The story on tax reform continues to progress. Last week, the Senate Finance Committee held another in its series of hearings on the various aspects of reform. This hearing, entitled “How do Complexity, Uncertainty, and Other Factors Impact Responses to Tax Incentives?” brought forth witnesses Dr. Robert Carroll, Dr. Eric Toder, and Dr. Raj Chetty.
The internet feed of the hearing was playing in the background on our computers last Wednesday when this exchange took place:
Senator Snowe: Dr. Carrol, could you give us some comments on [the corporate-only approach to tax reform because that is a problem, requiring flow-throughs to be obviously double taxed at both the entity level and the individual level rather than simply paying one tax rate?
Dr. Carroll : I think a very large consideration is the role of the corporate tax and the role of flow-throughs – one of the advantages of the flow-through reform is it affords businesses and business investment one single layer of tax for businesses operating in the flow-through form that are not subject to the double tax. And the double tax brings with it a lot of important tax biases. It affects business decisions in important ways; it discourages the incentive for companies to pay out profits as dividends, which affects corporate governance, it affects the debt equity choice. It raises the overall cost of capital in the economy. And those are all considerations that I think need to play into that discussion.
Senator Snowe: I appreciate that. Does either one of you want to comment, Dr. Chetty, Dr. Toder?
Dr. Toder: I would certainly agree with most of what Dr. Carroll said, and really note that the ideal way to tax business income is the way we tax S corporations. We would like to attribute the income to the owners and the only reason we have a corporate tax is for large and frequently traded companies–very hard to do that and identify the owners who would pay the tax. So where you can do that, we should do that, and that is the right treatment. And I also believe we can’t look at corporate tax reform in isolation without looking at the effect on flow-throughs, and also the effect on the taxation on corporate income at both the individual and the corporate level. Part of the reason we’ve given tax breaks to individuals in very low capital gains and dividends rates is to adjust the double taxation of corporate income. And so if we are going to reduce the corporate rate we might think about how we tax individuals and maybe we don’t need to give them as much preferential treatment. But I think putting things in a box-corporate tax here and individual tax there is not the right way to go.
Obviously, we added the emphasis there to highlight the line that caught our attention. We’ve known from his past work that Dr. Carroll recognizes the value of the pass-through tax structure to encourage capital investment and employment. It’s great to see that Dr. Toder recognizes its virtues as well. This is exactly the message we’ll be taking to the Hill in the next month.
Ryan Budget
House Budget Committee Chairman Paul Ryan introduced his budget plan this morning. As The Hill notes, the release of this budget coincides with the latest round of negotiations for the current year’s funding.
This week, all eyes will be on Capitol Hill to see if lawmakers can hammer out a spending agreement that will yet again avert a government shutdown.
The current continuing resolution will fund the government through April 8, and Republicans and Democrats are still haggling over a long-term spending package. With conservatives pushing for deep cuts and contentious policy riders as part of any agreement, Congress still has work to do if it wants to keep the government up and running for the rest of the fiscal year.
Next year’s budget will also be a hot topic this week, as House Budget Committee Chairman Paul Ryan (R-Wis.) is slated to unveil his 2012 budget resolution on Tuesday. Ryan will likely propose changes to Medicare and Medicaid, but will stop short of specific recommendations on Social Security.
The budget itself is an aggressive effort to get federal spending and deficits under control. According to the Wall Street Journal:
House Republicans proposed a budget for the next fiscal year that would spend $3.53 trillion — $179 billion less than President Obama’s plan — and aims to bring the budget into balance, excluding interest payments, by 2015.
The GOP budget for 2012, crafted by Rep. Paul Ryan, would mark a reversal of a years-long trend of growing deficits.
The proposal stands little chance of becoming law, but it marks an extraordinary political statement by House Republicans, and it amounts to a gamble that voters are so concerned about the size of government that they are willing to accept significant cuts in popular programs.
On the tax front, the Ryan budget calls for comprehensive reform of both the individual and corporate codes while holding federal revenues at or below 19 percent of our national income, or roughly in line with their historic levels. The federal budget is just an outline, and all these policies would have to be enacted through the tax-writing committees, but it is nonetheless nice to see a policymaker who understands the role of pass-through firms to employment and investment.
Regarding the process, the Ryan budget is just the second step (the President’s budget is first) in a very long and often frustrating legislative dance. The House will consider this budget sometime in April, and if it passes, send it to the Senate where Senate Budget Committee Chairman Kent Conrad (D-ND) has his own ideas of what the federal fiscal policies should look like. Assuming the Senate passes its own budget variation, the two sides will get together to work out their differences.
Like the WSJ, we seriously doubt the process will get that far, but then we’ve been surprised before. These are extraordinary times for the federal government’s finances.
