Does Business Learn?: Tax Breaks, Uncertainty, and Political Strategies

by Sandra L. Suarez

Overview

Firms in the United States have many political advantages when compared to other groups in society. They are the best-represented group in our nation's capital; they operate more Political Action Committees; and their lobbyists are among the most experienced political operatives. Yet firms are uncertain about their political power and hence about the effectiveness of their political strategies. This book deals with how firms decide which strategy to pursue among the existing alternatives when it comes to defending policies that play to their interests.

Sandra Suárez looks at the efforts of business to influence government policy in a detailed study of the efforts of major American corporations to protect the tax credit applicable to profits from investments in Puerto Rico. This rare longitudinal case-study explores the abilities of U.S. pharmaceutical and electronics companies to adapt their political strategies to a fluid and uncertain political environment. Drawing on interviews with tax lawyers, corporate lobbyists and government officials, the author follows the behavior of the same group of companies over the past twenty years.

This book advances a learning-based explanation of business political behavior, which argues that past political experience accounts for patterns of political behavior that government structures and salient issues alone cannot explain. Centered on attempts to protect an important tax break for business, the possessions tax battles provide an appropriate case for examining the value of the business learning approach.

Although written with a political science audience in mind, this book addresses issues that will resonate widely with sociologists, management researchers and students alike.

Sandra L. Suárez is Assistant Professor in the Department of Political Science, Temple University.

Product Details

ISBN-13:	9780472111190
Publisher:	University of Michigan Press
Publication date:	07/25/2000
Pages:	208
Product dimensions:	6.00(w) x 9.00(h) x 1.00(d)

About the Author

Sandra L. Suárez is Assistant Professor in the Department of Political Science, Temple University.

Read an Excerpt

Does Business Learn?: Tax Breaks, Uncertainty, and Political Strategies

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By Sandra L. Suarez

University of Michigan Press

Copyright © 2000 Sandra L. Suarez
All right reserved.
ISBN: 0472111191

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CHAPTER 1

Political Uncertainty and Business Strategy

For interest groups, the law of resources is that on any given day, any given group will have more relevant issues before it than it can possibly handle.

--Jeffrey M. Berry (1997, 90)

The history of the political behavior of American business in the past forty years is varied. Bauer, Pool, and Dexter's influential account of business political action suggested that in the late 1950s and early 1960s, business was not really interested in influencing the political process. Then Lindblom explained that business's political behavior had less to do with its apparent indifference to Washington than with its privileged position in society. Why would firms need to be politically active if public policy was designed to favor business? During the 1970s and early 1980s business attitudes changed as the role of the government in the economy grew. Most accounts agreed at the time that a major political mobilization by American business occurred in response to new political threats to its interests. All of these studies explain business behavior as a response to the political environment at the time. Yet it is also clear from the patterns of firm behavior that even when firms have clear political preferences which remain constant over time, their political strategies may be inconsistent with current events.

This book follows over time the political behavior of the same group of firms concerning a political issue of great importance to them. I reconstruct the political battles surrounding one of the longest-lasting and most complicated corporate tax breaks in the Internal Revenue Code: the U.S. government tax credit applicable to U.S. firms doing business in Puerto Rico, also known as the possessions tax break. A twenty-year longitudinal analysis suggests that the behavior of firms attempting to protect their political interests is determined not only by the condition of the political environment but also by the lessons learned from prior political experiences. Uncertainty about political outcomes persuades firms to be attentive to politics. But because they are operating in a fluid and complex political environment with a myriad of interests to pursue, firms also face uncertainty about the optimum political strategy. Hence, I argue that to understand why at any given point in time firms may decide to rely on their structural power, mobilize to lobby in competition with other firms, or engage in collective action, we should consider the consequences of their ability to acquire and preserve knowledge from past political experiences and bring it to bear on current political behavior.

Research has shown that compared to other groups, such as labor, which are concerned with a broad range of social issues, firms concentrate on issues of importance to their business operations. The political behavior of firms is generally geared to profit maximization. It does not follow, however, that firms' political preferences are always clearly identified. Firms may not be aware of the impact of particular or broad policy decisions on corporate profits. And even when the impact of policy decisions is evident, firms may not know how to translate their interests into specific policy preferences. In this book I go a step further. I argue that even when profits are clearly at stake and firms are aware of their interests, their political strategies are not readily formulated.

