- June 2016
The endless tax-extenders:
For the first time in decades, Congress – and the taxpayers – rang in a new year without starting a year-long kabuki dance working toward the December extension of a long list of expiring tax provisions. The final tax bill enacted at the end of last year made the most significant of the “tax extenders” permanent – a measurable victory for business and individual taxpayers.
The permanent extension of more-than 20 of the repeatedly-expiring tax provisions was important not just for the certainty it provides to taxpayers, but because it will help pave the way for much-needed comprehensive tax reform. Without going deeply into legislative weeds: “revenue neutral” tax reform legislation will be required to meet a “revenue baseline” calculated by the Congressional Budget Office. The repeated expiration and subsequent extension of the revenue-reducing tax extenders created artificial increases in that baseline, thus requiring tax reform legislation to raise billions more in revenue than it otherwise would. Permanent enactment of the extenders will stop that see-saw effect, change the baseline, and make tax reform a more achievable goal.
Real Tax reform: What will it look like?
The GOP Leadership in both houses of Congress, and some key Democratic tax-writers, have long championed comprehensive tax reform. Last year the Chairmen of both the House Ways & Means Committee and the Senate Finance Committee, Congressman Paul Ryan (R-WI) and Senator Orrin Hatch (R-UT), made the case aggressively for reform, but their efforts were unsuccessful.
Corporate-only tax reform: Early in 2015, Chairmen Ryan and Hatch indicated their willingness to deal with President Obama on business tax reform on his terms, accepting his demand that only corporate tax rates be reduced – likely to 25% -- while leaving pass-through businesses with a top statutory tax rate of almost 40%. Both Chairmen said they would attempt to find tax deductions for pass-through businesses to attempt to offset the 12-15 point tax rate advantage C Corps would enjoy under that plan – increased Section 179 expensing and expanded Section 199 domestic production deduction were both mentioned – but both Chairmen said they would not push for a rate reduction for pass-through businesses.
The Washington business community was very surprised by the Chairmen’s move since both had long advocated equitable treatment for the pass-through community. Even less credible was the proposal to handle tax reform in a two-step process in which corporate reform would be done now and the individual tax code would be reformed after the 2016 elections, if Republicans recapture the White House and retain control of the U.S. Senate – less than certain bets in normal circumstances, and an increasingly dubious assumption with presumptive GOP presidential nominee Donald Trump running double-digits behind Hillary Clinton in the polls and GOP Senate candidates worried that Trump’s weak standing could jeopardize their elections as well.
More surprising still was their apparent belief that Congress could pass legislation that would give the 1.6 million C-corporations a significant competitive advantage over the more-than-30-million pass-through businesses. In reality, corporate-only tax reform is politically unattainable. Any proposal to reduce the tax rate only for C-corporations would 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.
The business community in Washington communicated – clearly and repeatedly – to the Committee Chairmen that attempting to pass corporate-only reform would doom any chance of passing anything at all. In fact, there are a number of coalitions advocating for corporate tax reform, and many of those coalition leaders also know that their goal of corporate reform cannot be achieved if it is aggressively opposed by the pass-through community. Perhaps reluctantly, the GOP chairmen accepted the verdict that corporate-only reform could not pass, and moved on to other options—a position taken today as well by new House Ways & Means Committee Chair Kevin Brady (R-TX).
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 tax rates in the U.S. far below the statutory 35 percent rate – some actually get U.S. tax refunds.
The inescapable result of some corporations reducing or eliminating their U.S. tax liability is a cost-shifting from those with low effective rates to those 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 almost 30 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 have much more in common with high-rate-paying S-corporations than with large corporations with very low effective rates.
International-only tax reform: With the prospects for comprehensive reform doomed by the Administration, and corporate-only reform a non-starter with the pass-through community, the Congressional tax writers began discussing reform that would deal only with our international tax law, without reducing corporate or individual tax rates.
