Lost in all the hoopla over the Treasury’s new inversion policies was the accompanying update to their corporate tax reform outline. You can read the whole 30-page document here, but the bottom line is that not much has changed.
The plan still treats the pass-through community as second-class citizens by broadening the tax base for all businesses while only reducing rates for those organized as C corporations. As a result, successful pass-through businesses would be subject to 45 percent top rates on a broader base of income – a double whammy coming just three years after the Fiscal Cliff hiked their tax rates.
That’s simply a non-starter with Congress. From Politico:
McConnell also said he’s not interested in corporate-only tax reform, noting “most American businesses are not corporations” and lawmakers are not going to “carve out one section of American business and give them breaks and leave the others with very high rates.”
The plan also makes clear just how far apart the Administration and Congress are on tax policy.
The Ways and Means Committee continues to work on an international reform package that, by all accounts, includes an innovation box as the sweetener to help offset some of the new enforcement provisions. Meanwhile, the Administration spends two pages explaining why innovation boxes are a bad idea.
Finance Committee Chair Orrin Hatch (R-UT) continues to refine his plan to integrate the corporate and individual tax codes – something more than 100 national business groups have argued is an essential component of tax reform. Meanwhile, the Administration stands by their budget plan to increase shareholder taxes instead. (Exactly how combining lower corporate rates and sharply higher shareholder taxes helps to improve business taxation or encourage more investment here in the United States is not discussed in the Administration’s outline or anywhere else. It’s simply incoherent.)
And finally, while the majority in Congress stands uniformly opposed to raising taxes, the Administration’s plan explicitly calls for at least two significant tax hikes – a one-time 14 percent assessment on un-repatriated profits that would pay for new infrastructure spending, and a retroactive tax hike to offset to last year’s extender package. As Politico notes:
The Obama administration now wants to pay for that giant tax deal approved in December. After agreeing to stick the bill’s $680 billion cost onto the deficit, the administration now wants business tax reform to cover that cost. “Reforming the business tax system must be done in a fiscally responsible manner, including paying for December’s business tax cuts,” the administration said in an update of its business tax reform framework.
Most observers doubt there’s any chance for meaningful tax policy this year. The net result of this framework is to make that more clear.
Corporate Tax Base v. Business Tax Base
As noted above, there’s lots to dissect in the Treasury update, but you need not go further than the first paragraph to find something offensive. When it comes to the business community, it is obvious this Administration is focused only on large corporations.
America’s system of business taxation is in need of reform. The United States has a relatively narrow corporate tax base compared to other countries—a tax base reduced by loopholes, tax expenditures, and tax planning.
But the US doesn’t have a corporate tax base – it has a business tax base that includes both corporations and pass-through businesses. The good news here is that the US business tax base is large and growing.
According to the Tax Foundation, the business tax base made up 9 percent of US income prior to the 1986 Tax Reform Act, but makes up 11 percent today. That’s bigger. True, the corporate tax base has declined from 8 percent of US income in 1986 to 5 percent today, but the growth of the pass-through business community during that same time from just one percent to 6 percent has more than offset that decline.
So corporate-only tax reform advocates like the Administration are fond of pointing out that the corporate tax base has eroded over the past three decades. What they never point out, however, is that the business tax base – including both corporations and pass-through businesses – has grown significantly since the 1986 Tax Reform Act.
That’s a good news story that every tax writer in DC needs to learn.
The tax extenders front has been busy in the last couple days. First, there was the rumor Monday that negotiators were close to a deal. Tuesday, details emerged of a $450 billion package mixing ten permanent items with a two-year extension (2014 & 2015) of most other items. And then yesterday evening the White House issued a veto threat against the package, leaving its prospects very much up in the air.
What’s remarkable about the White House veto threat is that it occurred at all. To our recollection, this is the first time in six years the White House and Senate Majority Leader Harry Reid have been publicly crosswise on legislative policy. Reid negotiated the package with House Ways and Means Chairman Dave Camp and it includes several provisions – including making the state and local tax deduction and the mass transit benefit permanent – that Reid and other senior members of his caucus have historically supported. So it’s obvious the Reid office and the White House are no longer in close communication, at least on tax matters. As the Hill reported:
Democratic aides on Capitol Hill said that the White House quickly made it clear Tuesday that it was, in the words of one staffer, “livid” over a deal that would have indefinitely extended tax priorities for both parties. Senior administration officials reached out to Democratic lawmakers to get that message across, aides added, with even Obama and Lew trying to marshal opposition. “This is a terrible deal for Democrats,” one aide said.