How do firms develop the strategies they believe will maximize their political influence? An explanation of the political behavior of business must address both external and internal factors. External factors constitute the current political environment, while internal ones are firms' preexisting behavioral tendencies. These internal tendencies embody the lessons firms have learned from prior political experiences and determine the manner in which they will interpret and adapt to a fluid and ambiguous political environment. When their political interests are at risk, firms respond in the same way individuals do when faced with an uncertain environment: they rely on instinct. Firms' political instinct is based on lessons learned from past successes and failures, and it results in a tendency to fight the last war whenever their political interests are threatened. The aim of this book is to specify the process by which firms learn and adapt their strategies to a changing political environment.

Firms' formulation of their political strategies is presented as a two-step process. In the first phase, when firms first realize that the political process threatens their interests, their political behavior will be based on what they have learned from their prior successes and failures. In the second phase of their response, firms may change their behavior as they try to adapt to the political environment at the time. Salient political issues and government structures comprise the political environment to which business attempts to respond as the political process progresses.

Learning, as the term is used here, means acquiring knowledge from experience. Firms get information about the consequences of their political behavior from prior experiences. This experiential learning guides firms' unreflective, automatic responses, serving as a prism through which they assess immediate political threats to their interests and the potential effectiveness of different political strategies. The end result is a political strategy that initially reflects the lessons learned from prior political battles and then slowly adapts to the current political situation. The experiences of firms at this time, in turn, will guide their political responses in the future.

Illustrating the significance of learning by business necessarily requires the study of an issue that has been of importance to the same group of firms for a considerable period of time. For this reason, political battles surrounding the possessions tax break provide an ideal empirical setting. A majority of the firms covered in this study have been investing under the rules of the possessions tax credit for more than thirty years, and since the early 1970s the law was a recurrent element of the public-policy agenda in Washington. Equally important, the costs of the elimination of the tax break were evident to the firms.

For most people not familiar with the intricacies of the U.S. tax code, the possessions tax break remained, until its partial repeal in 1996, an obscure federal provision. But for most U.S. pharmaceutical firms and many electronics companies, the possessions tax credit has been more important in reducing their federal tax bills than have foreign tax credits, tax deferrals, capital gains tax breaks, or investment-tax credits. The conventional wisdom is that before its repeal in 1986, the investment-tax credit was the most attractive tax break for capital-intensive firms. But that was not the case for the group of Fortune 500 companies with operations in Puerto Rico. In fact, "for pharmaceutical companies there was no comparison." For example, in 1973 Eli Lilly used the investment-tax credit to reduce its federal tax liability by $1.1 million but used the possessions tax credit to reduce it by $13.2 million; in 1976 Motorola used the investment-tax credit to reduce its federal tax liability by $2 million and the possessions tax credit to reduce it by $6 million; and in 1984 Merck reduced its federal tax liability by $2.9 million through the investment-tax credit and by a staggering $70.7 million through the possessions tax credit. These examples are typical among the largest pharmaceutical and electronics companies.

The possessions tax credit alone enabled some of these firms to reduce their federal taxes by more than 50 percent. One notorious example was the case of G. D. Searle. In 1975 the federal corporate tax rate was 48 percent, yet the company used the possessions tax break to reduce its liability by 33 percentage points, which translated into a 70 percent reduction in the company's federal taxes owed. Searle's case was not an exception. In 1993 the federal corporate tax rate was 35 percent, and Upjohn used the possessions tax credit to cut its liability by 22.5 percentage points, a 64 percent reduction in the company's federal taxes. And between 1989 and 1994 Johnson and Johnson used the possessions tax credit to reduce its federal tax liability by $1.1 billion. So important was this provision to pharmaceutical companies that the Wall Street Journal reported in August 1993 that drug stocks had taken a hit after financial analysts reduced their earning forecasts the moment it became evident that President Clinton would sign into law a significant reduction in the tax credit. Over the years the Internal Revenue Service (IRS) has taken to tax court Eli Lilly (1985), G. D. Searle (1987), PepsiCo. (1995), the Coca-Cola Company (1996) and others in an effort to recapture some of the federal tax revenue forgone as these companies sought to make the most of the possessions tax credit. The IRS did not always win because the tax court found that companies had followed the law.