Under current law, U.S. corporations are taxed on profits earned abroad as well as those earned at home, but taxes on their foreign income are deferred until that income is “repatriated” back to the U.S. Given that the U.S. has one of the highest corporate income tax rates among industrialized nations, U.S. multi-national companies are disinclined to bring their foreign earnings back to the U.S., and many take aggressive steps to further avoid the high U.S. taxes.
The international tax reform proposed by Congressional leaders would move the U.S. to a territorial tax system – that used by most of our world-wide competitors – under which we would tax only income earned in the United States, rather than taxing foreign-earned income of U.S. corporations as we do now. Included in such an international tax reform would be “deemed repatriation” – a one-time tax on corporations’ foreign-held earning as if they had been repatriated back to the U.S.
Since this proposal would not have included a reduction in the corporate income tax rate it did not face active opposition from the pass-through community, but strong opposition was heard from the representatives of domestic C-corporations. These corporations, including a large majority of wholesaler-distributors, have no significant foreign operations and would therefore not benefit from international reform, but often pay an effective U.S. tax rate much higher than that paid by multi-national companies. They saw international-only reform as exacerbating the already unfair cost-shifting of the corporate tax burden from the low-rate paying companies to them as high-rate payers.
Further complicating the issue, a new concept was added to the international tax proposal – a “patent box” or, more broadly, an “innovation box.” Used in some European countries, an innovation box regime is designed to persuade companies to conduct their research and experimentation in their home countries by taxing the income derived from that innovation activity at a reduced tax rate.
An innovation box would benefit only a small segment of the employer community – mostly high tech firms and pharmaceutical manufacturers – and Congressional proponents assured the rest of the business community that the proposal would be modest and limited, and would pose no obstacle to broader tax reform to be considered later. However, that quickly proved to not be the case. Advocates for Silicon Valley companies made it clear that if the U.S. wants these companies to keep their R&D here rather than moving it overseas, the U.S. would have to enact a broad and expansive innovation box, not one narrow or limited in scope.
Under their plan, the innovation box was expanded into an “intellectual property” (IP) box, and – from their own statement – “the definition of qualifying IP should be broadly defined to include all types of innovation IP, including patents, know-how, trade secrets, copyrights, and other non-marketing innovation IP.” Moreover, they said the tax rate on such income should be competitive with European rates, specifically referencing the eventual 10% rate in Great Britain.
House Ways and Means Committee member Charles Boustany (R-LA) released an innovation box tax proposal in the summer of 2015, which tracked much more closely to the Silicon Valley concept than the “narrow, small and limited” patent box first discussed. Much to everyone’s surprise, the Boustany bill was “scored” as costing $280 billion over ten years – the amount by which Federal tax revenue would be reduced – by no means a small sum.
With the release of the score of the Boustany bill, the chances of enactment of international-only tax reform fell sharply. While most domestic-only C-corporations and pass-through businesses would not be directly impacted by an international tax reform proposal, the indirect impact was suddenly measureable, and large.
In order to enact broad tax reform that significantly reduces tax rates without dramatically increasing the deficit, other sources of revenue have to be found to “offset” the revenue loss that the reduced tax rates would cause. It is assumed that Congress would find that revenue through “base broadening” – eliminating tax expenditures, preferences and deductions – and that taxpayers would trade the loss of those expenditures for a lower tax rate. If the proposed innovation box were enacted taking almost $300 billion in revenue off the table, only a small subset of businesses would benefit, but there would be almost $300 billion less in revenue available to lawmakers to offset lowering tax rates for the rest of the employer community. In other words, the innovation box, and international tax reform overall, is clearly a threat to rate-reducing tax reform for all other taxpayers.
