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February 25, 2013
Rebooting Tax Reform Planning
by Clint Stretch

Full Text Published by Tax Analysts®

by Clint Stretch


Clint Stretch argues that until Congress can find a way forward on spending and tax rates, comprehensive corporate tax reform likely will remain a matter of discussion rather than action.



Clint StretchClint Stretch is senior tax policy counsel for Tax Analysts.


The uncertainty created by the promise of corporate tax reform will not be resolved soon or easily. The delay means that business leaders must work to perfect their current law tax planning and their legislative strategy while also preparing for the opportunities that an eventual reform will present.


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For at least five years, Washington has been talking about corporate tax reform with growing enthusiasm. The case for reform is strong. A broad, bipartisan consensus understands that the U.S. corporate tax system creates competitive disadvantages for U.S. companies, encourages tax planning that has questionable economic benefits, and has rates that are too high. This consensus goes even deeper with an apparent agreement that tax reform should not increase corporate taxes. President Obama, Senate Finance Committee Chair Max Baucus, D-Mont., and House Ways and Means Committee Chair Dave Camp, R-Mich., all advocate various reforms. In the last two years, many businesses responded to the possibility of tax reform by hesitating in their current-law tax planning, modeling potential reforms, and gearing up the lobbying activities. Yet nothing happens.

The uncertainty created by proposals to change international tax rules, repeal tax benefits, and lower corporate rates at times seemed paralyzing. It adds risk to tax planning under current law, to decisions about how to engage in the tax reform process, and ultimately, to preparing for transition to, and implementation of, a new tax law. Business leaders want to know whether and when this uncertainty will be resolved and how to manage tax opportunities and risks in the meantime.

Although many hurdles must be overcome to achieve corporate tax reform, there are three major barriers to seriously beginning the process. They will not be removed easily. Understanding the barriers should give business leaders more confidence to move forward in addressing the opportunities and risks presented by the current system. It should also give them more flexibility to appropriately plan for the contingencies of eventual reform.

These barriers are (1) a political system that cannot agree on how much tax should be imposed, (2) the need for any reform to provide a system that is sustainable over the long term, and (3) the inherent difficulty of action on corporate income taxes without also addressing individual income taxes.

A Political System That Is Not Ready

The first barrier to corporate income tax reform is a political system that is ill-prepared to undertake tax reform because it cannot find agreement on important goals and is wrestling with many other controversial, nontax issues. The most basic question in designing a tax system is how much tax should be collected. Washington cannot answer or even approach that question in a straightforward manner. During the presidential elections, it sometimes seemed that everyone might agree on an approach similar to that proposed by the Simpson-Bowles commission. In the first debate, Republican nominee Mitt Romney said the president "should have grabbed" the Simpson-Bowles plan. Obama said his plan was like that by Simpson-Bowles but with "some adjustments."

For the record, the path Simpson-Bowles proposed would lead to radically different levels of tax and spending than current policy provides. Simpson-Bowles called for fiscal 2020 spending of 21.8 percent of GDP and revenues of 20.6 percent, resulting in a deficit of 1.2 percent of GDP. As the table on the next page demonstrates, that contrasts sharply with the current levels of tax and spending as stated in the Congressional Budget Office's February 2013 alternative budget baseline.1 The alternative baseline assumes that expiring tax provisions like the research tax credit are extended, that a scheduled but repeatedly deferred cut in Medicare physician payments is further deferred, and that the nearly $1.2 trillion in spending cuts required by sequestration does not occur. In effect, the alternative baseline projects the budget as it would be if current spending levels and tax rates were left in place. The table also presents the House Republican blueprint for the fiscal 2013 budget, which, while leading to a deficit similar to that recommended by Simpson-Bowles, does so by focusing on spending.

                      2020 Projection (percentage of GDP)
 _____________________________________________________________________________

                                                                   Publicly
                              Revenue     Spending     Deficit     Held Debt
 _____________________________________________________________________________

   Simpson-Bowles              20.6%       21.8%         1.2%        65.5%
   CBO alternative baseline    18.3%       23.0%         4.7%        81.1%
   House FY2013 blueprint      18.5%       19.5%         1.0%        65.1%

The CBO alternative baseline reveals that even after the spending cuts and tax increases of the last two years, Washington is on track to spend $5 for every $4 it collects in taxes. The House Republican budget would solve the remaining budget gap almost entirely through spending cuts, and Republican leaders on both sides of Capitol Hill have announced that with the recent increase in top rates, they are done with tax increases. In contrast, the Simpson-Bowles solution would require nearly more than $2 of tax increases for every $1 of spending reduction.2

Those ideological disagreements over spending and taxes are unlikely to be resolved in a grand bargain. Rather, Washington likely will continue to narrow the gap on taxes and spending incrementally. Until that is accomplished, comprehensive reform will be difficult to pursue. In the meantime, many business leaders regard persistent deficits and legislative gridlock as presenting more risk than any particular solution might. But they have also found that speaking out in the interest of compromise rather than ideology can come at a high political cost. A corporation's executive leadership and board of directors will want to ensure that their company has a consistent and managed message on these issues.

