Senator Elizabeth Warren really hates it when corporations that report billions of dollars in profit pay little or no tax to Uncle Sam. (She’s totally steamed about Amazon.)
As a policy-oriented presidential candidate and scholar of business law, Warren favors technical solutions to perceived problems, and last week she tackled this one in a post on Medium. She proposed what she called a real corporate profits tax on the most profitable 1,200 U.S. companies, a measure that seemed compelling in its simplicity and appeal to fairness. On closer examination, however, her plan would distort the U.S. tax code and degrade corporate governance.
To see why, it's important to realize that corporations calculate their profit using at least two different accounting methods. The first method, using guidelines from the Securities and Exchange Commission, determines how corporations calculate the earnings they report to Wall Street. A separate set of accounting guidelines from the Internal Revenue Service is used to formulate corporate tax bills.
Warren argues that companies game the system, using one method to report high profit to investors and drive up their stock price, and another to report low profit to the IRS to keep taxes down. By that logic, she contends, highly profitable companies ought to be taxed on the higher of the two figures.
But it doesn’t really work that way because the two sets of guidelines have different objectives. Scrapping one or the other would cause all sorts of problems.
The SEC guidelines are designed to minimize corporate fraud and misrepresentation. The goal is to prevent managers from fooling a company’s owners, the shareholders, about how much the company is earning. Before the SEC was established in 1934, corporate managers had been known to pull all sorts of elaborate scams.
One of the most common was to set up a shell company owned exclusively by the managers. The managers would then have the main corporation purchase goods or services from the shell company at inflated prices. This would drain profits from the main corporation while enriching the management.
Once the scheme had gone as far as it could, the managers would have the main corporation declare bankruptcy, leaving its shareholders with nothing. To prevent the shareholders from catching on ahead of time, the managers would issue profitability statements using obscure accounting tricks.
So the SEC forced corporations to calculate profits using generally accepted accounting principles. GAAP has a number of provisions that most people would consider odd, but are important for discouraging misrepresentation. For example, revenue is counted when it is earned, regardless of when it's received.
That means, for example, that when shoppers buy gift cards for Christmas, the money they spend doesn’t count as revenue to the company that issued the gift card. Only when a customer actually uses the gift card to buy something does the company get credit for earned revenue.