases of "padding," the effectiveness of this means of tax avoidance is pretty well limited to the "psychic" income an individual may derive from a certain amount of gracious living at company expense. Yet, in the ag gregate, the corporate extravagance resulting from it may be considerable. Beyond the dollars and cents, enormous harm has been done to business by the colorful mythology that has grown up around practices designed to help the indi vidual avoid losing the greater part of his pay to taxes.

Externally, the exaggerated impression of rampant abuse has damaged public respect for, and confidence in, business. Internally, it has chipped away here and there at business morale and business ethics. What is overlooked in the glib flood of moralizing preachments induced by all this is the one central fact: a tax philosophy that seeks to level incomes has driven business to seek whatever means it can find within the law to stimulate the thing it must have-a high level of excellence in individual performance. Human nature being what it is, material rewards are the way to get such a performance. The tax structure being what it is, resort to devices of avoidance is inevitable. Corporate financial practice is tailored to tax consid erations in important ways. With earnings taxed at 52 per cent, and interest on debt deductible as a business ex pense while dividends must be paid from after-tax income, 90 THE MORGAN GUARANTY SURVEY there is an immense predisposition to finance by debt rather than by the issue of new equity. Even in 1961, when price-earnings ratios of common stocks were at or near all-time highs, and dividend yields were below bond yields in many cases, corporations raised only $3.7 bil lion by stock issues and $9.4 billion by bond and note flotations.

In its ultimate exaggeration-and extreme tax rates breed extremes of avoidance-the corporate propensity for borrowing in preference to other means of raising capital is expressed in the so-called "thin" incorporation. The owners put up capital principally in the form of loans to the business rather than purchases of stock. The interest, provided certain tests are met, is a deductible expense to the business; it is, of course, taxable income to the lender, but it comes out of the corporation free of the profits tax that would apply to earnings from which dividends would be paid. The avoidance is perfectly lawful and, in terms of tax law, eminently sensible. In terms of business practice, it mayor may not be sound, depending on specific circumstances; the dangerous thing is that, by penalizing equity as it does, the tax structure may hopelessly blur judgments as to proper balance among the sources of capital in a soundly based enterprise.

Meanwhile, the steeply progressive tax rates on per sonal income, by taking the luster off dividend payments for some stockholders, have influenced some companies to retain a larger proportion of earnings than would otherwise be held in the business-and larger indeed THE HIGH COST OF HIGH TAX RATES 91 than some income~conscious stockholders might like to see retained. Penalty for Staying in Business In combination, the high rates of corporate, personal, and estate· taxes have the effect of creating an all but ir resistible "death wish" in the successful, small, closely held company. The owner of such a company is likely to have as his principal concern, not how he can expand and insure the continuity of the venture, but rather how he can most advantageously sell it out, liquidate it, or cut down his share of ownership-all in defense against potentially confiscatory taxes. If the enterprise represents-as is likely-the bulk of the owner's total means, he faces the prospect that on his death the business will have to be sold to pay the estate tax, which can be as high as 77 per cent. Since a sale forced by such circumstances might have to be made well below a fair price, the owner is inclined to antici pate the event and put the company up for acquisition.

He is further encouraged in this by the prospect of ex changing the operating profits of future years-taxable at the high rates applicable to ordinary income-for a present capital gain in the form of cash or stock received from the sell~out, taxable at a lower rate and in the case of stock perhaps not taxable at all until ultimately turned into cash. This tendency of the tax laws to impel the liquidation of small companies, or their consolidation into larger 92 THE MORGAN GUARANTY SURVEY ones, is especially ironic in view of the declared national policy of assisting small business. But tax considerations can also push larger companies into mergers or acquisi tions that have little other advantage to recommend them. Any company that has experienced losses and will not be able to offset the full amount of them against profits within the allowed carry-back and carry-forward periods may be worth more to some other company than it is to its owners (a sort of "How To Make Money withou t Really Succeeding").

It Sometimes Pays To Lose Corporate trafficking in losses has been diminished in recent years by changes in the tax law, and classified ad vertisements seeking out losers are hardly ever seen in financial journals any more. Under certain circumstances, however, the present high tax rate on corporate income can still make a deficit seem to be worth real money and, for tax purposes, actually so to be. A windfall effect of the steepness of income tax rates, particularly those on upper levels of personal income has benefited states, municipalities, and other public entities able to issue debt securities bearing interest ex empt from federal income taxes. The higher taxes are, the more the exemption is worth-to lender and bor rower alike. For an individual whose income is taxed at a rate well above 50 per cent, say, the prospect of re turn on a business investment involving appreciable risk must be juicy indeed to match the attractiveness of THE HIGH COST OF HIGH TAX RATES 93 a tax-free bond issued by a state or municipality with a strong credit rating. As a result, such borrowers have been able to get money cheaper than even the federal government. Average yields on U. S. Treasury bonds currently are almost a full percentage point, and those on top-grade corporate bonds about I ~ points, above those on municipal obligations.

The borrower's bonus created by money fleeing from high taxes may, of course, prove in some cases to have a boomerang effect. The low cost of debt doubtless has in duced some communities to go overboard on expendi tures, a problem for their taxpayers, present and future. The total of state and local debt has almost quintupled since 1946, from $15.9 billion to $75.0 billion. It would be unrealistic to suppose that reduction, even substantial reduction, in tax rates would put a complete stop to the economic waste that is involved in the great game of hide-and-seek waged between the taxed and the taxer. If levies, however, were pitched at more moderate levels, much of the energy and effort now devoted to avoidance, and much of the resultant economic distor tion, could be saved. That alone would go some way to ward offsetting the loss in revenue-not to speak of the lift in incentive that tax reduction would afford, or of the fiscal stimulus that could be expected to spur the economy to an increased pace of activity.