The politics of tech's tax breaks

Do incentives used to lure tech companies keep money from public schools--and thus hurt U.S. efforts to stay competitive?

Anne Broache Staff Writer, CNET News.com
Anne Broache
covers Capitol Hill goings-on and technology policy from Washington, D.C.
Anne Broache
12 min read
Symantec received what must have been an unpleasant surprise at tax time this year: A $1 billion bill from the federal government.

The security software company revealed last month that the IRS alleged it underpriced intellectual property related to its Veritas acquisition that was licensed to its Irish subsidiary for tax reasons. For its part, Symantec says it paid all appropriate taxes in 2003 and 2004 and plans an appeal.

Every individual and business, of course, tries to pay the minimum amount of taxes legally required. But technology companies that try to minimize their tax burden sometimes draw accusations of hypocrisy from liberal advocacy groups and academics--mostly because the same companies want more government spending on education and research.

Symantec, for instance, is a founding member of a trade association that lobbies for more federal research funding and more government spending to teach children cybersecurity. And when Cisco Systems recently hosted President Bush in Silicon Valley, the president and company executives called for better math and science education. Last fall, Microsoft Chairman Bill Gates did the same.

Yet under one method of reckoning corporate taxes, in one well-known and isolated example, neither Microsoft nor Cisco paid anything to Uncle Sam or state tax collectors in 2000.

Nobody is saying that any technology company has done anything improper. Rather, critics suggest, businesses should voluntarily write fatter checks to tax collectors.

"So many of these high-tech CEOs are out there beating the drums about the fact that the decline in education in the U.S is...hurting international competitiveness," said Michael Mazerov, a tax specialist at the Center for Budget and Policy Priorities, an advocacy group that generally opposes tax cuts. "At the same time, these same companies are seeking and getting huge tax breaks from state and local governments that are negatively affecting the ability of these governments to provide educational services."

The tech industry isn't alone. Government auditors analyzing IRS data in 2004 estimated that between 1996 and 2000, 61.3 percent of large U.S. corporations with at least $50 million in gross receipts reported zero tax liability mostly because of legally permissible deductions. (Similarly, a self-employed individual who makes no money because of no profits may be able to escape paying federal income taxes that year.)

Another favorite complaint of critics is tax breaks that state and local governments dangle to lure valued businesses. A deal between Intel and Rio Rancho, N.M., gave the chipmaker an estimated $645 million in tax breaks, for instance. Intel has also saved hundreds of millions of dollars through tax breaks designed to lure companies into building large manufacturing plants in Oregon and Arizona.

"In the long run these are costly because the state has less money in order to invest in schools and infrastructure and the kinds of things that would be conducive to creating a powerful labor force in the future," said Dave Wells, who teaches in Arizona State University's Interdisciplinary Studies Program.

This view is hardly universal. For one thing, executives have a legal responsibility to shareholders to maximize income within the bounds of the law. Also, nobody would argue that an individual who takes advantage of a legal tax break--such as the adoption tax credit--would be a hypocrite for griping about potholes in roads or poor teachers in schools.

Critics of corporations miss the point, says Lew Rockwell, president of the free-market Mises Institute. "There are a lot of premises in that argument" about companies not paying enough, Rockwell said. "One is that the more government spending, the better the education. If anything, the more money spent on public education, the worse the education. Certainly funding goes in the opposite direction of SAT scores."

A chart prepared by The Wall Street Journal in 2004 shows no relation between increased education spending by states and student test performance. As per-pupil spending went up, some states showed worse performance among students, some showed better, and many remained flat. Washington, D.C., city schools, for instance, had the highest increase in spending over a five-year period but eighth grade reading scores showed no improvement.

"They assume that the state owns 100 percent of everyone's income and assets, and everything that you're allowed to keep is a subsidy," Rockwell said. "That's entirely the wrong way of looking at things."

The "single sales factor" formula
The critics who accuse technology executives of hypocrisy are few but vocal. They point to examples like Microsoft, which calls for more education spending but takes advantage of legal tax breaks.

At a summit with academics in Redmond, Wash., last summer, for instance, Gates credited federal computer science grants for turning around the nation's performance in the area after the 1980s, when it was viewed as prone to "falling behind" other world powers.

Escaping the tax man

There's no way to know how much in taxes each corporation pays every year. But a very rough estimate can be obtained from financial disclosure statements (which use different accounting rules). Here are some examples of companies that may have been able to avoid paying taxes once in a while. But because tax returns are confidential and the companies don't divulge that information, nobody knows for sure.

Apple Computer
Estimate of taxes paid in 2005: $453 million
Including stock option benefit: -$25 million

Estimate of taxes paid in 2001: $74 million
Including stock option benefit: -$7 million

Cisco Systems
Estimate of taxes paid in 2000: $2.17 billion
Including stock option benefit: -$326 million

Estimate of taxes paid in 2000: $5 billion
Including stock option benefit: -$256 million

Source: SEC 10-K forms and annual reports

Now, with such funding on the decline, "we'll certainly be as strong an advocate as we can be that the government is making a mistake here, and throughout the world I think governments should fund computer science research," Gates said during a question-and-answer session with Maria Klawe, the dean of Princeton University's engineering school.

