- January 2013
The fiscal cliff compromise legislation enacted in early January was predominately a tax bill (and did little to address out-of-control spending, see separate staff report), raising hundreds of billions in new revenue and significantly altering the tax landscape going forward. While there was a lot to dislike about both the tax bill and the unseemly process that led to its passage, the legislation did contain some very good provisions. Most important, many of the tax changes in the bill were permanent changes, removing in those cases the uncertainty that taxpayers have faced during the 12-year drama of expiring tax rates.
Among the most significant provisions:
- Marginal income tax rates are permanently extended for taxpayers earning up to $400,00 for singles and $450,000 for married couples (unfortunately, the reduced rates for earners above those thresholds will return to the pre-2001 level of 39.6 percent);
- Capital gains and dividends tax rates are permanently extended at 15 percent up to the $400,000/$450,000 income levels and permanently set at 20 percent above those incomes (note that under the previous law dividends would be taxed at the taxpayers’ individual tax rates of up to 39.6 percent -- before the ObamaCare 3.8 percent Medicare surtax on investment income and .9 percent Medicare tax increase take effect);
- The Death Tax is permanently set at 40 percent of estates over $5 million per spouse, and current policy on portability and unification were made permanent;
- The phase-outs of the personal exemption and itemized deductions (PEP and Pease) were permanently repealed for earners under $250,000 (single) and $300,000 (married) (but these phase-outs are reinstated for upper income earners) ;
- The Alternative Minimum Tax (AMT) was permanently “patched” and indexed to inflation;
- The temporary payroll tax cut was allowed to expire;
- Bonus depreciation (50 percent) was extended for one year; and
- Section 179 small business expensing was extended at $500,000 through 2013 (after which the amount is scheduled to revert to the pre-2001 level of $25,000).
Literally dozens of additional tax code provisions were also extended for one or two years, including many business tax credits and deductions generally packaged together as an “extenders bill.”
With so much of the uncertainty removed from the tax code, attention is likely to turn this year on Capitol Hill to comprehensive tax reform.
Prospects for tax reform:
House Ways and Means Committee Chairman Dave Camp (R-MI) has long been a strong champion of comprehensive tax reform, and is joined in that commitment by Senate Finance Committee Ranking Republican Orrin Hatch (R-UT). Ironically, both the temporary and permanent extensions in the tax bill enacted in January provide incentives for acting on comprehensive tax reform in this Congress.
First, comprehensive tax reform would be expected to be permanent – not another 10-year hodge-podge of temporary and expiring tax law. And given our spiraling debt, a reform package would be expected to be either revenue-neutral or to raise more revenue. In that context, the importance of the permanence of the extensions enacted in January cannot be exaggerated: extending the individual income, capital gains and dividend tax rates “scores” as a revenue loss of $1,052.273 trillion (over ten years), and “patching” AMT and indexing it to inflation costs a staggering $1.815 trillion. Had those provisions been temporary rather than permanent, legislators crafting comprehensive reform would have had to find sufficient revenue to cover the permanent enactment of those provisions, before they even began considering other reforms of the code.
(There is of course a down-side to these tax provisions being permanently enacted without offsets in the fiscal cliff legislation: the Congressional Budget Office (CBO) reported that the legislation will increase the federal deficit by more than $3.5 trillion. There will have to be an accounting for that increased deficit as Congress tackles the next fiscal reform effort, but at least it can be considered in context of overall fiscal policy and spending, not automatically come from the tax/revenue side of the equation.)
Second, the fact that the new law extends only temporarily dozens of expired or expiring provisions means that all of those provisions are now set to expire yet again at the end of 2013 or 2014. The irrational moving target of temporary tax law creates taxpayer uncertainty and inspires creative tax avoidance – both of which can be eliminated by enactment of comprehensive tax reform.
Components of the tax reform debate:
Taxing the rich: The just-enacted tax bill increases tax rates on upper income individuals and pass-through companies, a policy demanded by President Obama as part of his campaign to “make the rich pay their fair share.” Having now had to permit the top rate to rise in order to prevent a $4 trillion tax hike on all taxpayers, Congressional Republicans argue that the next step in fiscal reform must be reining in runaway government spending.
However, in a press conference just before Congress acted on the fiscal cliff legislation, the President announced that he would insist on even more tax increases as part of further fiscal reform. He has subsequently reiterated his demand that “millionaires and billionaires” pay “a little bit more.”
The President has made the “fair share” argument a fundamental part of his governing philosophy, but he deliberately ignores the facts in making the argument. Upper income earners now pay far more than their fair share, as tax distribution tables and the progressivity of our tax code clearly demonstrate. According to IRS date analyzing the 2010 tax year, the top 1 percent of income earners paid 37.4 percent of income taxes; the top 5 percent paid 59.1 percent of taxes; the top 10 percent paid 70.6 percent of taxes, and the bottom 50 percent of earners paid only 2.4 percent.
