Key elements of the tax code rewrite proposed yesterday by House Ways & Means Committee Chair Dave Camp (R-MI) came straight from the playbook of the 1986 Tax Reform Act. The most surprising: As in 1986, it would pay for individual tax cuts by boosting taxes on corporations—at least temporarily.
Hard to believe, perhaps, but true. Camp would cut individual income taxes by nearly $590 billion over the ten-year budget window. And he’d raise business tax revenue by about $520 billion over the same period, not counting the bank tax and other changes in excise taxes.
But therein lies the rub: Much of the new business tax revenue is temporary and will disappear after a decade. What’s going on here?
Remember, the House GOP leadership required Camp to reduce the corporate tax rate to 25 percent from the current 35 percent. He did it, but phased the rate reduction in over five years. He’d also repeal the corporate alternative minimum tax, and make permanent two tax cuts that are traditionally included in a package known as “tax extenders” (increased small business expensing and the R&E credit). In total, these changes would reduce corporate revenues by nearly $880 billion through 2024.
The plan would pay for those revenue losses by repealing or modifying a large number of business tax rules. It would scrap dozens of highly targeted, industry-specific credits, repeal a special deduction for domestic manufacturing, and eliminate generous accounting rules for inventories. But two changes bring in the most revenue:
Eliminating accelerated depreciation ($270 billion). The proposal would repeal the current tax law’s favorable depreciation system (the Modified Accelerated Cost Recovery System, or MACRS) which generally allows firms to depreciate capital assets faster and over shorter time periods. Instead, most investment would be written-off more slowly, but indexed for inflation.
Amortizing R&D and advertising expenses ($360 billion). Instead of expensing these costs in the year they are incurred, firms would have to capitalize them over several years. Research expenses would be deducted over five years. Firms could deduct half of their advertising expenses right away, and write-off the rest over 10 years.
The other big revenue raiser comes from Camp’s restructuring of the taxation of U.S.-based multinationals. His move toward a “territorial” tax system (“participation exemption system with base erosion protections” for tax nerds) would be more than offset by a one-time tax on foreign earnings that are parked overseas, payable over 8 years. This transition tax would generate $170 billion within the ten-year budget window, but little revenue beyond 2024.
Camp would make few big changes to the structure of “pass-through” businesses—those firms taxed on individual rather than corporate returns—even though he included many in one of his earlier discussion drafts. Owners of businesses organized as sole proprietorships, limited liability companies (LLCs) or other partnerships, and S Corporations would continue to pay individual income taxes at ordinary rates as high as 35 percent (including the 10 percent surtax). However, income attributable to domestic manufacturing would be exempt from the surtax.
Add it all up and the Camp proposal would raise more revenue from businesses in the ten-year window than under current law. But does he really raise their tax burdens?
Probably not. The largest revenue raisers in the budget window are provisions that affect the timing—rather than the level—of deductions, and the temporary transition tax on deferred foreign profits. The timing changes raise more revenue during the transition than in the long-run (when higher deductions from past investments partially offset lower deductions for current investments) and revenue from the transition tax will rapidly disappear beyond 2024. Combined with the phased-in corporate rate cut and other international tax changes, this suggests that, on balance, businesses will be winners from this proposal.
The Congressional Budget Office’s latest update, released today, provides a snapshot of fiscal policy in the short run, the medium term, and the long run. CBO disclosed its short-term analysis in May: If automatic spending cuts and tax increases kick in as scheduled at the end of the year, the U.S. could be thrown back into recession. Meanwhile, few quibble that in the long run, demographics and the continued rapid growth in medical costs will require spending that exceeds the capacity of our current tax system.
CBO’s midterm projection, however, is more controversial. The agency warns that over the next decade, continuing temporary tax policies – in particular the 2001/03 personal income tax cuts – will lead to unsustainable levels of annual deficits and debt.
But there is nothing inevitable about this excessively glum estimate. There is a far better alternative.
What if Congress retained the level of taxation set by current law, but collected the money in a much smarter way?
Of course, Congress could just do nothing. Allowing temporary tax policies to expire as scheduled would result in small and manageable federal deficits over the next ten years. However, many aspects of tax policy implied by “current law” are problematic—most notably, the Alternative Minimum Tax would hit an additional 50 million middle and upper-middle class households by 2022.
There is a better way. In an article published yesterday in Tax Notes, Ed Kleinbard, former Chief of Staff of the Joint Committee on Taxation, and I present an alternative post-2012 personal income tax regime, the “Better Base Case”. Quite simply, the Better Base Case would raise the same level of revenue as the CBO’s current-law baseline, but in a way that addresses the most troubling aspects of reverting to the tax laws in place in 2000. Specifically, we would let the temporary tax cuts expire as scheduled under current law and then make the following changes:
- Limit the value of personal itemized deductions to 15 percent
- Permanently patch the alternative minimum tax (AMT)
- Retain the child tax credit at its 2012 level
- Tax qualified dividends at the same 20 percent maximum tax rate that applies to long-term capital gains
- Restore the estate tax to its 2009 form ($3.5M indexed exemption and a 45% rate)
The resulting tax system is more efficient, more equitable, and (most importantly) meets the most basic requirement of a tax system—it raises the revenue required to fund the spending needs of the federal government. If nothing else, it provides a useful benchmark against which to measure other competing tax proposals.
We recognize that the level of revenue implied by the CBO baseline is uncomfortable for many to accept. Indeed, it is more than President Obama has proposed in his annual budgets. But we argue that it represents a minimum level of revenue necessary over the next decade to meet our current spending needs. And despite hyperbolic claims to the contrary, it would not significantly impact people’s work effort, or the pace of economic growth and job creation going forward.
