Starbucks had already mastered the art of doing business on multiple continents as it grew from a niche coffee retailer in Seattle into a global brand with thousands of outlets from Saudi Arabia to Peru. Now the company smelled a fresh opportunity that required a presence in mysterious territory with its own unique culture: Washington, D.C.
It was 2004 and Congress was considering a law that would provide substantial tax breaks to nearly any company engaged in manufacturing. Though this term conjured images of textile factories and steel mills, Starbucks argued that the definition of manufacturing should -- for purposes of calculating its tax bill -- be stretched to include the roasting of coffee beans.
Starbucks hired an outside lobbyist, Michael Evans of the Washington powerhouse K&L Gates, paying his firm $60,000 that year, according to lobbying reports. Evans was only a year removed from his previous incarnation as a top lawyer on the Senate Finance Committee, the panel that writes the nitty-gritty of tax law. At his urging, lawmakers soon delivered what became known as "the Starbucks footnote," a clause added to a 243-page tax bill called the American Jobs Creation Act.
The provision enabled Starbucks to claim something called a "domestic production activities" tax deduction on each cup of coffee sold in one of its American retail stores. The measure has since saved Starbucks $88 million, according to the company.
Starbucks asserts that its tax savings are entirely legitimate. The company annually roasts, blends and distributes some 300 million pounds of coffee beans in the United States -- activity that can indeed be considered manufacturing, according to a spokesman. The company hired a lobbyist to ensure its right to claim a tax deduction on coffee sales at a time when Congress was considering language that would have specifically barred retailers from that benefit, the spokesman added.
The story of how Starbucks worked its footnote into the law, and the origin of the production tax break more broadly, highlights the special-interest jockeying that typically determines the details of the American corporate tax code. A veritable army of lobbyists -- many sprung from the same Congressional bodies they are paid to influence -- insert language to bills tilting the rules in favor of their corporate clients, often with little or no public debate.
As President Obama and congressional leaders confront a March 1 deadline to strike a deal that will reduce the federal budget deficit or otherwise accept automatic spending cuts, Washington now echoes with familiar talk that eliminating tax breaks and closing loopholes presents a simple way to raise revenue.
Obama explicitly advocated that approach during his State of the Union address on Tuesday night. "We should do what leaders in both parties have already suggested, and save hundreds of billions of dollars by getting rid of tax loopholes and deductions for the well-off and well-connected," Obama said. "After all, why would we choose to make deeper cuts to education and Medicare just to protect special interest tax breaks? How is that fair?"
But an exploration of the machinations that secured tax breaks for Starbucks and dozens of other corporations and trade associations in the name of encouraging manufacturing underscores the stark difficulties of reforming the tax code: Any change involves taking on deep-pocketed corporate interests and the legislation they have pursued to extend benefits to their enterprises. What one critic may call a loophole represents a cherished privilege to the industry that put it there. The same well-connected lobbyists who got the language into the legislation can be hired anew to try to preserve it.
Corporate tax loopholes generally weigh in as minor budget items when considered individually, but collectively the stakes are huge. Last year alone, corporate tax breaks and loopholes added up to $150 billion in lost revenue for the U.S. Treasury, or enough to fund three Hurricane Sandy-size relief bills. Moreover, Congress rarely reviews corporate breaks to determine if they are working as intended. Instead they endure, sometimes for decades.
"There's this fundamental problem that once these get into the law, there's no formal process for ever revisiting them," said Edward Kleinbard, a law professor at the University of Southern California and former chief of staff for Congress' Joint Committee on Taxation. "They tend to just develop a life of their own."
In short, raising revenue by closing supposed loopholes would force Congress and the White House to identify and dismantle the sorts of elaborately constructed provisions that have allowed Starbucks and thousands of other companies to annually claim billions of dollars in tax savings by declaring themselves manufacturers.
'A LOBBYIST'S DREAM'
Calls to eliminate the production tax deduction have come from practically every group or researcher that has studied it. Most notably, the bipartisan commission tasked with finding ways to reduce the federal deficit -- chaired by former Republican Wyoming Sen. Alan Simpson and the former chief of staff to President Clinton, Erskine Bowles -- targeted the domestic production benefit for elimination, along with a host of other corporate tax loopholes. The end of special subsidies would "create an even playing field for all businesses instead of artificially picking winners and losers," the commission's 2010 report concluded.
