Last week, at the request of the House Ways and Means Committee, I testified on how Congress could reform the mortgage interest deduction, a popular tax expenditure provision with a big sticker price.
The congressional Joint Committee on Taxation estimates the mortgage interest deduction will cost $380 billion over the next five years, making it one of the largest individual tax preferences in the Internal Revenue Code. The Urban-Brookings Tax Policy Center estimates that 40 million taxpayers will benefit from the deduction in 2015.
In spite of its widespread use and large fiscal cost, the deduction does little to promote home ownership. It provides no subsidy to the nearly two-thirds of taxpayers who do not itemize and only a modest subsidy to those in the 15 percent bracket.
The subsidy’s value is largest for families in high tax brackets who are most likely to own a home even without preferential tax treatment. Instead of promoting more home ownership, the deduction mostly encourages those who already own homes to buy larger and more expensive houses with borrowed money.
If Congress wants to encourage homeownership, it could direct more of the tax subsidy to prospective homebuyers who straddle the line between renting and buying. Two ways to better target the subsidy: Replace the deduction with a uniform percentage tax credit for mortgage interest, or provide an investment credit for first-time home purchases.
Replacing the deduction with an interest credit has enjoyed bi-partisan support. It’s been endorsed by the federal tax reform panel appointed in 2005 by President George W. Bush, the National Commission on Fiscal Responsibility and Reform appointed by President Obama, and the Debt Reduction Task Force of the Bipartisan Policy Center.
In my written testimony, I provided estimates for the effects of four potential reforms:
• Eliminating the deduction.
• Limiting it to interest on the first $500,000 of home acquisition debt.
• Replacing it with a 15 percent refundable credit on the first $25,000 of eligible interest.
• Switching to a 20 percent non-refundable credit for interest on the first $500,000 of home acquisition debt.
All these options would raise taxes and reduce the subsidy– mostly for upper-middle income taxpayers. Replacing the deduction with a credit would reduce tax burdens on average and increase the housing subsidy for those in the bottom 80 percent of the income distribution.
The revenue gains from all these options would be smaller if they are part of a broader tax reform that lowers marginal individual income tax rates. In that case, some options would even lose money. With lower rates, eliminating deductions raises less money, but new credits would cost just as much.
It is important to recognize that proposals to pare back the mortgage interest deduction could adversely affect housing prices, though how much of a hit they’d take is uncertain at best. Introducing reforms gradually would reduce risks to the housing market, though such transition rules would delay both the revenue gains and the improved incentives from the reforms.
The current mortgage interest deduction is hard to justify on policy grounds. Implementing policy reforms such as those I presented to the committee would encourage more homeownership at a lower fiscal cost. But designing appropriate transition rules that reduce market disruptions while simultaneously retaining the benefits of reforming the mortgage interest deduction will be challenging.
House Republicans, former GOP presidential hopeful Mitt Romney, and the chairs of President Obama’s 2010 fiscal commission, Erskine Bowles and Alan Simpson, have all called for changing the way the U.S. taxes multinational corporations. The concept: Shift from a system where U.S. firms pay U.S. tax on their worldwide income to one where they’d pay U.S. tax only on what they earn at home—a structure known as a territorial system. A territorial system would accomplish this by removing the current tax that U.S. multinationals pay, net of foreign income tax credits, on dividends that their foreign affiliates repatriate to the U.S. parent company.
Backers of a territorial tax, including CEOs of many multinationals themselves, argue that the current worldwide system puts U.S. firms at a competitive disadvantage since they must pay the high U.S. tax rate on repatriated profits earned by their affiliates in low-tax countries, while multinationals based in territorial countries pay only the local tax rate on these profits. They also argue that since nearly all of the rest of the world uses a territorial system, it only makes sense for the U.S. to follow suit. The United Kingdom and Japan are the latest nations to eliminate their taxes on repatriated dividends.
These are compelling claims but for one problem: Existing territorial systems are in fact hybrids that include elements of a worldwide tax. And the current U.S. system is itself a mix of worldwide and territorial systems, in large part because it allows U.S. companies to defer tax on foreign income until they repatriate those earnings back to the U.S.
Any new system in the U.S. would almost certainly be a hybrid as well. As a result, the benefits to U.S.-based multinationals would vary widely. Some firms would come out ahead, but others would not.