Moreover, we’re hearing that part of the White House’s motivation for blocking this package is their belief that doing so will generate momentum for corporate-only tax reform. This kind of reform has been roundly denounced for leaving out and penalizing a majority of the private sector businesses in this country, but the White House and Treasury have been much more active on that front and appear to believe that such a deal is possible. (We don’t.) Here’s what our friends at Capital Alpha had to say about that:
The President is making a deliberate and contemplated move to set the ground rules for discussions of fundamental tax reform and corporate tax reform next year with the incoming Republican majority. The President won’t talk about revenue neutral tax reform in a vacuum. His terms for tax reform include big payoffs for constituencies of the progressive left in terms of policy goals and economic benefits. Such has been his position all along, which is why we have always been skeptical of tax reform next year.
As to the package, it’s broad and includes lots for the pass-through community to like. For starters, it would make permanent two S corporation specific provisions – the shorter holding period for built-in gains and the basis adjustment for charitable donations – as well as popular provisions like the R&E tax credit and small business expensing. Here’s the complete summary from Tax Notes:
The deal would make permanent the following 10 provisions:
- the research credit, simplified according to the provisions in a House-passed bill (H.R. 4438) to make the credit permanent but also including the provision from the Senate Finance Committee package providing start-up businesses the ability to claim the credit against payroll taxes;
- section 179 expensing;
- the state and local sales tax deduction;
- the American opportunity tax credit, indexed to inflation after its renewal in 2018;
- the employer-provided mass transit and parking benefits exclusion;
- the reduced recognition period for built-in gains of S corporations;
- the rules regarding basis adjustments to the stock of S corporations making charitable contributions of property;
- the rule allowing some tax-free distributions from IRAs for charitable purposes;
- the deduction for charitable contributions by individuals and corporations of real property interests for conservation purposes; and
- the deduction for charitable contributions of food inventory.
The remainder of the package will mostly follow the extenders bill the Senate Finance Committee approved this spring to renew through 2015 all but two of the 55 traditional extenders that expired in 2013.
However, the deal will phase out the wind production tax credit, ending the incentive after 2017.
It also includes House-passed modifications to the bonus depreciation provision that would expand the definition of qualified property to include owner-occupied retail stores and lift restrictions to allow for more unused corporate alternative minimum tax credits, which businesses can claim in lieu of bonus depreciation, to be used for capital investment.
So where do things stand? We are hearing conflicting reports. One word from the Hill is that the deal is off and that negotiators will have to start over, probably with a one-year extension for 2014 only (Boo!). Other reports, however, suggest that Senate Democrats are not backing down. It is possible yesterday’s package could move through both the House and the Senate despite the White House’s objections, and we’re hearing some Senate offices are working the membership to make that happen.
With everybody home for Thanksgiving, we won’t have a better idea where the votes are and what Senate leadership decides to do until next week when everybody returns. In the meantime, the tax world has more than just turkey to chew over this holiday! Stay posted.
A compilation of the business tax related stories that caught our eye
Administration on Tax Reform
The President’s economic advisors have been unusually busy in recent weeks. National Economic Council Director Jeffrey Zients was firm in his conviction that tax reform could get done in the new Congress, citing the “remarkably overlapping” approaches of Obama’s plan and the Camp draft.
It is true there are some common themes in the Camp and Administration proposals, but also there are major – and fatal – differences as well, including:
- The Camp Draft is budget neutral while the Administration’s plan would raise revenue;
- The Camp Draft adopts a territorial tax system while the Administration appears to strengthen our world-wide system; and
- The Camp Draft is comprehensive while the Administration plan would reduce rates on corporations only – an approach rejected by Democrats and Republicans alike.