More important in the context of tax reform, there simply is not enough revenue available from the top tax bracket payers to finance tax and fiscal reform, even if we were to enact completely confiscatory tax rates. As the CATO Institute’s Dan Mitchell wrote in a Wall Street Journal article in January, 2012:
“[T[here aren't enough wealthy people to finance big government. According to IRS data from before the recession, when we had the most rich people with the most income, there were about 321,000 households with income greater than $1 million, and they had aggregate taxable income of about $1 trillion. That's a lot of money, but it wouldn't balance the budget even if the government confiscated every penny—and if it did, how much income do you suppose would be available in year two.
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. What the President proposes is not more “fairness” in our code; it is more redistribution of wealth.
Corporate vs. individual tax reform: We can expect an increase in the intensity of the debate over whether reform of the individual and corporate tax codes should be handled separately or as one package. 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.
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. Based on results of a survey conducted of our members, 62.4 percent of NAW member companies are pass-throughs; 37.6 percent are C-Corps. 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 the corporate tax rate were to be reduced without a commensurate reduction in individual rates, 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, in addition to the just-enacted increase in the top marginal rate to 39.6 percent, upper income earners will pay an additional .9 percent Medicare tax, PLUS a .3.8 percent Medicare payroll surcharge on the UNEARNED income – a top marginal tax rate of more than 42 percent.
The largest U.S. corporations can be expected to focus on the corporate tax rate, but the recent fiscal cliff debate has brought the interests of those large corporations into direct conflict with those of individual taxpayers and pass-through businesses. For example, as the debate in Congress heated up in December, a group of about 170 CEO’s of large corporations jointly signed a Business Roundtable (BRT) letter to Congress and the President calling for new revenues to deal with the fiscal crisis and specifically opening the door to having that revenue come from increased individual income tax rates – reversing BRT’s previous call for extending all the individual tax rates. (You can read the BRT letter here.)
Adding to the controversy, Boeing CEO and BRT Chairman Jim McNerney, in a press call following release of the BRT letter which opened the door to increased individual tax rates, called for lowering corporate tax rates: “Some of the optimism from earlier in the year can be regained, McNerney said, if lawmakers do something to avert the fiscal cliff—with corporate tax reform in the mix. His personal view, he said, is that reform should be revenue-neutral. Drop the corporate tax rate, slash deductions, and free up money trapped abroad, he said. But do it in a way that doesn’t increase the corporate tax burden.” (emphasis added - National Journal, December 12, 2012)
Reaction from the small business community was swift and angry. In a release from the National Federation of Independent Business, NFIB President Dan Danner said: “It’s easy for corporate CEOs to say that individual tax rates ought to be raised; their companies don’t pay taxes at the individual rate . . . It’s easy for big business to point to another group and say ‘raise their taxes . . . It’s unfortunate that some business leaders are so cavalier in asking the government to raise taxes on someone else – namely, on small business – while protecting corporate profits and Wall Street.”
Reaction from Capitol Hill was also swift. Ways and Means Committee Dave Camp and Finance Committee Ranking Republican Orrin Hatch sent a strongly-worded letter – to each of the of the CEO’s who signed the BRT letter – objecting to their call for individual tax rate increases and calling on them to support tax reform that benefits small as well as large businesses. You can read the Camp/Hatch letter here.
Effective vs Marginal tax rates: Related to the debate over individual vs corporate income tax rates is the issue of effective vs marginal income tax rates. This issue has increased in intensity in the last year or two as a result of news reports about multi-national corporations taking advantage of deferral of taxes on foreign income, foreign tax credits and the many complex provisions in the tax code that enable them to shift their money from country to country without incurring any US tax obligations. Many of these multi-national firms pay effective corporate income rates in the US of far below the marginal 35 percent rate – some actually getting U.S. tax refunds.
GE was the poster child for this story for many months, but recent stories detailing the tax-avoidance actions of companies like Google, Starbucks, Amazon and Apple have forced GE to share the stage. (You can read a recent article describing Google’s tax avoidance actions here.)
The inescapable result of large, multi-national firms reducing or eliminating their U.S. corporate tax liability is a cost-shifting from the multi-nationals with low effective rates to the mostly-domestic companies with high effective rates. Most wholesaler-distributors are high effective rate payers – our survey data shows that NAW C-Corporations have an effective tax rate of 31.9 percent on average – and so they and others are bearing an unfair and disproportionate share of the corporate income tax burden.
Tax reform advocates often call for reform that lowers rates, eliminates deductions and broadens the tax base to create a more fair system. For that goal to be achieved, however, it is effective and not marginal rates that have to be considered. In that context, the high-rate-paying C-corporations will have much more common with high-rate-paying S-corporations than with the large corporations with very low effective rates.
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, and we expect it to again be proposed in 2013. 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, last summer a 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).