Inversions and Tax Reform

Yesterday’s letter from Treasury Secretary Jack Lew on inversions is just the latest headline on an issue that has dominated the tax discussion ever since Pfizer proposed to merge with AstraZeneca back in May.  As the chart below notes, the number of companies moving their headquarters overseas is accelerating and it’s sending a strong signal that something is very wrong with our tax code.


The motivation for inverting is simple – it allows companies to avoid paying US taxes on foreign earnings.  This is a uniquely American problem.  Most major economies have territorial tax systems that only collect tax on income earned within the home country’s borders.  The US, on the other hand, has a modified worldwide system that imposes US tax on all income regardless of where it is earned.  The US system is “modified” in that it includes two significant exceptions to the worldwide approach:

  1. US taxpayers get a credit for any foreign taxes paid on their income; and
  2. US tax only applies to income that is repatriated (paid as a dividend) back the parent corporation.

As other countries have reformed their corporate tax codes and lowered their tax rates, the incentive for US companies to invert has grown.

Adding to their motivation is the policy risk that the US tax system will become even more punitive in coming years.  High profile Democrats, including President Obama, have run on platforms that include “ending tax breaks that send jobs overseas” – i.e. ending or curbing a company’s ability to defer paying US tax on foreign earnings.  No country, not even those few that still have worldwide tax systems, has ever adopted this approach.  These proposals have never been seriously considered by Congress but they do expose the large gulf in vision on tax reform and serve as a potent reminder that action taken by Congress may not be business friendly.

So get out while you can.

The best way to address inversions is to reform the tax code to encourage more companies to organize here in the United States.  The “fix it with comprehensive tax reform” response has been adopted by many tax writers in Congress, but how long can they stick with this refrain when nobody believes thoughtful tax reform is possible under this administration?

On the other hand, it is highly unlikely that Congress sits back and passively watches while all our best companies invert.  Inversions may have limited real economic effects – most inversions are a legal exercise, not an economic one – but it looks bad and something must be done.

Secretary Lew argues for a two-step approach.  First, enact legislation that raises the barrier to inverting in order to slow the tide of companies moving their incorporation papers overseas.   Second, enact comprehensive tax reform that would make the US more attractive.  It is hard to argue with step two here – and we’re glad to see the Administration support the concept of comprehensive reform – but step one is sure to prove ineffective.  US companies are already structuring spin-offs that would get around the proposed, tougher anti-inversion rules.

We have a better idea that also involves two steps.

Why not officially adopt a territorial system now, and then move comprehensive tax reform later?  After all, what’s the difference between Congress enacting a territorial system through a statute and companies acting organically to accomplish the same end through deferral and inversions?  You end up in the same place.  Moreover, how much could a shift to a statutory territorial system cost the US Treasury if we already have a de facto territorial system in practice?  It can’t be much, so just make it official and remove the incentive for US companies to jump through all these legal hoops in order to invert.

Then the discussion could shift to the real issues confronting the tax code, including the excessive tax rates we impose on individuals, pass-through businesses, and US corporations alike.  The corporate community is right to argue that high US taxes are driving investment and jobs overseas.  These excessive rates are not limited to corporations – they include even higher rates on individuals and pass-through businesses – and, unlike inversions, excessive tax rates have a tangible and negative effect on our economy.  That’s the real challenge with our current tax code and that’s what real tax reform needs to address.

Nobody Here But Us Unicorns

Last week, National Public Radio ran a story suggesting that while business groups are focused on the pending rate hikes and the impact they will have on jobs and investment, actual business owners are less concerned. According to NPR:

We wanted to talk to business owners who would be affected. So, NPR requested help from numerous Republican congressional offices, including House and Senate leadership. They were unable to produce a single millionaire job creator for us to interview.

 

So we went to the business groups that have been lobbying against the surtax. Again, three days after putting in a request, none of them was able to find someone for us to talk to.

