Issues over the Horizon

Corporate America’s Next Big Scandal

By Michael D. Greenberg and Robert T. Reville

Michael Greenberg is a RAND social scientist specializing in civil laws and regulation. Robert Reville is director of the RAND Institute for Civil Justice.

Although the businesses are usually surprised, most scandals involving corporate ethics are predictable.

Before the scandal breaks, practices that are widespread are assumed to be ethical. A change in economic circumstances triggers new scrutiny of business practices, and then — voila — a scandal. This was the sequence for Enron, WorldCom, and Tyco, and it’s playing out now in the subprime lending collapse.

Where is it likely to surface next? Signs point to corporate income tax avoidance. Corporations routinely engage in extensive tax planning and elaborate schemes to minimize their tax burdens. Offshore tax sheltering, stock option write-offs, and “synthetic leases” are all examples of the complicated accounting and business strategies that corporations follow to take maximum advantage of tax laws. Taking advantage of loopholes can be legitimate. At times, it is even encouraged: tax credits for the purchase of hybrid vehicles, for example. But the line is fuzzy between tax avoidance, which is legal, and tax evasion, which is not. In 2006, a scandal emerged at accounting firm KPMG over tax shelters marketed to wealthy clients — a harbinger, in our view, of things to come.

The Internal Revenue Service (IRS) estimates that the difference between what corporate taxpayers voluntarily pay and what they are legally obligated to pay — the so-called “corporate tax gap” — was $32 billion in 2001. Such figures are notoriously hard to estimate, but this is broadly consistent with other evidence. One study found that among a sample of 250 large U.S. corporations, the annual effective tax rate declined from 2001 to 2003 — a period when corporate profits rose substantially — and dozens of major U.S. corporations paid no income taxes for at least one year during that interval. Statistics from the U.S. Department of Commerce and the IRS show that the proportion of net corporate income actually paid in federal taxes declined substantially from 2001 to 2004. Perhaps it is no coincidence that, according to the U.S. Government Accountability Office, only about 1 percent of corporate returns are reviewed by the IRS.

In the Last Half Century, Corporate Income Taxes Have Fallen Sharply as a Percentage of Total U.S. Federal Tax Revenues
In the Last Half Century, Corporate Income Taxes HaveFallen Sharply as a Percentage of Total U.S. FederalTax Revenues
SOURCE: The Decline of Corporate Income Tax Revenues, Washington, D.C.: Center on Budget and Policy Priorities, October 24, 2003, Table 1.
NOTE: The 2000–09 average reflects historical data through 2002 and federal government projections for the remaining years, assuming that existing tax breaks will expire as scheduled and will not be extended.

Meanwhile, demographic shifts, such as the retirement of the baby-boom generation, could lead to a fiscal crisis and a requisite change in economic circumstance that would trigger the next wave of corporate scandals. The Congressional Budget Office has estimated that Social Security and Medicare, which accounted for 5 percent of gross domestic product in 2004, will rise to 13 percent by 2025 and 19 percent by 2050. This combination of “tropical instability,” in the form of a cash-strapped federal government, and the “warm water” of corporate tax avoidance strategies together could create the conditions for a perfect storm, in which widespread tax avoidance practices abruptly become illegal and fraudulent.

The line is fuzzy between tax avoidance, which is legal, and tax evasion, which is not.

In the United Kingdom, tax authorities have been promoting a voluntary “Tax in the Boardroom” agenda to target corporate tax avoidance. This approach is catalyzing greater scrutiny of tax practices by UK corporate board audit committees, and tax practice is increasingly seen as part of a company’s corporate social responsibility program. If the boards of American companies learn from some of the best practices of their British competitors in reviewing tax avoidance strategies, they may be able to avoid the next big scandal. square