David Cay Johnston

If President Barack Obama can persuade Congress to reduce the corporate income tax rate to 28 percent from 35 percent, he will move tax rates closer to what other modern countries charge.

But his plan to treat “manufacturing” as a special category, with a 25 percent tax rate, brings us to what I call Obama’s hamburger problem.

The problem is how to define manufacturing. To paraphrase Justice Potter Stewart on obscenity, I know manufacturing when I see it; I just don’t know how to define it in tax law.

Assembling automobiles is considered manufacturing. So what about assembling two hot protein discs with special sauce, lettuce, cheese, pickles, onions — all on a sesame seed bun?

The notion of hamburger-making as manufacturing may seem silly, a bit like the 1981 U.S. Agriculture Departmentproposal to classify ketchup as a vegetable for school lunches. But classifying activities as manufacturing or not becomes crucial if manufacturers pay taxes at a reduced rate.

Imagine all the high-paying jobs Obama’s plan would create. Companies of all kinds will want to hire more tax accountants and lawyers making the case their client’s business activity is manufacturing. These are not the sort of additional jobs America needs.

There could also be more work for economists, engineers and historians whose expertise would be tapped for creative ways to expand the definition of manufacturing. We have the prototype for the reduced manufacturer’s tax rate in the Domestic Production Activities Deduction, a law implemented in 2005 which comes with a plethora of complex eligibility rules that already create more work for tax professionals.

DRAG ON ECONOMY

Scrutinizing tax returns to determine what is and is not manufacturing would further require a diversion of IRS auditors, lawyers and specialists from the more important job of hunting for calculated tax evaders. Inevitably there would be litigation aplenty, a boon to trial lawyers but a drag on the economy.

Building an automobile obviously involves manufacturing. Rocks must be refined to turn their useful elements into steel and aluminum. Much of the added value will be in the engine and transmission, where steels made with special alloys must be heat-treated and machined to endure enormous, and rapid, twisting forces. Increasingly cars are built with plastics, sophisticated chemical compounds that must be created from base materials and then molded or extruded.

But should mere assembly of an automobile qualify as manufacturing? Does fitting the already manufactured pieces together qualify as manufacturing? And what if the parts were all manufactured in, say, Japan while the only activity in the United States was assembling them into a whole?

Would tax law define manufacturing as the process of making a car as a whole? Or would companies lobby for laws that break it into parts with profits earned at different stages of production taxed at different rates? Would that, in turn, mean accounting practices that load costs onto one stage of production to take profits at the 25 percent rate and losses, such as an assembly line, at the 28 percent rate?

Imagine a car company that reports a $200 million profit to shareholders. Now imagine that it reports a $300 million manufacturing profit taxed at 25 percent and a $100 million assembly line loss at the 28 percent general corporate rate. The company’s profit would still be $200 million, but its blended tax rate would be just 23.5 percent.

Hamburgers may seem like pure assembly, but a case can be made that they are more like manufacturing than assembling a car from finished parts made overseas.

Your local hamburger joint starts with raw meat, fresh or frozen. If it comes in lumps then someone must make the meat into uniform discs or squares. Then the protein must be fried, grilled or broiled. Only then can the meat, lettuce and whatnot be assembled.

Eight years ago the Bush administration used this very example to warn about the unintended consequences of tax incentives for manufacturing.

The 2004 Economic Report of the President asked, “when a fast-food restaurant sells a hamburger, for example, is it providing a ‘service’ or is it combining inputs to ‘manufacture’ a product?”

The comment, put in a box on its own page to draw attention to the issue, also noted that “sometimes, seemingly subtle differences can determine whether an industry is classified as manufacturing. For example, mixing water and concentrate to produce soft drinks is classified as manufacturing. However, if that activity is performed at a snack bar, it is considered a service.”

Taxing different corporate activities at different rates is a bad idea unless you think we need more national income spent on gaming the tax system. Let’s not go there.

