GOP Leadership Fight Will Continue, Implications for Tax Reform

October 9, 2015 by · Leave a Comment 

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.

Manufacturer Retailor
Net Income $100 $100
Section 199 Deduction $9 $0
Taxable Income $91 $100
Tax Rate 35% 35%
Tax $31.85 $35
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.

Legislative Update and Treasury’s Effective Rate Study

October 2, 2015 by · Leave a Comment 

Legislative Outlook, Post-Boehner Announcement

Speaker Boehner’s announcement that he plans to retire at the end of October has implications for tax policy and next year’s spending levels.  Here’s our outlook for both.

International Tax Reform:  Lots of noise on the tax front.  The latest rumors on the Ryan-Schumer plan to pair highway funding with international tax reforms are that:

  1. The plan is complete and has been sent up to the Administration for their review and sign-off;
  2. The plan is not finished and is hung up over a disagreement regarding how much to spend on highways;
  3. The plan will be presented to the Ways & Means Committee members this morning,
  4. Only options will be presented to Ways & Means Members this morning;
  5. All of the above; and/or
  6. None of the above

One rumor we’ve heard that does appear to be valid is that the innovation box and base erosion provisions have been redrafted to reflect the comments the Committee has received over the past couple months, including the addition of pass through businesses to the innovation box benefits.

Can a package of international reforms and highway funding pass?  The ascension of Kevin McCarthy to Speaker should help. He had this to say on Morning Joe earlier this week:

“If we pass a highway bill with tax reform at the same time, that’s policy. That changes the inversion process; that means more money comes back to America.  That puts a six-year highway bill on to the floor and starts moving and building roads that we need in American infrastructure.”

Not everyone is convinced.  Politico reports this am that Finance Chair Orrin Hatch remains “doubtful” a deal can be struck in time:

“Frankly, I don’t see how you can do what they want to do in this length of time frame that we have,” said Hatch. “We need to solve the highway bill now.”   

Meanwhile, taxwriters were targeted with competing letters on international reform, the first from left-leaning economists who dislike them and the second from a small group of US-based multi-nationals who support them, particularly the innovation box parts of the plan.

Where that leaves us is anybody’s guess, but the renewed focus on the larger tax reforms will once again push off action on the much needed extenders bill.  It’s now October, and those provisions have been expired for more than nine months.  Just saying.

Budget and Debt Limit: On the other side of the ledger, Boehner’s pending retirement freed him up to negotiate a short term spending bill to keep the government open through December 11th, and appears to set the stage for a Boehner-led year-long spending bill to move through Congress prior to the end of October.  The goal is to get next year’s contentious spending and debt limit votes out of the way before McCarthy takes over as Speaker, to give him a clean start so to speak.

Treasury gave that effort a little momentum with their most recent debt limit letter, which suggests the government will run out of credit and need to shut down around November 5th, about a month earlier than previously thought.  The earlier drop dead date is attributed to lower than expected tax revenue collections.  Not good.

So two tracks for tax and spending for the month of October – track one is the on-going Ryan-Schumer effort to couple highways with international tax reforms, and track two is the effort to fund the government for 2016 coupled with raising the debt limit before the November deadline.  It is possible these two negotiations are combined before the end of the month, but for the moment they appear to be taking place in two different rooms with two different groups of negotiators.  Should be an interesting October.

New Treasury Effective Rate Study

Economists at the Department of Treasury and NBER last week released a paper reviewing the average taxes paid on business income, by entity type.  We went through a similar exercise several years ago (you can read our study here), so we printed up a copy and took a look.  Here’s the headline graph:

Treasury Rate Chart

As you can see, the average tax rates for S corporations and C corporations are in the same basic range, while the averages for sole proprietorships and partnerships are significantly lower.  Below we itemize our initial thoughts regarding the substance of the paper and the quality of the estimates.

Click here to read the full post.

S-Corp Comments on Innovation Box

September 10, 2015 by · Leave a Comment 

The S Corporation Association submitted comments today to Ways and Means Committee Members Rep. Charles Boustany (R-LA) and Rep. Richard Neal (D-MA), sponsors of the draft “Innovation Promotion Act of 2015.”

