Economics, Accounting, & Taxes
11/1/20
As the above table suggests, quite a number of companies had managed to avoid paying federal taxes for years. That listing only goes through 2015, but the number of non-payers dramatically spiked after enactment of the Tax Cuts and Jobs Act (TCJA), passed in December 2017. According to CBS news, in 2019 “60 profitable Fortune 500 companies paid no taxes on a total of $79 billion of profits earned in 2018.” [Source: https://www.cbsnews.com/news/2018-taxes-some-of-americas-biggest-companies-paid-little-to-no-federal-income-tax-last-year/]
Among the provisions of the TCJA were (a) the lowering of the corporate tax rate from 35% to 21%, (b) allowance to accelerate the depreciation schedule used in the calculation of taxable income, and (c) more generous deductions in connection with the exercise of employee stock options. The first of these provisions clearly lowered the amount of federal taxes that would be collected, all else being equal; but it doesn’t at all explain how companies might pay no taxes. The remaining two provisions, however, likely played important roles in that regard. Both served to reduce the measure of taxable income relative to the amount that otherwise would have applied; and if those deductions grew to the point that they exceeded gross income, a zero tax obligation would result.
Unfortunately, validating the claims that companies haven’t paid any income tax is no small feat when tax filings are not a matter of public record. Public companies do have to file financial statements with the SEC, but these submissions follow generally accepted accounting principles (GAAP), which, in many critical ways, don’t conform to the same definitions and conventions used by the IRS. Specifically, expenses (or deductions) allowable on GAAP income statements differ from those permissible by the IRS. In particular, the depreciation deduction allowed by the IRS generally provides for a faster write-down than does the GAAP presentation — a lot faster.
A larger deduction on a tax filing necessarily reduces the associated tax obligation, but what may not be well-understood is that this effect is temporary — at least in theory. Consider this hypothetical: Suppose a company has stable revenues of $10 a year. At the start of a 5-year period it buys a piece of depreciable equipment for $5, and let’s assume the equipment has a 5-year life. To keep it simple, we assume no other expenses are incurred. Under these assumptions, income exclusive of depreciation considerations would be $10 per year.
With straight-line depreciation, the depreciation expense would be $1 per year, such that GAAP income before taxes would be $9 per year. Suppose the IRS permitted an extreme acceleration of depreciation, allowing for 100 percent of the cost of the equipment to be fully depreciated in the first year. In that case, taxable income would be $5 in the first year ($10 of income less $5 of depreciation deduction), but in each of the next four years the taxable income would be $10.
If the IRS had used the same depreciation schedule as that used for GAAP, taxable income would have been $9 in each of the 5 years; and, applying a corporate income tax rate of 21%, the annual tax amount would have been $9 x 21% = $1.89. Thus, for the five years, the company would have ended up paying $9.45 (= 5 x $1.89). Instead, the IRS receives $1.05 for the first year’s taxes (= $5 x 21%) and $2.10 (= $10 x 21%) for each of the next four years. For the whole five years, then, the accumulated tax requirement is $1.05 + 4 x $2.10 = $9.45 — the same as would have been received without the accelerated depreciation schedule. Thus, it appears to even out in the end — although it doesn’t.
What’s lost in this exercise is the time value of money. Although the nominal tax amounts paid would be the same with or without this accelerated depreciation allowance, the accelerated depreciation allows the corporation to defer the payment of the tax, which effectively provides the corporation with what amounts to as an interest free loan. It’s a nice subsidy if you can get it.
I hope it’s clear from this simple example that IRS rules allow for a shifting of the timing as to when taxes get paid, but unless a change in the tax rate arises during the deferral period, the overall nominal taxes required would not be affected. With the passage of the TCJA, the tax rate did change, however, and companies that were able to defer their tax payment obligations in advance of the tax rate reduction ended up enjoying a substantial tax reduction.
This issue aside, the identification of a company that has not paid taxes in a given year, may be somewhat of a misdirection. I didn’t do an exhaustive review, but I did look at two, high profile companies that had reportedly not paid any income taxes in 2019 — Amazon and Netflix. [Source: https://itep.org/60-fortune-500-companies-avoided-all-federal-income-tax-in-2018-under-new-tax-law/#:~:text=Earlier%20this%20year%2C%20ITEP%20reported,%2C%20US%20Steel%2C%20and%20Whirlpool.] In both cases, their GAAP income statements showed a different picture. That is, both companies showed positive income tax deductions for 2019 on their GAAP income statements.
These representations may seem to be inconsistent with the charge that the companies paid no corporate income tax; but, in fact, unless there is willful misrepresentation, the two statements may both be correct. The critical point is that the GAAP figure reflects accrual accounting, which means that the amount shown on the GAAP income statement reflects the relevant allocation of the taxes for the year in question, irrespective of when those payments are actually made.
Economically, the accrual figure is the much more meaningful amount. Put another way, highlighting that a company hasn’t paid taxes in any given year may be somewhat of a red herring. That said, finding that companies have been able to defer taxes year after year after year would seem to be a reflection of a flawed taxing system — one that allows companies to enjoy the effect of zero interest loans for multiple years. In that instance, the red herring may actually stink, and corrective action would be in order. That’s the situation in which I believe we find ourselves.
Whatever justification for allowing more generous accelerated depreciation to have been authorized under TCJA, it’s hard to fathom why the logic of a straight line depreciation allowance would or should be overridden to allow companies to avoid paying their fair share of taxes on time. The rules currently in place seem to incentivize companies to pyramid their exposures year after year to try to extend their deferrals ad infinitum. Why should this opportunity be available?
I find this dichotomy interesting: In December 2017 when the TCJA was enacted, the economy had been in in its eighth year of recovery. There was no pressing need for expansionary fiscal policy; but even so, the TCJA was enacted, giving a windfall benefit, indiscriminately, to virtually all corporations. Let’s be clear. That’s a benefit that directly lines the pockets of shareholders. Fast forward to today. In the midst of a pandemic that has left millions out of work, Congress can’t find a way to extend the benefits of our most vulnerable.
There’s something wrong with this picture. With any luck, however, it will be corrected shortly after January 20.