PHOTO: Russia’s President Dmitry Medvedev (2nd  L) and U.S. President Barack Obama (R) eat their hamburgers during lunch at Ray’s Hell Burger in Arlington, Virginia, June 24, 2010.     REUTERS/Kevin Lamarque

By David Cay Johnston
The views expressed are his own.

Every day we hear politicians and pundits say that government spending cannot lift the economy out of the worst slump since the 1930s, which is as sensible as saying that 2-1=3 or that water and flour make steak.

Those who said after President Barack Obama’s speech last week to Congress that government does not create wealth, does not create jobs and cannot stimulate the economy spoke nonsense. So do those who say that only private business creates wealth, as if any revenue going to taxes destroys wealth.

Adam Smith, who figured out market capitalism in his 1776 book “The Wealth of Nations,” could set them straight. We have plenty of equally competent economists who understand these issues today. They just do not get the attention that the news media lavish on high-profile politicians and pundits who speak with absolute certainty on matters about which their words show they know nothing.

So why are politicians and commentators who speak economic nonsense treated as sages? And why do so many journalists uncritically repeat their nonsense?

Sadly, the answer is that too few people in public life understand economics, numbers or algebra. Too few people learned, or remember, the crucial concept underlying matters of economics and finance known as accounting identities.

ACCOUNTING IDENTITIES
Accounting identities are statements that must be true no matter how you arrange the components. Thus 2+1=3 just as 3-1=2. Likewise, net worth equals assets minus liabilities just as assets equal liabilities plus net worth and profits equal revenue minus costs. But water plus flour does not equal steak.

In economics, Gross Domestic Product equals consumer spending plus government spending plus investment plus the net of exports and imports. Or in its simplest form: Spending = Output = Income.

Economics is like a circle, as Smith figured out 235 years ago. More spending by government creates jobs, whether at war plants making smart bombs, dredging ports so cargo moves efficiently or stimulating the gray matter between young ears to create productive adults. Bombs ultimately destroy value, while ports and education add value.

Now, refreshed on the bedrock economics of accounting identities, consider these statements by three prominent Republican lawmakers:

“We need to cut spending now in order to create jobs in America” — House Speaker John Boehner on the floor of the House of Representatives in July 2010. “If government spending would stimulate the economy, we’d be in the middle of a boom” — Senator Mitch McConnell in March 2011. “Government doesn’t create jobs, you do” — Representative Nan Hayworth, M.D., speaking in January to business leaders in her New York district.

None of the comments makes sense. The first violates the accounting identity that spending equals income. The second assumes that the stimulus was big enough to make up for the fall in private sector jobs, when it was less than half what accounting identity algebra showed was needed. The third is just plain nonsense.

JOBS ARE KEY
It is certainly true that jobs are key. People with jobs are taxpayers, while those without tend to become taxeaters. More wages mean more spending, which is income to others.

As John Maynard Keynes observed in 1932: “There is no possibility of balancing the budget except by increasing the national income, which is the same thing as increasing employment.”

None of this means that President Obama’s jobs package, which has no hope of becoming law, is the optimal approach. It relies, however, on sound principles.

On the other hand, creating jobs that cost more than they add in value destroys wealth. That is why a defense plant for which Senator McConnell wants to get a federal loan guarantee of $1.7 million per job makes no sense economically.

We also inhibit future wealth when we fire teachers, let roads fall apart so that truck traffic slows and repair bills rise, and ignore weakened dams whose collapse would destroy property and lives. Cutting research funds just sends researchers to China and India, along with future fortunes.

Investing in education, research and infrastructure all add to economic inputs and, in turn, increase economic outputs.

In general the market does a better job of allocating capital for investment than government does. But when the market fails, as with the unregulated insurance and bad loans that destroyed so much value in the last decade, then the only way to stop the vicious cycle of decline is for government to temporarily make up the difference through more spending. Saying otherwise is the economic equivalent of arguing that water and flour make steak.