This study is also relevant to our broad understanding of the dynamics of business-government relations. Compared to other countries, the American tax system is characterized by an abundance of tax breaks. Political battles involving corporate tax breaks involve government decisions about how to fund public spending and firms' decisions about how to prevent changes to the tax system that could negatively affect their balance sheets. And while the possessions tax credit is one of the oldest U.S. corporate tax provisions, its history is not as exceptional as it might seem. Rather, as Heinz and his colleagues point out, "the business of policy making involves working and reworking issues with a long history. Not many new items get on the agenda, and few matters are disposed of quickly." In this sense, the political battles surrounding the possessions tax break are representative of most political issues and exemplify how well-endowed interests adapt to changing situations and political circumstances.

The narrative reconstructs the political response of U.S. pharmaceutical and electronics firms to U.S. government efforts to repeal the possessions tax credit at four critical junctures: during the processes leading to the Tax Reform Act of 1976, the Tax Equity and Fiscal Responsibility Act of 1982, the Tax Reform Act of 1986, and the Omnibus Budget Reconciliation Act of 1993. The experiences of the firms involved in these battles are not meant to be taken as representative of the experiences of American businesses regarding all issues at each time. Rather, one of the premises of this study is that the political fortunes of business as well as its political strategies vary across issues. Firms pursue different political interests simultaneously. And, in the same way that different issues have different policy-making structures, firms are likely to have different learning scenarios depending on the issue.

The learning model I propose also does not explain the behavior of all individual firms. And while the behavior of U.S. firms with operations in Puerto Rico provides empirical evidence to support the learning view, not all companies behaved in the way the learning model predicts, for two reasons. First, the learning model is based on the general behavior of a critical mass of firms. Accordingly, the model highlights the tendency of individual firms to behave in a certain way when confronted with different political environments. Second, an attempt is made to account for the most important factors that could have an impact on the conduct of firms. But other factors, such as the personal characteristics of the different Washington representatives, for example, may also affect firms' political strategies. The history of the possessions tax credit, however, enables us to test the validity of the learning model to explain the likelihood of firms' decisions to rely on their structural power, engage in fragmented lobbying, or employ a collective-action strategy to protect their public-policy interests at different points in time and in different political contexts.

For example, in the mid-1970s, pharmaceutical and electronics firms doing business in Puerto Rico did not mobilize for political action when Congress proposed eliminating their federal tax break on Puerto Rico-based profits. The companies behaved this way because they had no memory of ever having to mobilize for political action to protect their tax break. Notwithstanding the political behavior of the companies, the tax law was retained and improved as part of the Tax Act of 1976. In 1982 Congress again threatened to eliminate the tax break. Based on their experiences in 1976, the companies initially did not mobilize for political action in spite of the fact that they were operating in a new political environment. The companies eventually adapted and engaged in fragmented lobbying. The failure of the companies to mobilize in time and collectively allowed the political process to continue uninterrupted, in their own view resulting in serious limitations to the tax break.

Based on their 1982 experiences, the companies decided to organize for political action. A lobbying group was formally created in 1983 under the name Puerto Rico-USA Foundation (PRUSA). By the time the Treasury first unveiled President Reagan's tax-reform project containing a proposal to repeal the tax break in late 1984, the companies had been ready for a year. Remarkably, the tax break survived the Tax Reform of 1986, and the companies attributed their success to the strength and unity of their coalition. Finally, President Clinton, who during his campaign blamed pharmaceutical companies, along with the medical community, for the high costs of health care, proposed eliminating the tax break as part of his first budget proposal to Congress in 1993. The companies' automatic response was to rely on the coalition strategy that had worked so well in 1986. Only when the companies adapted to the new political environment did the coalition break down.

The behavior of pharmaceutical and electronic firms in 1976, 1982, 1986, and 1993 suggests that their political strategies were a response to the preceding period as much as they were a response to current dominant political issues and government structures. These four political processes, comprising six different instances of business political response to threats to their interests, support the claim that business learning determines to a great extent firms' ability to adapt in real time to a shifting political environment.