While some worry about relatively high U.S. taxes on foreign source income, others worry that some U.S multinationals pay little tax on their domestic income. Multinational companies can shift their reported income from the U.S. to low-tax jurisdictions by allocating interest expenses and other fixed costs to domestic operations and manipulating the prices they report on intercompany transactions (transfer prices). This erodes the domestic tax base, especially for companies with large amounts of intangible assets such as patents, technical know-how, and brand identification. There is no easy way for tax authorities to determine what price companies should charge their affiliates for the use of these assets.
All countries have rules to protect their domestic corporate tax base. Transfer pricing rules and limits on interest deductibility (“thin capitalization” rules) curb income shifting. Other rules depart from a pure territorial system by requiring companies to pay an immediate tax on passive income accrued in foreign jurisdictions or by imposing a minimum tax on income from tax havens. For instance, the U.S. “subpart F” rules apply accrual taxation to portfolio investments and certain other foreign-source income.
While the United Kingdom and Japan have eliminated their taxes on repatriated income, they are also re-assessing their taxes on foreign accrued income. Japan taxes on a current basis foreign income that is subject to local tax rates of less than 20 percent. The U.K. limits the deductibility of interest expense against U.K income and is considering reforming rules for taxing accrued foreign profits.
U.S. lawmakers are trying to find the same balance. House Ways & Means Committee Chairman Dave Camp (R-MI) has proposed a territorial tax that would exempt 95 percent of foreign dividends received. But he’d also tighten subpart F and enact new thin capitalization rules. In addition, he’s considering three options to prevent base erosion –a tax on excess returns (similar to a proposal by President Obama), a version of the low effective tax rate test used by Japan, and inclusion in subpart F of intangible income from low-tax countries.
In practice, going territorial would eliminate all or most of the tax on repatriated dividends from foreign affiliates. But to counter increased incentives to shift reported profits overseas, the move to territorial could also include new rules to prevent income shifting and increased accrual taxation of some foreign source income.
These changes would eliminate the lock-in for repatriated profits, but could raise the tax burden on profits left overseas. Such a switch could increase economic efficiency because the lock-in of funds overseas imposes costs on multinationals, while producing no revenue for the U.S. Treasury. But would this benefit U.S. multinationals? Some corporations will indeed benefit from the chance to bring back their overseas profits without paying today’s repatriation tax. But others, who have learned how to avoid tax on their intangible profits under the current rules, may find themselves paying more. As with much else, the devil is in the details. Some corporations may regret getting what they wished for.
Those of us who have spent much of our careers in Federal tax policy offices have reason this week to feel vindicated. While the two political parties could not be further apart in their ideologies and their views about the proper role of government, the budget resolutions in both the Republican House and the Democratic Senate have taken a firm stand in favor of reducing special tax breaks.
The House Ways and Means Committee, in a letter signed by all its Republican members to Budget Committee Chairman Paul Ryan, states its intention to “make the tax code fairer by scaling back preferences that distort economic behavior and often benefit only a narrow group of individuals and businesses.” These cuts in preferences will be needed to meet Chairman Ryan’s goal of a tax code that raise the same revenue as current law with sharply lower individual and corporate rates.
The Democrats’ Senate Budget Resolution calls for “deficit reduction of $975 billion to be achieved by eliminating loopholes and cutting unfair and inefficient spending in the tax code for the wealthiest Americans and biggest corporations.” This consensus on the need to reduce tax breaks is truly extraordinary.
Tax wonks should celebrate this new development. For years, we have fought against proposals by politicians of both parties to lard the tax code with more special credits, deductions, and exemptions for supposedly worthy purposes. We have argued that these preferences make the tax law more complicated, distort economic choices, create unfairness in the treatment of taxpayers with equal ability to pay, and produce a general public cynicism with the income tax system. We have called the preferences “backdoor spending” or “tax expenditures” and argued that many of them would not stand up to scrutiny if introduced as direct spending programs.
With the notable exception of the Tax Reform Act of 1986, we have become accustomed to losing one battle after another. And we have become resigned to defeat, explaining why politicians prefer tax breaks over direct spending and why that’s not always such a bad thing.
