GAO Still Underestimating Corporate Effective Tax Rate

December 2, 2013

The Government Accountability Office (GAO) has backtracked a bit from their claim that the U.S. corporate effective tax rate is 12.6 percent. In a letter to the editor of Tax Notes, GAO revises their estimate up to 22.9 percent, which is more in line with other estimates. GAO got the higher number by adding in a measure of foreign income and foreign taxes, net operating losses carried forward, and also averaging over the three year period 2008-2010.

This is about as a good as it gets in terms of a recent snapshot post-financial crisis. The problem is that the financial crisis is the worst economic crisis since the Great Depression, and it destroyed corporate profits in 2007, 2008, 2009, and 2010. By law, these massive losses may be carried both forward and back multiple years, essentially spreading the true measure of profit across a decade or more. Therefore, a more representative measure of profits, and the effective corporate tax rate, would include a few years prior to the financial crisis as well. Doing that, based on 15 years of data 1994 to 2008, yields a corporate effective tax rate of 26 percent when counting only federal corporate taxes, and 32 to 33 percent when counting foreign corporate taxes on foreign income.

Bruce Bartlett discusses much of this as well in his article in the NY Times, but he confuses the issue by referring to a Bureau of Economic Analysis (BEA) measure of corporate profits that includes not only C corporations that pay tax under the corporate tax code but S corporations that pay tax under the individual tax code. A more accurate measure is income subject to tax according to the IRS, restricted to C corporations, which is shown below with the most recent data through 2010. It clearly illustrates the collapse of C corporation profits from 2007 to 2009 with a partial recovery in 2010. The chart also shows federal corporate income taxes paid on those profits, which go up and down along with profits.

The next chart shows the effective tax rate, i.e. federal corporate income taxes divided by income subject to tax, which is exceptionally low in the years 2008 to 2010, i.e. precisely the years GAO uses. The law did not change substantially in those years, rather the low effective tax rates are largely attributable to an increase in the foreign tax credit, meaning companies earned more of their profits abroad and paid taxes on them there rather than in the U.S. This may or may not be a long term trend, but for the time being it makes sense to average over more than just those three years. The average effective tax rate over the entire 17 year period (1994 to 2010) is 25.5 percent. It also makes sense to account for these foreign taxes and foreign income, which is a complicated task but when that is done the long term average effective tax rate is about 32 or 33 percent and it has probably changed little with the addition of the most recent two years of data.

Update: In this week's issue of Tax Notes, Drew Lyon of PWC shows that GAO's new analysis still fails to properly adjust for net operating losses carried forward and for foreign taxes on foreign income. Lyon concludes that the corporate effective tax rate is well above what GAO claims.

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