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Washington Wire: Beyond Tax Expenditures: Revenue Raising Options for Tax Reform

Published by Michael J. Novogradac on Sunday, July 1, 2012

Journal cover July 2012   Download PDF

Last month, in a keynote address delivered at the Bipartisan Policy Center, Senate Finance Committee Chairman Max Baucus, D-Mont., laid out his goals for comprehensive tax reform. He said a 21st-century tax code must promote four goals: generating jobs from broad-based growth, competitiveness, innovation and opportunity. Baucus is just one of a number of lawmakers expected to tackle comprehensive tax reform in the coming months and years. President Barack Obama weighed in earlier this year, positing five recommendations for business tax reform that included eliminating certain tax expenditures and reforming the business tax base. House Ways and Means Committee Chairman Dave Camp, R-Mich., proposed lowering the top tax rate to 25 percent by broadening the tax base, which to a large extent would be done by cutting or eliminating tax deductions and tax credits, as well as income exclusions.

President Obama, Baucus, and Camp each have proposed reducing or eliminating tax expenditures to reduce tax rates. In his remarks last month, Baucus said, “We need to take a hard look at each and every expiring provision to decide which to make permanent and which to eliminate … Every tax provision needs to prove it has a tangible benefit to our economy or society. If not, it doesn’t belong in the tax code.”

But tax expenditures alone may not offer enough revenue to allow for revenue-neutral or revenue raising tax reform. Moreover, eliminating some of the largest and most widely used tax expenditures would be extremely difficult. Thus, it’s likely that lawmakers in their pursuit of revenue-neutral or revenue raising tax reform will consider other revenue raisers that currently are not considered “tax expenditures.”

Taxation of Pass-Through Entities
In 2011, the Obama administration was reported to be considering taxing pass-through entities with more than $50 million in gross receipts as corporations. Baucus also suggested that taxing large pass-through entities as corporations may be necessary to achieve any meaningful reduction in the corporate tax rate. Speaking at a hearing on May 4, 2011, he did not specify an income level at which pass-through entities should be taxed, or whether he would support the change – only that the idea should be considered.

In testimony on September 14, 2011, the U.S. Chamber of Commerce warned that increasing marginal rates on pass-throughs would harm small businesses, which it says are more likely to operate in pass-through form. The Chamber cites research from the Tax Foundation, which reports that more business income is taxed under the individual income tax code as pass-through businesses than is taxed under the traditional corporate income tax code. The number of pass-through businesses nearly tripled between 1980 and 2007, from roughly 10.9 million to more than 30 million, according to the Tax Foundation. In the same time period, the group says net receipts from pass-through entities saw a six-fold increase, from $315 billion to more than $1.8 trillion. As such, the growth in number and income of pass-through entities may be used as arguments both for and against changing the rate at which they are taxed.

Higher Taxes on Capital Gains and Dividends
Currently, long-term capital gains and qualifying dividends are taxed at a top rate of 15 percent. The top tax rate on ordinary income is currently 35 percent. Absent congressional action, the top tax rate on capital gains will increase to 20 percent in 2013 and the top rate on dividends will climb to 39.6 percent. In addition, the Affordable Care Act included a surcharge on investment income of 3.8 percent, which would raise the effective rates to 24 percent for capital gains and 43 percent for dividends. In 2010, Baucus proposed making permanent the current capital gains rate for taxpayers with incomes up to $250,000 for married couples and up to $200,000 for individuals. He also proposed continuing to treat dividends as capital gains for all taxpayers. Also in 2010, the Bowles-Simpson Deficit Reduction Commission suggested a top tax rate of 28 percent for individuals and corporations. To accomplish this reduction, the commission called for taxing capital gains and dividends at the same rate as ordinary income.

Opponents say this would increase the double taxation of income produced by labor and capital in the corporate sector. Speaking at a Senate Finance Committee hearing on September 14, 2011, Stephen J. Entin, president and executive director of the Institute for Research on the Economics of Taxation, warned, “Increasing the double taxation of corporate income by raising tax rates on capital gains and dividends would dramatically reduce capital formation and wages, and would not raise the expected revenue.”