Wyden Tax Reform Bill Reintroduced
The Hill was on the Senate side yesterday as well, with Senators Ron Wyden (D-OR) and Dan Coats (R-IN) introducing this year’s version of Wyden’s tax reform package. The Hill writes:
Wyden and Coats could announce they are introducing tax reform legislation as early as Monday, a Senate aide said. The measure is expected to be similar to the bill that Wyden introduced last year with then-Sen. Judd Gregg (R-N.H.).
The Wyden-Gregg plan - which was released in February 2010 and did not gain much traction in a Congress that was concentrating on other issues in a midterm year - would have reduced the top corporate rate to 24 percent, from its current 35 percent.
It would have also simplified the individual code, shaving the tax brackets from six down to three (15 percent, 25 percent and 35 percent), and was found to be roughly revenue-neutral by the Urban-Brookings Tax Policy Center.
Unlike the Obama Administration’s plan for tax reform, which is limited to the corporate code only, the Wyden reform would address both the corporate and the individual side. But is it good for S corporations and other pass-through firms? Hard to tell. The Tax Policy Center has a great summary of the bill as introduced last year, and it reveals a package of changes that cut both ways. On the positive side, the Wyden bill would:
- Repeal the AMT;
- Repeal PEP and Pease;
- Increase the Standard Deduction;
- Institute a new, three rate structure of 35, 25 and 15; and
- Reduce the corporate rate to 24 percent.
Presumably the new rate structure would also eliminate the new 3.8 percent investment tax adopted as part of health care reform last year and made effective in 2013. So those are the good parts. On the negative side, you have:
- The 35 percent bracket starts much earlier;
- Higher rates on investment income (22.5 rather than 15 percent);
- Less favorable depreciation and expensing rules; and
- Repeal of other deductions applying to pass-through firms.
So, as we said, it’s a mixed bag. But the idea of holding the top pass-through rate steady (actually increasing it for a large number of shareholders — couples earning between $140,000 and $379,150, for example) while broadening their tax base raises a red flag with us.
According to the Tax Policy Center, reducing the corporate rate reduces collections by nearly a trillion dollars over ten years, while eliminating certain business tax provisions increases revenues by $768 billion. Meanwhile, the new rate schedule for individuals raises revenues by around $600 billion over the same decade. Add it up, and it certainly looks like a significant tax hike on pass-through firms. Maybe the elimination of the AMT and other provisions would offset this increase, but it is hard to see how.
That said, another report sponsored by the Manufacturers Alliance last summer had a generally favorable view of the economic benefits of Wyden-Gregg, but didn’t appear to explore the interaction between corporate and individual taxpayers.
At the end of the day, we appreciate the work Senators Wyden and Coats put into developing their tax proposal, and the fact that it attempts to make sense of both the corporate and the individual tax codes. It’s a complicated business, but we hope the introduction of this legislation helps get the broader discussion of tax reform moving.
Raising Taxes on Investors
Since we’re deep into tax reform here, another post caught our eye that was worth passing on. Howard Gleckman writes in Forbes regarding the following question, b”Should we cut corporate taxes by raising rates on investors?”
Our initial reaction was that they are one in the same. Investors own the companies after all, so a tax on one is a tax on the other. But the point of the question and the underlying Tax Policy Center paper written by Dr. Toder (the same as above), Ben Harris, and Rosanne Altshuler appears to argue that shifting the tax burden from the corporate entity to the shareholder would make it more attractive for firms to locate in the United States.
While this isn’t really an S corporation issue, it does strike us that getting the tax policy right here has implications for the taxation of all business income. As Gleckman observes:
Economists believe that all income should be taxed once but only once. By that standard, the current taxation of corporations is a mess. In theory, corporate income is double-taxed – once at the firm level and again when income is distributed to shareholders through dividends or capital gains. In reality, some is taxed repeatedly while some is not taxed at all.
To avoid this, many economists have argued for a fully integrated system where corporate income is paid either entirely at the business level or fully by shareholders. In fact, the vast majority of U.S. firms already do this by organizing themselves as pass-through entities such as S corporations and partnerships.
For those companies structured as C corporations, the advantage of shifting the imposition of tax from the entity to the shareholder is it helps make the U.S. a more attractive place to invest:
Shifting some taxes on corporate profits from firms to shareholders has some obvious advantages. The biggest may be that it would reduce those disincentives for companies to invest at home. A tax on shareholders is based on where they live, rather than where their profits are earned. Thus, a lower corporate tax and a higher shareholder tax may, on balance, help keep investment in the U.S.
Which investment?The corporate investment? Sounds plausible. But what about the shareholder investment? In the competition between U.S. and foreign investors, this policy would have the effect of raising taxes on U.S. investors and cutting them for foreign investors, resulting in a shift of ownership from domestic to foreign. So we might see more U.S. investment at the corporate level under this policy, but where would the earnings go? And the investors? Capital has the ability to cross national borders, after all.
Instead of raising taxes on shareholders, why not eliminate them, as the Bush Administration proposed back in 2003? This policy was initially developed as part of the Treasury 1992 integration study, and has as much relevance to today’s debate as it did twenty years ago. Might be something for Congress to take a look at.