But the manufacturing tax deduction remained, along with the Starbucks footnote, enduring not only as a financial benefit for giant companies willing to engage in clever accounting but also as a symbol of a tax system vulnerable to manipulation by Washington lobbyists.
The senior lawmakers who championed the American Jobs Creation Act claimed it would not add to the federal deficit. Those claims soon proved wildly off target: The new law provoked a frenzy of lobbying by major companies that staked often-dubious claims on being manufacturers, expanding the permissible definition of the term to an extent that startled even jaded Washington observers.
"It was a lobbyist's dream," said Rebecca Wilkins, senior counsel for federal tax policy with the left-leaning Citizens for Tax Justice. "They loaded it up with everything. It is full of special-interest provisions and tax loopholes."
By 2008, thousands of private and small businesses had found a way to claim a tax break under the law. In its most recent budget, the White House estimated that the manufacturing deduction costs the government more than $14 billion a year in lost revenue, while projecting an additional $80 billion loss over the next five years.
Former staffers, legislators and others familiar with the crafting of the 2004 tax legislation say senior congressional leaders, including then-House Ways & Means Committee Chairman William Thomas -- a California Republican who has since retired -- loaded up the bill with goodies in order to win votes, or to satisfy their own constituents. Along the way, they said, lawmakers and lobbyists stretched the manufacturing definition like a tube sock over a basketball to allow architects, utilities and even newspaper companies to claim that what they do counts.
Thomas did not respond to requests for comment.
The final product included a big break for oil and gas companies, which had explicitly been excluded from the old export subsidy. The bill also included dozens of one-off special goodies to sway lawmakers to vote for the bill, including an odd provision that allows Native American whaling captains to take a charitable deduction on up to $10,000 to buy whale-hunting equipment, inserted at the request of the late Republican Alaska Sen. Ted Stevens.
Despite promises that the tax break would create jobs, Congress never followed up to determine whether that actually happened. Indeed, in the nine years since the bill passed with bipartisan support, U.S. manufacturers have shed more than 2.3 million jobs, though there is no way to tell how many jobs might have been lost if not for the manufacturing deduction. Although nearly one-third of all corporate income qualifies for the tax deduction, only 9 percent of American jobs are in the manufacturing sector, according to federal data.
Beneficiaries of the legislation say they simply capitalized on a tax benefit that helps them grow their businesses and hire more workers. Zack Hutson, a Starbucks spokesman, said his company is constructing two additional facilities to roast and distribute coffee in the U.S., in part because of the benefit. The facilities will employ hundreds of workers, he said. "We are proud to be investing in American manufacturing at a time when many other U.S. companies are sourcing products from overseas," Hutson said.
But tax-reform advocates view the break differently: as an example of how corporations are able to use their lobbying might to press for special benefits under the tax code, and how once written down, these breaks are nearly impossible to revoke.
American oil companies, for example, receive tax breaks worth billions dating back to the 1920s meant to keep them competitive with foreign suppliers. (In 2011 the three largest U.S. oil companies made a combined profit of more than $80 billion, according to the White House.) Moreover, when a new priority comes along -- such as a desire to incentivize clean-energy production -- new tax breaks are layered on top of the old.
"The tax code is riddled with special-interest provisions that need to be reviewed thoroughly and systematically," said Earl Pomeroy, who served for more than a decade on the House Ways & Means Committee as a Democrat representing North Dakota.
Although lawmakers have often cast the elimination of these loopholes as a "tax increase," in reality they are domestic spending programs in disguise. The only difference is the accounting: Instead of a government program that would count as an expenditure, these tax breaks represent federal revenue that never arrives.
Another costly parcel of tax breaks, known as "tax extenders," expire every year, prompting a new round of lobbying to maintain them. In theory, these tax breaks should come up for review. In practice, congressional aides cut and paste the language into each year's new budget bill without change. This year's legislation to avoid the so-called fiscal cliff contained dozens of these extenders, including a provision that allows multinational firms to avoid paying U.S. taxes by indefinitely holding revenue offshore.
Recently, some of the same companies that have been the most successful at avoiding U.S. taxation have urged lawmakers to deal with the national debt. In December, Boeing Corp.'s chief executive, Jim McNerney, urged "everybody to give a little" to avert a fiscal crisis. Boeing's effective tax rate from 2008 to 2010, meanwhile, not including deferred income, was -1.8 percent on $9.7 billion in profit, according to Citizens for Tax Justice. (The U.S. corporate tax rate is 35 percent.)