The White House jumped on the story, joking that opposition their “Millionaire Surtax” was “bogus.” As White House Spokesman Jay Carney told reporters:

And it’s what you all write in your stories when you say, the President and Democrats support this surtax, or this way of paying for job-creating measures or tax cuts; Republicans say no because it will hurt small business. Well, one news organization decided to ask the leadership offices of the Republicans on the Hill whether or not — or just to give them an example of the small businesses that would be affected. And for three days they got nothing. And there’s a reason for that. Because, as the Treasury Department has done in its study, the simple fact of the matter is, is that less than 1 percent of all small businesses would be affected by this kind of request that millionaires and billionaires pay a little bit more. That’s just a fact.

So next time you write a story, or produce a spot that cites that opposition, I think a second sentence might be worth adding, which is that it’s bogus.

This week, Senate Majority Leader Harry Reid joined the chorus, stating on the Senate floor:

Republicans have opposed our plan to pay for this legislation with a tiny surtax on a tiny fraction of America’s highest earners. The tax would only apply to the second million the wealthiest Americans earn.

But Republicans say the richest of the rich in this country - even those who make millions every year - shouldn’t contribute more to get our economy back on track. They call our plan a tax on so-called “job creators.” Yet every shred of evidence contradicts this red herring.

 

National Public Radio went looking for one of these fictitious millionaire “job creators.” A reporter reached out to business groups, the anti-tax lobby and Republicans in Congress hoping to interview one of these millionaires. Days ticked by with no luck.

 

Millionaire job creators are like unicorns - impossible to find.

That’s because only a tiny fraction of people making more than $1 million - about one percent - are actually small business owners. And only a tiny fraction of that tiny fraction is traditional job creators. Most of those business owners are hedge fund managers or wealthy lawyers.

 

They don’t do much hiring. And they don’t need more tax breaks.

 

A couple points of clarification. First, the Treasury report cited by the Majority Leader doesn’t say that only 1 percent of people who make more than $1 million are small business owners – it says that only 1 percent of all small business owners make more than $1 million. The report actually says that 84 percent of people who make more than $1 million had some income from a flow-through business income.  That’s 84 percent, not 1 percent.

As we have pointed out before, the number of firms is irrelevant. What matters is the volume of activity. The report showed that people making more than $1 million earned 39 percent of all flow-through income. Similarly, the Joint Committee on Taxation estimates that 34 percent of all active flow-through business income would be hit by the tax.

Second, the surtax proposed in the Senate in recent months is only one of three marginal rate hikes set to begin January 1, 2013. The other two are the expiration of the lower 2003 tax rates (including the restoration of the Pease deduction phase-out, which is effectively a 1.2 percent surtax) and the imposition of the new 3.8 percent tax on investment income. Shareholders of profitable S corporations today pay a 35 percent tax on their business income. If the surtax before the Senate is adopted, that top rate will rise to 50 percent beginning in 2013.

These proposed tax hikes will hit shareholders with as little as $200,000 in income. The rhetoric is all about millionaires and billionaires, but the policy being pushed will affect business owners with just a fraction that much income.

2013 Rates Married/Single

36%  $250,000/$200,000

39.6%  $390,050/$390,050

3.8% Surtax $250,000/$200,000

5.1% Surtax $1 Million/$1 Million

Does it make a difference? Ask the Administration and those members of Congress eager to cut the corporate rate. Why cut the corporate rate? Because the current 35 percent rate is out of synch with the rest of the world and it makes our large businesses less competitive. So what’s different about flow-through businesses? They employ more Americans and contribute more to economic output than those firms that pay the corporate rate. Marginal rates affect their competitiveness too.

