As individuals, our income is usually pretty straight forward. We know how much we bring home with our paychecks, and if we have investments, it is pretty easy to know how much cash goes into our account from them. Individuals have a good understanding of what money they will have on hand (at least the individuals who practice some sort of responsible financial management).
Corporations, on the other hand, are a little more complex. Mafia movies often depict a shady accountant in the back room that “cooks the books” and creates sets of books to show auditors, and a different set to show his bosses. It may seem as though this practice is confined to businesses that have ill intentions for bad deeds. However, public corporations in the US are required by law to keep at least two sets of books. They must keep one set for investors and another set for the Internal Revenue Service. Each set has its own rules and laws, and provides an entirely different picture of company profits.
Private corporations, which typically represent individually-owned or family-owned businesses (and many partnerships), are legally required only to keep a set of books following the laws and rules of the IRS. However, whether public corporation or private corporation, none of the accounting rules truly represent a picture of what individuals might think of as “take home pay”. Corporate income is really just a product of accounting concepts and theories that are used for the purpose of reporting in different regulatory environments. Try asking a friend you know who owns a business what his income is and you will typically receive a response of something like, “Well, do you want to know how much I make on paper or do you want to know how much I put in the bank?”
If, for tax purposes, we look at a system for measuring corporate profits that is more closely aligned to what individuals think of as their personal profits, there is a good argument that taxes are much more fair, more simplified, cost far less money than current reporting, and benefits small start-ups that aid in the growth of our economy. One accounting concept that is really not a part of either GAAP (the set of books required by the Securities and Exchange Commission for investors) or tax accounting is the concept of free cash flow. It is an attempt to strip away the various accounting tricks that are used to manipulate profits into a number for either tax efficiency or inflated earnings. It attempts to examine strictly cash moving into and out of the company. It is much more like a company’s “take home pay”.
While free cash flow is not technically a part of GAAP, it can use the numbers derived from GAAP financial statements. Thus, the need for two sets of books for public corporations is eliminated, and only a statement of free cash flow is required for the purpose of taxation. This would save US corporations billions in the work of keeping and preparing two sets of books and two sets of financial statements. It is also a more fair measure of what actual cash is profited within the company.
Early years of a private business are difficult, requiring large cash outlays for capital expenditures necessary for getting the business operational. During times of expansion, additional capital expenditures are also required in order to keep the business growing. These times are hardly good times to punish a company with additional taxes when it desperately needs and may not have free capital to pay taxes. As a practical, overly simplified example, let’s say you open a business selling widgets. You buy 100 widgets to sell at a cost of $10 per widget, so that your cash outlay is $1,000. The first year, you were not able to judge demand yet, and were only able to sell 10 widgets at a price of $15 each. According to current accounting principles, you made a profit of $50 and would be taxed on that. However, in your mind, you really basically had a significant net loss of $950 from your original cash outlay. Is it fair to tax you when you are really losing money? Furthermore, at a time when you are growing your business, doesn’t it make more sense to let you retain as much capital as possible so that you can hopefully grow and employ people?
The US has one of the highest corporate tax rates in the world. Most nations recognize that corporations (public and private, large and very small) produce large numbers of jobs. They want them to grow and increase those jobs. The best corporate tax policy should be one that seeks to create wealth for all and a growth in economy. From a governmental income point of view, that grows the tax base and increases tax income, while at the same time creating an economy more beneficial for the people. A low tax rate on cash flow rather than the accounting anomaly of profits serves the purpose of supporting growth and new jobs in the economy. A low tax on cash flows is more fair, eliminates the majority of accounting manipulations that create additional unfairness, renders enormous amounts of regulations unnecessary, reduces corporate accounting to only one set of books, strengthens corporate expansion and growth, encourages capital expenditures that benefit the economy, and it just makes much more sense. It also eliminates a long-time unfair practice of taxing profits twice. Corporate dividends would only be taxed as a part of individual investor income, and would not be included within corporate taxes.
* Danny Chabino has owned his own business for 20 years. He has been a proud employer and operator of a small retail business for 16 years.
This post was written by Danny Chabino.
The views expressed here belong to the author and do not necessarily reflect our views and opinions.