Facebook's $500 Million Tax Refund and The BIG Political Lie

Over the next nine months, leading up to the Presidential election, conversations about optimal tax rates are certain to play a major role. Much of the recent media focus has already addressed the low effective tax rates paid by both Warren Buffett and Mitt Romney (although the light in which the two are held is a world apart). Current debate generally regards the low level of taxes paid by both men as being “unfair,” leading to calls for higher income tax rates on the wealthy. Although this proposed solution seems obvious, the reality is that neither Buffett or Romney will end up paying significantly more even if income tax rates return to the levels during the Clinton era.

How could this be? Behind this confusion lies innumerable intricacies within the US tax code, where rates differ for varying types of income and the laws are littered with various deductions, credits and provisions. Facebook’s upcoming IPO displays a perfect example of the unintended consequences of US tax laws. In Options and Taxes: Is a "Facebook" tax next?, Aswath Damodoran (NYU finance professor) comments that:

“Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him.”*

On the surface, this seems reasonable since Zuckerberg will be paying nearly 40 percent between federal and state income taxes. The criticism stems from the corporate tax deductions that Facebook is permitted based on the exercise of employee stock options, including Zuckerberg’s. As WithumSmith + Brown states in Tax Aspects of the Facebook IPO (Alternate Title: Mark Zuckerberg Could Buy Most of Europe With His 2012 Tax Bill):

“Assuming Facebook stock reaches a price of $40 per share on the open market, the corporate deduction related to the exercise of employee options will be in the billions; large enough not only to enough to wipe out the comany’s 2012 taxable income, but also –according to the prospectus — to generate an NOL [net operating loss] that will be carried back to generate $500 million in tax refunds.”

From a distinctly corporate perspective, Facebook, which may earn upwards of $2 billion in pre-tax income this year, will not only owe nothing in taxes but may actually receive a $500 million refund. How is it that an extremely profitable company ends up with a sizable tax refund? Why has GE and numerous other companies not paid taxes during the past decade despite earning substantial profits (G.E.’s Strategies Let It Avoid Taxes Altogether)? Why does Warren Buffett pay a smaller effective tax rate than his secretary?

When these questions are posed, a typical response suggests these outcomes represent the natural workings of a free-market system. Sadly this could not be farther from the truth. As Mish Shedlock points out in Is Romney to Blame for Paying Low Taxes or is 72,536 Pages of Tax Code to Blame? What's the Real Solution? Thanks to AMT, Man Pays 102% Tax Rate, “from 1984 until now, 46,236 pages of tax code have been added.” (shown below) Anyone would be hard pressed to find an economist who believes this level of complexity is either efficient or representative of a free-market economy. 

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Image from Tax Law Pile Up

The reality is that consistent increases and alterations of US tax code, over the years, is primarily intended to benefit a special group or class. A rational choice perspective of public policy and administration implies that much, if not most, of this tinkering is done at the behest of groups with the largest political sway (funding capacity and desire).

Improving the tax system is possible both from the perspective of reducing government intervention and increasing progressiveness. Unfortunately the right (conservatives) has been persuasive in convincing individuals across the political spectrum that a complex tax code is part of a free-market system. In The End of Loser Liberalism: Making Markets Progressive, Dean Baker expresses his feelings on this subject noting:

“the vast majority of the right does not give a damn about free markets; it just wants to redistribute income upward.”

It’s important to note that the left (liberals) has also been complicit in this false perception, frequently adjusting the tax code in regressive ways to garner political funding and support.

Heading towards the election, both political parties will try to represent the current US tax system as “unfair” in an effort to push new laws that will “right” the system. Adding more layers of complexity, however, is unlikely to make the outcomes either more efficient or progressive. Overcoming the current trend requires exposing the truth that our current tax codes do not represent a free market. Hopefully both sides of the political spectrum can join together in encouraging politicians to create a far simpler, progressive tax system.

*Zuckerberg plans to exercise options for 120 million shares with an exercise price of $0.06. The nearly $5 billion profit assumes a per share value of approximately $40.