Reply to Robert Gordon & James Kvaal’s WSJ letter

In a letter to the Wall Street Journal (Nov. 5), Robert Gordon and James Kvaal responded to my critique of their estimate that McCain’s tax plan would cut big oil’s taxes by $3.8 billion. They claim that “corporations as profitable as ExxonMobil pay a 35% rate on more than 99% of their profits.” Yet they also say, “Our code is riddled with special interest deductions, credits and exemptions that shield corporate profits from tax.” Well, which is it?

If big oil companies actually “pay a 35% rate on more than 99% of their profits,” then Gordon and Kvaal might be justified in ignoring McCain’s bold plan to end the oil companies’ “deductions, credits and exemptions.”

As the Committee for a Responsible Federal Budget noted, “Senator McCain … would repeal special expensing rules for oil and gas companies, eliminate the foreign tax credit for oil companies, disallow expensing of exploration and development costs, encourage an increase in royalty rates for drilling on public land, subject working interests in oil and gas to the passive loss rules, eliminate 15 percent tax credit for enhanced oil recovery costs for tertiary wells, and eliminate special depreciable lifetimes for certain assets used by oil companies.”

CFARB estimated that McCain’s plan to tighten up deductions and credits would raise oil company taxes by $6 billion in 2013. That would certainly be offset to some extent, of course, by lower tax rates—30% in 2010-11 and 28% in 2012-2013 (Gordon and Kvaal wrongly assumed the rate would drop to 25% in 2009).

If big oil really pays 35% tax on virtually all their profits, however, then such loophole-closing would simply be a waste of time.

If big oil does not surrender 35% of profits to the IRS, however, then Gordon and Kvaal’s estimates (which assume that statutory tax rates are the same as effective tax rates) are worthless.

Their estimates are based on earnings reported to the SEC — earnings as defined by Financial Accounting Standard Board (FASB) accounting rules, not by IRS reporting rules. Gordon and Kvaal acknowledge that “The figures reported on tax returns … may differ because corporations employ different methodologies for calculating income for accounting and tax purposes.”

If any corporation reported SEC/FASB earnings to the IRS, they would be in very big trouble with the IRS. If they reported IRS earnings to the SEC, they would be in very big trouble with the SEC.

FASB, for example, insists that the “fair value” of nonqualified stock options be estimated when the options are granted, regardless of their ultimate worth. The IRS, by contrast, is not about to let firms deduct the estimated cost of anything. The IRS insists that companies deduct the labor cost of stock options only if and when they exercised and therefore taxed as individual income.

Using a matched sample of financial statements with tax returns, George Plesko of the University of Connecticut business school found that “financial reporting information does not allow a user to infer important information about a firm’s tax attributes.”

Ignoring Plesko’s well-known point, Gordon and Kvaal report that ExxonMobil paid $4.3 billion in federal income tax in 2007, which they assume was 35% of their domestic profits as shown on SEC financial reports.

Their estimates then “present each corporation’s estimated savings from reducing the corporate tax from 35 percent to 25 percent.”

Since a 25% tax rate is 28.57% smaller than a 35% tax rate, they figured that ExxonMobil would have saved 28.57% of $4.3 billion, or $1.2 billion. They repeated such naïve arithmetic for the entire Fortune 200.

ExxonMobil’s accounting profits were almost $41. billion, worldwide, but 68% of their revenue came from overseas according to Forbes (Apr 21). If profits are roughly proportionate to gross revenue, then U.S. earnings would have been $13 billion (32% of the total), and a tax of $4.3 billion happens to be 33% of $13 billion.

At first glance, that might appear consistent with Gordon and Kvaal’s claim that companies as profitable as ExxonMobil really do pay 35% of profits to Uncle Sam. But that would contradict their other claim that “deductions, credits and exemptions … shield corporate profits from tax.”

If we repeat that same exercise for the least international oil companies on the Gordon-Kvaal list, it looks as if Valero paid 40% of domestic profits in federal tax and Conoco Phillips paid 47.6%. As economist and accountants understand, the reason accounting earnings generate such unbelievably high tax rates is that it is just not possible to infer effective corporate tax rates from accounting earnings as Gordon and Kvaal attempted to do.

As I wrote, “That is not economics; it is not even competent bookkeeping.”

Messrs. Gordon and Kvaal thought I was criticizing them for being lawyers rather than economists or competent bookkeepers. On the contrary, I was criticizing President-elect Obama for using estimates from John Podesta’s Center for American Progress Action Fund —a 501c4 political lobby with a rather obvious bias. Unlike any think tank, such political action funds are free to engage in lobbying and campaign activity. Indeed, Gordon and Kvaal boast that “our results have been featured in millions of dollars worth of advertising.” Well, that certainly adds credibility doesn’t it?