Now both parties appear to be coming around to our long-held point of view. But there’s still a big problem: With the exception of a reference to benefits for corporate jets in the Senate’s resolution, there is no mention of a single tax benefit that the Committees would eliminate. And most of the money from tax expenditures comes from popular and widely used provisions, such as the exemption of employer benefits for health care and the home mortgage interest deduction.
The Senate Democrats do suggest some type of across the board limit on tax expenditures claimed by high-income taxpayers, an approach Governor Romney also discussed in the presidential campaign and Republican economic advisor Martin Feldstein promotes. But both sides have yet to identify the specific preferences they would remove to reach their revenue targets.
So I’ll keep the champagne bottle corked. Until the tax-writing committees offer specific proposals, we may only be seeing the tax side equivalent of familiar promises to control spending by eliminating “waste, fraud and abuse.” And, of course, Congress will have a hard time judging as wasteful any tax break that benefits a mobilized constituency. But we can still hope.
The Tax Policy Center (TPC) has estimated that going over the fiscal cliff will raise taxes on average by about $3,500 per household in tax year 2013, compared with extension of 2011 tax law. But tens of millions of Americans have a much more immediate problem. They’ll face a huge tax increase when they file their 2012 tax returns early next year. And many of them don’t even know it.
The trouble: A number of major tax benefits expired earlier this year, including the deductibility of state and local sales taxes as well as many business incentives. But by far the biggest problem comes from the expiration of the temporary increase in exemption levels under the alternative minimum tax (the “AMT patch”).
In 2011, the exempt income levels under the AMT were $48,450 for single taxpayers and $74,450 for married taxpayers. If Congress fails to act, these exemptions will decline to $33,750 for singles and $45,000 for couples. As a result, 28 million more taxpayers will be hit by the AMT, and many of the 4 million who would owe AMT even with a patch will owe even more.
Overall, AMT liability will rise from $34 billion to $120 billion. Of that $86 billion increase, new AMT taxpayers will owe $64 billion—an average of about $2,250–while those currently on the tax will pay another $22 billion—an increase of about $5,500 each over the nearly $8,500 average they would pay with a patch.
If you suspect that a tax that affects 32 million households is not limited to the rich, you are right. It is true the enhanced AMT will hit upper middle-income taxpayers the hardest – 98 percent of those with adjusted gross income between $200,000 and $500,000 will pay an average of almost $11,000 in AMT on top of their regular tax liability.
But taxpayers with more modest incomes won’t be spared. About 88 percent of taxpayers with incomes between $100,000 and $200,000 will pay an average AMT of over $3,100, while 61 percent with incomes between $75,000 and $100,000 will be hit with AMT liabilities averaging nearly $1,500. Even many making between $50,000 and $75,000 will get hit: About 22 percent will have to cough up an average additional tax of more than $1,100.
To make matters worse, many of these taxpayers have no idea they will owe this extra tax when they file their 2012 returns. Withholding schedules for 2012 did not reflect the expiration of the patch and it is a safe bet that few taxpayers factored it into their estimated payments for tax year 2012. One can hope that underpayment penalties will not be assessed on AMT taxpayers who paid too little withholding and estimated tax this year. But even without penalties, an extra $1,000 or more in unanticipated liability in April will be a cruel hit on many middle-income families.
I wish I could end this post here. But the damage goes beyond those who will pay more taxes. The unpatched AMT includes complex rules for reducing certain tax credits and deductions under the regular tax if these benefits would otherwise make a taxpayer subject to AMT. IRS has designed its systems under the assumption that Congress would patch the AMT for tax year 2012 and will need to make extensive changes absent a patch. As a result, IRS estimates that over 60 million taxpayers, nearly half of all individual tax filers, may not be able to file their 2012 returns until March or later. So even if you won’t owe more tax this spring, your refund may be delayed for months.
Those lawmakers who seem willing to drive us over the cliff should consider how their failure to fix the AMT would affect millions of Americans. They are going to need a good story to tell taxpayers whose refunds will be delayed and a better one to tell those who will owe thousands of dollars more in taxes come April.
