Enron’s Taxing Business
The tax law had a lot to do with this company’s downfall.
Mr. Bartlett
is senior fellow at the National Center for Policy Analysis
February 6, 2002, 8:00 a.m.
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we learn more and more about the widening Enron scandal, it is starting
to look as if the U.S. Tax Code deserves some of the blame. Because
the U.S. taxes corporations more heavily than any other major country,
U.S corporations must work harder to exploit every opportunity for
tax relief that they can find. Failing to do so would put them at
a competitive disadvantage vis-a-vis companies based in Germany, Italy,
and elsewhere. Unfortunately, it appears that Enron may have tried
a little too hard to save on taxes, ultimately contributing to its
downfall.
The core of the problem is that interest payments are a deductible
business expense, whereas dividends are not. This means that when
corporate profits are paid out to bondholders in the form of interest,
they are taxed only by the recipient. Profits paid out to shareholders,
on the other hand, are taxed twice: first at the corporate level by
the corporate income tax, and again by the individual income tax when
dividends are received by shareholders.
Obviously, this makes it far more attractive for companies to raise
capital by selling debt than by issuing new common stock. And this
is exactly what they have done. In 1960, non-financial U.S. corporations
paid out more than twice as much money in the form of dividends as
they paid out in interest. By 1997, they were paying out 40% more
in interest than in dividends.
Not surprisingly, corporations have become highly leveraged. At the
end of 2000, U.S. corporations had $4.7 trillion in debt outstanding.
In good times, this is not a problem. But when times are bad, as they
are now, and corporate cash flow declines due to falling sales, a
heavy debt load can trigger bankruptcies.
The reason is that bondholders are legally entitled to their interest
payments. Should a company be unable to meet them, they fall into
default and the bondholders may seize corporate assets, just as individuals
can lose their homes if they fail to make their mortgage payments
on time. By contrast, shareholders generally have no right to receive
dividends. When profits are down, corporations can cut dividend payments
or eliminate them altogether.
Thus, leverage is a two-edge sword. On the one hand, it helps the
corporate bottom line because interest is deductible, saving on taxes.
But on the other, leverage increases the risk of bankruptcy during
economic downturns. Consequently, corporations must carefully balance
their debt-to-equity ratio. If they become overleveraged, it can trigger
a lower bond rating that will raise its borrowing costs, and "sell"
recommendations by financial analysts that will lower its stock price.
What Enron appears to have done, according to reporting in the Wall
Street Journal, is try to have it both ways — issuing de
facto equity that looked enough like a bond to allow dividend payments
to be deductible as interest. It also allowed Enron to increase its
leverage without appearing to do so.
The transactions were extremely complex, requiring Enron to set up
hundreds of partnerships based in foreign tax havens. Enron was assisted
in setting up these partnerships by some of Wall Street's biggest
banks and law firms. Needless to say, the IRS took a dim view of Enron's
strategy and challenged it repeatedly. However, the U.S. Tax Court
ruled in Enron's favor. This meant that only Congress could fix the
problem. The Clinton administration's efforts to get a legislative
fix failed.
In the end, Enron's strategy was successful, in the sense that it
accomplished what the company wanted it to accomplish. According to
Citizens for Tax Justice, a liberal group, Enron paid no federal income
taxes in 4 out of 5 years between 1996 and 2000. It was also able
to borrow vast sums, greatly increasing its leverage, without such
borrowing showing up where analysts and bond-rating agencies could
see it. When the recession hit and energy prices collapsed, the financial
house of cards Enron had built came tumbling down.
The common law has long recognized the existence of something called
an "attractive nuisance." For example, if
someone owns a swimming pool and fails to take reasonable safeguards
against its use by uninvited guests, he can be held liable should
someone drown in it. I believe that the tax law has become something
like this — encouraging unsound financial practices such as those
that brought down Enron.
This does not excuse any criminal behavior that may have taken place.
But it appears that what really got Enron into trouble were not its
illegal actions, but those that were perfectly legal, although highly
unwise. If there are any
indictments, the Tax Code should be considered a co-defendant.
s
we learn more and more about the widening Enron scandal, it is starting
to look as if the U.S. Tax Code deserves some of the blame. Because
the U.S. taxes corporations more heavily than any other major country,
U.S corporations must work harder to exploit every opportunity for
tax relief that they can find. Failing to do so would put them at
a competitive disadvantage vis-a-vis companies based in Germany, Italy,
and elsewhere. Unfortunately, it appears that Enron may have tried
a little too hard to save on taxes, ultimately contributing to its
downfall.