Corporate Taxes: A Mess Begging to Be Cleaned Up

"A dirty little secret," Columbia economist Richard Clarida has said, "is that the corporate income tax used to raise a fair amount of revenue."

He's right. But at the same time, American corporations on average pay some of the highest tax rates in the world. The corporate tax code has turned into the ultimate dead weight: It raises a small and ever-shrinking amount of revenue, yet it's overly burdensome for businesses.

President Obama unveiled a plan to overhaul the corporate tax code yesterday by lowering the tax rate while getting rid of dozens of loopholes, exemptions, and carve-outs. Before we get to the details, let's put some context on America's corporate taxes.

Corporate taxes have been shrinking quickly and consistently for half a century, and they now represent a near record-low percentage of GDP:

Sources: Office of Management and Budget and author's calculations.

In 1945, corporate taxes were roughly equal to personal income taxes, raising $16 billion and $18 billion, respectively. Today, the difference is tremendous. Personal income taxes in 2011 totaled $1.1 trillion, while corporate taxes brought in $181 billion -- a difference of sixfold. As a percentage of all federal taxes, corporate taxes fell from more than 30% in the 1950s to 6.6% in 2009.

At the same time, those complaining that corporate taxes are too high may have a point. Compared with other industrialized countries, the U.S. has one of the highest effective tax rates:

Source: PricewaterhouseCoopers.

This is no way to compete on a global scale.

But there's one problem with this table: The U.S.' average corporate tax rate masks volatility among businesses. Some U.S. corporations get away without paying any taxes at all, while other have rates far above the average.

Electric utility companies, for example, pay an average tax rate of 33.8%, while software companies pay an average of 10.1%, according to TheNew York Times. Trucking companies pay an average tax rate of 30.9%, while drug companies pay an average of 5.6%. In the five years ended 2010, Boeing (NYS: BA) had an average effective tax rate of 4.5%. Southwest Airlines (NYS: LUV) , 6.3%. Prudential Financial (NYS: PRU) , 7.6%. General Electric (NYS: GE) paid an average rate of 14.3% over the period.

Why are these rates so low? Sometimes companies offset current tax liabilities with losses suffered in previous years. This is the way it should be, and it is similar to the rules individuals enjoy when they lose money on investments.

But deductions, loopholes, and carve-outs are also to blame. When New York Times columnist David Leonhardt asked the four companies mentioned above why their tax rates were so low, their responses were nearly uniform: deductions. Boeing made a big contribution to its pension fund and deducted research for new planes. Prudential invested in low-income housing units, which are tax-deductible. Southwest explained: "For book purposes we depreciate our planes over approximately 25 years, but for tax purposes we get to depreciate them over seven years." General Electric wrote off losses from the financial crisis, but its 1,000-person internal tax department didn't hurt, either.

Or take Google (NAS: GOOG) . As Bloomberg reported in 2010, the Internet giant saved $3 billion in taxes over three years by "using a technique that moves most of its foreign profits through Ireland and the Netherlands to Bermuda." Bloomberg elaborated on the strategies, called the "Dutch Sandwich" and "Double Irish":

No one should fault Google for doing this. It's following the law to maximize shareholder value.

But what should get under your skin is that only a company as rich as Google -- one that can afford the legions of accountants, tax lawyers, and lobbyists -- can arrange such a deal. If you're a small mom-and-pop business owner, try setting up a "Dutch Sandwich" through TurboTax. It doesn't work. You're stuck with a 35% tax rate while richer companies pay far less. There are really two corporate tax codes: one for those who can afford to exploit it, and one for everyone else. That's wrong. And since the largest companies with the biggest incomes are the most wily at exploiting the tax code, corporate tax revenue as a share of the economy is nearing irrelevancy.

Enter President Obama's plan to overhaul the tax code. In short, it lowers the top corporate tax rate to 28% from 35% while removing layers of loopholes and deductions. Deductions that tweaked how inventory is calculated; oil and gas subsidies; using insurance companies as tax shelters; and deductions for private jets, among others, would all be on the chopping block. Companies would be required to pay a minimum tax on profits earned overseas (minus a deduction for foreign taxes paid) to discourage routing income through tax havens. Offshoring your production? Say goodbye to writing off the relocation costs.

Is the president's plan (and it is merely a plan; most of it will probably never become law) perfect? No. It's short on details, and what details are available can be -- and will be -- rebutted by many.

It claims, however, that "the President is committed to corporate tax reform that does not add a dime to the deficit, over the next decade or thereafter." That ultimately means some companies will pay more taxes than they do now, and others will pay less. Tax rates will go down while the tax base will be widened. When you grasp the distortions that current loopholes and deductions create, this is exactly what needs to happen. Tax reform that doesn't affect the budget deficit while creating a more level playing field is always a step in the right direction.

At the time thisarticle was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Google and Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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