Last week, Politico reported more details on the pending Administration tax reform plan. As Mike Allen reports:
Treasury Secretary Timothy Geithner plans to ignite the debate by unveiling a white paper that advocates lowering the top corporate tax rate from the current 35 percent to less than 30 percent and as low as 26 percent, according to aides. The proposal is likely to fall between 26 percent and 28 percent.
To pay for that, the proposal will call for closing loopholes and slicing exemptions. The two main ones are a tax deduction for domestic manufacturing and accelerated depreciation for capital equipment.
Agreeing on how to rework corporate taxes will be tough, and many aides remain privately pessimistic. But the two sides’ willingness to try to find common ground is a notable departure from their stances on most other contentious issues on the Capitol Hill docket.
Geithner has already begun his campaign with a series of closed-door meetings with CEOs, academics, labor unions and liberal and conservative think tanks. Aides say he was encouraged by the response. At the White House, Jason Furman, principal deputy director of the National Economic Council, is working the issue.
Meanwhile, we have yet another quote from Finance Committee Chairman Max Baucus (D-MT) on the need to push larger pass-through businesses into the corporate tax structure, this time explicitly as a means of paying for the broader reform:
Baucus: “I agree that our corporate statutory rate is way too high. We have to get it reduced. The question is how you do it. And, I think, I could be wrong on this, but say if the 35 were reduced to 26, it’d probably mean all tax expenditures would have to be repealed. Including deferral. Including the R&D tax credit. And obviously, that’s something that doesn’t make sense. So we have to find some system that lowers the rate, when possible, and someone thought of, tax pass throughs. Treat them as corporations after they earn a certain income. Because so much business income is through pass throughs in addition to C-Corps, and just lowering the rate only — just tax expenditures is not gonna provide enough revenue to lower the rate to a low enough level to cover the difference most people are looking for. So we’re gonna, maybe, have to look at pass throughs, and say they gotta be treated as corporations if they earn above a certain income. Theres so much pass-through income today, business income. We’re gonna have to find some way to address that if we’re going to get the corporate rate down to what we want.”
So, it is clear the Administration and key folks in the Senate are intent on pushing the idea of corporate-only tax reform that dings some, if not all, pass-through businesses.
What’s less clear is the point of this exercise. Tax reform that punishes the majority of America’s employers to reduce taxes for large multinationals would likely run into political and policy challenges, and is unlikely to be supported by a broad cross-section of Republicans and Democrats.
The Politico story suggested this effort would only move forward as part of a broader package of debt reduction and overall tax reform. Let’s hope so, because by itself, it’s unlikely to fly.
The Math of Tax Reform
Between the Politico story, the Baucus quote and other sources, the plan being crafted by Treasury is beginning to come into focus. Here are the basic elements as we understand them:
- Reduce the corporate tax rate to between 26 and 30 percent.
And, to pay for it:
Eliminate certain — not all – big-ticket business tax expenditures, including the manufacturing deduction and accelerated depreciation. May include others like LIFO.
- Require certain pass-through firms with revenues above $50 million to pay taxes as C corporations.
What is unclear is whether all pass-through entities with more than $50 million will have to pay taxes under the corporate code, or just some subset of them. Also unclear is whether the plan will include some type of relief for pass-through businesses affected by the elimination of targeted tax expenditures. For example, if an S corporation manufacturer uses both the manufacturing deduction and accelerated depreciation, under this reform it will have to pay more in taxes (and even more when they raise rates in 2013) on a broader base of income.
To address these issues, Treasury could propose to reduce rates for pass-through business income as well, they could offer pass-through firms an income tax deduction to offset the impact, or they could split the use of deductions/expenditures by eliminating them for C corporations only. (The most effective solution would be to reform both the individual and corporate codes together as Ways and Means Chairman Dave Camp (R-MI), Budget Chairman Paul Ryan (R-WI), and now House Speaker John Boehner (R-OH) have all proposed — that is our preferred approach.)
Considering the rate range targeted above, it’s unlikely Treasury is considering any of these options. Back in 2007, Treasury calculated that eliminating all business deductions would allow them to reduce business tax rates (for both C corporations and pass-through firms) to 27 percent. The current Treasury plan would preserve many deductions, and yet they are seeking to get the rate even lower, and at this point, only for C corporations. That suggests that pass-through firms are being excluded from the lower rates and instead being asked to pick up the tab.
One immediate challenge facing the reform outlined above is the manufacturing sector. Our Ernst & Young study found that more than four out of five manufacturers (81 percent) are structured as pass-through firms, and they rely on accelerated depreciation and the manufacturing deduction on the hit list. In the current political and economic environment where “jobs” are a premium, doesn’t it seem odd that the Administration would plan to broaden the tax base on 81 percent of manufacturers?