ITEP makes a myth

The Institute on Taxation and Economic Policy (ITEP) instigated the articles about Amazon’s and Netflix’s income taxes, which I recently wrote about. I wasn’t aware of ITEP before then. So I decided to search for other things published by ITEP. One that I found was this, The 35 Percent Corporate Tax Myth.

It was written when the main corporate income tax rate was 35% and before The Tax Cuts and Jobs Act reduced said rate to 21%. The following are quotes from the executive Summary of the report:

“Profitable corporations are subject to a 35 percent federal income tax rate on their U.S. profits. But many corporations pay far less, or nothing at all, because of the many tax loopholes and special breaks they enjoy. This report documents just how successful many Fortune 500 corporations have been at using loopholes and special breaks over the past eight years.”

“Two hundred and fifty-eight Fortune 500 companies were consistently profitable in each of the eight years between 2008 and 2015.”

“As a group, the 258 corporations paid an effective federal income tax rate of 21.2 percent over the eight-year period, slightly over half the statutory 35 percent tax rate.”

The 21.2% is the amount of federal income tax as a percent of “profit,” which is partly explained in Appendix 1 of the report. “Our report is based on corporate annual reports to shareholders and the similar 10-K forms that corporations are required to file with the Securities and Exchange Commission.” U.S. companies are required to prepare these documents according to a set of accounting standards, conventions and rules known as Generally Accepted Accounting Principles, or GAAP. What the report calls “profit” is GAAP net income before tax (not mentioned in the report). The authors determined the U.S. part of it when it was not separately shown.

However, the amount of federal income tax is the 35% statutory rate times taxable income in accordance with the Internal Revenue Code and regulations. Income taxes are not based on “profit” as used by ITEP, and the report shows no taxable income amounts. The two italicized things are often very different. I will illustrate with an example.

X Corp has $110 operating income ignoring depreciation. It also makes a capital expenditure of $50 which is depreciated over 5 years, since what is purchased is considered useful for 5 years for GAAP accounting. So X’s GAAP net income before tax is $100 (= $110 - $50/5). For income taxes X takes advantage of one of ITEP’s favorite targets for criticism, accelerated depreciation. The prevailing tax law allows the $50 capital expenditure to be deducted immediately. Therefore, its taxable income is $110 - $50 = $60. Tax is 35% * $60 = $21. From one perspective the $21 is 21% of GAAP net income before tax or profit. From a different perspective the $21 is 35% of taxable income. Is the 35% a myth? ITEP’s answer is obvious, but I don’t think so.

To make the example a little more complete, suppose X also has $110 operating income ignoring depreciation the next year. Absent another capital expenditure X’s GAAP net income before tax is again $100, while its taxable income is $110, since the prior year’s $50 capital expense has already been fully deducted. (If the next three years were like year 2, GAAP net income and taxable income would both sum to $500. The difference between the two series is a matter of timing.)  

If instead in the second year X makes another $50 capital expenditure depreciable over 5 years, its GAAP net income before tax is $90. Taxable income will again be $60. This scenario is more likely for a growing business. That’s one reason how the corporations in ITEP’s report consistently showed an average 21.2% “effective” tax rate (as a percent of profit, not of taxable income).