The Fiscal Cliff's Biggest Danger

As the end of 2012 approaches, the so-called "fiscal cliff" of tax increases scheduled to take effect for the 2013 tax year has gotten a lot of attention. Some policymakers have called for extensions of current tax cuts, while others seek more broad-based tax reform that could have even bigger impacts on both companies and individual taxpayers.

One aspect of the tax debate that many policymakers ignore, however, is the fact that when it comes to taxation, businesses constantly respond to changing conditions. In particular, if tax conditions in the U.S. get worse for the big corporations that represent a massive part of the overall corporate tax base, then you can't count on them just to pay up. Rather, they'll move on to greener pastures, leaving small businesses and ordinary taxpayers potentially footing an even bigger portion of the overall bill.

It's already happened
Many companies have already responded to the increasingly hostile tax environment by getting out while the getting's good. As a recent Wall Street Journal article highlighted, many companies have moved their corporate headquarters out of the U.S. in the past 10 years, taking advantage of other countries with more advantageous tax treatment to improve their bottom lines.

In particular, energy companies have been quick to move outside the U.S. for tax purposes. Weatherford (NYS: WFT) and Transocean (NYS: RIG) moved to Switzerland, where corporate taxes run at about 16% -- less than half the 35% U.S. corporate tax rate. Offshore drilling company Ensco moved to the U.K., and since the move, the company said its effective tax rate has fallen from 19% in 2009 to 10.5% during the second quarter of 2012.

But the trend has gone beyond oil and gas. Eaton (NYS: ETN) is planning to merge with Cooper Industries and take advantage of an exception to a U.S. law that tried to clamp down on overseas moves. Because Cooper is an Irish company, Eaton can choose to have its new headquarters in Ireland as well, where corporate taxes run at around 12.5%. Similarly, insurance company Aon (NYS: AON) established a new home in the U.K. and expects major tax savings as well.

What's wrong?
Moving to less tax-costly countries is just one tactic that corporations use to avoid the full impact of U.S. taxation. With other weapons in their arsenals, such as holding foreign profits offshore to keep from having to pay U.S. taxes on repatriated taxable income, U.S. corporations keep truly colossal amounts of income out of reach of the IRS.

Yet some proposed solutions don't really address the fundamental issue. Ideas like repatriation tax holidays and lower corporate tax rates could have a temporary impact and cause some short-term opportunistic responses among corporations. But as long as big gaps exist between different taxing jurisdictions, companies will have incentives to game the international tax system.

One interesting idea, though, would admit that trying to tax corporations is ineffective but would aim to collect by different means. Specifically, rather than imposing taxes on businesses, the IRS could borrow a page from provisions it makes for specialty niche companies and treat them as pass-through entities, taxing investors. Just as investors in Annaly Capital (NYS: NLY) pay full ordinary income tax rates on their income, so could imposing higher tax rates on shareholder dividends (which could be made mandatory) also make tax collection more effective. And with corporate taxes eliminated, a higher tax on dividends could still leave investors ahead on an after-tax basis.

Only a partial solution
Of course, shunting tax liability onto shareholders raises its own problems, as collecting what might be considered U.S. source income from foreign taxpayers is often extremely challenging. But by taking the emphasis off companies with nearly endless resources to fight taxes and instead putting it on investors who generally lack those resources, the U.S. Treasury might end up ahead.

Solving the fiscal cliff won't happen overnight. But it's important for policymakers to understand the second-order effects that their tax proposals will have. Otherwise, they could end up doing exactly the opposite of what everyone intends for them to do.

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Fool contributor Dan Caplinger treats danger very seriously. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital, Ensco, Transocean, and Aon. Motley Fool newsletter services have recommended buying shares of Annaly Capital and Aon. 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 Fool's disclosure policy stares danger in the eye.

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