After a frantic day of listening to rival briefings and addressing reporters’ questions on the new tax reform plans unveiled by President Obama and Governor Romney, an old tale stuck in my mind. It was the famous Hans Christian Anderson fable of the emperor and his new clothes. You know the story: A powerful emperor hires two men representing themselves as expert weavers to make him a new and beautiful suit. He then goes to display his new clothing in public. The story concludes:
The emperor marched in the procession under the beautiful canopy, and all who saw him… exclaimed: “Indeed, the emperor’s new suit is incomparable! What a long train he has! How well it fits him!” Nobody wished to let others know he saw nothing, for then he would have been unfit for his office or too stupid. Never emperor’s clothes were more admired.
“But he has nothing on at all,” said a little child at last. “Good heavens! listen to the voice of an innocent child,” said the father, and one whispered to the other what the child had said. “But he has nothing on at all,” cried at last the whole people. That made a deep impression upon the emperor, for it seemed to him that they were right; but he thought to himself, “Now I must bear up to the end.” And the chamberlains walked with still greater dignity, as if they carried the train which did not exist.
That brings us to the new tax plans of Romney and Obama. In one sense, they were very different, as one would expect from two candidates with diverse philosophies and constituencies. Obama addressed corporate tax reform. Romney, who had already proposed to reduce the corporate rate, focused on individual taxes. Obama’s plan was complex and detailed; Romney’s simplistic.
But beneath the deep differences, there were striking similarities. Both men promised a 20 percent marginal tax rate cut – Obama in the corporate income tax rate, Romney in individual income tax rates. Both promised to pay for the rate cuts by closing loopholes. And, although Obama has advanced some proposals to end corporate preferences, both refused to identify fully (or, in Romney’s case at all) the specific measures needed to pay for the rate cuts.
All that is missing is a little child who will point out the obvious.
I woke up to the headlines in today’s Washington Post – House Majority Leader Eric Cantor and Senate Minority Whip Jon Kyl were walking out of the budget negotiations. The Democrats, they said, were insisting that revenue increases be part of any agreement. No revenue increases were acceptable – period. Not even the closing of loopholes that few could defend with a straight face would pass muster. As the Post editorial writers noted this morning, Tom Coburn and other Senate Republicans may think it is OK to cut ethanol subsidies, but because that is scored as a revenue increase, it will never be acceptable to the House majority.
I ate a healthy breakfast in my comfortable air-conditioned house and stepped into the air-conditioned car in my garage to head for the DC Metro. As I drove into a nearby suburb to catch the subway, I noticed all the traffic lights were out. Today we have another power failure, affecting who knows how many homes and businesses. It will just be a blip on the evening news. The drivers adjusted, treating the nonfunctioning traffic signals as four way stop signs, and I soon arrived at the Metro. Today, the trains on the line I take were running on schedule. But at my downtown station, one of the deepest in the system, none of the escalators were working. We trudged quietly and uncomplainingly up the steps in the heat and humidity. And metro escalator failures are such a common event, I doubt it will get any news coverage.
But we are told we don’t need to spend more on these or other public services or public and private infrastructure. In fact, if they are in the public sector, we should cut them. And no one should have to pay higher taxes – especially those with the highest incomes who may rely less on public services or the social safety net. The worst thing we can do is to enact “job-killing” tax increases. If we have 9 percent unemployment following a decade of tax cutting, imagine how bad it would be if we reversed course. Instead, we are told, we need deep and immediate spending cuts, although advocates of these cuts sometimes forget that people who work on publicly funded projects also have jobs.
You may think I just woke up in a bad mood today. But that would be wrong. I woke up in a good mood. After all, it’s Friday. It was the series of breakdowns – none an extraordinary event – in the first hour of the day that soured my outlook.
We do face a serious long-term budget problem going forward. And both spending cuts and revenue increases will need to be part of the solution. I hope our leaders can find sensible ways to pare spending that maintain key infrastructure and protect our most vulnerable citizens. And I hope they find ways to raise revenue that eliminate outmoded preferences, spread the burden fairly among those with different incomes, and minimize economic harm. But sometimes, I confess, I am not very optimistic that any of this is about to happen and today is one of those days.
Individuals who just filed their taxes this year might be wondering why they face high tax rates when big corporations apparently manage to escape the tax net. In the March 25, 2011 New York Times, David Kocieniewski reported that the nation’s largest corporation, General Electric, earned a profit of $14.2 billion in 2010, while claiming a tax benefit of $3.2 billion. He went on to note that the strategies GE and other corporations have followed to reduce their taxes, combined with tax law changes that have encouraged more businesses to file as individual taxpayers, have pushed down the corporate share of the nation’s tax receipts from 30 percent of all federal revenue in the mid-1950s to 6.6 percent in 2009.