Beyond a basic agreement on how much tax should be collected, tax reform also takes time and focused leadership. Serious legislative action on the Tax Reform Act of 1986 began when President Reagan delivered an Oval Office address calling for reform on May 28, 1985. Former Ways and Means Committee Chair Dan Rostenkowski immediately supported the concept. The resulting legislation was signed 17 months later and was generally effective beginning in 1987. That precedent suggests that even if a broad bipartisan consensus supported a single approach to tax reform -- which was the case in 1985 but not today -- the resulting reform likely would not be effective until 2015 at the earliest.

The Congress that considered TRA 1986 was unusual in that it dealt with few major controversial pieces of legislation at the same time. Today, other controversies are competing for our leaders' attention. Three relate directly to the larger issue of deficits: the sequestration, which is scheduled to take effect on March 1; the March 27 expiration of the continuing resolution that funds the government; and the debt limit, which recent legislation suspended until May 19. In addition to those urgent budget-related issues, immigration reform, gun violence, the minimum wage, and the farm bill (by September) will all vie for congressional priority. Focusing on fundamental tax reform in the midst of those other legislative concerns would be difficult. Moreover, the 2014 midterm elections will quickly start influencing political behavior.

A delay in moving forward on tax reform will mean continued uncertainty about future law, but it also gives corporations time to prepare for an eventual reform through enhanced business and political strategies. If a business concludes that comprehensive tax reform is unlikely to be effective before 2015 or 2016, it can focus tax department resources more on current threats and opportunities and less on contingency planning. Although the latter still will require an added layer of analysis to understand the effects that an eventual tax reform might have on planning, and consideration of steps to manage tax assets and liabilities in light of the possibility of a significant midterm rate reduction.

Importantly, if spending and tax decisions in Congress are implemented separately at different times, as seems likely, or if the tax issues in play are relatively unimportant to a particular corporate taxpayer, the company will have greater flexibility lobbying for federal spending programs that affect the business.

A Zero-Sum Game

The second barrier to comprehensive corporate tax reform is a broadly shared belief that corporate tax reform must be revenue neutral. Reform cannot result in an overall reduction in corporate tax payments, which would shift tax burdens to individuals; rather, it should redistribute tax burdens within the corporate sector. Unfortunately, analyses to date suggest that a revenue-neutral approach to reform would be more difficult to establish than simply paying for lower rates by repealing tax expenditures -- an approach that dominates the tax reform sound bites.

In October 2011 the Joint Committee on Taxation provided an analysis of the lowest corporate tax rate that could be enacted through revenue-neutral legislation repealing or modifying the major corporate tax expenditures. The JCT assumed all changes would be effective in 2012, and it estimated that for the period 2012 through 2021, the lowest corporate rate that could be achieved in a revenue-neutral manner would be 28 percent. A 28 percent rate is significantly higher than many advocates of corporate tax reform have suggested.

The JCT's analysis serves as a warning about how difficult the path to corporate reform will be as Congress tries to find enough revenue by changing existing tax benefits to dramatically lower the rate.

Another challenge presented by revenue-neutral tax reform arises when the analysis is extended beyond the 10-year budget period for which Congress analyzes tax and spending changes. Rate reductions lower taxes in all future periods. Repealing tax expenditures such as favorable accounting methods or accelerated depreciation does not, however, raise significant revenue in all future periods. In the JCT's 2011 analysis, more than half of the revenue generated from repeal of tax expenditures came from these kinds of timing changes rather than from changes in such items as exclusions or credits. As a result, revenues from these changes beyond the budget window likely would be insufficient to fully offset the cost of the rate reduction.

The president and Treasury have already identified this issue in their joint February 2012 framework for business tax reform:


    While a number of the measures that raise revenue in corporate reform -- most consequentially, ending accelerated depreciation -- raise more revenue in earlier years than they do in later years, the President is committed to corporate tax reform that does not add a dime to the deficit, over the next decade or thereafter. Put simply, the President will only accept business tax reform that is fiscally responsible.3

Quite apart from the principle asserted by the administration, the issue of costs beyond the budget window has practical legislative impact. A commonly proffered strategy for overcoming various hurdles in tax reform is to require reform as part of budget reconciliation. Reconciliation mandates a level of increased or decreased revenues to be reported by the taxwriting committees and provides procedural protections to their recommendations that would compel a Senate vote on them. The process was used to enable passage of the Clinton tax increases of 1993 and the Bush tax cuts of 2001 and 2003.

