- September 2012
The expiring 2001 and 2003 tax rate reductions:
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, an un-patched AMT reaching millions of additional middle class taxpayers, and dozens of additional expiring tax provisions.
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.
Allowing the reduced tax rates to expire (including not patching the AMT) would increase Federal revenue by about $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 “fairness” arguments that permeate the political debate today, emphasized by many of the speeches at the just-completed political nominating conventions. As a case in point, the Senate voted on earlier this year – and defeated – legislation to impose the so-called “Buffett Rule” to require all taxpayers with income over $1 million to pay a minimum 30% of their income in taxes. (The legislation is named after Warren Buffett who declared it unfair that he should pay a lower effective income tax rate than that of his secretary.)
The President made the “Buffett Rule” the focal point of his call for a more “fair” tax code, ignoring the fact that millionaires like Warren Buffett (and not coincidentally, Mitt Romney) pay a lower effective tax rate because much of their income is from capital gains and dividends -- return on their investments – not salary or wages. The tax code deliberately taxes investment income at a lower rate, now as low as 15%, to encourage those investments in the economy.
The President also claims that his proposed tax hike on capital gains and dividends is not only fair, but would help address the debt. These claims are simply false; the amount of revenue that would be generated from the “Buffett Rule” would not make a dent in the deficit. Charles Krauthammer, in a Washington Post column earlier this year, summed up the President’s false claim this way:
”Okay. Let’s do the math. The Joint Committee on Taxation estimates this new tax would yield between $4 billion and $5 billion a year. If we collect the Buffett tax for the next 250 years — a span longer than the life of this republic — it would not cover the Obama deficit for 2011 alone. As an approach to our mountain of debt, the Buffett Rule is a farce. And yet Obama repeated the ridiculous claim again this week. “It will help us close our deficit.” Does he really think we’re that stupid?”
The tax issues confronting our policy makers with the scheduled expiration of dozens of tax policies at the end of the year are huge, and deserve both serious and honest debate and deliberation.
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. But they argue that tax rates should go up for upper income earners so that they pay their “fair share” – ignoring the inconvenient facts that the top 5 percent of filers now pay more than 58 percent of income taxes, the bottom half of all filers pay only 2.3 percent of income taxes, and 51 percent of filers pay no income taxes at all.
In fact, according to the Organisation for Economic Co-operation and Development (OECD), the United States already has the most progressive income tax system in the industrialized world – as well as the highest corporate income tax rate. What the President proposes is not more “fairness” in our code; it is more redistribution of wealth.
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 reduce the investment activity necessary for economic growth and job creation. Increasing individual tax rates would specifically harm the job-creating businesses that file taxes under the individual rather than the corporate tax code.
Congress will have to deal with these issues before they adjourn for the year to avoid the massive tax hike that recent studies show would put our economy back into recession. In December of 2010 Congress and the President agreed on a two-year extension of all the tax rates, but this year the President has repeatedly and adamantly said that he will not sign legislation extending the reduced rates on investment and upper income earners; Republicans in the House say they will not pass legislation to extend only the lower-and middle-income rates.
Both sides believe they have leverage in this matter. The President believes the Republicans are so concerned about the defense cuts scheduled to take effect in January that they will agree to the President’s tax demands in trade for legislation changing the sequester to protect defense. Republicans believe the President needs to keep his repeated promise not to raise taxes on those with incomes under $250,000 that he will reluctantly agree to extend all the reduced rates rather than allow the tax increase on middle-income earners.
How this game of chicken will come out is obviously unknown at this point, and will almost certainly be impacted by the November elections.
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 (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 last year 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 recently 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 year, 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 has been included in each of the budgets the President has submitted to Congress. 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. With increased discussion about major tax reform, 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 have also closely monitored the activity at the Securities and Exchange Commission (SEC) as they considered convergence of U.S.GAAP with the International Financial Reporting Standards (IFRS). However, a recently-released and long-awaited SEC staff report on convergence made it clear that the Commission will not fully adopt IFRS, noting that there are accounting issues that cannot easily be reconciled, and specifically noting LIFO as a key example. Adoption of IFRS by the SEC was a serious threat to LIFO, since its use is not permitted under the international standards, and elimination of that threat is very good news as it removes 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).