Add to those differences the fact that the Administration’s draft landed with a thud when it was released back in 2012 and has barely been discussed since, and the idea of House Republicans and the Obama Administration coming together on tax reform in the next Congress seems laughably remote.
Meanwhile, Council of Economic Advisers Chair Jason Furman spoke in New York the other week on tax reform, offering additional context to the Administration’s tax reform proposal and addressing some of the concerns that have been raised. We’ll have more to say about this later, but this paragraph caught our eye:
On the economic merits, it is important to remember that C corporation income is partially taxed at two levels while pass-through income is only taxed at one level. As a result, today C corporations face an effective marginal rate that is 6 percentage points higher than that on pass-through businesses. Although the President’s Framework would cut and simplify taxes for small business, including small pass-through entities, for larger businesses we should be moving towards greater parity—with the goal of equal effective rates on an integrated basis, a goal that would not be served by parallel reductions in individual and corporate tax rates.(Emphasis added)
That’s not exactly true. Recall that our study on effective tax rates released last year found that S corporations face the highest effective tax rate of any business type. Those estimates were based on real businesses and actual tax returns.
The numbers Jason is referring to are based on hypothetical future investments. They can be found in a three-year-old Treasury analysis under the heading of “Effective Marginal Tax Rates on New Investment.” Jack Mintz authored a comprehensive critique of these estimates for the Tax Foundation last February, some of it pretty damning.
For our purposes, we will just point out that Treasury’s analysis, correctly done, would be appropriate if you wanted to measure the tax burden on marginal investment decisions – should we build that new facility, should we buy that piece of equipment, should we use debt or equity? – but it doesn’t support the notion that C corporations today pay a higher effective rate than pass-through businesses. You need to estimate average effective tax rate to make that claim, which is what our study does.
Jason is right to point out that the double tax on corporations hurts US competitiveness. That’s the reason the pass-through business community advocates for its reduction as an essential goal of tax reform. There’s little point in reforming the tax code if the result doesn’t reduce the tax on investing in the United States, and the best path to achieving that is to tax business income once at reasonable rates and then leave it alone. That’s how S corporations are taxed today, and real reform would move C corporations in that direction.
Ryan on S Corporations
Contrast the Administration’s approach with that of Representative Paul Ryan (R-WI), a leading contender to take the gavel as the next Chairman of the Ways and Means Committee. He recently gave a speech at an event hosted by the Financial Services Roundtable in which he made clear the importance of improving the tax code for all businesses, including S corporations and other pass-through businesses. Here’s what he had to say:
“Tax reform is one of those things that we don’t know if we’re going to be there at the end of the day, because we want to make sure that, as we lower tax rates for corporations, we do the same for pass throughs.
You know, a lot of people in the financial services industry – banks – are subchapter S corporations.
Where Tim [Pawlenty] and I come from, “overseas” is Lake Superior, and Canadians are taxing all of their businesses at 15 percent. And our subchapter S corporations, which are 90 percent of Minnesota and Wisconsin businesses, are taxed at as high as a 44.6 percent effective rate.
So we have to bring all these tax rates down, but we have a problem with the Administration being willing to do that on the individual side of the tax code.”
We’ve been beating the “comprehensive tax reform” drum for three years now and it’s nice to see key policymakers embrace the message.
American Progress on S Corp Payroll Taxes
Meanwhile, Harry Stein of the Center for American Progress is out published a report with broad recommendations on how to best reform the tax code. Among its suggestions is one to close the “Edwards-Gingrich loophole,” an issue we’ve covered extensively in the past. On that subject, the S Corporation Association has developed the following position:
- We don’t support using the S corporation structure to avoid payroll taxes. We represent businesses that comply with the law, not sneak around it.
- It’s not a loophole, its cheating. This issue is often described as a loophole, but that’s not accurate. Underpaying yourself in order to avoid payroll taxes is already against the rules.
- The IRS has a long history of successfully going after taxpayers who abuse the S corporation structure. The current S corporation rules on this have been in place since 1958.
- Any “fix” needs to improve on the current rules. That means they need to be easier to enforce and they need to target wage and salary income only. Employment taxes should apply to wages only, not investment (including business) income.