Two claims from the recently released Government Accountability Office (GAO) report on corporate income taxes are receiving widespread attention in the media. The first is that in 2012, 70% of all active companies paid zero corporate taxes and 20% of “profitable” companies had no tax liability. The second is that the effective tax rate for large profitable corporations amounted to about 16% of their “pre-tax income.” As it turns out, a closer look at the underlying IRS tax data shows that these claims rely heavily on how we define “profitable” and “pre-tax income.” Here’s why.
Corporations with zero tax liability
The IRS Statistics of Income provides data on the total returns of all active U.S. corporations. The GAO study relies heavily on data provided in the Corporation Complete Reports. Looking more closely at the 2012 data (Table 18) and restricting the sample to the types of companies that the GAO included in its report, my own analysis finds the following. In 2012, out of 1.6 million corporate tax returns, only 51% were returns that had positive “net incomes,” and only 32% were returns that had positive “incomes subject to tax.” These are both measures of pre-tax income. However, while “net income” generally refers to the net profit or loss after allowing for certain usual deductions (such as depreciation allowances, compensation payments and interest), “income subject to tax” allows companies with positive “net incomes” to claim an additional deduction as a result of prior-year operating losses. These losses can be carried forward to offset taxable incomes in years when firms are making a profit or have positive net incomes; this is known as a net operating loss deduction (NOLD). For 2012, the data show that approximately 20% of companies with positive “net incomes” (or profits) claimed a net operating loss deduction resulting in a zero tax liability.
So my analysis of the data shows two things: first, the GAO claim that 70% of companies paid no income tax is largely because more than 50% of these companies had zero profits or net incomes, and therefore they had zero tax liability. Even tax reform is unlikely to get us to the point where we would start taxing unprofitable companies.
Secondly, some of these currently “profitable” (positive net income) companies have experienced large losses in prior years. For these companies, the NOL deduction allowed them to reduce their tax liability to zero. This trend explains the 20% of currently “profitable” companies that are paying zero taxes. Again, the NOLD provision is a largely sensible provision in the tax code. As per a recent report by the Congressional Research Service, having this provision in the tax code improves economic efficiency and reduces the distorting effect of taxation on investment decisions. The intent of this provision is, for example, to avoid a company with 5 years of consecutive operating losses of $20 million each having to pay income tax in year 6 simply because it realizes income of $20 million in that year. The principle underlying NOLD is intended to allow companies to get out of the hole of accumulated losses before the government can start claiming its fair share of the company’s income.
Effective Tax Rates
The 16% tax rate that is receiving wide attention is calculated by the GAO as total taxes paid divided by “net income.” However, the real taxable income or tax base (as intended in the tax code) is different from “net income” because, as discussed in the previous paragraph, it allows companies with positive net incomes to further write off losses incurred in previous years, using the NOLD. Only after accounting for the loss carryforwards and certain special deductions, do we get to the taxable income of the company, or what the IRS defines as “income subject to tax.” So the difference in effective tax rates (ETR) also comes from whether we define “net income” or “income subject to tax” as the pre-tax income. In a recent post, the Tax Foundation explains the many reasons why net income may differ from taxable income. A series of earlier Tax Foundation studies using data for 1997-2008 compute the ETR using the “income subject to tax” in the denominator, and find that in 2008 firms with asset sizes between $5 and $100 million had an the average ETR of 32.5%.
In the table below, using IRS data (Table 2), I compute the effective tax rate using both measures of the tax base for large companies in 2012.
Effective Tax Rates, 2012
These differences are striking. With pre-tax income defined as “income subject to tax,” the effective tax rate is nearly 20 percentage points higher than what we get using “net income” as the tax base. One reason this divergence matters currently is because over the course of the recession, many companies likely accumulated operating losses and their ability to use them in later years lowers their “income subject to tax.”
Of course, there are many different ways to define average effective tax rates. A January 2016paper by the Office of Tax Analysis shows that there is wide divergence in tax rates depending upon the methodology used and particularly depending on the treatment of loss making firms.
A 2006 NBER paper by Alan Auerbach constructs a measure of average taxes paid and shows that average tax rates were above 45% in 2003, primarily because of the way losses are treated in the corporate tax code. So it is important to bear in mind that the 16% rate is the consequence of a chosen methodology and is at the lower end of comparable estimates.
In fairness to the GAO, page 10 of the report highlights several reasons why firms may pay no federal tax. They claim that in “each of the years from 2008 to 2012, between approximately 49 to 54 percent of all active corporations had negative net tax income.” They also note that “corporations had positive net tax income that was completely offset by net operating loss deductions carried forward from prior tax years. In each year from 2008 to 2012, approximately 15 to 19 percent of all active corporations had their income completely offset in this manner.” Finally, they add that “the use of federal tax credits appears to have had little effect on the number of corporations that paid no tax in each year.”
So, the GAO clearly acknowledges that the reason 70% of companies are paying no taxes is because they are either not currently profitable or they are able to offset taxes because of prior-year losses. Further, using taxable income to compute ETRs, I find that effective tax rates are fairly close to the statutory rate of 35%, at least when using aggregate data.
As usual, headlines are more about hype than substance in this election season. We cannot simultaneously worry about U.S. companies inverting to low-tax countries to take advantage of low tax rates, while also claiming that U.S. companies already pay really low taxes. Clearly, the devil is in the details.
Cross-posted from American Enterprise Institute.
Photo by @RocketSpace
Aparna Mathur is a resident scholar in economic policy studies at the American Enterprise Institute. She received her Ph.D. in economics from the University of Maryland, College Park in 2005. At AEI, her research has focused on income inequality and mobility, tax policy, labor markets and small businesses. She has published in several top scholarly journals, testified several times before Congress and published numerous articles in the popular press on issues of policy relevance. Her work has been cited in academic journals as well as in leading news magazines such as the Economist, the Wall Street Journal, Financial Times and Businessweek. Government organizations such as the Congressional Research Service and the Congressional Budget Office have also cited her work in their reports to Congress. She has been an adjunct professor at Georgetown University’s School Of Public Policy and has taught economics at the University of Maryland.