OUR SCREWED-UP TAX CODE It eats up time and money and -- worst of all -- penalizes saving and investment. Washington has just made it worse. What could make it better?
By Rob Norton REPORTER ASSOCIATE Tricia Welsh

(FORTUNE Magazine) – The U.S. tax system is an unwieldy, inefficient, ungodly mess -- and this summer's shenanigans in Washington have just made it worse. It penalizes the very investment we need to create jobs and improve living standards. It makes U.S. companies less competitive internationally and encourages them to expand overseas instead of at home. It even helped deepen the recent recession and is helping suppress whatever vitality the current recovery contains. No wonder so many of the folks who know the beast best -- corporate tax directors, economists, attorneys, accountants, and business executives -- are increasingly eager to tear it apart and build something better. How screwed up is the U.S. tax code? Just listen. ''I would repeal the Internal Revenue Code and start over,'' says Shirley Peterson, who was IRS commissioner under George Bush and now practices law at Steptoe & Johnson. Chimes in Paul R. Huard, a senior vice president with the National Association of Manufacturers: ''You'll never be able to dismantle what we have done to the system. You need to throw it in the can and come up with something new.'' Concludes William Modahl, director of tax affairs at Digital Equipment: ''I personally believe we are near the end of the road on income taxation.'' Paul H. O'Neill, CEO of the Aluminum Co. of America (Alcoa), is so fed up he has weighed moving the Pittsburgh metalmaker's legal center of incorporation out of the U.S. Heavy IRS exit penalties make such a drastic move expensive. O'Neill just happens to know the cost for Alcoa: $500 million. But, he says, ''it's awfully tempting when you look at all the consequences of living in this zoo we've created for ourselves.'' The tax changes imposed by the new Clinton budget plan will make the zoo considerably more inhospitable in a number of ways. Start with complexity. Eleven years of incessant nickel-and-dime deficit reductions and ten legislative overhauls have turned the tax code and its attendant regulations into a multivolumed thicket of confusion. (Several more forests will have to be mown down to add the changes in this year's legislation.) In addition, any reader seeking enlightenment requires a wallful of commentaries to translate the code into something like English. No tax lawyer knows it all, few know much of it, and it may have become, in effect, unknowable. Says Sandy Navin, director of taxes at General Mills: ''There are areas of the tax code where you have no way of telling whether you're coming up with the right answer, because of the complexity. You wait until the audit and hope you can come to an understanding with the government.'' Chrysler's chief tax counsel, John Loffredo, has a team of 30 tax pros at his Highland Park, Michigan, headquarters and another 25 at two subsidiaries -- typical staffing for a major U.S. corporation. (Loffredo is the fellow pictured on the facing page with the six-foot-high Tower of Babel that is his company's 1991 tax return.) He also has two offices full of IRS agents -- nine on any given day -- camped out at Chrysler, haggling over past and present audits and appeals. Says Loffredo: ''They could end the income tax system today, and I'd still have ten years of work to do just settling up past disputes.'' The costs of complying are staggering. University of Michigan economist Joel - Slemrod is the leading authority on the subject. In a new survey of 1,300 large companies, he found that they spent an average of $1.6 million a year each complying with the code. He figures the total annual cost of corporate tax compliance exceeds $8 billion. Slemrod also calculates that the average household spends $343 in time and money doing its individual taxes, for a total of $38 billion. So toss in the annual budget of the IRS ($6.5 billion), and the total bill for merely coping with the U.S. tax code tops $50 billion a year. That's nearly 1% of the nation's total output of goods and services -- more than the IRS collected last year from all excise taxes on gasoline, alcohol, and tobacco. MORE damaging than this waste of time and money is the way the code distorts -- and in some cases discourages -- business investment. Example: One obscure provision of the new budget bill lengthens the recovery period for depreciation on new, nonresidential real estate investment from 31.5 years to 39 years. This was done to generate $3.4 billion in revenue between now and 1998. (The President had originally asked for an extension to 37 years, but Congress added two more years to squeeze out an extra few hundred million dollars.) Problem is, the less favorable tax treatment reduces the incentive to build new facilities. The change will reduce construction spending by more than $3 billion per year, according to Mike Montgomery, an economist at DRI/ McGraw Hill. Just what the struggling real estate market needs, right? It gets worse. Today many companies in capital-intensive industries complain they are being pinched hard by the IRS even though they are losing money. The airlines, for example, have lost $10 billion since 1989 but have had to scrounge up at least $673 million in cash over that three-year period to pay a special federal tax. In many cases they have had to borrow money to do so. The source of this madness is a fearsome chunk of the tax code known as the alternative minimum tax (AMT). The AMT was created in 1969 to ensure that