- January 2015
For the first time in several years, Congress – and the taxpayers – began a year without facing any significant changes in the tax code. The Fiscal Cliff tax changes enacted in January, 2013, have now been in effect for another full year, and as tax season begins this month, a lot of upper bracket individual and pass-through taxpayers are being reminded about the tax increases that took effect last year.
Comprehensive tax reform in the last Congress:
Former House Ways and Means Committee Chairman Dave Camp (R-MI) was a strong champion of comprehensive tax reform, and was joined in that commitment by Senate Finance Committee Chairman Ron Wyden (D-OR) and Ranking Republican Orrin Hatch (R-UT).
When Congressman Camp announced his intention to retire at the end of 2014, he redoubled his effort to move tax reform in his last Congress. After months of public hearings, comments, and debate, Congressman Camp inexplicably took the tax reform debate out of public view in late 2013, initiating a series of closed-door, totally off-the-record meetings with Republican members of his committee.
The tax reform process became much less transparent as a result of the closed-door meetings, resulting in a significant concern in the business community that decisions on tax reform that would directly impact their business or that of their member companies were being made behind closed doors rather than through a process that permitted comment and debate.
In February, 2014, Chairman Camp finally released his tax reform “Chairman’s Draft” and many of the concerns of the business community were realized. There were many commendable provisions in the “Chairman’s Draft,” most notably his call for a reduction in the corporate income tax rate to 25%, with the loss of revenue off-set by the repeal of dozens of special interest deductions and tax expenditures. But Mr. Camp had long promised that his tax reform proposal would achieve tax parity between the 1.6 million C corporations and the more-than-30-million businesses organized as pass-through entities which pay taxes on the individual side of the tax code. In that critical context his proposal came up short. A significant majority of wholesaler-distributors are pass-through entities, so this issue is of critical importance to our industry.
Under the Camp proposal, the top statutory individual income tax rate – the rate paid by successful pass-through businesses – was set at 35 per cent, a full 10 points higher than the corporate rate. Even more troubling, the Camp proposal included an additional penalty for upper income earners – a “Modified Adjusted Gross Income, or MAGI – that would require those earners to include as taxable income the value of their employer-provided health insurance, contributions to IRA or 401(k) plans, tax exempt interest, untaxed social security income, and more. Those upper income individuals and pass-through businesses would also lose most of their itemized deductions, and the benefit of the lower tax rates.
Independent analyses of the Camp bill reported that the true effective top individual tax rate was closer to 45 percent than 35 percent, a full 20 points higher than the proposed 25 percent corporate rate.
Of particular interest to our industry, Chairman Camp also proposed a top individual rate of 25 percent for manufacturers organized as pass-throughs, affording one industry unfair preferential treatment over other industries. He also included repeal of last-in, first-out (LIFO) inventory accounting – see more on this at the end of this staff report.
Not surprisingly, the Camp draft received very little support from the business community, or from taxpayer advocacy groups, and it quickly moved to the back burner in Washington. Nonetheless, the proposal was of concern because it was the first broad and comprehensive tax reform proposal in Congress in decades, and could have become the starting point for reform measures in the next Congress.
Prospects for reform in the 114th Congress:
The key tax-writing players in Congress in this new Congress have all changed. Former House Budget Committee Chairman (and Vice Presidential candidate) Paul Ryan (R-WI) has taken the reins at the House Ways and Means Committee. Former Senate Finance Committee Chairman Ron Wyden (D-OR) is now that Committee’s Ranking Democrat and veteran Senator Orrin Hatch (R-UT) is the new Senate Finance Committee Chairman. All agree on the need for comprehensive tax reform. Chairman Ryan outlined the tax reform that is needed in his previous House Budgets. Senator Wyden has twice offered bi-partisan tax reform proposals, once with former NH GOP Senator Judd Gregg and then with Indiana GOP Senator Dan Coats. And in December Senator Hatch released a lengthy (340-page) “Comprehensive Tax Reform for 2015 and Beyond.”
One thing that has been missing from the recent debate on tax reform, however, is the active participation of the Administration. The last time comprehensive tax reform was successfully considered – in 1986, almost 30 years ago – President Reagan and his Treasury Department were fully committed to achieving reform, offered a series of concrete proposals, and worked with Congressional Democrats to get it done. On Capitol Hill, Democrat House Ways and Means Committee Chairman Dan Rostenkowski (D-IL) was also both committed to reform and willing to work with the Republican Administration to make it happen.
