Tax Notes, July 17, 2006.
Corporate tax receipts have gone up along with rising corporate profits. . . . In addition to a growing economy, I think some of that increase is also because of continuing efforts to combat corporate tax abuse and improve corporate tax compliance.
Chuck Grassley, R-Iowa, June 13
The recent growth in corporate tax revenue has been astounding. In 2003 Treasury collected only $132 billion in corporate income tax. By 2005 the figure had soared to $278 billion. And the surge has not subsided: Based on receipts for the first eight months of the fiscal year ending this September, tax specialists at the Congressional Budget Office expect that the federal treasury will receive a whopping $330 billion from corporations before they close the books on 2006. That would be by far the most rapid three-year growth spurt in corporate receipts over the last 50 years.
Two factors explain the 2003-2006 boom in the corporate tax.
First, Congress passed several tax laws that had the effect of postponing tax payment until the second half of the decade. Second, corporate profits are on a strong cyclical upswing after the economy hit bottom in 2001-2002.
We did all the math (see the appendix) and found that about one- third of the increase was because of changes in the law and that most of the remainder was due to profit growth. (See Figure 1.)
The Real Story
It is understandable that all of us — including Grassley — have been distracted by the recent roller coaster ride in corporate tax receipts. But the real story is not the trend in corporate tax receipts over the last three years, but over the last decade.
Since 1997 corporate tax receipts have not kept pace with corporate profits. A ballpark estimate of the unexplained shortfall for 2006 is $47 billion. In other words, given changes in tax laws and corporate profits over the last decade, corporate tax receipts for fiscal 2006 should be about $377 billion, instead of the $330 billion now being predicted by the CBO.
Figure 2 depicts the trend. It shows corporate effective tax rates over the 10-year period from 1997 to 2006. There are many ways — not one of them perfect — to compute an effective tax rate. The measure used here is actual Treasury fiscal year receipts divided by fiscal year domestic corporate profits, as measured by the Commerce Department. The figures have been adjusted to remove the effects of tax legislation enacted since 2001 so that we can see the changes because of other, unexplained factors.
The average effective tax rate for the first five years of the period is 29.7 percent. For the second five years, the average effective tax rate (with adjustments for changes in law) is 26.1 percent. The 3.6 percentage point shift represents an unexplained decline in the effective corporate tax rate.
Applying the 3.6 percent difference to estimated corporate profits of $1.312 trillion for 2006 yields our estimate of a $47 billion shortfall in the current fiscal year.
There is always the temptation to suspect — as Grassley does in the quote that leads this article — that what we cannot explain might be attributable to changes in the popularity of "corporate tax abuse." And certainly we cannot rule out an increase in tax shelters, aggressive transfer pricing, or other tax avoidance techniques as causes of the shift depicted in Figure 2.
But there are other, less sinister possible causes for a real decline in effective corporate tax rates. They include: increased use of S corporations, increased corporate holdings of tax-exempt bonds, increased deductions for bad debts (not included in the official profit measure), a reduction in capital gains realizations (taxable but not part of official profits), and increased tax-exempt Federal Reserve Bank profits (included in the official profit totals). Also, as explained in the appendix, the data may be playing tricks on us.
But one thing we can conclude for sure: The current burst in corporate receipts should not give us any comfort that the era of corporate tax shelters is coming to a close. Sorry, Chairman Grassley, it may be that your job has only just begun.
Explaining the $198 Billion Increase in Corporte Tax Receipts
From 2003 Through 2006
(Dollar amounts in billions)
Corporate Tax as a Percentage of Profits, 1997-2006
(Estimated effects of post-2000 legislative changes removed)
How the Numbers Were Calculated
An effective corporate tax rate is the ratio of some measure of corporate taxes over some measure of corporate profits. Our measure of corporate tax receipts uses actual Treasury collections for each fiscal year through 2005. For fiscal 2006, which ends on September 30, we used the latest CBO estimate of $330 billion. (See the CBO's Monthly Budget Review, Fiscal(Text continued on p. 218.) Year 2006, July 7, 2006, p. 2, available at http://www.cbo.gov.) That figure is nearly identical to the just-released estimate of $332.3 billion from the Office of Management and Budget. (See the OMB's Fiscal Year 2007 Mid-Session Review, Budget of the U.S. Government, Table S-8, "Receipts by Source," p. 38, available at http://www.whitehouse.gov/omb/budget/fy2007/pdf/07msr.pdf, or from Tax Analysts as Doc 2006-13161 or 2006 TNT 133-22 .)