Also in December, Starbucks CEO Howard Schultz urged baristas in 120 D.C.-area locations to write "come together" on each cup of coffee sold. In a letter, Schultz said the "small gesture" was meant to encourage lawmakers to "fix the debt" -- a reference to a corporate-backed effort to pressure Washington into reducing the deficit through a mix of tax and entitlement reform.
Unlike many of the companies backing Fix the Debt, Starbucks pays a relatively high corporate rate, averaging about 32 percent over the past five years. But the company has run afoul of authorities in the United Kingdom for effectively avoiding taxes in that country by shifting its tax burden to an affiliate in the Netherlands, where tax rates are lower. In response to a public outcry, Starbucks recently agreed to pay about 20 million pounds in British corporation tax over the next two years.
"We know that we are not perfect," wrote Kris Engskov, the head of the company's U.K. division, in an open letter to British customers. "We hope that over time, through our actions and our contribution, you will give us an opportunity to build on your trust and custom."
'ACCOMMODATIONS AND COMPROMISE'
The legislation that eventually became the vehicle for the Starbucks footnote had its roots in an international trade dispute between the United States and Europe.
Laws dating back to the 1970s gave U.S. companies a series of tax subsidies for exporting goods ranging from textiles to paper products to fruits and vegetables. European countries argued the laws unfairly skewed the market in favor of American companies selling abroad. After a three-decade fight, the World Trade Organization in 2000 sided with Europe. It concluded that the European Union could assess more than $4 billion in penalties if the U.S. government continued the subsidies.
Faced with the threat of punishing tariffs on U.S. exporters, Congress in 2002 started exploring ways to rework the tax breaks for exports. Rep. Thomas, the California Republican who chaired the House Ways & Means committee at the time, took the lead.
The international trade penalties, which Thomas likened to a "nuclear weapon," became a primary concern for the tax writers on the committee. Thomas introduced a bill in 2002 that would have repealed the disputed subsidies and created different tax incentives for American multinational firms operating abroad.
But the legislation went nowhere and encountered criticism from business groups, whose leaders said the proposed tax benefits weren't enough to make up for repealing the subsidies. Thomas tried again in 2003, and the new legislation raised an idea that would prove popular: a tax break for American manufacturers to replace the subsidies for exporters.
The concept generated interest in the Senate, too. During a July 2003 Senate Finance Committee hearing, Sen. Max Baucus (D-Mont.) said any repeal of the disputed subsidy "should also provide benefit to all domestic manufacturers" and could provide a "needed boost" to the sector.
But the question of what "manufacturing" really meant quickly became a point of contention. Both the House and Senate bills introduced in 2003 included language referring to the decline of jobs in the manufacturing sector. The proposed bill from Thomas's House Ways & Means Committee referred to a broad array of business activities, including film and computer software production, that was "manufactured, produced, grown or extracted" within the United States. Depending on the interpretation, the language could mean tax breaks for farmers, miners, home builders, oil companies, even fast-food restaurants.
Though little-known outside Washington circles, the leaders of the chief Congressional tax-writing committee wield tremendous influence over policy, and as such often have the closest ties with lobbyists who try to curry favor for coporate interests. A Sunlight Foundation analysis done last year in collaboration with National Public Radio found that the average lawmaker on the House Ways & Means committee raised an estimated $250,000 more in contributions from individuals and political action committees than the average member of Congress.
The committee also had the second-highest number of former staffers move on to become lobbyists, according to the Center for Responsive Politics, a tradition known as the "revolving door" that gives well-connected lobbies unique insight into the day-to-day mechanics of legislation. The Senate Finance Committee, its counterpart in the other chamber, had the highest number of revolving-door staffers.
John Buckley, the Democrats' chief counsel on the Ways & Means committee at the time, said that Thomas "decided to do some favors" after his desired approach -- a tax break for multinational companies -- fell apart.
Democrats on the Ways & Means Committee said that with Republicans in the majority, they were kept out of the process. "There did not appear to be a clear rationale about who got in and who did not," said Pomeroy, the North Dakota Democrat. "One can only assume that some lobbying shops were more effective than others."
Throughout 2003 and 2004, more than 110 companies and trade associations registered to lobby on the tax legislation being considered in both the House and Senate, according to disclosure forms. Those with close ties to Congress seemed to fare particularly well:
- Bechtel, a major international construction and engineering company, hired Jeffrey McMillen, a staff director on the Ways and Means committee who left Congress in 2004 to work for Akin Gump.
