- January 2012
The expiring 2001 and 2003 tax rate reductions:
It’s Groundhog Day again, as Congress is yet again facing the looming expiration next January of the income, capital gains and dividend tax rate reductions enacted in 2001 and 2003, a significant increase in the estate tax and an un-patched AMT reaching millions of additional middle class taxpayers.
As noted in the separate staff report on budget and fiscal matters, the tax issue is complicated this year by the mandate to Congress to impose discretionary spending caps and to make plans that accommodate the spending sequester set to take effect in January 2013. (It is worth noting that there has already been discussion in Congress about passing legislation to repeal or modify the sequester before it takes effect next year.)
Allowing the reduced tax rates to expire (including not patching the AMT) would increase Federal revenue by more than $ 4 trillion, based on the static economic scoring the government uses, and would – at least in theory – address the debt and deficit crisis almost without having to tackle government spending. While some therefore advocate allowing the reduced rates to expire; others argue that raising taxes would have a disastrous impact on our already weak economy by slowing growth and recovery and costing jobs. Many also argue that it is too much government spending that has caused our debt crisis, not too few taxes.
The issue is further complicated by the class warfare and “rich versus poor” arguments that permeate the political debate today. Allowing all the tax rate reductions to expire would impose a tax increase on taxpayers at all income levels, including middle and lower income earners – a tax hike that President Obama and his Congressional allies oppose and believe would be politically damaging to their re-election prospects. They argue instead that taxes should be raised only on upper income earners.
Republicans argue that taxes should not be raised at all, especially during a recession, and that raising taxes on upper income earners penalizes success and would cause economic harm to the job-creating businesses that file taxes under the individual rather than the corporate tax code.
These are arguments that have been made repeatedly in recent years, and we can expect them to intensify as the November elections and the deadline for Congressional action to extend the reduced rates both approach.
The payroll tax cut debate:
Congress ended its first session last December tangled in a messy fight over whether to extend the payroll tax cut that was enacted a year earlier, arguably to put more money directly into the economy to stimulate spending and create jobs. That tax cut was scheduled to expire December 31, 2011.
After weeks of wrangling over whether to enact a full-year or short-term extension of the payroll tax cut and how to “pay for” that cut, the Senate and House finally agreed to enact a short-term, two-month extension to prevent a tax increase this month (the Senate position), but to proceed on a regular-order basis with a formal conference committee of the House and Senate to consider a longer-term resolution to the matter (the House position).
Significantly, the payroll tax cut issue may end up having consequences far beyond that single tax issue. First, there are a number of additional tax measures in search of a legislative vehicle, including a number of so-called “extenders” – provisions of tax law like the R&D tax credit which are technically temporary but are extended every year. The bill will also most likely carry an extension of unemployment insurance (UI) benefits.
Finally, the year-long extension of the payroll tax rate cut “costs” a significant amount in terms of lost revenue. The tax extenders also involve lost revenue, and the unemployment insurance is direct spending. The larger the package of measures Congress considers in the payroll tax cut bill, the more new revenue the conferees will need to find to “pay for” the tax cuts and UI extension. We are watching this process closely to ensure that LIFO repeal or other business tax hikes do not become “pay-fors” in the payroll tax conference report.
Comprehensive tax reform:
While the chances that Congress and the President will agree on a comprehensive tax reform bill in this volatile election year are very small, there is enough discussion of the issue that it warrants mention and commands our continuous monitoring.
In principle, tax reform is a worthy goal. However, there is a growing division between domestic companies that pay an effective corporate income tax rate at or above the marginal 35% rate, and the large multi-national firms that have been able to significantly reduce their U.S. taxes through use of preferences in the tax code (many of which they lobbied to have included in the code), especially foreign tax credits and deferral of taxes on their foreign income. As case in point, GE has been on the receiving end in the last couple years of a lot of attention for paying no U.S. corporate income taxes on billions of dollars of US revenue. GE has become the poster child for corporate tax avoidance, but they are not alone in their notable success in reducing their effective tax rates to single digits.
The inescapable result of large, multi-national firms reducing or eliminating their U.S. corporate tax liability is a cost-shifting: the mostly domestic companies – and most wholesaler-distributors – end up bearing an unfair and disproportionate share of the corporate income tax burden. Therefore real tax reform that lowers rates and broadens the tax base would be welcome. But, as always, the devil is in the details.
C corporations vs. pass-through businesses:
Also critical to the discussion of tax reform is the question of whether we should tackle reform of just corporate income taxes, or of both the individual and corporate tax code. This is of immense importance to the business community because of the growing predominance of Subchapter S Corporations and other “pass-through” entities (i.e., partnerships, sole proprietorships, and limited liability corporations) in the economy today.
Pass-through entities, of course, do not pay corporate income taxes, but pass their earnings through to their shareholders, owners, partners, etc., who then pay taxes on those earnings on their individual tax returns. And pass-through entities are growing at a pace that far outstrips traditional C corporations. According to the Tax Foundation, there are approximately 1.9 million C-corporations in the U.S. today, and about 30 million pass-through entities. And according to a study completed just this past April by Ernst and Young, in 2008 pass-through entities comprised nearly 95 percent of all businesses, and employed 54 percent of the private sector workforce.
If only the corporate tax code is reformed with a significant reduction in corporate income tax rates and elimination of deductions and preferences, the result could be a more level playing field and even-handed corporate tax policy, although inevitably some corporations would end up owing more taxes and some less.