However, when reconciliation is used, a Senate rule (the Byrd rule) prohibits measures that increase the deficit for a fiscal year beyond those covered by the reconciliation measure. That requirement subjected the Bush tax cuts to a sunset provision. It would be difficult to draft legislation that complies with the Byrd rule requirements while still relying on accounting adjustments, changes in depreciation schedules, and mandatory recognition of previously deferred amounts as principal sources of funds for lower rates.

Managing risk in the zero-sum game is very different from managing opportunity in the tax cutting environment that dominated the last decade. Corporate leaders in the C-suite and on boards of directors must be more involved in guiding corporate strategy on tax legislation than they traditionally have. As deficit reduction efforts continue, the first challenge for business will be to preserve the current tax benefits until reform occurs. If corporate tax benefits are curtailed in a deficit reduction context to raise revenue, the available supply of reforms to offset the cost of rate reductions shrinks, and the amount needed to fund any given lower rate increases. Obama's budgets have repeatedly proposed actions such as modifying international tax rules or repealing specific tax expenditures, such as the last-in, first-out inventory method.

The second challenge in this zero-sum game is that the universe of potential adverse actions is unknown. Efforts to achieve the low tax rate could force Congress to look beyond tax expenditures for sources of additional revenue. Previously suggested options have included limiting the deductibility of interest on corporate debt, raising the rates at which shareholders pay tax on dividends and capital gains, and substantially modifying international tax and financial products tax rules to broaden the tax base.

The third challenge for businesses in this zero-sum game is how to retain a unified business community that shares in the sacrifices as well as the opportunities. Lawmakers will work to build a coalition supporting reform even if that means dividing the business community. If a particular industry or business segment is protected in tax reform, the remaining companies will end up paying more through a smaller rate reduction or deeper cuts in tax benefits.

The final challenge is that in revenue-driven legislation, transition relief is often limited. That means that as reform becomes more likely, businesses will have to actively manage their taxes, as well as tax-sensitive products and services.

Corporations Do Not Vote

The third barrier to comprehensive corporate tax reform is the reality that for elected officials, any corporate tax reform must be accepted by individual constituents as reasonable. Even for staunch congressional advocates of reform, the paramount political question is whether a broad-based corporate income tax reform can safely be enacted in the absence of a complementary reform of the individual income tax system.

Two factors lead to the conclusion that it cannot. First, current law produces a combined top income tax and wage tax rate on self-employed individuals and small businesses that is nearly 43 percent. Lawmakers could find it difficult to defend a 28 percent or lower corporate tax rate in comparison to that 43 percent rate.

Second, Congress cannot simply repeal various business tax benefits and ignore the effect on unincorporated businesses. Fundamental fairness would require that those effects be offset somehow. Determining how to do that would add a new layer of complexity to the business tax reform debate. The alternative would be a simultaneous broad-based individual income tax reform.

Our political system, however, is far from prepared to reform individual income taxes. Here are just three factors to consider: First, there is no consensus on the size of individual income taxes or the top individual income tax rates. Republicans oppose any tax increases. Democrats, when they call for a balanced approach that includes taxes, are necessarily talking about individual income tax increases. This is true because the individual income and payroll taxes are where the money is. Over the last three decades, the individual income tax and payroll taxes accounted for 80 percent of all federal revenues while the corporate income tax accounted for only about 10 percent.

Second, even a revenue-neutral individual income tax reform would be controversial. For example, the largest tax expenditures that would have to be repealed or dramatically limited to lower individual income tax rates are the incentives for retirement savings and the exclusion for employer-provided healthcare.

Third, nearly half of individuals do not owe federal income tax under current law. So nearly half of all households would have no direct gain from reform of the individual income tax system, especially a reform that increases their taxable income by limiting healthcare and retirement tax benefits.

Steering a Course

Until Congress can find a way forward on spending and on the level of taxes, comprehensive tax reform will likely remain a matter of discussion rather than action. This gives corporate leaders valuable time in which to work with their tax departments to perfect current tax planning and their legislative strategy, as well as time to develop marketplace strategies that optimize opportunities created by reform when it occurs.


FOOTNOTES

1 Congressional Budget Office, "Budget and Economic Outlook: Fiscal Years 2013 to 2023" (Feb. 2013).

2 To put this in context, the difference between the Simpson-Bowles commission's levels of taxation and the CBO's alternative baseline, 2.4 percent of GDP would be nearly $400 billion of taxes in terms of 2014 GDP.

3 See "The President's Framework for Business Tax Reform" (Feb. 2012) .


END OF FOOTNOTES

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