GE of course has its own defense of its tax position and Mr. Kocieniewksi was careful to attribute GE’s low reported taxes to aggressive tax minimization strategies and successful lobbying, not to any illegal tax evasion. And there are many reasons that taxes reported on financial statements may not provide a very accurate picture of a company’s effective tax burdens.
But what struck me more in the article was the apparent sharp decline in corporate receipts. Is the corporate tax really going away or was this just a cleverly constructed example?
Let’s start with the two time periods cited in the article, the 1950s and 2009. Corporate taxes were much higher in the 1950s than they are now, measured either as a share of all federal receipts or as a share of gross domestic product (GDP). High rates enacted during World War II were still in effect (from 1952 to 1963, the top corporate rate was 52 percent, compared with 35 percent today), globalization of corporate activity had barely begun, and U.S. corporations faced little competition from foreign-based multinationals. In contrast, in 2009, we were in the deepest economic slump since the Great Depression and corporate profits dropped sharply. Revenues from corporate taxes plummeted from 2.7 percent of GDP in 2007 to just 1 percent in 2009 (see TPC graph).
So, what has been the long-term trend in corporate revenues? Corporate receipts as a percentage of GDP were indeed much higher in the 1950s than today and were still higher than today in the 1970s. But in recent decades, including CBO’s projections for 2010-2019, corporate receipts have been remarkably stable as a share of GDP. Here are the figures:
Following a sharp dip after Congress enacted massive corporate tax breaks in 1981 (mostly reversed in the Tax Reform Act of 1986), corporate tax collections have stayed fairly constant at slightly under 2 percent of GDP and between 10 and 11 percent of federal receipts for most of the past thirty years. If the CBO projections are correct and Congress does not enact additional corporate tax cuts, they will remain in the same range in the next decade as well.
Within these broader trends, there have been some sharp annual ups and downs resulting from the economic cycle and enactment of temporary tax incentives. And we know there are ways that some large corporations can and do legally reduce their tax liability. Corporate tax receipts are a less important source of federal revenue than they were in the early post-war period. But the data simply don’t support a conclusion that the corporate tax is going away.
George Orwell once wrote: “If thought corrupts language, language can also corrupt thought.” I am reminded of Orwell and his deep concern with the misuse of language for political ends when I see pols of both parties label tax expenditures as “loopholes” or “earmarks.”
The House Budget resolution promises an individual tax reform that “simplifies the broken tax code, lowering rates and clearing out the burdensome tangle of loopholes that distort economic activity.” The Fact sheet describing President Obama’s new budget framework calls for “individual tax reform that closes loopholes and produces a system which is simpler, fairer, and not rigged in favor of those who can afford lawyers and accountants to game it.” The bipartisan National Commission on Fiscal Responsibility and Reform notes that the tax system is riddled with tax expenditures and adds, “These earmarks not only increase the deficit, but cause tax rates to be too high.”
The Congressional Budget Act of 1974 defines “tax expenditures” as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of liability.” The late Stanley Surrey, a Harvard law school professor turned top Treasury tax official, promoted the use of the term “tax expenditures” to highlight the increased use of the federal income tax as a vehicle for Congress to enact backdoor spending. And they are very big: the annual revenue loss from these provisions now totals more than $1 trillion.
But the largest tax expenditures are not loopholes or earmarks snuck into the law in the dead of night to benefit a shadowy handful of super-wealthy individuals or well-connected corporations. Rather, they benefit tens of millions of taxpayers. Among the biggest: itemized deductions for home mortgage interest, charitable contributions, and state and local taxes, exemption of income accrued within tax-preferred retirement saving accounts, and the exemption from tax of employer contributions to health insurance plans. IRS data show that 39 million taxpayers claimed deductions for home mortgage interest and charitable contributions in 2008, and 35 million deducted state and local income taxes.