Former Intel CEO Craig Barrett has made similar pitches during trips to Washington, saying that China and India will pull ahead of the United States without education reform. In an interview with CNET News.com, Barrett said: "The only way to be the most productive society in the world is to lead in new areas of technology" by diverting more tax dollars toward basic research at universities.

At the same time, Intel is among a number of Silicon Valley companies backing a movement that could shave millions of dollars off their tax payments to California, a state that boasts the overall highest tax rates in the country.

In California, where the corporate income tax rate is a flat 8.84 percent, Intel, Oracle, Apple Computer and others are lobbying for a bill that would implement what is known as a "single sales factor" formula for calculating state corporate income tax payments.

Most states give equal weight to three factors--the share of a company's total nationwide investments, payroll and sales that occur in that particular state--when deciding how much tax is owed.

But under the single sales factor formula, they would consider only a company's sales in the state. Translated, that's a boon to manufacturers that make most of their goods in one state but conduct most of their sales elsewhere.

The idea already has caught on in 10 states, including Oregon, where Intel has had operations for 30 years, and Massachusetts, which has one of the highest corporate income tax rates in the nation. Six more states are currently phasing in the new method, but it's far more of a blessing for the companies than for the governments involved, said Mazerov of the Center for Budget and Policy Priorities.

"In virtually all states, it leads to a really substantial revenue loss," Mazerov said, adding that recent estimates from California pegged its potential losses from would-be corporate income tax revenues at $110 million per year. Mazerov's group generally opposes tax cuts and laws that would make it more difficult to raise taxes in the future.

Supporters of the single sales factor formula and other state tax breaks argue that it's a valuable stimulus that encourages building new plants--and creating new jobs--in an economic climate where going overseas is often cheaper.

"Right now it costs an average of $1 billion more to open a leading-edge manufacturing facility in the U.S. versus other countries," said Jennifer Greeson, an Intel spokeswoman. "The biggest difference isn't labor or construction costs, it's taxes."

The chipmaker once cited tax breaks inserted into Arizona's annual budget as one of several reasons it decided last summer to build a $3 billion microprocessor plant there. Arizona's recent adoption of an 80 percent sales factor formula, which stops short of considering only a company's sales in tax calculations but still gives them 80 percent weight, also "created a more positive environment for investment in the state," Greeson said.

State and local incentives valued at $279 billion over 15 years were also a "critical factor" in Texas-based Dell Computer's decision to open a new manufacturing plant in Winston-Salem, N.C., last October, said Colleen Ryan, a company spokeswoman. Dell said it hoped to hire 1,500 employees within five years of the $100 million facility's opening.

"This is a performance-based incentive program. That is, Dell does not receive tax credits unless we meet our job creation targets," Ryan said.

At the time the deal was announced, North Carolina Governor Mike Easley, a Democrat, said the decision made "good economic sense" and estimated it would bring $700 million in net revenue to the state over 20 years.

But not everyone shared such a rosy outlook. Before the plant even opened, the North Carolina Institute of Constitutional Law filed a class-action suit against the state and local governments, accusing their multimillion-dollar tax breaks of violating provisions in the U.S. Constitution that guard against discrimination "in favor of in-state economic activity and against interstate commerce."

A state superior court judge in Raleigh, N.C., heard oral arguments from Dell and the state attorney general on April 26 and is expected to rule this week on whether that case will proceed.

The practice has also generated enough controversy to attract the attention of the U.S. Supreme Court. The constitutionality of Ohio's investment tax credit, which can be used to offset a certain percentage of new machinery and equipment purchased by manufacturers, was the focus of a case called Daimler-Chrysler v. Cuno. The justices heard arguments in March and are expected to issue a ruling by the end of June.

"The problem with corporate taxes is that they're disguised ways of taxing individuals."
--Fred Smith, president, Competitive Enterprise Institute

"This case has the potential to sort of take some of the tax competition weapons out of the arsenal of all states," said Mazerov, the Center for Budget and Policy Priorities researcher. "That would be a good thing. The competition would still continue, but it would be constrained somewhat by this decision."

Until then, local citizens will continue effectively subsidizing city services for big business, advocates of higher taxes claim.

"The water, the sewage, the lights on the streets, just all of the different infrastructures that a city and state have to provide, that is paid for somewhere," said Meizhu Lui, executive director of the Boston-based advocacy group United for a Fair Economy, which supports higher personal and corporate income taxes. "So what they offer in terms of jobs is really far less in terms of what they get back."

The difficult problem of calculating taxes
There's one nearly intractable problem in trying to figure out how much a company paid in taxes, though: Nobody knows what really happens. Only the IRS and the company itself do, and neither routinely makes that information public.

