Posted by: bmeverett | May 11, 2011

What in the World is a “Rich Corporation”?


President Obama and the Congressional Democrats are thrilled to death with their latest political trick: reducing the deficit by eliminating tax deductions and raising tax rates for Big Oil. Last Saturday, Senator John Kerry (D-MA) said about the deficit, “We can do better, but only if politicians are willing to put aside the ideology and ask the wealthiest Americans and richest corporations to share in the responsibility, rather than just asking senior citizens to carry all the burden through radical changes to Medicare.” Sounds great. Make the corporate fat cats cough up the money so grandma doesn’t have to give up her medicine. I’m sure this plays very well with the Democratic base, but does it make any sense?” What exactly does Senator Kerry mean by a “rich corporation”?

We have enough trouble defining “rich” for individuals. Take, for example, two people. Person A has assets of $10,000,000 which he keeps in a money market fund paying 0.1% annual interest. Person B has earned $30,000 a year for the last 20 years and has no net worth, but wins a $250,000 lottery prize. Our tax code says that Person A, with an income of $10,000, is poor and would probably have zero income tax liability. Person B would be treated as rich and would pay the highest marginal tax rate. According to President Obama, Person B doesn’t pay enough tax.

This definitional problem is much worse for businesses. At least the two people in my previous example were individuals. A corporation is a collective enterprise owned by an undetermined number of people. Let’s compare two law firms. Firm #1 has two lawyers each making $1,000,000 annually. Firm #2 has a hundred lawyers, each making $50,000 a year. Which firm is “richer”? Firm #1 makes $2 million a year, while Firm #2 makes $5 million per year. Does that suggest that firm #2 should pay tax at a higher tax, while firm #1, being smaller, should catch a break from the IRA?

The current assault on corporations quite naturally focuses on oil companies. Why not, with gasoline at $4 gallon? The current Democratic proposals, which claim to eliminate “subsidies” in fact deny normal tax treatment to five large oil companies with familiar names: ExxonMobil, ChevronTexaco, ConocoPhillips, BP and Shell. Other oil companies, since they are just little guys, would keep their tax breaks. Fair?

Let’s compare two actual oil companies: ExxonMobil and Dorchester Minerals, both publicly traded. Last year, Exxon Mobil had revenues of $364 billion while Dorchester had revenues of only $61 million. ExxonMobil earned $35 billion in profits, while Dorchester earned $34 million, one one-thousandth as much. Surely Dorchester is the poor little guy, while ExxonMobil is the rich guy. Shouldn’t ExxonMobil pay not only higher taxes, but higher tax rates?

But these are corporations, not individuals. Each company is owned by shareholders who invest their money for a return. Who gets the higher return? Last year, Dorchester earned 14.2% on its assets, while ExxonMobil earned a 10.4% return. Not so simple after all. Who exactly owns these companies? ExxonMobil’s senior management owns 0.09% of the company, while Dorchester’s senior management owns nearly 20% of their company. Nearly half of all ExxonMobil shares are owned by institutional investors, such as mutual funds and pension funds. Vanguard Mutual Funds was the largest single ExxonMobil shareholder at the end of 2010 with about $16 billion in shares. Some Vanguard customers are wealthy but others are not. In fact, 55 million American families (including 16% of households with annual incomes of less than $25,000) own mutual funds with an average account size of $36,000. Most of these mutual funds have some ExxonMobil shareholding.

At the end of 2010, pension fund holdings of ExxonMobil stock included the College Retirement Equities Fund (TIAA-CREF) with $2.5 billion, the California State Employee Pension Fund (CalPERS) with $1.1 billion, the New York Teachers Retirement System with $1.3 billion, the Wisconsin and Florida Pension Funds with about $900 million each. Virtually every pension fund in the US has some ExxonMobil shareholding. Most of ExxonMobil’s shareholders are probably unaware that they own the stock or that punitive government tax policy would hurt their pensions.

Compared to ExxonMobil’s 50% institutional ownership, Dorchester’s is less than 20%. That means that 80% of Dorchester’s shares are owned by its senior management and individual investors. Are these really the people who should be protected from additional taxes while teachers’ pension funds should be punished? This makes no sense at all.

Behind the Democrats’ proposal is a distorted understanding of profit. A common misconception, carefully nurtured by the Democratic Party, is that companies set prices to recover their costs plus a profit margin. Socially responsible companies set a modest profit margin, while greedy and powerful companies set high profit margins. In this view, profits are directly responsible for high prices, and reducing profits will therefore bring prices down.

Let’s go back to Economics 101. Prices are set by supply and demand in competitive markets. (Democrats always imply that oil companies collude even though dozens of government investigations over the years say otherwise.) Since companies cannot determine prices, they can earn profits only by investing wisely and operating their businesses efficiently, thereby creating a differential between the market price and their costs.

Let’s take as an example two home building companies, working in the same community where a standard three-bedroom house sells for $250,000. Company X plans its construction projects carefully, selecting its building lot only after careful study and determining in advance what materials and labor are required at the site on which day. Its management negotiates the best possible terms for high-quality lumber and other supplies. The company hires only skilled and professional employees and pays them well. They show up on time and complete their work quickly and to a high standard. It takes Company X 90 days to complete a house.

Company Y on the other hand, plans poorly. It selects a building lot with drainage problems, requiring costly landscaping changes. Frequently it has workmen on the site without the right materials or vice-versa. It buys all its materials at high prices from a company operated by the owner’s brother-in-law. It doesn’t pay its employees well and therefore has high turnover with employees often failing to show up for work. It takes Company Y 150 days to finish a house, resulting in high financing costs.

When the houses are finished, each sells for $250,000. Company X makes $30,000, while Company Y makes only $5,000. Over time, Company X’s business will grow, while Company Y is likely to be in trouble. That’s how the market works. According to the Democratic Party’s view of profits, Company X is acting in a greedy and anti-social manner and should be punished. Company Y, however, is the “little guy” who needs a helping hand and favorable tax treatment from the government. Does anyone really believe that housing prices will come down if we get rid of all the Company X’s and replace them with more Company Y’s?

The Democrats should be embarrassed to peddle this nonsense with a straight face. This is the direct result of our elected officials caring nothing about what’s true and only about what plays well for focus groups.

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