GOP Leadership Fight Will Continue, Implications for Tax Reform

Well that didn’t go as planned.

House Majority Leader Kevin McCarthy’s surprising withdrawal from the Speaker’s race Thursday put an end to John Boehner’s carefully orchestrated plan to pass a raft of difficult bills this month, turn over the Speakers’ gavel to McCarthy on the 29th, and ride off into the sunset.

We still expect Boehner to successfully negotiate deals on spending, debt limit and highways, but where does all the turmoil leave tax policy?  Our friends at Tax Notes asked around and got this response:

Tax observers said McCarthy’s withdrawal makes it more difficult to achieve any kind of complicated tax legislation by the end of the year.

“Today’s news probably makes it even harder to do anything complicated, and more likely we get another short one- or two-year [extenders bill] at the end of the year,” a tax lobbyist said.

When asked about how the tax agenda for this year would be affected, a House Democratic aide said, “The Republican party has bigger issues to sort out.”

A renewed focus on extenders would be nice.  It’s almost November, and they expired January.

But the Tax Notes story was written before the entire Republican apparatus turned its attention towards recruiting Ways & Means Chair Paul Ryan to replace John Boehner as Speaker.  If anybody has a chance to placate the so-called Freedom Caucus members, it would be Ryan, but he has made clear he isn’t interested in the job – he really likes being in charge of tax and entitlement policy.

So it’s unlikely he agrees to run, but it’s also unlikely the pressure coming from Republican leadership abates anytime soon.  Which means tax policy, and extenders in particular, will take a back seat until the Republican leadership question is resolved.

 

International Tax Reform Off the Table, For Now

In a related development, Ryan has officially given up trying to negotiate an international tax reform package with Senator Chuck Schumer.  As The Hill reported last Friday:

Ryan, the House Ways and Means chairman, and Sen. Charles Schumer (D-N.Y.) have held discussions for weeks over a potential deal that would have something for both parties — long-term and robust funding for highways, and more generous tax rules for multinational corporations.

The two powerful lawmakers had always faced a number of difficult hurdles in striking a deal, including an Oct. 29 deadline on highways and opposition from key Senate Republicans.

But aides to Ryan and Schumer also acknowledged on Friday that they had not bridged significant policy differences in negotiations, most notably over how much to spend on highways.

These negotiations had always been accompanied by a fair amount of skepticism, particularly among Senate leadership, but Ryan, Schumer, and others put in an enormous effort to construct a plan that could improve how we tax overseas operations while appealing to Republicans and Democrats alike.  It now appears that plan will have to wait until the 2016 elections and after.

 

More on Treasury’s Effective Rate Study

Having recently put out a paper on effective tax rates, we can confidently say that determining effective tax rates is really, really complicated.  This is particularly true for C corporations, where foreign income and foreign tax payments play such large roles.

That said, in a perfect world, an effective tax rate would measure the actual tax paid by a taxpayer in a particular year divided by the real income of the taxpayer in that same year.

The Treasury Department agrees.  Back in 2012, as part of an interesting discussion on tax burdens and effective tax rates in the President’s “Framework” on corporate tax reform, Treasury emphasized that its measure of effective marginal tax rates for corporations used “economic income” as the denominator.

In their more recent study, however, Treasury appears to use “taxable income” as the denominator, at least for C corporations.  From our perspective, that really undermines the whole point of doing an effective rate analysis.  Here’s why:

Take two businesses, one a manufacturer and one a retailor.  They both make $100 and pay a 35% tax rate.  The only tax benefit they receive is a Section 199 deduction of 9% for production income.

Manufacturer Retailor
Net Income $100 $100
Section 199 Deduction $9 $0
Taxable Income $91 $100
Tax Rate 35% 35%
Tax $31.85 $35
Effective Tax Rate According to Treasury 35% 35%

If you were the retailor in this example, you’d be a little annoyed that the Treasury Department was claiming your average tax rate was the same as the manufacturer who pays less in taxes on the same income.  Using “taxable income” removes the effect of most the business tax expenditures – bonus depreciation, accelerated depreciation, Sections 199 and 179, etc – from the analysis.  That’s obviously not the correct result, but apparently that’s the result Treasury reports in their paper.

So if Treasury is not measuring the effect of most tax expenditures on tax burdens, what are they measuring?  Setting aside tax credits and other adjustments, they are essentially measuring the effect of progressive rate schedules.  Think about it this way – if nearly all C corporation income was taxed at the 35 percent tax rate in 2011, while one third of pass through income was taxed at rates below 35 percent, then the “average” tax rate for pass through businesses will be pulled down by the lower rates.

But those lower rates are generally earned by shareholders of smaller, less profitable businesses.  What about big S corporations where shareholders do pay the top rates?  Our study showed that large S corporations pay the highest effective at 35 percent.  What does the Treasury study say about that?  It doesn’t.  The paper doesn’t break down average tax rates by company size, so there’s no means of comparing apples to apples, or in this case large S corporations to similar sized C corporations.

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