corporations and individuals would not escape paying taxes altogether by overusing investment incentives. In the 1986 tax reform, Congress gave the AMT new, considerably sharper, teeth. But few in smokestack America focused on the threat at the time. The economy was growing, exports were booming, and ''everybody was making money hand over fist,'' recalls NAM's Paul Huard. When business slowed as the 1990 recession got under way, companies that had ! invested heavily in plant and equipment in prior years found that the depreciation they were claiming on those investments made them subject to the AMT. The resulting cash crunch deterred new investment in many industries -- among them steel, forest products, and autos. Chrysler delayed some of its product decisions in the late 1980s when profits slumped, in part because the heavy investments it made earlier in the decade gave it ''excess'' depreciation and triggered AMT tax payouts. The ripple effect of such delays helped prolong the recession. Today half of all big companies in capital- intensive industries may be subject to the minimum tax, according to the NAM. The higher capital costs they face may be restraining new investment. Acknowledging the problem, President Clinton initially proposed changes that would have significantly relaxed the depreciation provisions of the minimum tax. But his relief plan was nibbled nearly to death by the ducks on Capitol Hill. The little of it that remains, says Red Caveny, president of the American Forest and Paper Association, ''will have virtually no effect on reducing the investment penalty in our industry.'' Another prime source of perversity in the tax code is its treatment of the foreign income of U.S. multinationals. Companies receive a credit for taxes paid overseas, and the money they earn abroad is typically not taxable until it is repatriated. But over and over again, Congress and the IRS have written complex provisions into the code to try to make companies pay as much tax as possible in the U.S. This is terrifically popular on Capitol Hill, where legislators tend to equate any overseas operations with ''exported jobs.'' Unfortunately much of this patriotic rulemaking has backfired. One set of IRS restrictions -- just tightened in the 1993 act -- is designed to limit how much money a company can accumulate in a subsidiary overseas. If cash on hand goes over a certain ratio of a local operation's assets, it is considered income in the U.S. and subject to tax. But companies are unlikely to let that happen. Says the tax director of one of the biggest U.S. multinationals: ''I have $30 million in Switzerland, and now I'm going to reinvest it in other foreign subsidiaries rather than pay these taxes. It's really stupid, and we wouldn't necessarily have done this otherwise, but hey, it's my job to make sure we have as much cash as possible.'' Why do dumb ideas like these become ensconced in the tax code? One big reason is that fixing them would cost the government revenue, and given the size and persistence of the federal budget deficit, tax legislation over the past decade has largely been driven by revenue needs, not by whether a policy makes economic sense. Consider the research and development tax credit. Most economists, liberals and conservatives alike, consider it a classic case of using tax policy to further a public good. R&D generates benefits to society greater than the benefits to individual companies, so the nation as a whole will be better off if the government provides a subsidy. Yet the credit is consistently treated like a political volleyball. It is renewed only year by year and sometimes allowed to expire only to be reinstated retroactively. In the latest go-round, Congress decided to extend it for three years because making it permanent, as President Clinton originally requested, would have forced budgeters to add $9.6 billion of lost revenue to their five-year deficit projection, vs. $4.9 billion. Such bogus accounting is more than misleading; it also imposes a serious cost. ''The signal such constant uncertainty sends a U.S. multinational is, Do your R&D offshore,'' says Robert Perlman, vice president for taxes at Intel. Hunger for revenue, whetted by soak-the-rich populism, is also behind the latest move to tighten the tax deductibility of business meals and entertainment. You can bet most Congressmen are well aware that ''business meals'' include the truck driver's on-the-road omelet as well as the arbitrager's expense-account caviar. And many on Capitol Hill also worry about the very real risk that limiting this deduction could cost a number of restaurant workers their jobs, much as 1990's imposition of a ''luxury tax'' sparked widespread layoffs in the boat-building and private aircraft industries (see box, next page). So why do it? Because cutting the deduction from 80% of cost to 50% is projected to produce a juicy $15 billion in revenue over five years. That almost equals the $16 billion that raising the corporate income tax rate from 34% to 35% is expected to generate. The new limit on business meals thus allows legislators to insist they held the line on raising the corporate rate still further -- the President's original target was 36% -- while, in effect, delivering a convenient, back-door rate increase. WITHOUT a doubt, the worst idea in the President's tax package -- albeit a politically popular one -- was his sharp increase in marginal tax rates. In place of the previous top rate of 31%, these will now range from 36% to as much as 46% for certain highly paid individuals, who gradually lose the benefit of