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.

Budget & Tax Policy Outlook

The agreement earlier this month between Senators Reid and McConnell reopened the government for a few months, but it failed to resolve any of the issues that precipitated the shutdown in the first place.B Therebs still no consensus on spending levels or tax policy beyond the end of the year.B Key dates in the agreement are:

  • December 13th — Target for budget conferees to agree to a uniform budget
  • January 15th — Current government funding resolution (CR) expires
  • February 7th — Debt limit reached again

At this point, agreeing to a budget resolution would be a big deal.B Not only could it establish spending levels for next year, it also could put into place expedited procedures for tax and entitlement reforms stretching over the next decade and beyond.B For observers cheering for something big, including comprehensive tax reform, a successful budget conference is an essential first step.

The odds of a positive outcome, however, are slim.B The huge gap between Republicans and Democrats remains while the December 13th target date lacks any enforcement mechanisms — if the conferees fail to agree by that date, nothing happens.

Meanwhile, Senate Majority Leader Harry Reid and House Minority Leader Nancy Pelosi oppose any reduction in the sequester cuts that doesnbt include higher taxes — Reid went so far as to say people bwantb to pay more taxes — while Senate Budget Committee Ranking member Jeff Sessions has made clear he opposes swapping the sequester for similar sized entitlement cuts.

So those folks hoping for a narrower deal will just have to wait, too.

On the tax front, Chairman Dave Camp continues to push his leadership, committee and conference to support a comprehensive, budget neutral package by the end of the year.B Webre on record strongly supporting this effort, and it appears hebs making progress.B Meanwhile, Finance Chair Max Baucus plans to begin releasing bdiscussionb drafts outlining various parts of his plan as early as next week, with the first release likely focused on international reforms. Thatbs good news and certainly a step forward.

But the big barrier holding tax reform back has less to do with drafts and House Republicans, and more to do with basic objectives.B Senate Majority Leader Harry Reid and the President continue to insist on a package that raises taxes, which obviously is a non-starter with the House.B Until they work out the top line number, getting an agreement on what the underlying policies will look like is next to impossible.

Meanwhile, therebs a long list of tax provisions set to expire at the end of the year, including the higher limits ($500,000) on Section 179 expensing, the R&E tax credit and the 5-year holding period for built-in gains.B Until the budget and tax reform questions are resolved, therebs little appetite on the Hill for discussing the prospects for these provisions, so everything is on hold. As the Hill wrote this week:

Renewal of a package of tax breaks for businesses and individuals worth tens of billions of dollars has become something of a holiday tradition in Washington. Each November and December tax writers battle over which benefits are really worth keeping while business lobbyists launch fevered campaigns to keep their tax bills low.

In the end, most of the package is often renewed, attached to some other must-pass piece of tax legislation.

But this year, lawmakers will likely not even go through the motions.

Members of the Senate Finance and House Ways and Means Committees expect to spend all of their remaining time this year working on drafting comprehensive tax reform legislation. The extenders package would be a distraction from that work, they say.

So the December target date for producing a budget resolution appears to be less of a deadline and more like a warning track, letting policymakers know that the end of the year is fast approaching and that therebs limited time to move forward on tax reform or, failing that, extenders.

It doesnbt have to be that way, of course.B Outside forces could emerge in the next two months to bring the two sides together.B For example, we always thought there was an inverse relationship between the success of the Affordable Care Act and the prospects for tax reform.B The worse the roll out, the more motivated the Obama Administration would be to change the subject and work with Congress on comprehensive reform.

Itbs hard to imagine a worse roll out than what webve seen over the past month, and yet the prospects for common ground between the House, Senate, and Administration donbt appear to be increasing.B Based on his comments in Boston this week, the President certainly doesnbt seem to want to change the subject.B Maybe it will take a little time. Or maybe nothing will happen.B Right now the latter appears to be the most likely outcome.B Given how much work Chairman Camp has put into the tax reform effort and how much a well-thought out plan is needed, that would be a shame.

The Importance of Pass Throughs

Put on your “must read” list a new paper from our friends at the Tax Foundation highlighting the importance of pass-through businesses to jobs and employment. It’s the best written and most comprehensive summary of the issue we’ve seen to date. Here’s how it starts:

Support for lowering the corporate tax rate – now the highest in the OECD – has been expressed by both Democrats and Republicans in order to improve the competitiveness of American businesses. However, they differ in their plans for the individual tax code. While Republicans have proposed lowering the top individual rate from 39.6 percent to 25 percent, in parity with the proposed corporate tax rate, Democrats are less willing to consider lowering the individual tax rate.

