On the heels of the release of the Ways and Means Committee’s discussion draft to reform the international tax code and drop the corporate rate to 25 percent, a Subcommittee of the House Committee on Small Business held a hearing Thursday morning to discuss how and why the business tax reform needs to include pass-through businesses.

Entitled “Pro-Growth Tax Policy: Why Small Businesses Need Individual Tax Reform,” the hearing was rife with good testimony. Tax Notes had a nice write-up on it this morning:

“Flow-through businesses would lose the benefit of widely used and long-standing provisions, such as accelerated depreciation and the charitable giving deduction,” Carroll said. He argued that while lower rates and a broader base generally benefit the economy, pass through businesses won’t benefit from that type of corporate reform as much as their C corporation counterparts. Only lower individual rates can benefit the more than 90 percent of total business entities organized as passthroughs, he said.

Carroll was joined on the panel by three small business owners, all of whom said the most important aspect of any tax reform is to provide a degree of certainty for planning purposes. To that end, they said many of the most popular expiring provisions, such as the research and development credit, should become permanent.

Subcommittee Chair Joe Walsh, R-Ill., noting that 54 percent of private-sector employment comes from passthrough entities, said that any tax reform proposals should not discourage passthroughs from adding employees. “Enacting policies that will keep passthrough taxes low will help small businesses spur our economy,” he said.

Bob Carroll, whose study continues to serve as the seminal piece of research on the macroeconomic impact of the pass-through sector, offered his testimony on how piece-meal tax reform could impact pass-thrus:

Elimination of business tax expenditures to finance a lower corporate rate can raise substantial issues for flow-through businesses. Flow-through businesses could potentially lose the benefit of widely used business tax provisions without the benefit of the lower corporate tax rate.

Based on Ernst & Young LLP estimates, eliminating all businesses tax expenditures would increase the income taxes paid by individual owners of flow-through businesses, on average, by 8 percent or $27 billion annually from 2010 through 2014.

He also discussed the value of the pass-through model to small business owners:

The expansion of the flow-through sector provides the important benefit of reducing the scope of the double tax on corporate profits, as well as providing additional flexibility in the ownership structure of businesses that may provide a better match to their management needs and capital requirements.

William Smith of Termax Corporation, an S corporation located in Lake Zurich, Illinois that employs 250 people and makes quality engineered clips and fasteners, made an important point regarding where companies like his get their capital:

Many companies like ours are structured this way because we are family owned businesses with a limited number of shareholders and owners who are often our siblings and increasingly our children and grandchildren. We initially became an S Corporation to avoid the double-taxation that a C Corporation faces.

The vast majority of company owners like us leave most of the money in the business, directly reinvesting in our employees, facilities, and equipment. This is an important point. Due to our current U.S. tax code, we are taxed on income we do not take out of the company but leave in the business to reinvest. This means we have fewer resources to put towards hiring, training, and buying new machines. In speaking to a few companies in our industry from Illinois, Wisconsin, and Ohio, small and medium sized manufacturers, based on wage and K-1 income, pay 36% in taxes, distribute 18% to owners, and reinvest 46% in the business.

And then Stephen Capp from Laserage Technology Corp, a forty-year-old high tech firm based in Waukegan, Illinois, made the case for keeping tax rates the same:

At the very least, the tax rate paid by pass-through businesses should be the same rate that applies to C Corps. Reducing the taxes for both S Corp and C Corp manufacturers would make us both more competitive relative to goods made elsewhere in the world. In addition, losing deductions without corresponding relief by lowering tax rates would similarly place Laserage at a competitive disadvantage. Losing the benefit of these deductions without corresponding relief in the form of rate reductions would be harmful to Laserage.

Just like our letter says.

Camp Releases International Reforms

As promised, Ways and Means Chairman Dave Camp released a draft of possible reforms on how we tax overseas income earned by U.S. businesses. The draft includes several options and is designed to begin the conversation regarding broader tax reform. In a release accompanying the draft, Camp made clear what the plan is:

Today, Ways and Means Committee Chairman Dave Camp (R-MI) unveiled an international tax reform discussion draft as part of the Committee’s broader effort on comprehensive tax reform that would lower top tax rates for both individuals and employers to 25 percent. In addition to rate cuts, the plan would transition the United States from a worldwide system of taxation to a territorial system - a move virtually every one of America’s global competitors has already made.

Camp unveiled the draft legislative language with a specific request - that employers, academics, practitioners and workers provide comment and add their voices to the legislative process.

