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The curious case of declining tax rates

ROI research magazine - UNC Kenan-Flagler Business SchoolYou might think corporate taxes are too high, too low or just about right. Whatever you think, you might be surprised to learn that effective tax rates for U.S. companies have declined over the last quarter century, even as the statutory rate held steady.

Edward L. Maydew, David E. Hoffman Distinguished Professor of Accounting at UNC Kenan-Flagler, and colleagues examine the declining rates in “Changes in Corporate Effective Tax Rates over the Past 25 Years.”

They discovered a mystery.

Since the Tax Reform Act of 1986, the statutory corporate tax rate has hardly budged. It was 34 percent in 1988 and rose to 35 percent in 1993. It’s stayed there ever since.

But effective tax rates – what companies actually pay as a percentage of their pre-tax profits –have steadily declined. Most companies pay less than the statutory rate, with some companies paying effective rates less than half of the statutory rate. A few companies pay more.

Lower effective rates don’t mean businesses are doing anything illegal. Many factors – depreciation, research and development write-offs, losses carried over from previous years and more – can result in lower effective tax rates.

A 25-year decline

Maydew and his co-authors — Scott Dyreng of Duke University, Michelle Hanlon of MIT and Jacob Thornock of the University of Washington — analyzed 54,028 firm-years, pulling financial data on thousands of public companies from 1988 to 2012. They looked primarily at the cash effective tax rate, equal to the cash taxes paid divided by the pre-tax accounting profits.

They chose to start the study in 1988 because that was the first full tax year for which the Tax Reform Act of 1986, a major overhaul of the tax system, took effect.

They found cash effective tax rates have declined, on average, about 0.4 percent annually over that 25-year period, leading to an overall 10 percentage point decline in effective tax rates. That translates into $109 billion less in taxes paid in 2012 compared to what would have been paid if effective tax rates had stayed level since 1988.

Corporate taxes are a significant source of revenue for the federal government, comprising about $242 billion or 9.9 percent of total federal receipts in 2012. But they are a distant third behind individual income taxes and payroll taxes as the biggest source of Uncle Sam’s revenue. Of course, Maydew points out that, economically speaking, individuals pay all taxes, whether they’re charged at the corporate level or the personal level.

Rates declined for both large and small companies, multinationals and domestic-only businesses, the researchers found. For multinationals, effective rates declined for income earned abroad and for income earned in the U.S.

Other countries reduced their statutory tax rates during the period studied and accounts for some of the decline in effective tax rates. But, it certainly doesn’t account for all the decline, Maydew says.

So Maydew and his co-authors looked at other factors. They analyzed variables such as R&D spending, intangible assets, capital expenditures, advertising expenses and whether the firm had foreign operations. They analyzed changes in tax laws, such as bonus depreciation, and changes in accounting rules.

There were still unable to explain the decline in effective tax rates.

“The things that we, as tax experts, would think of as natural explanations didn’t really prove to be explanations,” Maydew says. “We basically end with kind of a puzzle.”

Corporate tax variations

The research is the latest by Maydew and his co-authors that attempts to shed more light on corporate taxes. There’s an active area of research, Maydew says, exploring why different companies have vastly different effective tax rates.

In one study, Maydew, Dyreng and Hanlon, looked at how successful companies are at keeping their tax rates relatively low over long periods of time, as long as 10 years. Some companies are particularly adept at keeping their effective tax rate well below the statutory rate year after year, they found.

Their research, “Long-Run Corporate Tax Avoidance”, found that although there weren’t strong patterns, there was some clustering in effective tax rates by industry. Firms in the business equipment industry, for example, were more likely to sustain lower than average effective tax rates.

On the flip side, the study found that the apparel industry and printing and publishing industry had the highest effective tax rate over 10 years, at 35.5 percent and 37.2 percent, respectively. But industry clustering alone didn’t explain a great deal of the variation.

Leadership matters

One factor that might explain some of the variation is who the top executives are. In “The Effects of Executives on Corporate Tax Avoidance” in The Accounting Review, Maydew, Dyreng and Hanlon tracked the movements of 908 CEOs, CFOs and other top executives who worked at different public companies from 1992 to 2006.

Their analysis showed that some individual executives had a substantial impact on the taxes paid by the firms; however, they weren’t able to identify any characteristics of those executives (such as education, tenure or age) that are related to why these executives are more successful than others at driving down taxes.

Their analysis also doesn’t reveal what the long-term effects of those tax avoidance strategies might be. For example, a firm that benefited from lower effective tax rates over several years might eventually face higher tax liabilities in later years. Those are pending questions in their field.

Real-world implications

Maydew doesn’t express opinions on whether the corporate tax rates enshrined in U.S. law are good or bad because much of that depends on value judgments and points of view. There has been plenty of political and policy discussion of reducing statutory rates and broadening the tax base, he notes. Lowering rates would likely make the U.S. more competitive internationally. Currently, U.S. statutory corporate tax rates are higher than other advanced nations.

Broadening the base means altering the tax code to reduce the variation in effective rates, probably by eliminating provisions that allow some companies to shield profits from taxes.

“If other countries continue to cut their statutory tax rates to be more competitive, than I expect that U.S. companies will have to respond or the U.S. will have to respond in some manner,” he says.