Everyone wants tax reform. At least we pay lip service to the idea that the U.S. economy would be better off with lower rates, a simpler code, and fewer loopholes. Yet something everyone claims to support has proved elusive time and again. Why?
For starters, it's not clear that everyone's idea of tax reform is the same. Corporations want lower statutory rates; they are less enthusiastic when it comes to sacrificing their bought-and-paid-for tax breaks. Liberals want an even more progressive tax code, with higher rates on the wealthy. Conservatives want to reduce anything that looks, smells, or acts like a tax. And libertarians want a flat tax with no deductions and no subsidies for favored industries.
That said, the new year brings hopes for bipartisan agreement on a number of issues, including tax reform. The Republican controlled Congress plans to act quickly on a number of issues in the hopes of scoring some quick wins: the Keystone XL Pipeline; adjustments to the Affordable Care Act, including a repeal of the medical devices tax; infrastructure investment; new trade agreements, which congressional Democrats oppose but President Barack Obama supports; and Iranian sanctions.
As for tax reform—real reform, not tweaks around the edges—I'd advise lowering your expectations. On the corporate side, the U.S. boasts the highest federal income tax rate (35 percent) among developed nations. Lower that rate, and corporations have a lot less incentive to shift profits overseas.
It sounds like a win-win… until you get to the fine print. If corporate tax reform is to pay for itself, certain exemptions and deductions will have to go. That's where the second major hurdle to tax simplification comes in. What is in the national interest is not necessarily in individuals' or businesses' self-interest.
For example, the statutory tax rate is not the same as what corporations pay. (And here you thought GE maintained a 975-person tax department to double-check the math on the corporate return.) In a 2013 report, the General Accountability Office calculated that the effective federal tax rate for profitable U.S. corporations in 2010 was about 13 percent. Throw in foreign, state, and local incomes taxes, and it rises to 17 percent.
Many tax experts doubt the effective rate can be calculated with that degree of accuracy. But for most corporations, the effective rate "is in the 20s and varies greatly from year to year," especially in the wake of losses incurred during the financial crisis and Great Recession, says Martin Sullivan, chief economist at Tax Analysts. What we do know is that "the trend is down as off-shore profit-shifting into tax havens is occurring at an increasing rate," he says.
While tax inversions garnered all the attention last year, largely because of the public disclosure requirement when a U.S. company merges with a foreign entity and incorporates overseas, they represent a small portion of the revenue loss to the U.S. government. "All multi-nationals are doing profit-shifting," Sullivan says.
So lowering the corporate rate makes a good deal of sense in theory. In practice, it's not so clear-cut. If a CEO of a large corporation can exploit tax loopholes to reduce the effective rate to 20 percent, a statutory rate of 25 percent (Republicans' proposed target) or 28 percent (Obama's goal) doesn't maximize shareholder profits.
And that's where the ideal of lower tax rates and minimal loopholes gets mugged by reality. Dave Camp, the former Republican chairman of the House Ways and Means Committee, learned just how tough it is to garner support among his own party and the business community when he introduced his Tax Reform Act of 2014 in February. The cost of lowering the corporate tax rate to a stated 25 percent was, among other things, the elimination of accelerated depreciation, one of the three most costly corporate tax expenditures and something that "would hurt capital formation and manufacturing," Sullivan says.
Some economists question whether accelerated depreciation should be classified as a tax expenditure, defined as any reduction in tax liability as a result of special benefits to particular taxpayers. Labor-intensive firms get to write off employee salaries when they cut payroll checks, says Matt Mitchell, senior research fellow at George Mason University's Mercatus Center. "We shouldn't penalize companies that have to incur capital expenses in order to earn income."
Using individual tax expenditures, which dwarf those available to corporations, to achieve revenue-neutral corporate tax reform is probably a non-starter. Among the costliest tax expenditures, defined as measures that provide tax benefits to particular groups of taxpayers, are: the exclusion of employer-provided health insurance; 401k and other employer plans; and the mortgage interest deduction. Each of these tax breaks has a large, well-funded constituency behind it, willing to fight tooth and nail to maintain its preferential treatment. Sacrifice a tax break for the public good? Let the next fellow do it first.
The argument in favor of a broad tax base with fewer tax preferences is pretty straight-forward: It would increase economic efficiency and transparency; it would reduce the hours devoted to tax compliance and avoidance; and it would be, yes, fairer.
Along the way there would be winners and losers. Unless the public, with its myriad of special interests, is willing to accept short-term pain in exchange for the promised long-term gain of tax reform, the 114th Congress will find its mission impossible.
Caroline Baum is a contributor to e21. You can follow her on Twitter here.
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