Tax Reform: Challenges of Broadening the Tax Base

Tax reform is a long-standing topic for lawmakers and the many taxpayers, practitioners, and organizations who share similar ideas and concerns about our troubled tax system. For the past few years, the emphasis has been on lowering tax rates and broadening the base for revenue-neutral, comprehensive tax reform. Simplification and moving to some type of territorial system are also often part of the general plan.

In July, the Senate Finance Committee Bipartisan Tax Working Groups released five reports on tax reform. That month, a specific proposal for an innovation box, which taxes income from intellectual property at a lower rate, was offered in the House of Representatives. This article provides a summary of aspects of these activities and makes some observations about them to illustrate the challenges of broadening the base.

Senate Finance Committee Bipartisan Tax Working Groups

In January 2015, Senate Finance Committee leaders Sens. Orrin Hatch, R-Utah, and Ron Wyden, D-Ore., formed five working groups to review key areas of comprehensive tax reform (Senate Finance Committee press release (1/15/15)). These groups covered:

• Individual income tax.
• Business income tax.
• Savings and investment.
• International tax.
• Community development and infrastructure.

In March 2015, the Senate Finance Committee asked for public input by April 15 and received over 1,400 letters, all posted to the committee’s website (Senate Finance Committee press release (3/11/15)). Presumably, the working groups read all of this input, along with much they had gathered on their own, and discussed what was appropriate reform in their particular study area. In July, the reports of the five groups were released (Senate Finance Committee press release with links to each report (7/8/15)).

Following are some points gleaned from the individual and business reports that help tell a tale of the challenges of base broadening. Some of the efforts also indicate the challenges of simplification.

Report on individual taxes

The introduction to the 48-page report on individual taxation acknowledges that passthrough entities, which are primarily taxed in the individual tax system, must also be considered in tax reform. Among problems noted:

• The system is “frustratingly complex,” sometimes causing individuals to miss preferential rules.
• Many provisions expire every year.
• Identity theft risk.

The authors observe that base broadening “could either substantially reduce, or eliminate, many popular and widely utilized deductions, credits, and exclusions from income.” Reduced government spending was noted as an offset with the need to examine how much revenue the government needs. Additional issues raised for further discussion were how to distribute the “benefits and burdens” in the tax system and the desired level of progressivity.

The top 10 tax expenditures for individuals were noted (total added by this author):

Thus, the top tax expenditure “costs” about $785 billion over five years, and the top 10 add up to almost $4 trillion over five years.

The report observes that a 1 percentage point decrease in ordinary tax rates for individuals would reduce revenues, over roughly the same period as shown for the tax expenditures, by about $293 billion (on average, $58.6 billion per year).

The working group studied four areas as “ripe for possible bipartisan consensus”: home ownership, charitable giving, higher education, and tax administration. In the end, only the last three were addressed in the report.

Challenges: Despite starting with an acknowledgment of the tax preferences with the highest “costs” in reduced tax revenues, which are also the ones that present the largest opportunities to generate revenue to allow for lower rates, the report offers no suggestions in these areas. Thus, the working group did not analyze the purpose and effectiveness of any tax expenditures or how many individuals use them and their income level. The charitable giving and higher education reforms examined, such as increased percentage limits for qualified conservation contributions and larger education credits, would narrow rather than broaden the base. While the report includes an interesting discussion of a few existing proposals, it offers no plan for revenue-neutral tax reform for individuals.

Report on business taxes

The 140-page report on business income taxes does not offer a specific plan for reform but instead addresses what the members call “threshold issues” for reform: lowering the corporate tax rate and treating passthrough businesses equitably. It notes key underlying problems of complexity, economic distortion, and harm to international competitiveness. Possible savings from improved administration and compliance in the corporate tax area are noted, if their estimated $40 billion annual costs can be reduced.

The report highlights the effect of the tax law on business decisions, such as the rate differential of the Tax Reform Act of 1986, P.L. 99-514, that led to an increase in the number of flowthrough entities and a decline in the number of C corporations. Unlike the report on individual taxes, the business tax report offered a set of four principles for tax reform:

1. The business tax system should be internationally competitive and encourage job creation and economic growth, such as by lowering the tax rate.
2. Structural biases should be addressed (such as entity and debt-versus-equity decisions) and investment promoted.
3. Domestic innovation should be promoted.
4. “Remove complexity, encourage certainty and improve the taxpayer experience.”

Despite the principles and what might help reach them, such as a lower rate, a permanent research tax credit, and permanent rules, the report opted to provide “a non-exhaustive compilation of issues and provisions that the working group believes warrant further committee review as tax reform efforts continue.”

The report describes well the challenges of business tax reform. The “overarching challenges” include:

• Designing tax reform in a system of budget deficits and resolving the political debate over static versus dynamic scoring of the long-term revenue effects.
• A different situation today than in the mid-1980s. The Tax Reform Act of 1986 was helped by high individual tax rates (50% top rate), a willingness to increase business taxes to lower individual taxes, and broad interest in eliminating individual tax shelters (which also generated revenue).
• A need for bipartisanship and broad consensus for reform from Congress, the Obama administration, and the business community, including willingness to give up some existing provisions.
• The “cost” to reduce the corporate rate. Revenue-neutral reform will require about $10 billion per year of base broadening to lower the corporate rate just 1 percentage point. For context, the report lists various business tax expenditures. Eliminating the Sec. 199 deduction for domestic manufacturing would generate approximately $13 billion per year.
• Finding a way to treat passthrough entities “equitably.” The focus on corporate reform should not overlook the reality that over 90% of businesses operate in passthrough form and represent over 60% of total net business income.