What are our take-aways? Couple keys:

  • First, Chairman Camp is committed to approaching tax reform in a comprehensive fashion that includes both the corporate and individual tax codes;
  • Second, Chairman Camp is committed to a transparent process where stakeholders have an opportunity to fully review and comment — before they are voted on by Congress; and
  • Third, corporate reform is hard!

This last observation is targeted at all those who argue that Congress should take up corporate reform now and save the individual reform for later because, they claim, “corporate reform is easier.” Last week’s release demonstrates just how complicated it is.

So all in all, the roll-out of the international reforms last week is a big positive for the pass-through community. We are currently reviewing the draft and will have comments at the appropriate time, but to begin it’s appropriate to thank Chairman Camp for taking on this enormous task, and doing it in a manner that reflects extremely well on the Committee and the Congress.

Corporate-Only Reform — Never Say Die

Meanwhile, the push for corporate-only reform continues its death spiral. It’s reached the denial stage. According to CQ (“Corporate-Only Tax Rewrite Has Its Defenders):

Contrary to common assumptions, the challenge of rewriting the corporate tax system on its own is “political more than technical,” said John Buckley, a visiting professor at Georgetown University’s law school and a former Democratic aide on the Ways and Means Committee. Buckley and others argue that a corporate tax overhaul would be the most direct response to tax changes that other developed economies have embraced during the past decade.

We like John, but we’re not sure we agree. The challenge is both technical and political. Certainly, cutting taxes on large multinational corporations and paying for it by raising taxes on everybody else presents a formidable political challenge, but so does the policy of making wholesale changes to the corporate code. As evidence, review the international draft released by the Ways and Means Committee last week. It’s an impressive array of decisions and trade-offs. And that’s just one sliver of overall corporate reform.

Beyond this basic disagreement, we have been bothered by another apparent contradiction in the “corporate-only” push. The effort focuses cutting the tax rate paid by U.S. corporations. Our rate is significantly higher than the rate most foreign countries charge, and it makes investment in the U.S. less attractive. Fair enough.But those same advocates rarely include the second layer of the U.S. corporate tax in their reforms. In fact, many of them argue that we should raise taxes on dividends and capital gains to pay for it! President Obama appears to have taken that position, as have others. Here’s Martin Sullivan:

One novel approach to paying for a reduction in the corporate tax rate would be to increase the tax rate on capital gains and dividends, currently at 15 percent. Economists have long favored eliminating double taxation of corporate income, which can be done by eliminating tax at either the corporate or shareholder level.

In the past, the approach generally favored by Treasury to alleviate double taxation has been to reduce shareholder taxes. In his March 8 testimony before the Senate Finance Committee, Prof. Michael Graetz of Columbia Law School, a former Treasury official, said the Treasury approach has not withstood the test of time. Graetz has suggested a cut in the corporate rate and a tax increase on individuals in the form of a withholding tax on corporate shareholders and bondholders.

Since all business taxes — corporate, dividends, capital gains — are really shareholder taxes, how do you justify cutting taxes at the entity level but raising them at the shareholder level? It turns out there’s an explanation. More from Sullivan:

In a 2010 paper, economists Rosanne Altshuler, Benjamin Harris, and Eric Toder explored the possibility of returning the top dividend and capital gains rates to their pre-1997 level of 28 percent (“Capital Income Taxation and Progressivity in a Global Economy,” Tax Policy Center (May 12, 2010). They made a number of interesting observations. First, most OECD countries have moved in the opposite direction of the United States and have raised shareholder tax rates while lowering corporate rates. Second, because the cross-border mobility of individuals is less than that of corporations, such a change would reduce tax distortions in economic decision-making. Third, because the burden of corporate taxation is believed to increasingly fall on labor, a shift in tax from corporations to shareholders would increase the progressivity of the tax system. Lastly, the authors made a rough estimate and predicted that increasing the tax rate on dividends and capital gains to 28 percent could pay for a corporate rate reduction from 35 percent to 26 percent.

In other words, since corporations are more mobile than people, its better to raise taxes on people. You’ll preserve more of your tax base that way. There’s a certain level of reasonableness to this argument — from a tax collector’s point of view if not a politician’s — but it fails to recognize the most mobile asset of all: capital. The double tax on corporations is a tax on capital — the money people invest in the company. By cutting corporate rates, but raising rates on dividends and capital gains, you are failing to reduce the overall tax on capital, so you’re failing to encourage more of it to come here.

If tax reform is going to make investors more likely to invest and create jobs here in the United States, it’s going to need to reduce the overall tax burden on all forms of domestic business investment.