That means anyone trying to estimate a company's effective tax rate has to rely on filings with the Securities and Exchange Commission, which use different accounting rules. (In accounting circles, this is a well-known phenomenon called the "book-tax difference.")

CNET News.com estimated tax rates and figures based on a formula recommended by accounting experts we interviewed. That formula suggested that Adobe, Apple, Cisco, eBay, Microsoft and Yahoo all may have been able to skip at least one year without paying any taxes.

One reason for that can be found in the research and development tax credit, which is designed to encourage investment in new technologies. It has let companies shave millions of dollars off of what they owe the IRS.

Major technology trade associations and companies have been lobbying to make that tax credit permanent--a move endorsed by President Bush in this year's State of the Union address. They're hopeful that Congress will at least extend the credit, which technically expired on Dec. 31, 2005, sooner rather than later.

"It's the number one tax issue that we work on," said Stephanie Childs, vice president of tax policy for the Information Technology Association of America, whose members include Dell, IBM, Intel, Microsoft, eBay and Yahoo.

Other tax rate reductions, particularly in the case of technology companies, often occur through a tax benefit claimed as a result of employees exercising stock options awarded to them as compensation. Between 2000 and 2005, the 10 technology companies analyzed by CNET News.com apparently racked up $27.5 billion in stock option tax benefits--more than half of the $53.2 billion they ultimately paid in federal, state and foreign taxes during that time.

Accounting experts say this is entirely appropriate. "There is nothing remotely questionable...regarding either the legality or ethical propriety of deducting stock option exercises," said Richard Sansing, an accounting professor at Dartmouth College's Tuck School of Business.

Depending on the company, the line disclosing that deduction was sometimes buried in financial filings, far removed from any mention of income taxes, which drew criticism from watchdog groups. Controversial financial accounting standards rules that took effect last summer should change that.

America's sky-high corporate taxes
Another favorite practice, however, has drawn more widespread outcry from corporate watchdogs and a handful of politicians. It involves shifting company assets to foreign countries with more favorable tax regimes.

Microsoft, Oracle, Google and Apple are among the companies that have arguably managed to reduce their tax payments--in some cases substantially--by setting up subsidiaries in Ireland, where the corporate income tax rate is only 12.5 percent.

A BusinessWeek Online article last month described how Apple made a similar move domestically, setting up a company in Nevada to avoid dealing with tax-happy California. (An Apple representative confirmed the existence of a regional treasury office in Reno but said that otherwise, "We don't go beyond" the contents of public filings.)

Of the financial statements analyzed by CNET News.com, Google's appeared to be the only one that overtly acknowledged the impact of its Irish subsidiary on its tax payments.

"We currently anticipate that our effective tax rate will decrease to approximately 30 percent in 2005 from 39 percent in 2004, primarily because we expect that our Irish subsidiary will recognize proportionately more of our earnings in 2005 as compared to 2004," Google wrote in its latest annual report. Others acknowledged obliquely that their effective tax rate in the United States would likely be reduced because of earnings taxed at lower rates in foreign jurisdictions.

This should come as no surprise, say free-market groups who have long said that the U.S. corporate income tax rate is simply too high. (They view tax competition as a healthy way to keep business environments welcoming and not too oppressive.)

"It scares away investment and it encourages companies, Enron the most infamous, to go through these complicated machinations to try to shift their profits out of the United States," said Chris Edwards, director of tax policy studies at the free-market Cato Institute.

The first step? A corporate rate cut across the board, ideally followed by a complete eradication of the corporate income tax, Edwards said.

Technology companies have made a similar plea. In a letter sent late last year to U.S. Treasury Secretary John Snow (click here for PDF), the ITAA called for reducing the federal corporate income tax rate to 25 percent.

Economists generally agree that lower taxes foster business investment. Ireland's economy is booming after its corporate income tax rate was sliced to 12.5 percent. Former Eastern bloc republics like Georgia, Russia and Ukraine have lower corporate income taxes than those of the United States, which a 2002 KPMG study said were the fourth-highest in the world.

"The problem with corporate taxes is that they're disguised ways of taxing individuals," said Fred Smith, president of the Competitive Enterprise Institute, which advocates lower taxes. Corporate income taxes mean "higher prices, lower wages, or reduced dividends, all of which affect a lot of people who aren't wealthy," he said.

The topic recently arose at a Senate hearing on global competitiveness, where Intel Chairman Barrett urged Congress to rethink the corporate income tax rate. He blamed "the relatively high degree of taxation of U.S. corporate revenues in the U.S., compared to the tax concessions (of) foreign governments" for discouraging new investment in manufacturing plants on American soil.

ITAA selected its recommendation of 25 percent because, when combined with the average state tax rate, it would be in line with the 29 percent average recorded across the 30 countries that belong to the Organization for Economic Cooperation and Development--a kind of think tank funded by developed nations. Right now the U.S. rate of 39.3 percent, which factors in the state average rate, is the highest among OECD members, the letter said.

"They'd be happy with zero," said ITAA's Childs. "But I think we're trying to introduce a standard of reasonableness that will be politically viable."