As we learn more and more about the widening Enron scandal, it is starting to look as if the 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, nonfinancial 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 percent 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-edged 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 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 four out of five years between 1996 and 2000. It was also able to borrow vast sums, greatly increasing it 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.