Pass-through tax parity: With corporate-only reform unachievable because it leaves the more-than-30-million pass-through companies behind, there is increasing discussion of business tax reform that would tax all business income at the same rate, regardless of the source of that income. Under one frequently-discussed option, pass-through business income would be taxed separately at the corporate income tax rate on the taxpayers’ individual tax returns. And in April, 2016, Congressman Vern Buchanan (R-FL) introduced the “Main Street Fairness Act,” which would simply cap the top tax rate on most pass-through income at no higher than the corporate tax rate. Business response to the Buchanan proposal has been mixed as the details are being studied, but it is generally regarded as a positive step in focusing on the need for some kind of rate parity between traditional C corporations and pass-through businesses.
Corporate integration: On the opposite side of the “pass-through rate parity” debate is the increased discussion of “corporate integration,” led by Senate Finance Chairman Orrin Hatch (R-UT). Under the current U.S. tax code, there is a “double taxation” of some C-Corporation income – that income is taxed once at the entity level with a top income tax rate of 35 percent, and then taxed again when earnings are passed on as dividends and shareholders pay taxes on those dividends. Some economists argue that because of the double-taxation of corporate income, C corporation income is actually subject to a higher effective tax rate than pass-through income.
Under corporate integration proposals currently being developed by the Senate Finance Committee, the double-taxation of dividends would be eliminated and the corporate and individual tax codes integrated. There are several methods under consideration for eliminating the double taxation of corporate income – corporate integration is technical and complicated and has to factor in all aspects of domestic and multinational business tax issues – and as yet no consensus has been reached on which approach to pursue. Should agreement be reached on a corporate integration approach that both eliminates the double taxation of corporate income and treats all business income equally regardless of the type of business or how it is structured, it will a major move toward comprehensive tax reform.
Real Tax reform: When will we see it?
Despite the push for international reform, the new business-equivalency tax proposals, the innovative thinking on corporate integration, and real need to make our tax system more competitive . . . most tax pundits in Washington believe it unlikely that any significant tax bill will move this year. In addition to the controversy of the various proposals and the complexity involved in reforming the tax code, the Congressional session this year is much shorter than usual with seven weeks out in the summer for the presidential nominating conventions and usual August break, and adjournment early in the fall ahead of the November elections.
Despite the short session, House Republicans are moving forward with a “blueprint” on tax reform that was released on June 24th. The GOP “blueprint” proposes dramatic structural changes in the tax code, rather than just tinkering with the existing law. This new proposal includes a dramatic reduction in the corporate income tax rate – to 20 percent. They propose a less dramatic reduction in the top individual tax rate, lowering it to 33 percent from the current 39.6 percent, but they would also repeal the Obamacare taxes that raise the current top effective individual tax rate to about 42 percent. Significantly, their proposal would tax the business income of pass-through entities at a rate other than the individual income tax rates – in this case at 25 percent. Of course, a corporate rate of 20 percent and a pass-through tax rate of 25 percent do not achieve rate parity – in fact the percentage decline in the corporate rate they propose is quite a bit greater than the percentage decline in the pass-through rate. Nonetheless, it is notable that pass-through business income would NOT be subject to individual tax rates, which is a significant change from current law. Also notable in the plan is the provision to allow a company to fully expense most business investments. While inventory would not be included in the first year expensing, the use of LIFO is explicitly retained.
Despite the unlikelihood of any legislative action, what they propose this year will set the stage for action on comprehensive reform in 2017 – and we are engaged with them at every step to ensure that issues of critical importance to our industry remain part of the process.
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 has been proposed in every Obama budget, and was proposed last year by the Democratic Senate Finance Committee, and the Republican House Ways and Means Committee, despite a multi-year aggressive lobbying effort to prevent repeal.
The LIFO Coalition redoubled its effort, mapping out a strategy to convince tax writers to remove repeal from subsequent tax reform proposals.
In addition to our continuing grass roots lobbying effort, the Coalition 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 also launched a targeted media effort, with ads running in DC publications and op-ed placed in targeted Congressional districts across the country.
We expect LIFO repeal to continue to be part of the tax reform debate in this Congress, but are fully committed to continue our so-far-successful ten-year effort to prevent repeal.