Challenges: In 2013, the Senate Finance Committee issued 10 “Tax Reform Option Papers” that presented and analyzed various reform ideas. The 2015 report of the business working group followed a similar approach. When will the work move from listing ideas to the more difficult, but necessary task of drafting a reform package? For example, what tax preferences should be reduced or eliminated to “pay for” a rate reduction, and how much rate reduction is realistic using a static revenue analysis? Who will take the lead on issuing a proposed plan rather than continuing to list and analyze the options?

International tax reform activities

The 82-page report of the Senate Finance Committee working group on international tax includes 40 pages to explain the current rules and 15 explaining recent reform proposals. As part of a framework, the authors highlight the need to end the “lock-out effect” where elements of our current tax system encourage foreign over domestic investment. In addition to a territorial system, the report discussed patent or innovation boxes already in use in some countries including Belgium, France, and the United Kingdom. The authors suggest that the OECD base erosion and profit shifting (BEPS) report warrants attention to the patent box issue because Action 5 on harmful tax practices implies that existing patent box rules will be allowed if tied to research and development (R&D) and other business activities in the country offering the lower rate for income tied to the patent or innovation. Countries currently or soon to be using a patent or innovation box taxation will be lures for creating patents within their borders, which would harm U.S. innovation.

In July, Rep. Charles Boustany, R-La., and Richard Neal, D-Mass., both members of the House Ways and Means Committee, introduced an innovation box proposal with legislative language and technical explanation (as well as a section-by-section summary). The drafters seek comments on the proposal, including answers to eight specific questions. (See Ways and Means Committee press release (7/29/15).)

While some documents related to their innovation box proposal (such as a document on why it is needed), say the tax benefit is a lower rate on innovation box profits, the proposal is not actually a lower rate on profits, but is instead a deduction. The deduction is 71% of the lesser of (1) innovation box profits, or (2) taxable income without the deduction. Innovation box profits equal tentative innovation profit multiplied by a ratio of five years of Sec. 174 R&D expenditures to total costs. As with the Sec. 199 manufacturing deduction, the innovation box as proposed would require extra recordkeeping, special allocations, and multiple definitions. This innovation box proposal also includes a provision to reduce the tax consequences of the transfer of intangible property from a controlled foreign corporation to U.S. shareholders.

Sens. Rob Portman, R-Ohio, and Charles Schumer, D-N.Y., co-chairs of the Senate Finance Committee International Tax Working Group, praised the innovation box proposal as an approach “to protect our research, development, and American jobs” (Portman and Schumer press release (7/29/15)).

Rep. Paul Ryan, R-Wis., chairman of the House Ways and Means Committee, states that international tax reform is crucial to stop inversions of U.S. companies. While noting that it is not a “substitute for comprehensive reform,” there is a need to “modernize our system and stem the bleeding until we can achieve that kind of broader reform,” indicating he may separate international reform from rate reduction/base broadening reform (Ways and Means Committee blog (8/6/15)).

Challenges: Some of the tax reform challenges in international taxation include how to move to a territorial system from a worldwide system and what the transition rules should be. Also, should an innovation box be adopted? What is the effect on the possible rate reduction for U.S. companies that do not have R&D? How does it interact with the  Sec. 199 deduction and the research tax credit (assuming they remain)? What is the relevance of the OECD BEPS project on patent box taxation to the U.S. proposal? Finally, how does international tax reform affect efforts to lower tax rates in a revenue-neutral manner?

Looking forward

Is progress being made toward comprehensive tax reform, or are we in a perpetual study and discussion mode? The solutions are difficult and politically challenging because to lower tax rates in a revenue-neutral manner, tax preferences need to be cut. Without studying which preferences are least effective, the task cannot effectively advance. Most likely, tax reform efforts are stalled for now as Congress has many items on its plate, and the 2016 presidential race makes it easy to push off the task to the next Congress and president. As noted in the Senate Finance Committee business tax report, broad consensus is needed to enact comprehensive tax reform, as well as something as big as the 1980s tax shelter problem or attention from the media to garner broad support for tax reform.

Public education is also needed. How many workers are aware of recent research indicating that part of the corporate tax is borne by workers (Joint Committee on Taxation, Modeling the Distribution of Taxes on Business Income (JCX-14-13) (10/16/13))? How many know of the costs of a complex system? Who knows how the benefit of the more costly individual tax preferences are skewed to benefit higher-income taxpayers? How would reduction of any of these tax preferences permit a lower tax rate or a higher standard deduction for individual taxpayers?

What will help tax reform efforts move past the discussion stage to the action stage? And when will it happen?

Annette Nellen, Esq., CPA, CGMA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and maintains the 21st Century Taxation blog.