TCS Daily

Enabling Enron

By Stephen W. Stanton - February 26, 2003 12:00 AM

Will members of Congress ever make the tax code so ridiculous that they themselves cannot understand it?

Trick question. They already did.

The Joint Committee on Taxation ("JCT") issued a 2,700-page report on Enron's complicated tax schemes. JCT members had no idea the tax code let Enron legally do such very bad things.

The company is fifth among the 2002 Fortune 500, with annual revenues of $139 billion dollars. Yet from 1996 through 2001, Enron's total federal tax liability was a scant $63.2 million, a fraction of a tenth of a percent of even a single year's revenues. For five of those six years, Enron paid no federal taxes at all. The company's consolidated tax returns for 1996 through 2000 showed cumulative book income of over $13 billion dollars, yet its taxable income was only $76 million. To put that in perspective, only one dollar of income out of one hundred seventy one was taxable. (The ratio is a slightly less ridiculous 1 out of 43 using income numbers from annual reports.)

Congress Provides the Building Permits

The stock went from a low of 17.31 in 1996 to close the year 2000 at 83.12, more than quadrupling in value. Over the same five years, Enron paid dividends of $2.37 and less than nine cents of corporate taxes per share. It is not surprising that senators from both parties expressed righteous outrage. Chairman of the JCT Senator Charles Grassley said, "Enron was a house of cards. Schemers built that house."

Yes, Senator, this is true. But the JCT provided the building permits. Enron's actions were unethical, immoral, gluttonous, and reckless. However, they were legally defensible. Legal tax avoidance is nothing more than using the rules to your advantage. The JCT report does not assert that Enron broke any laws with its tax schemes. Instead, the report suggests only that Enron pushed the envelope, testing legal boundaries in the uncharted gray areas of tax law. So a joint congressional committee bears primary responsibility for the tax code's opacity.

In many cases, lawyers and accountants advised Enron that its tax strategies would "more likely than not" pass muster under an IRS audit or judicial scrutiny. In the U.S. legal system, a criminal defendant must be found to intentionally violate a law "beyond a reasonable doubt." Before implementing almost every tax scheme, Enron's officers were fairly certain that no law would be broken. In fact, Enron followed most tax laws to the letter.

It is not surprising, then, that the JCT report could not provide any smoking guns. The authors all but accepted that Enron had a reasonable basis for its positions. For example, the report suggested that certain subsidiaries "probably were required under section 482 to include in income a fee at least reflecting the full cost of providing" certain services. Yet the report admitted "the matter is not free from doubt, and cannot be conclusively determined." The authors also discussed alleged misuse of pension funds. The authors conceded that "the allegations, even if true, do not necessarily represent an illegal or improper diversion of funds."

The report is perhaps best summarized by the following quote: "Enron's behavior illustrates that a motivated corporation can manipulate highly technical provisions of the law to achieve significant unintended benefits." After months of research, the JCT report admitted that while Enron may have followed the letter of U.S. tax laws, the company's actions violated the intent.

Simple Rules for a Complex World

Fortunately, this nation is subject to the rule of law, not legislative intent. The tax laws are incredibly complex. Enron exploited them in unintended ways. As any engineer will tell you, the more complicated a system is, the more things can go wrong. The obvious way to avoid unintended consequences would be tax simplification. A first step would be to shake up the organization responsible for writing the tax laws in the first place, the Joint Committee on Taxation.

As indicated on the official website, "The statutorily prescribed duties of the Joint Committee are to: (1) investigate the operation and effects of internal revenue taxes and the administration of such taxes; (2) investigate measures and methods for the simplification of such taxes."

So much for 'simplification': Since the Committee was formed, the total number of pages of federal tax rules has ballooned to 45,662 for an increase of more than 9,000%. The committee achieved the exact opposite of its mandate.

Precedent Set

It may be time to scrap the JCT and start over. There is a precedent, and again, Enron was at the center. Enron took just as many liberties with accounting rules as it did with tax laws. The Financial Accounting Standards Board has long been responsible for the nation's accounting practices. Enron exploited FASB's permissive rules relating to stock options, off-balance sheet partnerships, and aggressive revenue recognition, allowing the company to spiral into bankruptcy with investment grade credit ratings.

For FASB's role as an unwitting co-conspirator, Congress completely overhauled the organization. The concept was simple enough: Since FASB wrote bad rules, the folks at FASB should be replaced with better rule makers. Senator Grassley proudly wrote of this accomplishment in his November column, "Congress acted swiftly this summer to strengthen accounting standards and make the system more accountable and transparent to shareholders, investors and workers." Thanks to the changes at FASB, we now look forward to a simpler and more reliable accounting system.

Unfortunately, no such change has been contemplated for the Joint Committee on Taxation. Rather than admit their role in the debacle, Committee members have chosen to vilify Enron. Some members have not conceded that the tax code is too complex, and they actually proposed additional layers of legislation to address loopholes (potentially creating others).

Not Rocket Science

Taxation is not rocket science. In fact, taxation is arguably one hundred times more complex than rocket science. The definitive text, Modern Engineering for Design of Liquid-Propellant Rocket Engines is only 431 pages, 1/100th the length of the tax code.

There is hope. Orrin Hatch sits with Grassley on the Joint Committee on Taxation. Senator Hatch is a longstanding advocate of tax simplification. There are many other voices on the Hill and in the Administration that will support his efforts. And in fairness, Grassley has only chaired the committee for little over a month and has long been in favor of tax reduction and greater tax fairness.

Change is possible, and it's overdue. As bad as Enron was, we cannot become a nation in which businesses are punished for obeying the law. It is time for the JCT admit its complex mistakes and fix them.

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