Four of a Kind
The American stock market last week had a horrible week: stockholders lost hundreds of billions of dollars on their investments. Underlying the sudden loss in value were a number of pieces of bad news. Worldcom, the latest villain of Wall Street, let slip that it would file for bankruptcy. The latest in a series of corporate scandals concerned fraud at a pharmaceutical plant owned by the respected medical firm Johnson and Johnson. In addition, a number of companies announced gloomy prospects for increased profits in future quarters. The poor results have properly been the focus of the financial press and of Congress. But the glare of the financial spotlight will likely miss some stories that underlie both the boom of the Clinton years and the bust of the Bush years.
Four stories will get little to no attention in the mainstream media. First, the Republican Party will make little effort in the near term to privatize social security, but it still views privatization as a goal. Second, Congress will debate the proper treatment of stock options but will mostly ignore the real problem with the current treatment of options. Third, Congress will also ignore an accounting gimmick that companies used to fuel the stock market boom of the 1990s but might rue using nowadays. Finally, no one in Washington will dare broach one idea that might forever squelch most corporate malfeasance.
The 2002 return of the American stock market should put paid to the notion that investing the social security trust fund in the stock market is necessarily a good idea. Even investors who avoided stocks tainted with scandal or placed in bankruptcy have seen their portfolios shrink. Congressional Republicans who used to proclaim the necessity to invest social security funds in the stock market are now keeping mum.
But the large investment firms know that there is money to be made from privatized social security, perhaps not by the investors, but by them. Accounts mean fees, and fees means profits. Investment firms love the stability of retirement accounts: investors often take long-term outlooks with their retirement funds. But the working class has been slow to use vehicles like IRAs, because the tax breaks are small to nonexistent for them. One way to get the working class to invest requires substantial tax breaks for IRAs for low-income taxpayers. (In the 2000 presidential campaign, Al Gore touted such a scheme.) Another way to get the working class into the stock market is to get Social Security into the stock market.
The richest Americans favor privatization over tax breaks for working-class IRAs for two reasons. First, tax breaks for the poor mean fewer tax breaks for them. Second, because Social Security offers a guaranteed return, on top of insurance for survivors and disabled workers, is necessarily offers a lower return than stocks have sometimes provided investors. The rich do not depend on the old age pension that Social Security provides, so the low returns on their investments are annoyingly low to them. The poor, on the other hand, rely on the guaranteed pension that Social Security provides. While the rich could easily withstand a substantial cut in social security benefits because the stock market failed to go up, the poor would be devastated.
The Republican Party favors privatization for all of the reasons that the rich do, but it has two other incentives to remake Social Security. First, the Social Security system is the most Democratic of government programs. Founded in the Great Depression by Franklin Roosevelt, it is almost universal in its scope. Fundamentally altering it would cut the tie between Social Security and the Democratic Party. Second, privatizing Social Security would put the onus on the stock market and off the government to keep the program fully funded. While candidate Bush promised to save $1 trillion of the projected surplus to pump into the Social Security Trust Fund, President Bush decided that his huge tax cut and his War on Terrorism were much more important.
Congress has shed much heat and a bit of light regarding stock options, which companies grant disproportionately to their executive employees and board members. The current debate in Congress is whether companies should necessarily deduct the cost of options from their net income, as they do on their tax returns. Executives in the technology industry, and their lawyers and accountants, have so far convinced both Democrats and Republicans in Congress that their industry will suffer needlessly if they have to expense stock options.
The truth is very different. Companies already get to deduct the cost of stock options on their tax returns, so changing the treatment on financial statements will not cost one iota. In fact, the recommended treatment, according to the Financial Accounting Standards Board, is for companies to deduct their cost against net income. The vast majority of companies have elected an alternative method, to show the expense only in the footnotes to their financial statements.
Corporate executives, when pressed, have explained that determining the cost of stock options is far from a trivial manner. But the companies that already deduct the cost of options use one of two methods. Some use the Black-Scholes pricing algorithm, a method so useful that it won its discoverers the 1997 Nobel Prize in Economics. Other companies determine the value of their options that they award by having investment banks provide prices to buy or sell blocks of them.
Corporations have a deeper rationale for keeping the cost of stock options out of their profit and loss statements. Executives know that many investors pay attention to net profits when valuing companies, not to income numbers buried in the financial statements. Coming clean about the real cost of operations will pull the wool out of the eyes of too many sheep on Wall Street.
Many companies during the stock market boom had ways to show greater profits than they could justify from operations. There are, of course, legitimate ways to report profits that are higher than operating profits. One way was to show the increased legitimate value of a company's investments in real estate, or other companies. But another way was to show that a company's pension plan was overfunded. During the stock market boom of the 1990s, many companies with defined-benefit pension plans found that the value of those plans had increased greatly.
Under the accounting rules for financial statements, any excess value in the plan must be added to net profit, and companies could determine for themselves what the reasonably expected rate of return should be for future years. Suffice it to say that 2002 will not be a good year for companies who assumed rates of return of about 10%, unless the stock market dramatically reverses itself by the end of the year. Companies that boosted their net profits in earlier years may be forced to take charges to reflect future underfunding of their plans.
Virtually every company that has shares listed on the American stock exchanges or sells bonds to the public must file annual and quarterly reports with the Securities and Exchange Commission. These reports include provisions for income taxes, without any detail required. While almost all corporations pay taxes on their net taxable income at a 35% tax rate, corporations have a host of ways to reduce their effective tax rates. Among these devices are tax shelters, some completely above board and some absolutely dodgy; accelerated depreciation allowed on tax returns but not financial statements; and moving operations to countries with lower taxes, either directly or indirectly.
Unlike charitable organizations, whose federal tax returns are subject to public inspection, corporate income tax returns are not publicly available. But Congress could change the rules that shield the corporate and partnership tax returns associated with corporations from public inspection. Doing so could shed a great deal of light on what tax shelters corporations are using; how they are reporting their international business; or whether they are taking any dubious tax positions. The IRS has for years had great trouble with corporate tax shelters because corporate and partnership tax returns can be complicated, and it has limited time, money, and personnel. If corporate returns were public documents, any interested citizens could, in theory, blow the whistle on anything untoward.
Congress is extremely unlikely to raise the curtain between corporate tax returns and the public. Corporations have perennially declaimed anything restricting their actions or increasing their scrutiny as anti-business. One need not be anti-business to want better disclosure from corporations. Without imprimaturs from governments, corporations would cease to exist. Their creation is supposed to serve the public interest, although not as directly as public charities do. They would not exist if not for the limited liability that their structures provide their owners and executives. It is not unreasonable for the public to expect something in return.
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