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.
Secretary Lew gave his tax reform speech this morning. It lasted maybe 10 minutes and he didn’t take questions afterwards. Given the buzz the speech’s announcement created on Wall Street and in tax policy circles, the event itself was a major disappointment.
The Obama Administration is beginning to resemble an old Brian Regan comedy routine about how passengers on an airplane get excited when the pilot comes on the intercom, even though the pilot never has anything good to say. Just a variation on the same old theme that the flight will be delayed because….
This Administration never appears to say anything new either. Faced with a raft of inversions, Lew used this speech to plug the Administration’s two-year old “business tax reform” outline that went nowhere two years ago, and has even less momentum today.
Raising the overall tax burden and increasing the penalty of our worldwide system is a non-starter for both political and policy reasons. From the pass through perspective, the Administration’s “business tax reform” plan is nothing more than corporate tax reform in disguise, with little or nothing to help S corporations and partnerships. The plan appears to offer lower tax rates for C corporations and higher tax burdens for everybody else.
Lew did tamp down expectations that Treasury would take strong administrative action to address inversions. In the speech, Lew announced Treasury would act “in the very near future” but also made clear whatever action they took would not be sufficient to fix the problem. Congress must act, he cautioned.
But action by Congress is also in doubt. Majority Leader Harry Reid earlier had signaled the Senate might take up inversion legislation when the Senate returns this week, but disagreements among key Democratic tax writers over the best approach may kill that effort.
So there you have it – after the President took ownership of the tax inversion issue by announcing his Treasury Department would address them administratively, Secretary Lew is now lowering expectations and attempting to toss the ball back into Congress’ court, where most observers believe it belonged the entire time.
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:
- US taxpayers get a credit for any foreign taxes paid on their income; and
- 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.