As you’ll recall, the two members released a “discussion draft” of their innovation box idea back in July and asked stakeholders to weigh in.  The box itself offers US firms a lower tax rate on some income derived from the use of patents, inventions, formulas, etc.  Our friends at the Tax Foundation identified three motivating factors in the introduction of the box:

  • The U.S. tax code has become increasingly uncompetitive;
  • Lawmakers are concerned that under the BEPS project, U.S. companies will be pressured to move related R&D to foreign countries to satisfy new foreign tax laws; and
  • Lawmakers want to encourage the creation of more research and development and the related jobs in the United States by providing a lower rate on its income.

Regarding our comments, you can read the whole letter here, but the two essential points are 1) the best means of encouraging innovation is to reduce tax rates on all business activity and 2) a more targeted effort to reduce rates on “innovative” activity should be drafted as broadly as possible, including applying it to S corporations and other pass through businesses.  As we noted previously, the innovation box draft currently applies to C corporations only.

A cornerstone of tax reform is to apply rules and rates evenly, so that investment and hiring decisions aren’t unnecessarily distorted.  An innovation box, by definition, targets a more narrow set of activities than across-the-board marginal rate cuts, but it doesn’t need to pick and choose among business types too.  Innovation takes place within C corps, S corps, and other pass through entities alike, so all these business should be included in the box.


Tax Extenders on Fall Agenda

Congress returns to a full legislative plate for September and beyond, including the following deadlines for action:

  • Iran nuclear deal (September 17th)
  • Government funding (September 30th)
  • Internet Tax Freedom Act (October 1st)
  • October 29th (Highway authorization)
  • December (Debt Limit)
  • Tax Extenders (December or January)

Add in the controversy over Planned Parenthood’s funding and it’s difficult to see how Congress manages to wade through all these deadlines unscathed.  Should be an interesting few months.

On the tax policy front, Congress needs to extend the so-called “extenders” before tax season officially begins next year.  As readers know, this batch of 50-plus tax provisions (including business-friendly provisions like the R&E tax credit, the shorter built-in gains (BIG) recognition period, higher limits on small business expensing, etc.) officially expired at the end of last year, but everyone in DC expects Congress to act this fall to extend them, both for the current year and for 2016.  There should also be an aggressive effort to make some of the provisions, including BIG relief, permanent.

We’ve commented previously on the adverse impact this on-again, off-again approach to tax policy has on businesses and their investment decisions.  As Jody Fledderman of Batesville Tool and Die testified earlier this year, the temporary expiration of these tax provisions has the effect of draining resources from his company, resources he can’t get back even when Congress retroactively extends the provisions.

This dynamic is one reason over 2000 businesses and trade groups wrote to Congress calling on them to act on extenders quickly.  As the letter, led by the National Association of Manufacturers, states:

Failure to extend these provisions is a tax increase. It will inject instability and uncertainty into the economy and weaken confidence in the employment marketplace. Acting promptly on this matter will provide important predictability necessary for economic growth.

The expired provisions should be renewed as soon as possible this year. We urge all members of Congress to work together to extend seamlessly on a multiyear basis, and where possible enhance or make permanent, these important tax provisions.

So Congress’ plate is full, but early action on extenders would be greatly appreciated by the business community.  It would instill a higher degree of certainty while representing an important step towards the reformed tax code everybody would like to see.


Pass Throughs and Bracket Creep

Add “bracket creep” to the list of tax challenges specific to pass through businesses.  According to the Congressional Budget Office, individual tax collections are expected to rise sharply over the next decade, in part due to wages rising faster than inflation.  As the TaxVox Blog noted:

The expected rise in individual income taxes is largely due to a phenomenon known as real bracket creep. Income tax rates are mostly indexed for inflation so nominal increases in income don’t boost effective rates. But when incomes rise faster than the rate of inflation, as CBO projects in a growing economy, that income is pushed into higher tax brackets. As a result, CBO figures individual income taxes will rise by 0.6 percent of Gross Domestic Product by 2025.

An increase of 0.6 percent of GDP doesn’t sound like much, but it works out to more than $150 billion in additional annual tax collections by the end of the decade.

Missing from the CBO report is any commentary on the impact bracket creep has on Main Street businesses.  While the vast majority of C corporation income is already taxed at the top corporate rate of 35 percent and is therefore immune to bracket creep if it occurs at all — does business income rise faster than inflation? – a sizable amount of pass through income is taxed at rates below the top 39.6 percent top rate.  Combined with the fact that pass through income is added on top of wage and salary income and it means that many S corporation shareholders will have their business income subject to higher effective tax rates over time.

So “bracket creep” joins the Alternative Minimum Tax, foreign tax credit treatment, and other tax policies and interactions that present particular challenges to the pass through business community.