We also acknowledge that an abrupt transition to this new regime would be inappropriate in a still weak economy. The Better Base Case is fully compatible with policies that would provide additional temporary fiscal support, either by phasing in tax increases or pairing them with other more stimulative tax and spending changes.
None of this is to say we oppose additional and more ambitious efforts to reform the tax system. However, those discussions, along with more fundamental debates about the role and size of government, should take place in a stable and rational fiscal context. That is what the Better Base Case achieves.
Three related issues dominate budget talk in Washington these days: eliminating the deficit, cutting spending, and reforming the tax system. Achieving the first will require accepting painful doses of the second and designing the third so we raise more revenue. No easy tasks there.
The difficulty shows clearly in a graph I prepared for a recent talk for the Tax Section of the American Bar Association (slides are available here) . The graph plots spending and revenues using the latest budget estimates from the Congressional Budget Office. Balancing the budget means getting to the dark blue 45-degree line where spending matches revenues. The further northwest of the line, the bigger the deficit.
For most of the past four decades, the federal budget has been above that line. Spending has averaged just under 21 percent of gross domestic product (GDP), well above the 18 percent average for revenues. Only for a few years, from 1998-2001, have revenues fully paid the government’s bills—those four lonely dots below the diagonal line. And the last few years have found us well above the balanced budget line with deficits around 9 percent of GDP.
Those huge recent deficits result mainly from reduced tax revenues due to the economic collapse and counter-cyclical policies on both the spending and the tax side. While the CBO baseline projects a substantially better deficit picture in coming years, much of the improvement results from the optimistic assumption that Congress leaves tax law alone. Specifically that means letting all of the temporary tax cuts extended by the December compromise legislation expire and discontinuing the annual “patch” to the AMT. Under those assumptions, CBO projects that revenues will increase from 15 percent of GDP this fiscal year to 20 percent by FY2014, leaving us still well above the balanced budget line in the graph.
And that is the good news. The longer-term outlook is even more troubling as demographics and health care costs that are rising faster than the overall economy put unsustainable pressures on the level of spending.
In order to have a credible path toward fiscal sustainability, we must move beyond the bickering about whether to extend the 2001-2003 tax cuts and for whom. Even with sizeable and painful spending cuts, the Federal Government will need more revenue than the 18 percent historical average. Policymakers must look to more comprehensive reforms, including base-broadening and exploring new revenue sources.
As Milton Friedman reminded us, “to spend is to tax.” We can’t keep pretending that spending and revenue are independent policy variables. At day’s end, we have to raise enough revenue to pay for the spending we choose. That said, political and ideological differences complicate any decisions on how much to cut spending and raise taxes to achieve long-run balance. As we consider fundamental tax reform, we should seek a system that not only can raise revenue efficiently, but also is flexible enough to adapt to changing spending priorities that our democratic process will ultimately determine.
No easy task indeed.
Howard Gleckman discussed some of the facts and issues regarding the role of small businesses in the debate on the expiring 2001 and 2003 tax cuts. Eric Toder expressed a strange sense of déjà vu. While everyone agrees that changes in the top two marginal tax rates would affect only a small share of individuals who report business income on their tax returns, proponents of full extension point out that those high-income individuals receive a large fraction of net positive business income. (JCT has estimated that fraction at 50 percent; TPC’s estimate is closer to 45 percent.) But what is less well known is what that business income consists of. How much represents the income of the neighborhood grocer or the owner of a small manufacturing firm? And how much represents the income of highly-paid professionals who take their income in the form of partnership shares, such as partners in law firms, accounting firms, and Wall Street hedge funds?
While the exact source of business income reported on tax forms cannot be determined, TPC recently released estimates that provide some additional information on the sources and distribution of flow-through business income which may yield further insights about the potential effects of allowing the top two tax rates to return to their pre-2001 levels.
The narrowest measure of small business income is that which is reported by nonfarm sole proprietors (on Schedule C of the IRS Form 1040). These would include the self-employed and many people running truly small family businesses, like the proverbial corner grocery store, but also would include some independent professionals (doctors, lawyers, independent consultants). The potential impact of raising the top two rates on these independent business owners is considerably smaller than the impact on taxpayers reporting business income from other sources. TPC estimates that fewer than 250,000 taxpayers, about 1.5% of tax units reporting positive Schedule C income, will fall within the top two income tax brackets in 2011. These high-income taxpayers will report $38 billion in income—just over 11 percent of total positive sole proprietor income and only about 4 percent of all flow-through business income.
The vast majority of business income reported by taxpayers in the top two tax brackets comes from partnerships and S corporations and these taxpayers report most of the net positive income from these sources ($400 billion, or nearly 63 percent of net positive income from such businesses). Not surprisingly, that income is also highly skewed within the top bracket. For example, just 17 percent of the $133 billion of partnership income in the top bracket goes to business owners reporting less than $500,000 of income, and 46 percent goes to those reporting less than $1 million. Income from S corporations is even more concentrated—64% of the $211 billion subject to the top rate is for owners with more than $1 million in income.
What do we know about the types of businesses that are generating these large incomes? Unfortunately the answer is not as much as we would like. Individual returns provide very little information about the underlying businesses and the IRS does not release any firm-level data to the public. A 2008 JCT study (see Table 8a) reports that 61 percent of net income from partnerships and S corporations is earned by firms with gross receipts over $10 million and fully 43 percent by firms with gross receipts in excess of $50 million. Those data suggest that the majority of affected income may not come from what we generally think of as a small business, although we do not know whether large and small firms differ in how they distribute income among taxpayers in different income groups.
A recent open letter from a number of prominent academic economists called for better access to U.S. government data for research purposes. Allowing researchers access to micro-level data on flow-through business returns would result in a better understanding of the key economic and behavioral responses central to this policy debate.