Revised International Tax Rules
Camp last year proposed transitioning the United States to a territorial system of taxation, which would exempt from taxation the foreign income of U.S. multinational firms. Proponents say a territorial system would enhance the competitiveness of U.S. firms in low-tax countries, potentially increasing the external benefits associated with multinationals’ activity in the United States. Opponents argue that the move would reinforce an already strong tax incentive to locate economic activity and profits in low-tax countries, which could further erode the corporate income tax base. Ultimately, a move to a territorial international tax system has the potential to raise or reduce revenue, depending on how it is designed. Even without a dramatic overhaul of the international tax system, as noted by Michael Mundaca, President Obama’s former assistant Treausry secretary for tax policy, some specific international tax proposals may be revisited, including proposals to determine the foreign tax credit on a pooled basis, to defer the deduction of interest expense related to deferred income, and to tax excess returns associated with the transfer of intangible assets to a related controlled foreign corporation.

Deductibility of Business Interest Expense
In his framework for tax reform, President Obama said reducing the deductibility of interest expense for businesses should be considered as part of tax reform. The administration said that a tax system that is more neutral toward debt and equity will reduce incentives to overleverage. In addition, the president contends that reducing the deductibility of interest for corporations could finance lower tax rates.

Last year, Camp and Baucus held a joint hearing to review the tax treatment of debt and equity in the context of comprehensive tax reform. At that hearing on July 13, 2011, University of Colorado Law School associate professor Victor Fleischer said the debt/equity distortion is costly on two levels. First, deals are restructured to reduce taxes and this erodes the tax base. Second, he said, “when a corporation restructures a deal to reduce taxes, the restructuring imposes an implicit cost on the corporations themselves: corporate manager s are willing to add complexity to their capital structure, distort corporate governance, and even change investment policy and other critical business decisions as long as the tax savings are worth it.”

Narrowing Tax-Exemptions for Not-For-Profits
Another way to raise revenue would be to limit the number of entities that qualify for not-for-profit status, and to narrow the activities eligible for exemption from income tax. Narrowing the definition of what constitutes a not-for-profit entity, and narrowing tax-exempt eligible activities, would have the direct effect of broadening the tax base. In an article earlier this year in Free Inquiry magazine, University of Tampa professor Ryan Cragun estimated that the U.S. government forgoes as much as $71 billion a year by not taxing religious institutions. And on May 16, Rep. Charles Boustany, R-La., chairman of the House Ways and Means Oversight Subcommittee held a hearing on tax exempt entities and the state of the tax-exempt sector in the context of the committee’s efforts toward comprehensive tax reform.

Taxation of Carried Interests
For several years lawmakers have proposed taxing carried interests as ordinary income. Proponents of the change argue that an “inappropriate loophole” allows some hedge fund managers, private equity partners, and other managers in partnerships to pay a 15 percent capital gains rate on income from carried interests. President Obama’s framework would eliminate this treatment and tax income from carried interests at ordinary income rates. Opponents contend such a change would have a much wider impact than anticipated especially on real estate partnerships.

Financial Transactions Tax
A lobbying campaign has emerged calling for a tax on financial transactions that it has dubbed a “Robin Hood Tax.” The campaign proposes a tax on trading in stocks that would average at about 0.05 percent, as well as a smaller tax on bonds, derivatives and currencies. On June 22, a group of financial industry professionals published an open letter in support of financial transaction taxes as a way to discourage a short-term trading mentality and potentially raise revenue. The letter acknowledges that concerns have been raised that financial transaction taxes could damage growth, but contends that “a growing body of evidence suggests that by reducing volatility and raising much needed revenue, the overall effect would be positive.”

ConclusionThe proposals mentioned here are just a few of the options other than cutting tax expenditures that may be considered in the ongoing discussions about tax reform. If you have additional thoughts on revenue raisers, let us know. Send an e-mail to [email protected].

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