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.
|Section 199 Deduction||$9||$0|
|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.
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.
Ways and Means Chairman Dave Camp (R-MI) released his long-awaited tax plan yesterday. The Chairman has worked hard to put out a plan that addresses the biggest challenges faced by the tax code, and he should be applauded for keeping this effort alive.
From day one, Camp has been our lead in promoting comprehensive reform that addresses both the individual and the corporate tax codes. Such an approach was needed if pass-through businesses like S corporations and LLCs were going to be treated in an even handed manner. This priority of leveling the playing field was embraced by our Main Street letter, signed by more than 70 business associations representing millions of employers, that called for equalizing the top rates on active income paid by all tax payers—individuals, pass through businesses, and corporations alike.
Somehow, however, that fairness message got lost in the drafting of the draft. So did simplicity.
Consider the new rate structure. The Committee says they reduced the rates from seven to just two – 10 and 25 percent. But they also included a 10 percent (10 percentage points, that is) surtax on incomes above $450,000. A surtax is really just another bracket by a different name. Everybody knows that. In fact, that’s how we got the current 39.6 percent bracket. It started as a Clinton-era 10 percent “surtax” on the old top rate of 36 percent, and just evolved into what it really is – a new, higher tax bracket.
So really there are three tax brackets – 10, 25, and 35 percent.
Then there is all that other stuff. The Obamacare 3.8 percent investment surtax is still there. For some reason, tax reform couldn’t address that atrocity. A new tax applied to a new definition of income, it taxes most forms of investment income above $250,000, including the S corporation income of passive shareholders.
There’s also a new, broader application of payroll taxes to S corporation income, including income from capital intensive businesses like manufacturers. Years ago, Congressman Charlie Rangel (D-NY) proposed to apply payroll taxes to income earned by S corporations in the personal services industries. Senator Max Baucus (D-MT) proposed a similar plan several years later. The rationale was to crack down on tax cheats, but the proposals went much further than that and would have raised taxes on businesses that were fully complying with both the spirit and the letter of the law. The Camp proposal would take the Rangel-Baucus idea even further by applying payroll taxes (in this case, SECA) to 70 percent of S corporation income earned by all active S corporation shareholders, regardless of what industry they are in. That appears to add 11.6 percentage points to the tax rate of S corporations below the FICA cap and another 2.7 points to income above that.
Then there’s the disparate application of the new 35 percent bracket depending on which industry your business is in. President Obama proposed several years ago to cut corporate tax rates to 28 percent for all C corporations, but if you were in manufacturing, you got a special lower rate of 25 percent. The Camp draft takes this “winners and losers” approach a step further, offering pass-through businesses with production income a 25 percent top rate while other forms of income (retail, engineering, services, etc.) pay a top rate ten percentage points higher.
Finally, there are the recaptures and cliffs. A cornerstone of “reform” has always been to eliminate thresholds and phase-outs as much as possible. A key part of the Bush tax reforms in 2001 and 2003 was to eliminate the notorious phase-outs known as PEP and Pease. Nothing makes the code more complicated than loading it up with one income phase-out after another. Low-income families today face a potent combination of phase-outs from the EITC, the child tax credit, and the new health care reform subsidies. The marginal rate cliff resulting from these phase-outs is the reason the CBO estimated the health care reform subsidies would encourage 2 million workers to stay home. The Camp draft invents several new ones that will impact pass-through business income. There’s the recapture of the 10 percent bracket, standard deduction, and child credit. That starts at $300,000. Then there’s the application of the new 10 percent surtax to previously untaxed employer-provided health benefits. That starts at $450,000.
The net result is a bewildering array of rates and thresholds for pass-through businesses, with at least 11— not two—different marginal rates. This chart is based on our first look at a very complex plan, so it might have some of the details wrong, but gives you a general idea of what we’re up against.
See the rate schedule on the right side for C corporations? That’s what tax reform looks like. Rational and even-handed. The rate schedule for individuals looks pretty good too, especially if you ignore the effect on marginal rates of payroll taxes and low-income credits, as this table does (we simply didn’t have the time to figure it all out).
The rate schedule for S corporations, on the other hand, is a mess. Why should it matter what industry you are in, or how involved you are in the business? Business income should be business income.
This is not to say that there aren’t good items in the plan. There are lots of them, including the lower marginal rates on labor and business income, the repeal of the individual AMT, the repeal of a zillion miscellaneous special-interest tax credits, the handful of provisions to improve S corporation governance, and more.
But each of these victories for fairness and simplicity is offset by a provision that moves in the opposite direction, like raising the tax burden on capital expenditures, increasing taxes on retirement savings, and increasing the top tax rate on capital gains and dividends.
The net effect of all this is that, even with the sharp reduction in corporate tax rates, the Camp draft increases the cost of investing in the United States! That’s not our assessment. That’s the assessment of the economic analysis circulated by the Committee to promote the plan.
So how did we get to this result? The main culprit has got to be the remarkable number of constraints the Committee placed on its efforts before they began crafting the plan, including:
- Budget neutrality;
- Neutrality with respect to income classes;
- Establishing a top rate of 25 percent for individuals, corporations and pass through businesses;
- No cross-subsidization between individuals, pass-through businesses and corporations; and
- Excluding health care from the plan, including health care taxes.
Einstein couldn’t have drafted a reasonable reform plan under these constraints; neither could the capable staff at the Ways and Means Committee. The result is that they neither stayed within their constraints – 3, 4, and 5 were all sacrificed to one degree or another – nor did they achieve the level playing field or simplicity at the heart of any real tax reform.
This is a discussion draft, so we’ll be working with the Committee to identify our concerns and work on changes. Our message to the Committee will be focused on what’s in this post. We will encourage them to return to first principles and remember why they started down the path of tax reform in the first place. The outlook for reform moving through the Congress may be bleak, particularly the Senate, but the ideas put forward by plans like this live on forever. It’s important to get them right.