President Obama to date has shown little interest in working with Congressional Republicans on tax reform; on anything, actually. His contribution to tax reform so far has been to offer talking points rather than serious proposals – Buffet Rule upper income surcharges, repeal of the deduction for corporate jets, etc. His one serious demand has been that tax reform be used as a means to increase taxes by $1.5 trillion or more; a demand rejected by Congressional Republicans who insist that tax reform be “revenue neutral” and raises no new tax revenue.
In a surprise move, the President announced in January that he intended to offer substantive tax reform proposals – “building on what we’ve already put forward” – and that he would work with the Congressional GOP majority to achieve reform, with staff discussions starting early in the year. It remains to be seen if the White House will seriously engage, and if that engagement will include willingness to compromise. If it does not, there is little chance of reform being signed into law during his presidency.
Revenue neutrality is critical to the tax reform debate but is only one of many issues that would have to be tackled. While it is clearly not possible to cover all those issues in this staff report, few of the key issues are covered below:
Corporate vs comprehensive reform:
Probably the single most important business issue in tax reform is how to create parity in the treatment of all businesses. There are some large corporations that are advocating for corporate-only tax reform, with the reduction in the corporate tax rate off-set by repeal of the hundreds of business deductions that litter the tax code. However, corporate-only tax reform is both poor economic policy and politically untenable.
There are approximately 1.65 million C corporations today, and more than 30 million pass-through entities which pay taxes on the individual side of the tax code. As noted earlier in this report, a significant majority – more than 62 percent based on our survey – of wholesaler-distributors are pass-through businesses. If the corporate income tax rate is reduced without a simultaneous reduction in individual income tax rates, successful pass-through businesses will face significant tax hikes since they would lose their business deductions with no reduction in their tax rate.
Increasing taxes on pass-through businesses makes little economic sense. According to Census Bureau data analyzed by the Tax Foundation, pass-through entities today account for a majority of all business income, and for 54% of business employment. Moreover, historically, small businesses have been the country’s primary job-creators. The number of pass-through entities and their contribution to the U.S. economy continue to grow, so this data will only become more compelling. Clearly a tax reform proposal that taxes these businesses at a higher rate than their corporate colleagues – and competitors – makes no sense economically.
Moreover, corporate-only tax reform is politically unattainable. Any proposal to reduce the tax rate for C corporations only, leaving non-C companies subject to significantly higher individual rates will certainly be aggressively opposed by pass-through businesses. That opposition would doom tax reform politically: there is no more powerful and effective grass roots force than the small- and mid-sized businesses that are a critical part of every electoral constituency, and if they are energized against tax reform it would have little chance of passing. That political reality has resulted in an increased interest in finding a solution to the business tax issue on the part of many in the large corporate community.
In recent years, efforts to include the growing pass-through business community in the tax reform debate have been notably unsuccessful, largely because the proposals have consistently given preferential treatment to C corporations and sought only to “do no harm” to the non-C businesses rather than seeking a policy solution that treats all businesses equally. One senator pushing corporate tax reform proposed that the corporate rate be lowered to 25 percent and that pass-throughs be allowed an ill-defined tax deduction to offset their loss of business deductions while still paying the higher individual rate – to “hold them harmless.” Republicans in Congress and the Administration have offered various forms of small business tax credits. Recently, an Obama Administration asked if an increased and permanent Section 179 small business expensing allowance would be sufficient.
The response from pass-through businesses to these proposals has been firmly and consistently negative. It was pointed out by service-sector representatives that Section 179 expensing does not help them very much, and by others that not all S Corporations are small businesses eligible for either targeted tax credits or Section 179 (one Administration official responded to that by asking what would be wrong with raising taxes on large S corporations).
Pass-through businesses and their representatives in Washington have insisted on rate parity, and that approach is finally being seriously considered. These discussions are in their earliest stages, and it is not yet known what specific proposals will be offered, but we will be closely watching and participating in this debate is it moves forward.