normal deductions and exemptions. The chief sin of higher marginal rates is that they intensify what is already the tax code's worst feature -- its persistent bias against business investment. Investment, after all, is the main motor that drives improvements in competitiveness and living standards. And while you won't find many policymakers or politicians arguing for ways to suppress it, the tax code has long done just that. It does so mainly by raising the cost of capital. Think of the cost of capital as the pretax return any investment must generate to cover operating expenses and still provide a sufficient after-tax return to attract investors. Any increase in corporate and individual income taxes inevitably raises the cost of capital and thus makes new investments less attractive, at the margin. Keep in mind that it is the combined effect of the corporate and individual income tax that does the damage. First the corporate income tax takes its bite out of corporate earnings; then the individual income tax is applied to what's left. Before the Clinton bill, the combined corporate and individual tax bite on earnings paid out as fully taxable dividends was 55%. Now the government's take is up to 61% -- and that's before state and local income taxes. Happily, because the top individual tax on capital gains was not raised, earnings retained by corporations -- which theoretically pay off for shareholders in the form of a rising stock price -- still face a somewhat lower burden. The new law worsens another long-standing perversity in the tax code -- the incentive it gives companies to finance investment with debt rather than equity. Debt makes out best from a cost-of-capital viewpoint because the interest on it is tax deductible for corporations. After corporate and individual taxes, only 39 cents remain of a dollar paid out in dividends, vs. 60 cents of a dollar of interest on corporate borrowing. That gap is troubling not just because U.S. business got too hooked on debt in the 1980s but because for many of tomorrow's growth companies -- startups and brainpower businesses with big research bills and small fixed investments -- issuing equity is their only option. Says George N. Hatsopoulos, CEO of Thermo Electron, a high-tech manufacturer in Waltham, Massachusetts: ''The absence of collateral makes it virtually impossible for such companies to rely on debt financing.'' Most of America's competitors in the global marketplace offer far more relief from the double taxation of corporate earnings. Germany, for instance, gives shareholders a credit against their individual taxes to offset the taxes already paid on dividends at the corporate level and imposes no tax whatsoever on long-term capital gains. Other nations such as Britain, Canada, France, and Japan allow either corporate or individual taxpayers a partial credit or deduction on dividends. Though many countries have higher corporate tax rates than the U.S., most also offer generous depreciation allowances (which permit corporations to drastically reduce taxable income) and various kinds of investment tax credits (which effectively forgive some taxes for companies that invest in plant and equipment). The 1986 tax reform eliminated most such breaks in the U.S., in exchange for lowering corporate rates. The U.S. code also penalizes corporate investment by favoring investment in housing -- which is essentially untaxed. The new higher tax rates only intensify housing's relative attractiveness. American politicians may wince at the point, but other countries are considerably less generous. Half the major industrial countries give no deduction for mortgage interest. Some, such as Italy, Spain, and the Netherlands, add an imputed return on your housing investment to your income, thus raising your taxes and diminishing real estate's edge over the alternatives. THE CONSEQUENCE of these international differences is that many U.S. companies confront higher capital costs than their competitors. That gap may explain, at least in part, why investment in private nonresidential capital grew a mere 2.3% a year in the U.S. during the 1980s, according to the Organization for Economic Cooperation and Development. By contrast, such investment rose an average of 5.2% a year among the OECD's 23 other member nations. For America's small businesses, the latest tax increases are coming through the front door like Arnold Schwarzenegger in Terminator II. Most small businesses are sole proprietorships, partnerships, or so-called Subchapter S corporations, whose owners pay tax as individuals. Though they don't face the double taxation that traditional corporations do, entrepreneurs who were paying 31% and now see their top rate climbing higher than 40% will still be & faced with a one-third increase in their marginal tax rates. And it's retroactive to January 1, 1993! The President and his top aides have spent a lot of time trying to put a positive spin on the small business impact of the tax bill. They point out the benefit of falling interest rates -- admittedly a big plus, though it's not clear how much their budget plan deserves the credit -- and assert that only a few hundred thousand of the nation's nine million small businesses will be hit by the higher rates. But it is the fast-growing small businesses, which are the catalysts of job creation, that are surely among the select group facing a tax increase. Predicts Mary Smalligan, a partner at Deloitte & Touche's office in Oakland: ''The companies that will be hurt the most are those that plow earnings back to fuel growth. The extra cut out of profits will