A spokesman for the architects association said his group pushed for inclusion because firms had benefited from the earlier exports subsidy. A spokeswoman for the Motion Picture Association of America wrote in an emailed statement that the film and television industry is a "vital component of the nation's overall economy." Bechtel did not respond to a request for comment.
All three industries -- construction, film production and architecture firms -- successfully convinced lawmakers that the manufacturing deduction should apply to them.
Indeed, each time lawmakers considered the bill, they stretched the definition of manufacturing a little more. One of the final additions was a clause that counts utility companies that produce electricity, gas and water as eligible among the ranks of domestic manufacturers. This was added during the conference committee, when Senate and House leaders meet to iron out differences.
Some of the perks attached to the legislation were gifts by individual Congress members to favored constituents, former staffers and others familiar with the tax law said. Then-House Speaker Dennis Hastert (R-Ill.), for example, won a repeal of excise taxes on fishing tackle boxes, as a gift to Plano Molding Co. of Illinois, the biggest manufacturer of those boxes. Sen. Zell Miller (D-Ga.) successfully pushed for a break on Chinese ceiling fan import tariffs. Observers construed that as a gift for the home furnishings giant Home Depot, which sells large numbers of Chinese-made fans and has its headquarters in Atlanta. To attract Southern Democrats, the House bill included a $10 billion buyout for tobacco farmers. Then-Senate Minority Leader Tom Daschle (D-S.D.), who was in a tight reelection fight he would ultimately lose, successfully pushed for tax breaks for ethanol producers -- an issue close to the heart of farmers in the Midwest.
As the bill got bigger, and more expensive, policymakers at the Bush White House began to sound alarms.
"Because the manufacturing category is not well defined, firms would have an incentive to characterize themselves as in manufacturing," White House economic staff said in a report issued in early 2004. "Whenever possible, policy-making should not be based upon this type of arbitrary statistical delineation."
In October 2004, John Snow, then the Treasury secretary, described the bill as "a myriad of special-interest tax provisions that benefit few taxpayers and increase the complexity of the tax code."
Some congressional leaders also spoke out against the legislation, referring to it derisively as the "no lobbyist left behind act."
"We missed a golden opportunity with this issue," Sen. John McCain (R-Ariz.) said in a July 2004 floor speech. "We could have passed a good, clean bill months ago that would have brought us back into compliance with World Trade Organization agreements." The goal of the legislation, he said, had been "lost to a host of special-interest add-ons."
Fifteen congressional Democrats signed a dissent, arguing that the vague definition of manufacturing was a "deeply flawed provision that provides special-interest benefits to large architectural and engineering companies like Bechtel and Halliburton."
Still, supporters of the bill insisted they were not straying from the core goals of manufacturing growth.
"This bill is about helping American manufacturing," Sen. Charles Grassley (R-Iowa), then the Senate Finance Committee chairman, said in the spring of 2004. "Working families are living in financial fear. We owe a secure future to these hardworking men and women."
In a CNBC broadcast, Larry Kudlow and Jim Cramer asked Thomas, the architect of the tax bill, about criticisms that it was laden with business perks.
"Look, this is the House of Representatives," Thomas said. "Accommodation and compromise are classic tools in the American system."
The Huffington Post reached out to many of the lawmakers involved in the 2004 tax legislation, including Baucus, the current Senate Finance Committee chairman; Sen. Orrin Hatch (R-Utah), the ranking Republican on the Finance committee and Grassley, the Senate Finance Chairman at the time. Spokesmen either did not return requests for comment or referred to past statements.
President George W. Bush signed the American Jobs Creation Act into law on Oct. 22, 2004. McCain didn't vote on the measure. Only three Republican senators voted against it. It also won the support of more than half of Senate Democrats.
PICKING WINNERS AND LOSERS
The political fight was over, but critics continued to slam the law as an overly complicated special-interest giveaway indefensible under any objective measure of fairness.
"There's always a certain amount of grease that's part of getting any tax policy changes through the process," Dan Mitchell, an economist at the conservative Heritage Foundation, told the Washington Post at the time. "But with this bill, the actual policy seems secondary to the grease."
Less than a year after the domestic production tax changes went into effect, Bush's "Advisory Panel for Federal Tax Reform" recommended a repeal, calling it a slice of the corporate tax code "that is targeted at a speciﬁc type of activity, but that creates complexity for everyone."
As an example, the report pointed to a section in the law that disqualified sexually explicit movies from the tax deduction. That caveat "places IRS agents in the awkward position of screening movies to determine whether they qualify for the deduction," the report found.
