The Administration released its outline for “business” tax reform today. Described by its authors as more than a set of principles but less than a fully-realized plan, the 22-page joint Treasury-White House release raises more questions for us than it answers.
Core to the plan is a reduction in the top corporate tax rate from 35 to 28 percent. Pass-through businesses would not benefit from the rate reduction. Manufacturing businesses would see a further reduction down to 25 percent through the use of a manufacturing deduction. Advanced manufacturing would receive a yet more generous deduction.
To offset the cost of the lower corporate rate and the more generous manufacturing deductions, the Administration would repeal LIFO accounting, repeal accelerating depreciation, tax carried interest as ordinary income, reduce (unspecified how much) the deductibility of interest, impose a new minimum tax on foreign income, and make larger-through business pay C corporation taxes. Several other small business tax expenditures would also be repealed.
The proposal includes some provisions to benefit smaller businesses, including expensing up to $1 million in investments, allowing cash accounting for firms under $10 million in gross receipts, and expanding the small business tax credit under health care reform.
Combined, the Administration indicates that the plan is designed to be revenue-neutral for the business sector.
Regarding our concerns, topping the list would be how pass-through businesses are treated. It’s no secret that a majority of business activity in the United States, measured either by employment or income, takes place within business structures other than C corporations — S corporations, partnerships, and sole proprietorships.
Despite this reality, today’s proposal from the Administration pays little attention to pass-through businesses except to raise their taxes. The base broadening would increase the taxable income of businesses that use LIFO, accelerated depreciation, and interest deductions, while the policy of forcing larger pass-through businesses to pay the corporate double tax would break from Congressional history and shift the tax burden onto large pass-through businesses and off even larger C corporations.
The report doesn’t specify a threshold, but last spring’s Ernst & Young study on pass-through businesses found that one-sixth of all private sector workers (nearly 20 million) work for large pass-through businesses with more than 100 employees. Those are the same employers likely to be forced into the harmful double corporate tax under the Administration’s proposal – a model that has been criticized by economist after economist as inefficient and actually discouraging of job creation and capital investment.
Our second concern is the proposal’s schizophrenic treatment of corporate earnings. Lowering the corporate rate is motivated by a desire to make our corporate tax system more competitive. OECD rates are lower (including Japan’s as of April 1st) and they generally offer at least some relief from the double tax on corporate profits. Reducing the corporate rate from 35 percent to 28 percent is an effort to level the playing field.
But what about the second layer of tax? If reducing the corporate tax rate will make our firms more competitive, why is the Administration proposing to raise the dividend rate, which would have the opposite effect? The important number here is the total tax on new investment, which would combine the corporate tax with the investor tax. Today, the two layers are 35 percent and 15 percent, so a dollar earned by a corporation would be reduced to 55 cents by the time an investor gets it.
Under the Administration’s proposal, the two layers would be the 28 percent corporate rate and the 39.6 percent dividend rate, plus 3.8 percent for the new health care surtax, plus 1.2 percent for the reinstatement of Pease. Combined, those tax rates reduce a dollar of corporate income down to just 40 cents. Add in the repeal of accelerated depreciation, LIFO accounting, the limitation on interest expenses, etc., and it’s likely the overall impact of the Administration’s proposal will be to raise the cost of new business investment compared to the cost today.
What’s particularly confusing about this outcome is that the report makes clear that Treasury understands this analysis. Throughout the report, they refer to effective tax rates and the cost of capital. Table A2 in the Appendix identifies the effective marginal tax rates on new business investment for the years 2013-2022 with both the corporate and the investor tax layers included.
So, under the banner of making our corporate sector more competitive, the Administration is proposing to raise the overall marginal effective tax on new business investment for corporations and pass-through businesses alike. Some smaller firms may see their effective tax go down through the expanded expensing provisions, etc., but the burden on the entire business community will likely go up.
And what’s the point of “reform” if the end result is a higher tax burden and a less competitive tax system? We expect this issue to be discussed extensively for the next year, with more details from the Administration on what they have in mind. Our initial glance, however, suggests there’s lots to oppose here, and little to support.