However, if the individual tax code is not reformed at the same time, the impact on the millions of mostly-small pass-through entities could be devastating. These businesses could lose the deductions and preferences that would be eliminated through corporate reform, without a compensating reduction in their marginal tax rates. In fact, under current law, the top marginal individual income tax rate will rise to 39.6 percent in 2013, with an additional 3.8% Medicare tax on upper income earners, PLUS a .9 percent Medicare payroll surcharge on the UNEARNED income of those upper income earners. In other words, if the corporate income tax code is reformed and the individual code is not, pass-through entities would lose some or all of their traditional business deductions and pay a top marginal tax rate of more than 42% on a significantly greater amount of their income.
The Obama Administration has consistently advocated reforming only the corporate code, while allowing individual rates to rise for upper income earners as they will under current law. Even more alarming, Treasury Secretary Tim Geithner has made several comments questioning whether companies should continue to be allowed to organize as pass-through entities in the tax code at all; a question also raised just this month in a front-page article in the Wall Street Journal.
(As an aside, during the tax debates in Congress last fall, imposing an income tax surcharge on incomes over $1 million of up to as much as 5% was considered. Several proposals were defeated in the Senate in large measure because of the impact of such a surcharge on business. According to recent Treasury Department data, of the 392,000 tax filers reporting Adjusted Gross Income (AGI) over $1 million, 311,000 of them were small business owners and a full 331,000 reported business income. In other words, 4 out of every 5 taxpayers who would be subject to the surcharge are business owners.)
While the prospect for enactment of comprehensive tax reform remains small, proposals have recently been floated that warrant watching. Last April, Senators Ron Wyden (D-OR) and Dan Coats (R-IN) introduced a tax reform bill that, while containing many sound reform policies, would reduce the corporate income tax rate to 24 percent while creating a top individual rate of 35 percent – an 11-point disparity likely to cause a great deal of harm to small business.
And more recently, Senator Rob Portman (R-OH) floated a corporate tax reform proposal that includes a reduction in only the corporate income tax rate. Senator Portman’s proposal is still being developed and he is aware of the problem caused by lowering corporate but not individual rates, but it is not yet clear how he will address the issue.
Finally, the Chairman of the House Ways and Means Committee, Dave Camp (R-MI) is a strong proponent of broad-based tax reform, but has clearly stated his intent to tackle both the corporate and individual rates at the same time.
NAW manages the Tax Relief Coalition, which has advocated for pro-business tax policy and lower tax rates since its creation in 2001. TRC today continues to advocate for sound tax policies, includes reform of both the corporate and individual tax code in its mission, and will be closely monitoring movement on the tax reform front this year.
As you know, LIFO repeal was included in each of the budgets the President submitted to Congress, and we expect it to again be in the Budget he submits in February. In addition, the Deficit Reduction Commission recommended LIFO repeal in its December 2010 report to the President. Most recently, last summer the President and Congressional Democrats recommended that LIFO repeal be included in a debt limit extension package.
NAW member companies and the members of our NAW-led LIFO Coalition have been aggressive and effective in making the case for LIFO to critical members of the House and Senate, and we believe are largely responsible for the fact that no action has been taken on repeal legislation. The success in preventing action on repeal is a text-book case of what business can achieve when it fully engages in the legislative process.
Despite the effectiveness of the businesses that worked to defend LIFO, we remain very concerned about possible repeal. In anticipation of the possibility that major tax reform might be considered in this Congress, the LIFO Coalition has resumed our grass-roots effort, especially with the key members of the tax-writing committees and the Congressional leadership. We are also, obviously, staying in close touch with those members outside the committees who have tax reform proposals of their own.
We also continue to monitor the activity at the Securities and Exchange Commission (SEC) as they move toward a decision on convergence of U.S.GAAP with the International Financial Reporting Standards (IFRS). Our most recent intelligence suggests that the Commission may have all-but-abandoned attempts to conform LIFO usage with IFRS, which would be very good news as it would remove one of the incentives for Congress to act on a legislative repeal (in order for Congress to spend the additional revenue that LIFO repeal would generate, there has to be a piece of legislation which the Joint Tax Committee can “score” to determine the amount of revenue it will produce; repeal by regulatory action of the SEC would not be “scored” and therefore the revenue would not be available for Congress to appropriate).
Repeal of the 1099 requirement and 3 percent withholding:
While very little tax legislation was even considered during 2011, two important tax measures were passed and signed into law.
First was the so-called “1099 bill” repealing the ridiculous provision in ObamaCare that would have required businesses to send 1099 forms to any entity to which they paid more than $600 a year – in the aggregate. After an aggressive lobbying effort, and despite the President’s initial support for the requirement, the 1099 provision was repealed; a huge victory for the business community.
Second, NAW has been working with the Government Withholding Relief Coalition to secure enactment of legislation to repeal the law that would have required government agencies to withhold 3% of the payment owed to government contractors for goods or services those contractors provided. The misguided withholding requirement was enacted in 2005 to address the so-called “tax gap” – the billions of dollars of taxes owed-but-not-collected every year – but was an ineffective and punitive over-reach and was therefore never implemented as the effective date was repeatedly postponed. After a six-year effort, the law was finally and permanently taken off the books when President Obama signed the repeal bill into law last November.