Paul Ryan’s Tax Reform Proposal

Late last month, Speaker of the House Paul Ryan released the tax reform component of his “A Better Way” task force project undertaken in collaboration with GOP House members.   It deserves serious attention.

The real importance of this proposal is the structural change it contemplates:  specifically, moving the tax system more toward a consumption base and changing the reach of the corporate tax.

Here are the key points: 

  • Moving toward a business cash flow tax  The proposal calls for an immediate write-off (expensing) of business investment combined with an elimination of deductions for net interest (special rules on interest deduction for financial services). 

 

  • Territorial and Border Adjustability  The task force calls for a “destination-basis” corporate tax system, meaning the reach of the corporate tax would be territorial and exports would not be taxed while imports would be subject to taxation.  Current World Trade Organization rules allow border adjustability for Value Added Taxes but not for corporate income taxes.  Speaker Ryan and his colleagues believe that moving toward a cash-flow method for taxing business income would make border adjustability possible under WTO rules.

 

  • Repatriation Holiday  Existing  earnings accumulated overseas would be repatriated subject to a low tax rate payable over eight years.

 

  • Treatment of Pass-Throughs  For C corporations the top rate under the reform regime would be 20%.  To solve the inevitable problem of the tax treatment of S corporations, partnerships, etc., the task force would distinguish between “reasonable compensation to owner-operators” which would be deductible by the business and payable by the recipient and active business income which would be taxed at 25 percent at the individual level. level.  Obviously this would require careful rulemaking.

 

There is much more to the task force proposal including suggested reform of the IRS, the development of a simplified “postcard” tax form for individuals with a large standard deduction (or, alternatively use of the mortgage interest and charitable deductions), elimination of the individual AMT, and repeal of the estate and generation-skipping transfer taxes.

Just as Kemp-Roth and similar tax proposals provided the intellectual framework for the tax reform of 1986 without fully anticipating the details, Ryan’s recommendations should set the boundaries for future tax reform, perhaps as early as next year.   Compared to what we have heard from the two Presidential candidates, the task force’s ideas have the added advantage of being serious.  It would be great if House Democrats would attempt a similar contribution to the policy mix on many of the same topics.

 

Hope for Tax Reform?

The Presidential campaign season thus far has not been remarkable for sparking intelligent public policy discussions.  And that does not bode well for how our nation’s economic problems will be addressed after the election.  Trade policy seems to be in the deep freeze.  Immigration reform has been infantilized.  And the most dangerous issue of all:  our large and rising national indebtedness, has been all but ignored or, worse, wished away with bizarre proposals about expanding entitlement programs whose effect, if adopted, would make the situation worse.

Is tax reform any different?  Perhaps not.  But there may be reason for very qualified optimism that something might be done next year.

For one thing, all of the Presidential candidates have reasonably detailed tax reform proposals that, if nothing else, would seem to signify a desire for reform.  Simultaneously, the two tax writing committees of Congress, the House Ways and Means Committee and the Senate Finance Committee are working on ideas that the next President could adopt, partially or in full, in an effort to achieve a bipartisan reform bill.

As for the American Business Conference, we continue to press for comprehensive tax reform.  Comprehensive instead of business because companies are organized for tax purposes in different ways.  That means changing the corporate tax alone will not help all firms.  To do the job right, we must change for the better the individual as well as the corporate tax.  It’s a tougher lift, to be sure, but it is the way to go.

Recently, ABC has associated itself with a coalition calling itself Parity for Main Street Employers.  This letter, sent to senior members of Ways and Means and Senate Finance, outlines the tax ideas of the group.  As ABC has done for some time now, the letter calls for integrating the corporate tax so as to eliminate the double taxation of corporate profits.  Second, it calls for a restoration of rate parity between pass through businesses and C corporations.  The end result would be an equitable, pro-growth taxation of all businesses instead of the uncompetitive mess we now endure.

The only thing that is missing from the letter, in our view, is that it does not mention reform of the way the nation taxes foreign profits.  On that point, ABC continues to press, in other fora, for adoption of a territorial system.

Scrap the Corporate Income Tax

Corporate tax reform is an evergreen issue in Washington.  Most recently, House Ways and Means Committee Chairman Dave Camp has produced a reform proposal that has justly been praised by the tax expert Martin Sullivan as “monumentally important” for its seriousness and workmanship.  It is also, as Sullivan, among others, admits, not likely to be enacted anytime soon.

