The High Cost of High Taxes

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 complexity 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 busi­ness 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 confused 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 lawful means, just as a traveler lays out his route to avoid 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 interest, 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—valuable as it is to the individual or company—is not a dollar earned so far as the total growth of the economy is concerned.

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 man­power 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 include the thousands of employees and executives of business 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 degree to which present taxation forces the defensive deployment of time and talent represents a deplorable waste.

Before and After

One business commentator has remarked that the tax 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 notseem worth the pain and effort when it is pointed out that they are well worth only 48 cents of the dollar. Conversely, 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 entirely unwholesome. Corporate philanthropy, which if properly administered, benefits so­ciety and ultimately the company itself as well, unquestionably has received 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, education, and related fields has become so related to the high tax rates on corporate and upper-bracket per­sonal income that some agencies dependent on voluntary donations are studying ways to meet the fund-raising problems 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 conjecture, for ex­ample, that postwar cost increases in the U. S. would have been less sharp—and the present competi­tive 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 Raising Pay

In the upper salary ranges, where personal income tax rates approach the point of total take­over, the problem 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 company, 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 income over a longer pe­riod and thus usually makes it tax­able at somewhat lower rates. The second can produce 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 personnel enjoy unusual perqui­sites in the course—or, some­times, 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 outright 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 aggre­gate, 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 individ­ual 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 considerations in important ways. With earnings taxed at 52 per cent, and interest on debt deductible as a business expense while dividends must be paid from after-tax income, 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 bil­lion 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 may or 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 personal 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 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 irresistible "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 anticipate the event and put the company up for acquisition. He is further encouraged in this by the prospect of exchanging 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.

For Tax Purposes, It Sometimes Pays To Lose

This tendency of the tax laws to impel the liquidation of small companies, or their consolidation into larger 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 acquisitions 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 with­out Really Succeeding").

Corporate trafficking in losses has been diminished in recent years by changes in the tax law, and classified advertisements 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 exempt from federal income taxes. The higher taxes are, the more the exemption is worth—to lender and borrower alike. For an individual whose in­come is taxed at a rate well above 50 per cent, say, the prospect of return on a business investment involving appreciable risk must be juicy indeed to match the at­tractiveness of 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 1¹/₄ 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 in­duced some communities to go overboard on expenditures, 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 Won’t Completely Stop

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 distortion, could be saved. That alone would go some way toward 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.

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Ideas on Liberty

Climate for Growth

One thing America is beginning to learn is that you cannot command growth. You can’t just order an economy or a plant to grow. You have to fertilize it, create a climate in which the plant naturally grows, because it can’t help doing so. You have to weed out hostile elements and keep the soil favorable to growth.

HENRY FORD II, What America Expects of Industry