Loopholes and earmarks are something entirely different. That great source of all knowledge, Wikipedia, defines a loophole as “a weakness or exception that allows a system, such as a law or security, to be circumvented or otherwise avoided.” From the same source, an earmark is “a legislative provision that directs approved funds to be spent on specific projects, or that directs specific exemptions from taxes or mandated fees.” When people think of “tax loopholes”, they rightly think of sophisticated transactions that enable the well-advised to avoid taxes that Congress wanted them to pay. When they think of “tax earmarks”, they rightly think of narrow and highly technical provisions slipped into legislation at the behest of a compliant Member of Congress. These provisions—once dubbed “rifle shots” — benefit only a few very specific taxpayers (sometimes only one), and are the tax equivalent of appropriated funds given to a single project or congressional district.
Labeling broad provisions that are easy to use and benefit millions of taxpayers as “loopholes” or “earmarks” exaggerates the benefits of tax reform. But worse than deceiving others is the self-deception this misuse of language produces. There are strong arguments for paring back or eliminating some of the large and popular tax expenditures and tax expenditures should certainly not get a free pass when Congress is cutting direct spending. And I agree that restructuring and cutting tax expenditures should be a big part of any effort to bring the deficit under control. But let’s not kid ourselves that these cuts will be easy or that cutting back on provisions like the mortgage interest deduction, exemption of employer-provided health insurance, or retirement saving incentives will affect only a few well-advised taxpayers. And let’s also not kid ourselves that we can raise any significant money from tax expenditures without touching these and other large and popular provisions.
Charles Krauthammer (Washington Post, April 8, 2011) writes that the “most scurrilous” criticism of House Budget Committee Chairman Paul Ryan’s fiscal plan is that it would cut taxes for the rich. This would, he says, be akin to making the same claim against the Ronald Reagan-Bill Bradley 1986 tax reform. Krauthammer goes on to assert that Ryan’s plan is “classic tax reform” that … broadens the base by eliminating loopholes.
The facts are otherwise. The Ryan plan, at least what we know of it, would inarguably cut taxes for the rich. It in no way resembles the 1980s tax reforms of either President Reagan or Senator Bill Bradley and Representative Dick Gephardt. And it most assuredly fails to eliminate loopholes.
Ryan proposes to reduce the top individual and corporate tax rates from 35 percent to 25 percent. And his plan does call for eliminating tax expenditures in general terms. But the Ryan budget does not offer a single specific proposal to eliminate any tax break. This is hardly a repeat of the original 1980s tax reform plans. The Bradley-Gephardt and Reagan tax plans differed in detail, but the original versions of both plans included specific provisions for eliminating tax preferences to pay for rate reductions and keep the income distribution fixed. In contrast, the Ryan blueprint explicitly proposes large rate cuts, but leaves the heavy lifting of paying for the rate cuts to the tax-writing committees.
It gets worse if you look at the detailed tax plan Ryan released last year—the “Roadmap for America’s Future.” That plan would also have reduced the top individual rate to 25 percent for individual taxpayers willing to give up most of their deductions. But big users of preferences could have chosen to keep their deductions and continue to pay at current rates. And the Roadmap also would have eliminated all taxes on corporate profits, interest income, dividends, capital gains, and inheritances and made up some of the lost revenue with a new consumption tax. As a result, the Roadmap would have placed almost the entire tax burden on wage earners. The Tax Policy Center last year estimated it would reduce overall annual tax payments to less than 17 percent of GDP and cut tax burdens for families in the top 1 percent of the income distribution to less than half of what they would pay even if all the Bush tax cuts were extended.
The 1986 Tax Reform Act also sharply reduced top tax rates, from 50 percent to 28 percent for individuals and from 46 to 34 percent for corporations. But, in contrast to Ryan’s Roadmap, the Reagan-Bradley reform eliminated significant preferences for investment income enjoyed by high-income individuals and corporations. Most notably, it taxed capital gains as ordinary income (dividends were already taxed that way), eliminated the investment tax credit and closed shelters then commonly used by high-income investors to escape tax. In a similar vein, the recent plans by the President’s Fiscal Commission and the Bipartisan Policy Center’s debt reduction task force would also balance cuts in tax rates with elimination of preferences for capital gains and dividends and removal or paring back of other tax benefits tilted towards the high end of the distribution.
Until we see the full details of the tax bill that the Ways and Means committee introduces, we cannot say how the House plan would affect either revenue or the distribution of the tax burden. But nothing suggests House Republicans are considering anything remotely resembling a repeat of the Reagan-Bradley tax reform act.