Asking tax collectors to define pornography -- a task that has vexed even the U.S. Supreme Court -- was not the only challenge for would-be interpreters of the legislation. Accountants and lawyers struggled to figure out if they could claim landscaping or painting done on a construction job as "domestic production" under the law, according to accounts in industry trade journals. For oil and gas production, they wondered, would sales of geological maps and geophysical recordings count?
"There's no accounting system on the planet set up yet to capture the information I need for this," Glenn Mackles, a principal with Deloitte & Touche, told Accounting Today in November 2004. "I just laugh to keep from crying every time I read the coffee bean example."
To critics, the Starbucks footnote came to symbolize much of what was wrong with the American tax system. Hutson, the Starbucks spokesman, said the company advocated for the footnote because an early draft of the bill specifically excluded retailers from the manufacturing benefit. He noted that even with the deduction, Starbucks has paid an effective federal tax rate of between 30.1 percent and 35.8 percent since 2006.
The average effective corporate tax rate paid by the largest U.S. companies is roughly 19 percent, though many large companies with extensive overseas holdings pay a much lower rate. Exxon Mobil, for example, which also benefits from the manufacturing benefit, paid an average effective rate of 14.2 percent from 2008 to 2010, according to Citizens for Tax Justice.
This disparity underscores a problem that plagues the entire tax code, reform advocates say. Instead of a fair approach that neither helps nor hinders any particular set of companies, it gives some businesses huge advantages over others, usually without much scrutiny.
"One of the main arguments to repeal this is because it is an administrative nightmare," said George Yin, a professor of tax law at the University of Virginia's Law School, who served as chief of staff for Congress' Joint Committee on Taxation in 2004. "But I think that's really the secondary issue. The bottom-line question that really doesn't get answered in all of this debate is: Why should we be favoring any of these businesses?"
The final bill, for example, rewarded large-scale food production but not the work of individual chefs or craftsmen. "While the gross receipts of a meat packing establishment are qualified," the final bill read, "the activities of a master chef who creates a venison sausage for his or her restaurant menu cannot be construed as a qualified production activity."
Despite questions about its fairness, and recommendations from lawmakers of both parties that it should go, the manufacturing deduction has survived.
A much-heralded tax reform plan proposed by former Sen. Judd Gregg (R-N.H.) and Sen. Ron Wyden (D-Ore.) in 2010 would have eliminated the deduction. In 2010, President Obama's Economic Recovery Advisory Board placed the domestic production tax break at the top of its priority list for corporate tax reforms. The board noted that if the deduction were to go away, the top tax rate for all companies -- including retailers and service companies that can't take advantage of it -- could be lowered by 1.4 percent.
In his renewed calls for corporate tax reform, Obama hasn't mentioned the deduction. Instead, this week, he proposed eliminating some off-shoring tax loopholes as part of broader corporate tax reform. At a speech at a North Carolina auto parts factory on Wednesday he called for lowering the top tax rate for manufacturers from 35 percent to 25 percent.
So far, the only measure that has served as a check on the manufacturing tax deduction, which costs taxpayers more every year, was the 2008 bailout bill, which limited the deductions for oil and gas companies to 6 percent, compared to 9 percent for other eligible industries. Otherwise, the bill has lived on -- even those parts of it that were supposed to expire.
As some provisions neared an expiration date, Congress simply added them to a $63 billion bundle of corporate tax breaks that it dutifully attaches to the budget each year, such as credits for building railroad tracks and accounting benefits for owners of NASCAR racetracks.
According to estimates by the Joint Committee on Taxation, the so-called NASCAR loophole will cost taxpayers $46 million this year and an additional $95 million through 2017. Supporters in Congress and industry groups have argued that the tax break is necessary to "maintain the current standard expected by our competitors and fans."
Most recently, Congress approved these extenders as part of the legislation to avert the fiscal cliff. At the same time, the payroll tax break, which helped American workers but did not have a powerful lobby fighting for it, was allowed to expire.
Jason Fichtner, a senior research fellow at George Mason University's Mercatus Center and a former senior economist with the Joint Economic Committee of Congress, said inequities in the tax code have the same effect as government spending programs, but without any of the required congressional oversight. "There's an accountability issue here, and a transparency issue," he said.
But he said the same political pressures that create tax breaks make them extremely difficult to repeal. "The interest-group pressure to keep these is so high, and the public understanding so low, that they keep going on for perpetuity."