The President’s budget is out, and for the second year in a row it seeks to redefine tax reform to fit its own purposes.
The vast majority of policymakers view tax reform as embracing two fundamental goals:
- Increased simplicity for both taxpayers and the IRS; and
- Lower marginal tax rates imposed on a broader base of income.
The President’s budget , however, would take us in exactly the opposite direction. Rather than simplify the tax code, it would make it more complicated, and rather than move towards lower rates and a broader base of income, it would selectively lower and/or raise rates based on priorities that have little to do with simplicity or overall economic growth.
Corporate-Only Tax Reform: The business community is united behind the premise that tax reform should be comprehensive and address the tax treatment of individuals, pass-through businesses and corporations. Nonetheless, the Obama Administration continues to push Congress to consider budget-neutral, corporate only tax reform instead.
Under this approach, Congress would eliminate business tax expenditures and use the new revenue to offset lower rates on C corporations. A 2011 Ernst & Young study made clear the challenge corporate-only tax reform presents to pass-through businesses. According to E&Y, a broad policy of eliminating business tax expenditures while cutting only corporate rates would raise the tax burden on pass-through businesses by approximately $27 billion per year- and that doesn’t include the additional hit to pass throughs from their increased marginal tax rates beginning as of January 2013. The most affected industries include agriculture and mining, followed by construction, retail trade, and manufacturing.
This shift in the tax burden happens because pass-through businesses use the same business deductions as their C corporation counterparts. So, if a simple reform package eliminated the Section 199 manufacturing deduction in order to offset a reduction in corporate tax rates, a manufacturer organized as a C corporation would lose the use of that deduction, but they would get a lower corporate rate in return. It is a mixed bag.
For the S corporation manufacturer down the street, however, there is nothing but downside. They too would lose the use of Section 199, but unlike their C corporation competitor, the resulting higher tax base is not offset by lower tax rates. Instead, tax rates on the pass-through manufacturer just went up. Corporate-only tax reform represents a double whammy on pass-through businesses’ higher tax rates imposed on a broader base of income.
To address this challenge, some advocates have suggested allowing pass-through businesses a deduction on their income, or even separating pass-through business income from individual income and taxing it at different rates. While these options might mitigate the adverse impact of corporate-only tax reform on pass-through businesses, it also inflicts serious damage to the tax reform effort in general.
Prior to the 1986 Tax Reform Act, the tax rates on individuals and pass-through businesses were significantly higher than the tax rate imposed on C corporation income. Here is how tax attorney Tom Nichols described the situation during his testimony before the Ways and Means Committee last year:
This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations. Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful. These provisions included Internal Revenue Code (the “Code”) Sections 302 (treating certain redemptions of corporate stock as dividends) and 304 (treating the purchase of stock in related corporations as dividends), as well as Code Sections 531 (imposing a tax on earnings retained inside the corporation other than for the reasonable needs of the business) and 541 (imposing a tax on the undistributed income of personal holdings companies deriving most of their gross income from investments).
In other words, business owners began making decisions based on the tax code and not on the needs of their business. The 1986 Tax Reform Act ended this dynamic. Corporate-only tax reform would restore it. It is literally ”anti-tax reform.”
Buffett Tax: The Buffett Tax is again included in the President’s budget submission as a means of raising revenue while ensuring that the tax code is more progressive and fair. Despite the frequency with which the President and others talk about the need for the Buffett Tax, the arguments in favor of the tax are uniformly weak.
Congressional Budget Office (CBO) analysis makes clear that the federal tax code is already strongly progressive. According to the CBO, the top 1 percent of taxpayers in 2009 paid an effective tax rate of 29 percent, or nearly three times the effective tax rate paid by moderate income taxpayers (11 percent).
Moreover, we already have three tax codes for individual income, not counting the payroll tax system used to finance Social Security and Medicare. That is, we already impose three distinct tax rate structures on three distinct definitions of income earned by individuals and pass-through business owners:
- The Individual Income tax
- The Alternative Minimum Tax (AMT)
- The Affordable Care Act Investment Tax
By any reasonable standard, tax reform should seek to reduce rather than to increase the number of tax codes we impose on families. Yet proponents of the Buffett Tax would impose yet a fourth tax code, this time on families and pass-through businesses earning in excess of $1 million dollars.
Under the Buffett Tax, families and business owners earning that much in income would need to calculate their taxes four different ways! First, they would calculate their taxes under the Individual Income tax, then under the new Investment Surtax, then under the AMT, and then, after adding all those taxes together, they would need to calculate their overall Buffett Tax liability and see if it is higher.
On this basis alone, Congress should reject the Buffett Tax concept.
For S corporations and other pass-through businesses, however, there are other reasons for rejecting the Buffett Tax. As discussed above, S corporations must make quarterly distributions sufficient for their shareholders to pay taxes on the business income. The Buffett Rule would exacerbate this challenge by forcing an S corporation to calculate and distribute additional earnings, even if only one of its shareholders has (or might have) income subject to the Buffett Tax. The result would be to drain additional capital and resources from S corporations seeking to build up their equity and working capital.
Finally, perhaps the most dramatic and unfair consequence of the Buffett Tax for closely-held business owners would occur in the context of a sale of the business. The current federal tax rate for sale transactions is 20 percent (before taking into account the 3.8 percent additional tax on net investment income). The Buffett Tax would increase this tax rate for taxpayers making more than $1 million, even if that higher income was triggered by a once in a lifetime transaction involving the sale of a business built up over decades, effectively punishing entrepreneurs for starting and building a successful business.
By definition, both corporate-only tax reform and the Buffett Tax would make the tax code more, not less, complex. They are anti-tax reform and should be rejected by Congress.