Tax Plan Attacked by Big Business

May 15, 2012

Eileen Appelbaum
Economic Intelligence (U.S. News & World Report), May 15, 2012

See article on original website

In February, President Obama laid out his framework for reforming corporate taxes. He proposed a substantial cut in the corporate income tax rate from 35 to 28 percent—a boon to companies, especially small businesses that lack the opportunities for tax avoidance that major companies regularly exploit.

As I wrote at the time, the president proposed to make this tax cut revenue neutral so it doesn’t increase the deficit. He called for reforming many of the provisions of the tax code that create significant inequities and economic distortions.

Last week, big business responded.

On Wednesday, CEOs of 18 of the nation’s largest companies sent a letter to Treasury Secretary Timothy Geithner objecting to the proposal to raise the 15 percent tax rate on dividends and capital gains for households making more than $200,000 ($250,000 if married). These CEOs claim that bringing the taxes of high-income households more in line with everyone else’s will reduce investment “when we need capital formation here in America to create jobs and expand our economy.” It’s a claim that rings hollow. U.S. companies are currently sitting on a mountain of cash that they aren’t investing, and many are engaged in buying back their own shares. This artificially raises share prices and serves no useful purpose, but it does increase the value of CEO stock options. The higher taxes might put a crimp in the lavish lifestyles of the wealthy, but they are unlikely to affect the investment behavior of companies. Notably, this change in the tax code would not affect anyone with household income under $200,000 a year or whose money is invested in a 401(k) or an individual retirement account.

And earlier in the week, Ernst & Young put out a report conducted on behalf of the Private Equity Growth Capital Council that challenged the administration’s proposal to limit the tax deductibility of corporate interest payments. This change to the corporate tax code would reduce the disparity in the tax treatment of debt and equity financing of investment. The administration did not specify what the limit might be, but Sen. Ron Wyden, a Democrat from Oregon, and Sen. Dan Coats, a Republican from Indiana, have proposed reducing the deduction from 100 percent of interest paid to 75 percent. This provision would have its greatest effect on private equity companies, which engage in leveraged buyouts that use lots of debt to acquire businesses for the portfolios of their investment funds. The ratio of debt to the enterprise value of publicly traded companies is about 14 percent, while companies acquired in leveraged buyouts have a debt-to-enterprise value of about 67 percent.

The Ernst & Young report claims that as a result of the Wyden-Coats tax plan, “the corporate capital stock in the United States would be smaller. … A smaller corporate capital stock would adversely affect worker productivity and, ultimately, living standards.” Sounds scary, but is it true?

As Dan Primack observes in his Fortune Term Sheet column, “The implementation of such a proposal need not lead to lower ROI prospects and, thus, less investment. Instead, it simply could result in private equity firms altering their equity-to-debt ratios [to take better advantage of the changes in the tax code].”

“In other words,” Primack concludes, they could “put more equity and less debt into deals.”

This could be good news for companies and communities. A recent study of 2,156 highly leveraged companies found that a very high proportion experienced financial distress. Default rates among these companies are very high, ranging from 12.3 percent for leveraged buyouts completed in 2001 to 31.6 percent for those completed in 1997. Looking at the recent period, the study found that a quarter of the highly leveraged companies in the study defaulted between 2007 and 2010. Defaults can end in bankruptcy, but even when they don’t, they lead to serious cutbacks that negatively affect lenders, customers, workers, and communities.

Not only would the president’s proposal to limit the interest deductibility of debt make the tax treatment of debt and equity more equitable, but more equity and less debt would reduce the rates of financial distress and bankruptcy. That would be good news for the communities that depend on these businesses for jobs and services.

Corporations and wealthy households trying to hang onto their unfair tax breaks want to label these changes in the tax code as “job killers.” As usual when this claim is made, nothing could be further from the truth.

Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research.

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