Wednesday, December 05, 2007

Tax Free, For Profit Corporation Idea

At the Renaissance Weekend this past Labor Day, I proposed the creation of an "F Corporation" as an alternative corporate entity to the traditional "S Corp", "C Corp", and 5013c non profits. Several people asked me to post this idea, especially given the political fireworks around the elections. This isn't intended to be political, but I'd welcome criticisms to be posted on the blog.

This "F Corporation" would be Free of federal taxation, but would be allowed to operate for profit. The catch is that upon incorporation, and for any share issuances thereafter, the US Treasury receives 35% of the equity.
Why this could make things better:
The Directors and Officers of a corporation have a fiduciary duty to benefit shareholders. This is a real, legal obligation. That obligation requires that Directors and Officers take action to maximize the cash flow from the business that ends up in the hands of the shareholders. One way this obligation is met is by avoiding payment to other stakeholders in the corporation--in particular the tax authority--since that stakeholder provides no direct benefit to corporate interests.
A significant amount of inefficiency exists because of this lack of alignment of interests between the government and the shareholders, as evidenced by the existence of an entire industry for corporate tax accounting and consulting.
Over time, the shares held by the US Treasury generate cash flow in two ways: first, through the payment of corporate dividends, in the same way that other shareholders receive dividends; and second, through the cash payment for shares when a corporation is acquired.
If tax payments were retained within a corporation, that capital could be reinvested and grown at a rate equal to the return on equity, less dividends. In the time period from 1802 through 1998, a dollar invested in Treasury bills—the effective return on tax receipts, would have grown by a factor of 3,847 while a dollar invested in large cap equities would have returned 9,856,849 times. (Source: Pioneering Portfolio Management, Swensen, page 61). Few people appreciate the magnitude of compounded returns over long periods of time. Compounding our national wealth in such a way could easily erase a federal debt that is otherwise insurmountable. Existing corporations could elect to irreversibly convert into “F Corporations.” This strategy leverages one of the United States greatest assets—efficient, well developed capital markets.
Argument against: What about the other stakeholders, like employees and the environment? Government taxation of corporations allows these interests to be represented by #1 diverting cash flows directly to the government for allocation and #2 changing corporate behavior through implementation of tax incentives and penalties.
Counter argument: The cash flow to the government from the equity interest is significantly higher than from direct taxation for 3 reasons: 1) the elimination of loss from tax avoidance and deferral strategies 2) the compounded returns gained from corporate reinvestment of capital, 3) the increase in corporate profitability due to the increase in ability to make decisions solely based upon profitability uncompromised by the considerations of tax implications. This increase in ultimate tax revenue to the government, by growing the pie, will give other stakeholders more capital for their needs. Moreover, legislators can still influence corporate actions through non-tax oriented laws. A good example of a law which changed corporate behavior without a tax motivation is Sarbanes Oxley.