Tax Reform Rehash

The release of Finance Committee tax reform discussion drafts on cost recovery and international tax have laid bare a reality that’s been hiding just below the surface for two years now the visions for reform embraced by the key House and Senate tax writing committees are dramatically different and move in opposite directions.

The international drafts are a good example. The Ways and Means draft would move the tax treatment of overseas income towards a territorial system, while the Baucus draft would move towards a more pure worldwide system by largely eliminating deferral. Here’s how the Tax Foundation described it:

Of the 34 most advanced countries, 28 use a territorial tax system, while only 6, including the U.S., use a worldwide tax system with deferral. No developed country imposes a worldwide tax system without deferral, though some have tried it with near disastrous effects.

Exactly how the two committees could bridge these broad differences in vision is unclear.

For pass-through businesses, the differences are just as stark. Neither committee has released details on overall rates or the treatment of pass-through businesses, but both have made clear the general direction they plan to take.

The Ways and Means Committee seeks comprehensive reform where the top rates for individuals, pass- through businesses, and corporations would be lowered and the differences between them reduced, helping to restore the rate parity that existed from 2003 to 2012. Other provisions in Chairman Camp’s draft would seek to close the differing treatment of partnerships and S corporations, creating a stronger, more coherent set of pass-through rules.

Finance Chairman Max Baucus, on the other hand, appears to actively oppose rate reductions for individuals and pass-through businesses even as he constructs his reform package around a core of cutting rates for C corporations. The inherent inconsistency of lowering corporate rates to make US businesses more competitive while simultaneously defending significantly higher rates on pass-through businesses is stark. The Baucus draft does make a vague reference to “considering” the impact on pass-through businesses, but it is clear that consideration amounts to nothing more than increased small business expensing or something similarly limited.

So the Finance Committee would cut corporate rates and ask S corporations and other pass through businesses to help pay for them. In the end, C corporations would pay a top rate of 28 or 25 percent, while pass-through businesses would pay rates 13 to 20 percentage points higher.

How do they justify this disparate treatment? The double tax on corporate income is often raised as leveling factor. As the Washington Post recently reported, “Today, the Treasury estimates, as much as 70 percent of net business income escapes the corporate tax.”

But “escaping” the corporate tax is not the same as escaping taxation. The simple fact is that pass through businesses pay lots of taxes, and they pay those taxes when the income is earned. The study we released earlier this year found that S corporations pay the highest effective tax rate (32 percent) followed by partnerships (29 percent) and then C corporations (27 percent on domestic earnings).

These findings include taxes on corporate dividends, so some of the double tax is included. They do not include capital gains taxes due to data limitations. Including capital gains would certainly close the gap between C and S corporations, but enough to make up 5 percentage points of effective tax? Not likely. Meanwhile, the study focused on US taxes only, so it doesn’t attempt to capture the effects of base erosion or the ability of C corporations to defer taxes on foreign income for long periods of time.

All in all, the argument against pass through businesses is based on some vague notion that these businesses are not paying their fair share. The reality is just the opposite. By our accounting, they pay the most. That means that, all other things being equal, today’s tax burden on S corporations makes them less competitive than their C corporation rival down the street.

Real tax reform would seek to make all business types more competitive by lowering marginal rates while also helping to level out the effective tax rates paid by differing industries and business structures. That’s the basis behind the three core principles for tax reform embraced by 73 business trade associations earlier this year: reform should be comprehensive, lower marginal rates and restore rate parity, and continue to reduce the double tax on corporate income.

These principles are fully embraced by Chairman Camp and the Ways and Means Committee. They appear to have been rejected by the Finance Committee. Which begs the question: What exactly is the goal of the Finance Committee in this process? Is it just to raise tax revenues? You don’t need “reform” to do that.

Whatever their goal, the gap between the House and the Senate is enormous, and unlikely to be closed anytime soon. Chairman Camp continues to press for reforms that would improve our tax code, but he’s going to be hard pressed to find common ground with what’s being outlined in the Senate.

Extenders

With the timeline for tax reform being pushed back, there is a bit more discussion of what to do about tax extenders. The whole package of more than 60 provisions expires at the end of the year and to date there’s been little discussion regarding how or when to extend them. As the Tax Policy Center noted this week:

It isn’t unusual for these mostly-business tax breaks to temporarily disappear, only to come back from the dead a few months after their technical expiration. But this time businesses are more nervous than usual. Their problem: Congress may have few opportunities to continue these so-called extenders in 2014. This doesn’t mean the expiring provisions won’t be brought back to life. In the end, nearly all will. But right now, it is hard to see a clear path for that happening.

While the future is murky as always, a few points of clarity do exist:

  • Nothing will happen before the end of the year. The House will recess this weekend and not return for legislative business until mid-January. Even if it took up extenders promptly after returning, which is highly unlikely, the soonest an extender package can get done would be February or March.
  • Coming up with $50 billion in offsets to replace the lost revenue will also be a challenge. Congress is tackling a permanent Doc Fix right now, which requires nearly three times that level of offsets. Coming up with an additional $50 billion will not be easy.
  • The lack of an AMT patch also is hurting urgency for the package. Congress permanently addressed the Alternative Minimum Tax earlier this year, which is good news, but that action also removed one of the most compelling catalysts for moving the annual extender package. Annually adopting the AMT patch protected 20 million households from higher taxes. That incentive is now gone.

All those points suggest that the business community has a long wait before it can expect to see an extender package move through Congress.

Or does it? One of the most popular extenders is the higher expensing limits under Section 179. This small business provision allows firms to write-off up to $500,000 in capital investments in 2013, as long as their overall amount of qualified investments is $2 million or less.

Beginning in 2014, these limits will drop to $25,000 and $200,000 respectively.

You read that correctly. Starting January, business who invest between $25,000 and $2 million in new equipment will no longer be able to write-off some or all of that cost in year one. Talk about an anti-stimulus. Coupled with the loss of bonus depreciation, the R&E tax credit, and the 5-year holding period for built in gains, and the expiration of extenders will have a measurable effect on the cost of capital investment for smaller and larger businesses alike.

This reality is beginning to sink in both on Main Street and the investment community, where certain industries rely on these provisions as a core part of their business plans in coming years. It’s too soon to see how much momentum the loss of these provisions will generate in coming months, but cutting the expensing limit from $500,000 to $25,000 in one year is bound to attract somebody’s attention.

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