give them a much higher cost of capital.'' Ronald Sandmeyer Jr., who runs Sandmeyer Steel, a small manufacturer with 175 employees in Philadelphia, reinforces that gloomy assessment. Says he: ''Higher taxes just mean less money left to buy new equipment and hire new people. We're going to have to be cautious.'' Some businesses retrenched even before the tax bill passed. George Sydnor is president of James McGraw Inc., a $40-million-a-year distributor in Richmond. His main customers are small manufacturers. Back in March 1992, Sydnor began hiring and expanding based on the strong orders that typically predate an expansion. But as uncertainty caused by the Clinton plan mounted, he got increasingly nervous. Says he: ''We decided to take all that overhead back out on the first of June -- 9% of our payroll, ten of our 155 employees.'' Discontent with the tax system, never muted, is likely to increase in volume as the pain inflicted by this year's tax increase filters out into the economy. At the same time, the need to keep hacking away at the budget deficit will keep the heat on Congress to find new revenues. Even the Administration's forecasts show the deficit barely falling and then growing rapidly again, beginning in 1997. All this is creating pressure in the policymaking corridors of Washington -- and not just in the universities and think tanks -- for real root-and- branch tax reform. A careful reading of the political thermometer suggests that the country may be in a period similar to that of the late 1970s, when ferment for reform was building and eventually boiled over into the Tax Reform Act of 1986. Even President Clinton, in a recent interview with FORTUNE (August 23), acknowledged his desire, once he finishes with health care reform, to have a national ''debate'' on tax reform, focusing on what tax regime would ''create the most jobs.'' Much of the talk has centered on the idea of adopting a European-style value-added tax (VAT) to augment or replace part of the income tax system. Clinton expressed interest in that concept in the FORTUNE interview. Coupled with sensible reform of the income tax -- broadening the income base by reducing deductions, easing the double taxation of corporate earnings, and cutting marginal rates, for instance -- a well-designed VAT could go far toward improving the U.S. tax system. But when Clinton's aides floated the idea of using a VAT to pay for health care reform -- on April 15, of all days -- that trial balloon was shot down with alacrity. And the short, unhappy life of the BTU energy tax -- the Administration's one true tax policy innovation -- also shows the difficulty of introducing a new kind of tax. A more revolutionary idea -- and the one most favored by many of the more than 40 tax specialists interviewed for this article -- is to replace the existing system with a far simpler tax code designed to encourage saving and investment. One who thinks such a change will come is David F. Bradford, a Princeton economist who in 1977 led the Treasury team that produced Blueprints for Basic Tax Reform, a cult classic among tax policy experts (and still in print). Says he: ''There is increasing doubt that the income tax as it exists now is a fair tax. It's not, and when enough people understand that, they'll say, 'Let's go back and rewrite the rules.' '' WHAT HE and others have in mind is a system known as a ''consumed-income tax.'' Several variations have been created over the years. What they have in common is that they tax gross income minus savings, so that citizens pay taxes on what they spend in a given year rather than on what they earn. This would essentially treat savings the way pensions are treated now under the tax code -- no tax when the money goes into your account but full tax when it's withdrawn. In a pure consumed-income tax system, there would be almost no other deductions. Rates of taxation, however, could be adjusted to whatever political realities required -- that is, they could be made as or more progressive than the current system. The corporate tax, under many variations ^ of this system, would be replaced with a much simpler tax on cash flow rather than on profits. The tax would thus get rid of nearly all deductions and their consequent complexity. A tax plan along these lines may soon be introduced in the Senate. It carries a more user-friendly name -- ''the savings-exempt income tax'' -- and its sponsors include Republican Pete Domenici of New Mexico and Democrat Sam Nunn of Georgia. Observes Senator Tom Daschle (D-South Dakota): ''There is growing bipartisan support in Congress for moving away from reliance on the income tax and toward a consumption-based system.'' The obstacles to accomplishing so massive a change are formidable. They include selling the concept to a highly skeptical citizenry, ensuring that the new plan doesn't become a lobbyists' cornucopia, and designing a transition from one system to another. But given the sorry state of the current system, the end result -- a more rational, pro-growth tax system -- surely makes the effort worth attempting.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/AMERICAN COUNCIL FOR CAPITAL FORMATION CAPTION: PUNISHING INVESTMENT Tighter depreciation rules under the alternative minimum tax force U.S. steelmakers to wait longer than competitors for a return on their capital investment.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: FEDERAL RESERVE BANK CAPTION: THE UNEVEN TAX BITE The deductibility of corporate interest payments explains this gap. The example above assumes taxpayers are in the 39.6% bracket.