Most everyone understands the difference between right and wrong, but some choose to ignore the lessons-people such as managed Enron, WorldCom and Sunbeam. There is no doubt that some corporate managers broke laws, should go to jail, and have thus shaken the confidence of many investors, some too stupid or greedy to acknowledge the signs that these firms were financially weak before they collapsed. But there also is clear evidence, as forensic accountants can attest, that institutional problems need correction. The origin of many problems is the U.S. tax code, which has caused, in the view of Cato Institute Chairman and economist William Niskanen, "landslide transfer of wealth from public shareholders to corporate managers."
Congress, wanting to appear tough on big business, passed a Sarbanes-Oxley Act of 2002 that does not change corporate governance but really takes punitive actions against chief executive and financial officers of public companies and requires them to personally certify that audit procedures and accountants' work are accurate. The Act also establishes a Public Company Accounting Oversight Board, funded by assessments on all public companies; it is constitutionality doubtful and a dubious delegation of authority. This law overlooks the problem and largest element of its solution, corporate tax reform.
Taking a step back shows that a weak economy has disabled business. Profits in manufacturing fell from $176.1 billion (B) in second quarter (2Q) 2000, to $50.9 B in 4Q 2001, before recovering to $91.9 B in mid 2002. Profits of S&P 500 firms fell from $120.2 B in 3Q 2000 to $63.3 B in 2Q 2002. Costs have been rising faster than prices: unit labor costs rose by 2.6% annually and prices by 1.5% during the 1998 through 2001 period, while after tax profit margins fell from 8.9% to 5.9%. These profits will not improve because of better accounting practices or executive certifications, but disabled businesses will suffer yet more because of tax policy.
The U.S. taxes corporations on worldwide income while most nations (half of 30 OECD states) have a territorial system that taxes firms only on domestic income. At a 40% (federal plus state) rate, U.S. corporate income tax is the fourth highest among OECD members. These rates have led to practices of "inversion" or re-incorporation in a foreign nation that only taxes domestic income, sale of the American company to a tax-friendly foreign owner and "earnings stripping" or the excessive lending by a foreign parent to their U.S. subsidiary in order to lower U.S. taxable income with large interest deductions. U.S. politicians need to get the message that lowering the statutory tax rate directly lowers the incentive for earnings stripping and that the inversion process only exists because of pig-eyed, territorial tax policy that has prompted foreign acquisition of U.S. companies to surge from $91 B in 1997 to $340 B in 2000. Demagogic attempts by Congress to block U.S. companies from inversions will only make matters worse and drive away industry, jobs and investment capital while taxing domestic income only and taxing capital gains, interest and dividends at standard and lower rates would essentially solve such problems.
This leads further into the morass of U.S. tax policy that fosters and abets bad behavior by assorted corporate crooks. (Incidently, the 327 federal securities class-action litigations filed against these crooks in 2001 are 60% more than the prior year and should jump again in 2002.) Tax codes favor debt over equity capital due to the double taxation of dividends. Most executive compensation (by law limited to under $1 million earned income) is based on future performance, reflected by stock price instead of actual results measured by earnings and dividends. Since dividends are not tax deductible, but interest on debt is fully deductible, equity capital is more expensive than debt. Also, since capital gains are taxed (20%) at half the rate of salary (~40%), stock options are a very attractive executive compensation. So, senior management has a major incentive to boost stock prices in a no-lose game. By eliminating these perverse incentives, equity for both executives and public shareholder can be restored, and the dishonest executives must resort to tricks of yesteryear, like robbing banks or church poorboxes, those targets more readily understood as out of bounds by the few corporate crooks that blemish our world.