Conventional Views

How do we account for the political behavior of business in the contemporary period? The theoretical literature on business and government does not provide convincing answers to this question. At any given point firms may choose to respond to threats to their interests by: (a) relying on their structural power, (b) mobilizing to lobby on behalf of their particular interests, or (c) joining other firms to lobby for their common good. These three strategic options are mentioned in the literature, but there has been no systematic attempt to explain what accounts for the variation in the political behavior of firms over time and across issues.

The structuralist approach, associated with the work of Charles Lindblom, argues that business enjoys a privileged position in society. Because business decisions affect unemployment, policymakers will be sensitive to the interests of business rather than risk an investment strike and the subsequent wrath of the electorate. Thus, Lindblom argues, the implicit threat of unemployment is generally enough to "repress" policy decisions, thereby making "government accommodation of business demands often routine and familiar." There is no need for "explicit exchange with businessmen" because there is a "tacit understanding . . . with respect to the conditions under which enterprises can or cannot profitably operate."

On many occasions, however, the implicit threat of unemployment alone does not suffice to protect the interests of business. It cannot be presumed, as Lindblom does, that policymakers, when presented with a policy issue, immediately consider its impact on business. It also cannot be presumed that policy-makers have the time necessary to study issues in depth--that is, they cannot be expected to always be aware of exactly how a piece of legislation affects their constituents or exactly how many jobs in their district may be affected. It is at this time that business may decide to mobilize for political action individually or collectively to persuade policymakers of the connection between a particular issue and the incentives necessary to continue investing.

An alternative to Lindblom's approach is the interest-group model, associated with the work of David Truman. Truman argues that interests organize rapidly and easily for political action to protect themselves against threats to their benefits. In turn, policymakers specifically rely "on interest groups for advice and assistance." Researchers disagree, however, about the likelihood and easiness of mobilization. Olson provides the dominant critique of the interest-group approach, arguing that interests behaving as rational actors have an incentive to free ride because they know that either way, they will enjoy the benefits of those that did mobilize for political action. However, Olson agrees that collective action is possible when a few of the larger units are willing to shoulder the cost of the organization because they have a bigger stake in the outcome of policy. Accordingly, Moe explains that when compared to other economic interests, such as farm groups and labor unions, evidence suggests that U.S. firms are more likely to form or join groups when they share political interests.

The collective action "problem" is not only a question of free riding, however. For firms that have overcome their tendency to free ride, the structure of the state poses another obstacle to collective action. Firms compete in the political arena in the same way they compete in the marketplace. And a federal system of divided government with administrative bureaucracies and specialized committees not only encourages businesses to mobilize politically but also invites them to pursue their own narrow interests. The structure of the state in the United States continues to preclude the development of a single business peak organization such as the Federation of German Industries or the Swedish Employers' Confederation. Furthermore, U.S. firms have become political actors in their own right and have set up offices in Washington to promote their particular interests.

Yet U.S. firms continue to support their trade and industry groups, such as the Pharmaceutical Research and Manufacturers of America and the American Bankers Association; to organize on the basis of size, as members of the Business Roundtable and the National Federation of Independent Business; and to join other firms to form single-issue groups such as the Coalition of Research and Technology to lobby for the R&D tax credit and the Coalition against Regressive Taxation to lobby against excise taxes. Hence, to assume business fragmentation across the board when there is considerable empirical evidence to suggest that firms successfully engage in collective action is as problematic as to assume that business automatically responds to political threats to its interests by organizing into groups or by relying solely on its implicit power to cause unemployment.

A Microhistorical Approach to Business Political Behavior

The historical perspective adopted in this book combines elements drawn from all three explanations of business political behavior. I argue that business strategies vary not only over time and across issues but throughout the political process as well. In the initial phase of the political process, firms' political behavior is automatic and based on knowledge acquired from past successes and failures. After the initial response, their behavior becomes more deliberate, as firms adapt to current political issues and new government structures. To understand why firms may decide to rely on their structural power rather than mobilize to lobby or may be divided instead of united in their political efforts we must understand the relative impact of learning from prior political successes and failures, new dominant political issues, and shifting government structures. This section discusses these three variables in detail.



Continues...

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