Rather than try to reform the beast, isn’t it time to think about getting rid of the corporate income tax with all of its complexity, enormous compliance costs, and perverse loopholes put in place by business lobbyists who regard tinkering with the tax as their own perpetual ATM machine?  Intelligent observers have suggested as much.  For example:

 

 

  • Lefty writer Matthew Yglesias, for his part, has given up on the possibility of corporate tax reform and advocates something “bigger and tougher:” abolition.

 

  • Economist Laurence Kotlikoff of Boston University believes that the there is a “worker based,” pro-jobs case for eliminating the corporate income tax, particularly for “young and future workers.”

 

  • Another commentator, Mark Levey, writing at the beginning of President Obama’s first term, somewhat optimistically hoped the new President would press for cutting the corporate tax rate to 0% as the “quickest way” to bolster the credit markets and “get money into the economy for true job creation.”

 

If getting rid of the corporate income tax seems hopeless, consider that in some ways it is already happening.  As ABC Chairman Al West testified before the Center for Strategic and International Studies’ Strengthening of America Commission two years ago, there has been an “explosion” of firms organizing themselves as Subchapter S corporations or as partnerships.

These “pass-through” entities avoid the corporate tax entirely and their growth in number therefore erodes the corporate tax base.  Nor are they all small businesses.  More than 14,000 Subchapter S corporations have revenues of more than $50 million.  We are thus, West noted, “in the position of having businesses of similar size selling similar products and services, yet facing different tax obligations based solely on the way they are organized.”

Ignoring, for a moment, the political difficulties, how would one eliminate the corporate tax while insuring that the wealthy do not subsequently use corporations as tax shelters?

One possible approach draws on Canada’s Gordon Commission from back in the 1960s.  It involves what might be called an extreme integration of the corporate and personal taxes. Each year shareholders would get a report (like a 1099) that would say, in effect, “we paid you X in dividends and paid Z in corporate taxes on that portion of profits. Add X+Z to your taxable income and take Z as a tax credit. We also reinvested A in the corporation and paid B corporate tax on that part of profits. Add A+B to your taxable income and take a tax credit of B.   Also raise your cost basis in the stock by A for the purpose of capital gains taxes.”

That approach effectively does away with the corporate tax. However, there are complications. How do you deal with sales of stock during the year? How do you deal with different classes of shares – preferred, voting, nonvoting, etc.?  The first problem could be dealt with using year-end records. Presumably the market would recognize that stocks purchased during the year came carrying a tax credit. The latter problem could be dealt with arbitrarily.

This proposal was deemed far too radical for conservative Canadians.  But it has a certain intellectual purity. The equivalent of a 1099 for shareholders would not be that complicated. As for keeping track of adjustments in cost basis for stock held for a long time, presumably this would be done through brokerage accounts (the vast majority of shareholders own stock through brokerage accounts).

Another approach could be drawn from the world of non-profits.  Foundations pay a tax based on failure to payout a percentage of principal every year. There are clear formulas and all foundations try to avoid paying taxes by meeting the disbursement requirements, which is the objective of the tax after all.

The same concept could be applied to corporations and undistributed profits. It could be based on a percentage of profits which would be easy to do as GAAP are clear and disbursements would be easily audited. The percentage to be paid out could begin by simply adopting the existing tax rate structure. It could be changed annually by reviewing tax revenues generated.

Actually most individual taxpayers that would receive these dividends would be in a higher tax bracket than the corporations and if the government so chose it could make this class of distributions taxed at a higher rate than ordinary income, capital gains or dividends. There could be thresholds of exemptions and accelerating rates based on levels of income.  “This,” one ABC member has written,” could be a no-brainer benefiting corporations and giving the government the opportunity to generate even more tax revenue. The money that corporations would save by not having to file tax returns would be substantial as would domestic business expansions and job creation.”

Of course if neither of these ideas, or anything similar, is likely to be put on the political table, if only for discussion.  That’s because, on tax policy, the power centers in Washington, while ostensibly in intellectual opposition to one another, almost always converge to enshrine the status quo, which is what they know best.  The problem is, in the current competitive world, the status quo is a recipe for decline.