The late Senator Daniel Patrick Moynihan once famously remarked that “everyone is entitled to his opinion, but no one is entitled to his own facts.” Despite what Krauthammer says, Ryan’s plan is not Reagan-Bradley. All he has shown us is tax rate cuts for high-income individuals and corporations. We’ll see if the current Congress comes up with something that really does close preferences at the top end to pay for Ryan’s highly skewed rate reductions. That would be a welcome reversal from what we have seen so far.
One of the biggest applause lines in the President’s State of the Union speech came from his promise to reform and simplify the corporate income tax:
So tonight, I’m asking Democrats and Republicans to simplify the system. Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years –- without adding to our deficit. It can be done.
That sounds straightforward. We did this, after all, in 1986. Congress lowered the top corporate tax rate from 46 percent to 34 percent (since raised to 35 percent), while closing many business tax preferences and raising more corporate revenue. What are the chances that we can do this again?
To get a rough idea, I added up the cost of business tax expenditures reported in last year’s budget. In all, they total about $640 billion between 2011 and 2015. About $506 billion of these losses (just under 80 percent) come from corporate taxpayers. Businesses organized as “flow-through enterprises”(S corporations, partnerships, sole proprietors) benefit from many of the same provisions as taxpaying corporations. Their owners would also pay more tax if we eliminate business tax preferences. So, any revenue-neutral combination of lower corporate rates and reduced business tax preferences would lower corporate tax receipts and increase individual tax receipts.
Over the 5-year period, estimated business tax expenditures add up to about a third of projected corporate receipts. If wiping them all out permitted proportionately lower rates, the top corporate rate could fall to 23 percent without any loss in overall revenue. But the actual potential rate cut would be different because of interactions among the various tax expenditures, interactions between the corporate tax rate and some tax expenditures, and behavioral responses. For one thing, the revenue gain from closing corporate preferences would be smaller at a lower corporate tax rate.
Now, look closer at these tax expenditures. It turns out that the ten most costly provisions benefiting business investment account for about 92 percent of the five-year revenue losses. How likely is it that these costly provisions would be repealed?
The largest estimated loss ($169 billion) over five years comes from deferral of foreign source income of U.S. multinationals. In the past, the revenue gain from eliminating deferral has been estimated as much smaller than the ongoing revenue cost under current law. And the corporate leaders now advising the President are likely pushing him to move in the opposite direction, following our major trading partners, who exempt foreign-source income. The second largest, accelerated depreciation of machinery and equipment, costs an estimated $147 billion. But this tax expenditure, which broadly subsidizes domestic investment for a wide range of business firms, has just been increased, with the support of the Administration, by allowing full expensing for investments made in 2011. The President has endorsed making the research credit permanent (scored at $13 billion over 5 years last year, but since increased because Congress extended it) and no one would even consider eliminating expensing of research and experimentation activities ($32 billion over 5 years). Other items among the ten costliest provisions that seem unlikely to get chopped include the credit for low-income housing ($36 billion), accelerated depreciation on rental housing ($41 billion), and exclusion of interest on hospital construction bonds ($21 billion). Adding up all these items reduces the potential saving from $640 billion over 5 years to just $180 billion, or less than 10 percent of 5-year corporate revenues. And even getting this far would require eliminating alcohol fuel credits –think, Iowa primary –($32 billion), the deduction for domestic production activities ($77 billion), preferential tax rates for small corporations ($16 billion), and all tax incentives for renewable energy ($26 billion, excluding alcohol fuels). The only tax breaks the President proposed removing in his speech were tax breaks for fossil fuels – a mere $14 billion over 5 years.
Enforcing a corporate tax is no doubt challenging in a global economy, where corporations can shift profits to low-tax jurisdictions. And many companies have legally escaped most of the corporate tax. The Administration may have new ideas on how to limit avoidance or to increase corporate receipts in ways their official tax expenditure list doesn’t show (such as revising inventory rules or limiting interest deductions). If it comes up with other good ideas, or proposes some of the items I dismissed as long shots, I would be pleasantly surprised. But, to paraphrase Willie Sutton, if we are going to broaden the corporate tax base enough to pay for a meaningful rate cut, we need to go where the money is. And from what I have seen so far, we aren’t there yet.