Or ask Christina Romer, the former Chair of President Obama’s Council of Economic Advisors who’s done an enormous amount of work in this area. The paper she co-wrote with her husband back in 2007 found that tax cuts and hikes not targeted at fiscal stimulus, as the surtax and other pending 2013 tax hikes certainly are not, have a large impact on economic output. As summarized by David Henderson of the Hoover Institute in Forbes:

The Romers carefully sift through all federal tax cuts and tax increases from 1947 to 2005 to figure out, based on the discussion at the time, whether the changes in tax policy were motivated by a desire to offset the business cycle or by other goals. When they strip out the tax changes meant to offset the business cycle, they find that the other tax changes were highly effective. A tax decrease of 1% of GDP raised GDP by about 3%, and, symmetrically, a tax increase of 1% of GDP reduced GDP by about 3%.

 

So how big is the proposed tax cliff awaiting flow-through businesses in 2013? The Reid 5.1 percent surtax is estimated to raise $24 billion in 2013, while the Obama 3.8 percent surtax would raise $20 billion that year. Meanwhile the expiration of the top two rates is another $35 billion. Add them all up, and the total hit is $79 billion, or about 0.5 percent of projected GDP for 2013. These estimates come from different reports, so there may be interaction not represented in the total, but the scale of what is being proposed is significant and disturbing.

Another point of clarification. The businesses affected by these tax hikes are not limited to “hedge fund managers or wealthy lawyers.” Eighty-one percent of all manufacturers in this country are organized as flow-through businesses. Meanwhile, one of the key findings of the Ernst & Young study we requested last spring was that larger flow-through businesses — those with 100 or more employees — accounted for one in six private sector jobs. That’s a lot of people working for so-called “unicorns.”

We’re not sure what steps NPR took to find business owners affected by the surtax, but it’s not surprising that taxpayers with large businesses to run are wary of spending time showing their personal tax returns to NPR. But the evidence from Treasury and the Joint Committee on Taxation is clear: the cumulative rate hikes under consideration to begin in 2013 are large and they will impact a significant percentage of overall business income. That’s what S-CORP is worried about.

Senate to Consider Surtax

Senate Majority Leader Harry Reid (D-NV) reportedly plans to bring up the President’s Jobs Bill this month and pay for it with a new 5 percent “surtax” on taxpayers making more than a million dollars. According to Politico:

Senate Majority Leader Harry Reid is eyeing a tax on the nation’s highest earners as a way to defray some of the $447 billion price tag for the White House-written jobs package-a move that would shift attention away from its underlying policies and more towards party politics. Sources on and off Capitol Hill said Reid wants to swap out the bill’s current rack of “pay-fors,” and replace them with a package including a surtax of 5 percent on millionaires.

And the New York Times:

The Senate majority leader, Harry Reid, Democrat of Nevada, said the surtax would raise $445 billion over 10 years, just about the amount needed to pay for the jobs bill. Mr. Reid said his proposal would “have the richest of the rich pay a little bit more -5 percent more to fund job creation and ensure this country’s economic success.”

Assuming the tax is exactly as described — a five percent tax on income exceeding $1 million — how many businesses might be affected? For business income, the recent Treasury study on pass-through business activity gives us an idea. These numbers are from 2007 so they are a bit dated, but unlike the more recent IRS data, they are broken down both by business owners and income levels.

According to Treasury, 392,000 taxpayers had incomes exceeding $1 million in 2007. Of those, 331,000 reported some level of business income, while 311,000 met the Treasury’s definition of “business owner.” (Click here to read our concerns about that.)

So, four out of five taxpayers targeted by the millionaire surtax are business owners. What negative impact might such a tax have on jobs?

Last December, the Heritage Foundation estimated the jobs impact of allowing tax rates on taxpayers making more than $1 million to revert to their old levels. They estimated average annual job losses of 198,000 for the decade, with 78,000 job losses in 2012. The tax hike described above is bigger.

So the Senate’s plan is to pay for the President’s Jobs Bill by raising tax rates on hundreds of thousands of business owners. If the point of the Jobs Bill is to create jobs, not lose them, we’re not sure this is the best approach.