The implications of these policy differences are considerable because of the tremendous growth in non-corporate business forms over the past thirty years. Today, there are vastly more non-corporate businesses than traditional corporations and they now earn more net income than traditional corporations. These businesses face top marginal tax rates higher than 50 percent in some states. Thus, ignoring the top individual tax rate – even while lowering the corporate rate – means the United States will continue to expose a broad swath of business to high tax burdens.

And how it ends:

As lawmakers consider policies to improve the competitiveness of American businesses, they should not forget that individual income tax rates are just as important to business activity as the corporate rate. The various proposals to raise income taxes on high-income earners, either by increasing the top marginal rate, closing “loopholes,” limiting deductions, or implementing a minimum tax, would fall very heavily on America’s non-corporate businesses. Pass-through businesses are currently facing top marginal rates on average between 44.5 percent and 47.5 percent and as high as 51.8 percent in California. These pass-through businesses account for a large percentage of business income and employment in the United States. Raising taxes on them could curtail their hiring and other investment plans, putting more strain on an already struggling economy.

The paper adds something new to the defense of the pass-through structure. Past arguments in support of a strong pass-through sector include:

  • Best Tax Policy: S corporations are the way business income should be taxed. It’s taxed once, when the business earns the money, and then that’s it.
  • High Effective Tax Rates: As our recent Quantria study demonstrates, pass-through businesses already pay a high level of tax, and they pay it when the income is earned.
  • More Progressive: By taxing business income using the progressive individual tax rates, policymakers ensure that business income is taxed in a progressive manner, with high income shareholders paying a higher rate, and lower income shareholders paying a lower one.
  • Diversification: Pass-through businesses spread investment and employment decision making across the country and into local cities and communities. As the recent financial crisis makes clear, diversification of these actions is critically important.

Thanks to the Tax Foundation, we can now add to that list “Economic Stability.” As the Tax Foundation notes:

It is also interesting to note the relative stability of pass-through business income to the volatility of C corp income. The period between 1999 and 2010, shown on Figure 2, is a good example of how volatile corporate income can be. After the tech bubble burst in 2000, C corp income plunged 24 percent over the next two years, after adjusting for inflation, and then rebounded 119 percent by 2005. After this temporary peak, C corp income fell again by nearly 33 percent over the next five years.

By contrast, pass-through income has not experienced such wild gyrations. After the tech bubble burst in 2000, pass-through business income actually increased in 2001. In 2002, net income fell by just 2 percent but then rebounded by 5 percent in 2003. In the four years after the 2003 tax cuts, the net income of pass-through businesses grew by nearly 60 percent, after adjusting for inflation. In 2010, pass-through business income exceeded C corp receipts by 40 percent.

Is there anybody remaining in Washington who still doesn’t understand the importance of pass-through business to our economic health? If you find them, please send them this Tax Foundation paper!

Breaking Up Tax Reform

Last week, Politico Pro is reporting something we’ve been concerned about for a while:

PATH TO PASSAGE? SENATE FINANCE COULD USE SMALL BILLS TO APPROVE TAX REFORM: The universal truth of tax reform is that it is, and always will be, hard to pass. But the folks over at the Senate Finance Committee are considering various ways to more easily push tax reform legislation through Congress – including splitting a comprehensive reform bill into smaller measures. Our Kelsey Snell reported for Pros that “separating business tax reform from the more contentious individual tax code would allow [Senate Finance Committee Chairman Max] Baucus to continue debate on corporate taxes, the international tax code and the treatment of some benefits for small businesses – where there’s more agreement between the parties – without opening a battle over how much revenue should be raised through changes to the individual code.”

The news outlet subsequently filed a couple corrections that left the story’s ultimate meaning in doubt, but the notion that you can split tax reform into small bites is definitely out there. Comprehensive is just too hard, some say, so let’s do a corporate bill where there’s more agreement.

Our concern with this approach is two-fold: First, we reject the idea that you can separate out the corporate tax code without doing significant harm to the pass through business sector. Corporate-only proposals to date would either raise taxes significantly on pass through businesses or they would treat them like second class citizens, instead of the majority source of employment and business income in the United States (see story above).

Second, the “consensus” on corporate reform is less than it appears and it will depend on the same, top line question confronting comprehensive reform — should it be budget neutral or raise revenue? Until that question is answered (and you know where we stand on that), any reform effort is going to face an uphill climb.

We support corporate tax reform, but only as part of a broader effort to reform the entire tax code.

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