Effective vs marginal rates:
Related to the debate over individual versus corporate income tax rates is the issue of effective versus statutory tax rates. This issue has increased in intensity in the last few years 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 U.S. tax obligations. Many of these multi-national firms pay effective corporate income rates in the U.S. far below the statutory 35 percent rate – some actually get U.S. tax refunds.
The inescapable result of large, particularly multi-national firms reducing or eliminating their U.S. corporate tax liability is a cost-shifting from those corporations 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 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, not just statutory, rates that have to be considered. In that context, the high-rate-paying C-corporations will have much more in common with high-rate-paying S-corporations than with large corporations with very low effective rates.
Dynamic vs Static Scoring:
All legislative tax proposals are reviewed by the Congressional Joint Committee on Taxation, which analyzes the proposals to determine whether each proposal will increase or decrease Federal revenue. Traditionally, Joint Tax uses a “static” score – they add and subtract revenue numbers on the assumption that no economic behavior will change as a result of the new tax policy: tax rate increases raise revenue and tax rate cuts lose revenue. “Dynamic” scoring assumes that economic activity will change in response to tax policy. For example, a reduction in the capital gains tax rate will prompt some taxpayers to sell assets they otherwise might hold, thereby increasing tax revenue and reducing the revenue loss that a static score would assume. The issue of how tax proposals are “scored” has been debated for years. Some conservatives have argued that tax cuts “pay for” themselves, raising as much revenue from increased economic activity as would be lost under a static score. Historic analysis has not supported that claim, but has clearly shown that there are behavioral changes in response to tax policy, and that static scores are inaccurate. Republicans have argued – with historical data to back up their claim – that tax cuts that spur economic growth will not result in as much revenue loss as static scoring projects. With Republicans in control of both houses of Congress now, the debate over dynamic scoring is sure to intensify.
NAW Tax Coalitions:
NAW helped form and helps manage the Coalition for Fair Effective Tax rates, which is and will remain actively involved in the tax reform debate, urging that reform be seen through the lens of effective, not just statutory, tax rates.
NAW also 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.
NAW also organized and manages the LIFO Coalition. NAW member companies and the members of the 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 to date. 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.
However, LIFO remains threatened today. LIFO repeal was proposed last year by the Obama White House, the Democratic Senate Finance Committee, and the Republican House Ways and Means Committee, despite a multi-year aggressive lobbying effort to prevent repeal.
Most troubling is the repeal proposal in the Camp tax reform bill, because their justification for repeal demonstrated a complete misunderstanding – or deliberate mischaracterization – of what LIFO is and what it does. What is clear is that for the tax-writers on the Camp staff, LIFO repeal became a source of $80 billion in new tax revenue, and the impact of repeal on the businesses which rely on LIFO was dismissed or ignored.
The LIFO Coalition redoubled its effort, mapping out a strategy to convince tax writers to remove repeal from subsequent tax reform proposals.
First, the Coalition sent a comprehensive letter to Mr. Camp and all members of the House of Representatives responding to the multiple errors and misinformation in their justification of repeal. If you are interested, you can access that letter here:
Also responding to the Camp proposal, Congressmen Jim Lankford (R-OK) and Mike Thompson (D-CA) drafted a letter to Chairman Camp urging him to remove LIFO repeal from his tax reform proposal, then circulated that letter to their colleagues asking them to add their signatures to the letter. The Coalition worked with Congressmen Lankford and Thompson to obtain additional signatures on the letter. As a result of that joint effort, 113 members of the House – a full quarter of the entire membership – added their signatures to the letter, demonstrating strong support in the House for retaining LIFO in the tax code. (Of note, Mr. Lankford was elected to the U.S. Senate in November, and plans to continue his fight for LIFO in that chamber this year.)
A similar effort was undertaken in the Senate, when the Coalition worked with Senators Joe Donnelly (D-IN) and Mike Enzi (R-WY) and helped garner 13 Senate signatures on a letter to the Obama Administration urging them to omit LIFO repeal from their tax proposal.
The Coalition also raised the funds necessary to enable us to hire a consulting firm to develop and implement a grass tops campaign. This effort is on-going, and has resulted in numerous very helpful contacts with key members of Congress, in their home states and districts, by business constituents, explaining the importance of LIFO to their businesses.
We expect LIFO repeal to again be a part of the tax reform debate in this Congress, but are fully committed to continue our so-far-successful 9-year effort to prevent repeal.