Man Without Qualities

Tuesday, May 14, 2002

As Inevitable As Paul Krugman's Economic Silliness and Taxes

Why are American corporations like Stanley Works re-incorporating themselves in low tax havens like Bermuda? Well, because it would save the company a lot of money and thereby benefit the company's shareholders a lot. As Paul Krugman says: "By incorporating itself in Bermuda, a U.S.-based corporation can — without moving its headquarters or anything else — shelter its overseas profits from taxation. Better yet, the company can then establish "legal residence" in a low-tax jurisdiction like Barbados, and arrange things so that its U.S. operations are mysteriously unprofitable, while the mail drop in Barbados earns money hand over fist."

Now, as a preliminary matter, it is best to rid the analysis of that latter bit about how the corporation can "arrange things so that its U.S. operations are mysteriously unprofitable, while the mail drop in Barbados earns money hand over fist," since that bit is just a silly red herring. What Mr. Krugman is suggesting amounts to misallocation of income among members of the corporate group (if done innocently) or criminal tax fraud (if the allocation deliberately does not reflect the groups economic reality). The Internal Revenue Code attaches no special penalty to income allocations that are "mysterious," despite Mr. Krugman's thought to the contrary. Misallocation disputes regarding the income of international corporate groups happen all the time, in ways having nothing to do with "reincorporation". For example, Japanese car companies sell portions of their cars to their wholly owned United States subsidiaries, which then sell the whole cars to American consumers. The United States subsidiary pays full United States taxes on its income (from which it deducts payments made to its parent for the cars), and the Japanese parent pays only Japanese taxes on the money it receives from its subsidiary. Determining the price paid by the wholly-owned United States subsidiary is an intra-group "allocation" issue, and such matters often result in big differences of opinion between the companies and the Internal revenue Service. (In Krugman-speak, the IRS sometimes takes the position that the Japanese company "arranged things so that its U.S. operations are mysteriously unprofitable, while the parent in Japan earns money hand over fist.") Happens every day. No big deal. Many good tax lawyers are employed almost exclusively in such disputes. And it’s not what the "reincorporation" trend is about. In other words, a Krugman red herring.

But the possibility of tax fraud raised by Mr. Krugman is also a red herring, because the problem is not tax fraud. Rather, the development is that American corporations are reincorporating to take advantage - full, legally permissible and highly tax-efficient advantage - of certain features of the internal revenue laws of the United States.

There is no need to insinuate "mysterious" conspiracies on the part of reincorporating American companies - but Mr. Krugman does so insinuate - and, of course, the insinuation involves a nasty act by a Bush administration tax official who issued "executive orders" helping it all along. What would a Paul Krugman column be without an insinuated conspiracy involving the Bush administration? Here, his allegation is that the Administration not only issued those executive orders, but doesn't really want to collect taxes! Mr. Krugman does not explain how he has obtained his deep knowledge of the Administration's "wants." Indeed, Mr. Krugman appears to have a macro installed in his computer to provide the Bush-conspiracy part of his columns week after week, the way other people run spread sheets.

As the above Japanese car example indicates, much of the income in an American-based international corporate group is often not the result of United States activities. The United States has no particular interest in taxing such non-United States income simply because the ultimate parent company happens to be organized under the law of a local United States jurisdiction - any more than the United States has an interest in taxing the income of the Japanese parent on sales to its United States subsidiary. And the prospect of "mysterious" allocations doesn't create a legitimate interest. The executive orders Mr. Krugman (and the earlier Times articles on the matter) complain about seem to have mostly the effect of rationalizing the corporate tax system to reduce US taxation of income it shouldn't be taxing in the first place. Or perhaps Mr. Krugman proposes that the US tax all of the income of any foreign country that does business in the United States at full US rates? That would at least bring to his thinking a certain consistency - although action in that direction would set off an international uproar that would make the current fracases over steel tariffs and the like look tame.

Since the board of directors of a corporation has a fiduciary duty to operate the corporation to maximize the financial benefit the corporation yields to its stockholders, the better question is: Isn't the board of directors of any American corporation NOT advocating an off-shore reincorporation to the company's shareholders in breach of its fiduciary duty to the shareholders? Shouldn't Mr. Lerach be reworking his standardized, copyrighted form of complaint against the directors of public corporations to add a cause of action based on the shocking and egregious allegation: "And the defendant directors willfully and maliciously refused to recommend and submit to the shareholders plans to reincorporate their corporation in Bermuda or a similar low tax jurisdiction, thereby costing their corporation and its shareholders literally tens of millions, if not hundreds of millions, of dollars per year!"

So why does Paul Krugman question the patriotism of Stanley Works for contemplating exactly this move, while simultaneously and irrelevantly castigating the Bush administration for supposedly questioning other unrelated people's patriotism for other unrelated matters?

And why, for that matter, would any sensible economist not be advocating the complete abolition of corporate taxes? The arguments against such taxes are standard and legion, have been around for many years, can be obtained from any competent tax professors for the cost of a few margaritas and the burden of spending an evening drinking with a tax professor, and are about as close to being the beneficiaries of the kind of "consensus" among serious economists so valued by Mr. Krugman as anything in that field. However, given the phrasing of the question, there is no need to address the matter here any further. [UPDATE: Jane Galt gives a nice list of some reasons why the corporate tax should go and says lots of interesting things about Mr. Krugman's latest silliness.]

Perhaps the most pernicious effect of the corporate tax is "double taxation" of dividends. Revenue is taxed first at the corporate level, and then again as income when it is distributed to shareholders. "Double taxation" does not happen with "tax transparent" business entities - such as limited liability companies - which can sometimes be substituted for the corporate form. However, equity interests in limited liability companies cannot be traded publicly and retain this tax advantage. So one effect of "double taxation" is to handicap public corporations in comparison to private limited liability companies. There is no good reason to do that. Other countries - such as Britain - seek to eliminate "double taxation" by the use of an "integrated corporate tax system."However, Mr. Krugman's only reference to other countries is a misleading comparison of their tax rates with US rates, with no mention given to the fact that the integrated tax systems of those countries eliminate part or all of the corporate level tax on corporate earnings distributed to shareholders as dividends.

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