Our measure of corporate profits is taken from domestic "profits before tax" from Table 1.14 (line 32) of the National Income and Product Accounts produced by the Commerce Department's Bureau of Economic Analysis (BEA). (For interactive access to the tables, see http://www.bea.gov/bea/dn/nipaweb/index.asp.) That measure, based on taxable income, does not include capital consumption adjustments and inventory valuation adjustments in the BEA's more widely cited profit figures known as "Corporate profits with IVA and CCAdj." Therefore, there is no need to make corrections for differences in tax and book depreciation and tax and book inventory accounting. Also, the measure of "domestic" profits — as opposed to "national" profits from BEA Table 1.12 — does not include profits from foreign activities of U.S. corporations.
For each fiscal year, profits were calculated by averaging annualized quarterly data from the last quarter of the prior calendar year and the first three quarters of the corresponding calendar year. So, for example, corporate profits for fiscal 2000 were computed by averaging the annualized figures for the fourth quarter of 1999 and the first three quarters of 2000.
In its midsession review (Table 2, "Economic Assumptions," p. 14), the OMB reports that its broad measure of corporate profits for 2005 is $1,438 billion and its estimate for 2006 is $1,672 billion — a 16.3 percent increase. Therefore, to arrive at our estimate of fiscal 2006 profits before tax, we increased by 16.3 percent our profits before tax figure of $1,128.7 billion for fiscal 2005 to arrive at an estimate of $1,312.4 billion for fiscal 2006.
Estimating the effects of changes in tax law on corporate tax receipts begins by reviewing all estimates by the Joint Committee on Taxation of tax legislation enacted since 2001. The changes that affect corporate receipts are identified in Table A-2 at the end of this appendix. Because some of the identified provisions also affect individual income tax receipts, all of the JCT estimates were multiplied by a factor of 0.8 to arrive at an estimate of the effect of legislated changes on corporate tax receipts. The combined effect of all the legislation from Table A-2 is summarized in column 3 of Table A-1 above.
The shaded cells of columns 2, 3, and 5 of Table A-1 contain the data that underlie Figure 1. The total change in corporate tax revenue from 2003 to 2006 was $198.2 billion. The total estimated change to tax revenue in fiscal 2003 from changes in tax law since 2001 was negative $41.4 billion. The corresponding figure for 2006 was positive $14.8 billion. Thus, by making 2003 revenue $41.4 billion lower than it would be otherwise and by making 2006 revenue $14.8 billion higher than it would be otherwise, tax law changes account for $56.2 billion of the increase in corporate tax receipts.
Therefore, we estimate that if there had been no changes in tax law, in 2003 corporate receipts would have been $173.2 billion. Dividing that figure by before-tax domestic profits of $727.8 billion yields an adjusted effective tax rate of 23.8 percent for 2003. If that tax rate were maintained — or, in other words, if tax revenue grew at exactly the same rate as profits — adjusted corporate tax revenue would have grown from $173.2 billion to $312.3 billion. Thus, increasing profits account for $139.1 billion of the growth in corporate tax receipts from 2003 to 2006.
The sum of the effects of tax law changes — $56.2 billion — and of profit growth — $139.1 billion — is $195.3 billion. That is almost 99 percent of the actual $198.2 billion change.
The figures in column 7 of Table A-1 are the data used in Figure 2. They are estimates of what effective corporate tax rates would be in the absence of changes in tax law since 2001.
Here are some of the data issues that could affect the estimates presented in this article.
Fiscal 2006 is only two-thirds complete, so all the data used in this article for fiscal 2006 are estimates and subject to change.
It is unlikely that pre-2006 corporate receipts data will be revised because they are simple tabulations, but BEA estimates of corporate profits are subject to revisions several years after they are first published.
The JCT final revenue estimates of tax legislation are made slightly before the time of enactment. They are subject to error, and to the extent that they are erroneous, the estimated reduction in tax receipts attributable to tax law changes would also be incorrect.
We have made only an educated guess — namely, 80 percent — about the portion of estimated revenue effects from the identified business tax changes that translate into changes in tax law.
Although those issues may seem formidable to a layperson, they are nothing out of the ordinary for empirical economic analysis. Moreover, we are not aware of any biases, so all potential errors, as far as we can tell, could either raise or lower the estimated shortfall in corporate tax receipts presented in this article.
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