Taxes and the Economy

There are two downsides to the weaker dollar. Inflation is likely to increase. Imported goods will increase in price as the conversion from foreign cost (price) to dollar cost (prices) increases. Domestic goods, and to a lesser degree services, will use this as an opportunity to increase prices. If inflation begins to rise, the Federal Reserve may feel compelled to raise interest rates.

The second concern is that new foreign capital invested in the US will decline, or more likely existing investments will move out of the US, affecting the equity and bond markets. On balance, however, the economy will improve with a continued decline in the value of the dollar and the economic recovery, albeit slow, will continue.

The economy certainly needs a boost to get growth, especially in productivity, back to historic levels. The Bush administration has proposed changes in the tax codes. While the changes bandied about in the press would not be beneficial, there are some changes in the corporate tax codes that would result in a quick increase in productivity and would continue to spur US economic growth for years.

The Corporate Income Tax versus Value Added Tax

The press has recently reported on companies that incorporate abroad to reduce their corporate income taxes. Less noticed is the number of firms that shift manufacturing plants abroad to avoid corporate income taxes.

A manufacturing company will set up a subsidiary in a tax haven country and transfer a phase of the manufacturing process to this country. It then shifts profits to this subsidiary, thereby avoiding US corporate income taxes. A computer manufacturing company will make many of the components in the US. They then ship these components abroad to be installed in the computer. The computer is shipped back to the US and sold. Most of the profits are reported as belonging to the foreign subsidiary. A pharmaceutical company will do the research and make the active ingredients for a drug in the US. The active ingredient will be shipped to the tax haven country to be manufactured into the tablets. Most of the profits appear as belonging to the foreign subsidiary.

The IRS is aware of this activity and audits these companies with the intent of assigning profits to the appropriate country. The IRS, however, usually settles for $0.05-$0.10 on the dollar of these taxes. While the companies will argue lower labor costs or other benefits to justify this transfer in manufacturing activities, it has been admitted by a major technological company that the cost of shipping, handling and lost and damaged goods are considerably more than any saving in costs. Without the ability to shift profits and avoid taxes these business structures make no sense.

The current corporate income tax has a number of other problems. It encourages the shift of technology abroad. When these manufacturing entities are located abroad, suppliers of some of these parts will also shift manufacturing locations. As more and more functions are shifted, some manufacturing and basic research is also shifted to support these foreign operations.

This penalizes successful companies. A successful company with profits pays taxes at the same time it provides jobs. A less successful company, one with little or no profits, pays no taxes. These companies that pay little or no corporate income taxes can continue on for years, tying up resources while competing against well-run companies.

Foreign companies pay little or no US taxes since they report profits in tax haven countries or in their home country. According to international trade agreements, no value added tax is collected on a company’s exports. Those countries that have this corporate tax structure have an advantage over US companies that must pay taxes on export items.

Replacing the corporate income tax with a value added tax would have immediate and long-term benefits to the economy. Companies would make business decisions on the basis of economic benefits other than tax benefits. This would result in a shift of manufacturing jobs back to the US over time. Manufacturing job opportunity would increase and manufacturing pay and benefits would improve.

Both company resources and government resources needed to account for business activities for tax purposes would be freed up for other purposes. It is much easier for the IRS to audit sales than to try to determine whether an item qualifies for special tax treatment. IRS agents and specialists now used to audit corporate tax returns could be transferred to the SEC to monitor financial statements and to insure that companies follow SEC guidelines.

The argument against this tax is that companies would use this as an opportunity to raise prices. This assumes that companies do not consider the tax effect when making investment and pricing decisions. It also assumes that companies are charging less for their goods and services than they could charge. Some companies will need to raise prices to pay the tax and some companies will fail sooner without this indirect subsidy. Other companies may charge less as their share of taxes paid will decline. All these changes are good for the economy.

The Stock Market

The stock market is still on a downward trend as stocks become more sensibly valued. The telecommunications sector offers some speculative opportunities but be prepared for gut-wrenching times, as a number of these companies will be added to the bankruptcy files.

With the changes in the value of the dollar vis-à-vis other currencies, companies with a large percentage of foreign sales, especially in Europe, should show improved sales and profits.

Several boards of directors, most notably Tyco and Quest, are now trying to protect their positions by distancing themselves from the top company executives. Too bad they didn’t do their job before investors and reporters disclosed problems.

Then we have the Jack Welch and the GE way, advertised in the Wall Street Journal. It appears GE was guilty of some of the same questionable accounting for profits that has caused other firms problems, which are now being corrected by GE. How soon we forget or choose to ignore.