POSSIBLE BLUEPRINTS FOR TAX REFORM
For true tax reform to move forward, Washington observers maintain that the full weight of the White House must be behind it. They point to former President Ronald Reagan’s leadership that was necessary in 1986 to combine the force of the White House, Treasury Department and the IRS in accomplishing the last major overhaul of the Tax Code. Based upon President Obama’s campaign statements, the President may be ready to make such a commitment to help establish a legacy for his second term.
A tax reform movement has been growing on Capitol Hill for several years as well and may provide a bipartisan opportunity on which to act. The House Ways & Means Committee held over a dozen hearings on tax reform in 2011 alone. In 2012, tax reform hearings before Ways & Means focused, among other issues, on closely-held businesses (March 7), retirement security (April 17), and capital gains (September 20). The Senate Finance Committee also held hearings in 2012 that included the examination of tax reform in connection with extenders (January 31), the state and local tax system (April 26), and education tax benefits (July 25). A March 1, 2012 letter from Ways & Means Chair Dave Camp, R-Mich, sums up the increasing resolve of those on Capitol Hill to follow through on tax reform:
“The Committee recognizes that a complex, burdensome, anti-growth tax code remains a significant obstacle to economic recovery and job creation. Accordingly, the Committee anticipates continuing its extensive efforts to simplify and reform the tax code for individuals, families, and employers …”
In the weeks leading up to the November elections, a number of lawmakers from both parties said that the Simpson-Bowles Plan (named for the co-chairs of the 2010 Presidential Commission on Fiscal Responsibility and Reform, Alan Simpson and Erskine Bowles) could serve as a framework for a tax and deficit reduction package in the lame-duck Congress and then for a more comprehensive overhaul of the Tax Code in the 113th Congress. President Obama appointed the 18-member commission of 10 Democrats and eight Republicans in early 2010. The commission, which met throughout 2010, issued its final report in December 2010. While the commission failed to reach a super-majority (14 of 18 members), members of Congress and the Obama Administration are now suggesting that the Simpson-Bowles plan be given a second look, to serve as a base from which both Democrats and Republicans can find common ground.
Six goals. The Simpson-Bowles plan has six goals:
• ▪ Achieve nearly $4 trillion in deficit reduction through 2020;
• ▪ Reduce the federal deficit to 2.3 percent of gross domestic product (GDP) by 2015 (2.4 percent excluding the plan’s Social Security reform);
• ▪ Reduce income tax rates, abolish the alternative minimum tax (AMT), and cut “backdoor spending” in the Tax Code;
• ▪ Cap federal revenue at 21 percent of GDP and get federal spending below 22 percent, and eventually to 21 percent;
• ▪ Ensure lasting Social Security solvency;
• ▪ Stabilize the national debt by 2014, and reduce it to 60 percent of GDP by 2023 and 40 percent of GDP by 2035.
Individuals. Various proposed tax reform plans would eliminate many income tax expenditures, simplify others and use the revenue to lower the individual income tax rates. The Simpson-Bowles plan projected that elimination of all deductions and credits would achieve a bottom individual tax rate of eight percent, a middle individual tax rate of 14 percent and a top individual tax rate of 26 percent.
IMPACT.
Some tax expenditures, such as the child tax credit, the earned income tax credit (EIC), the deduction for charitable contributions, and the deduction for home mortgage interest, would likely survive tax reform, many observers admit. However, retaining these incentives, or any others, would need to be offset by higher individual income tax rates.
IMPACT.
Flow-through of business income to the individual tax returns of sole owners, individual partners and S corporation shareholders creates a coordination problem in trying to align individual tax rates with proposed changes under corporate tax reform. Tackling both individual and corporate tax reform at the same time, however, may prove to be too large an undertaking. Treasury officials in the Obama Administration have appeared to favor concentrating on corporate tax reform first.
Capital gains/dividends. Under the Simpson-Bowles plan, all capital gains and dividends would be taxed at ordinary income rates (which will have been lowered by the elimination of tax expenditures). The plan notes that the effective tax rate on investment income could be reduced by excluding a portion of capital gains and dividends (for example, 20 percent) from income. However, to offset this exclusion while maintaining progressivity, the top tax rate on ordinary income would have to be increased.
Businesses. Many business tax expenditures would also be eliminated under the Simpson-Bowles plan and similar plans that aim to reduce the corporate tax rate. The Simpson-Bowles plan projects a top corporate tax rate of between 26 percent and 29 percent, contingent upon elimination of business tax expenditures.
Comment
The Simpson-Bowles plan specifies only a handful of business tax expenditures for elimination. These include the Code Sec. 199 domestic production activities deduction, and the Last In/ First Out (LIFO) method of accounting. The Obama Administration, in contrast, has made Code Sec 199 a centerpiece in providing a 25 percent effective tax rate for manufacturers under its corporate reform proposal issued in February 2012. The Administration’s FY 2012 Revenue Proposals (the “Green Book”), on the other hand, recommends repealing the LIFO method of accounting for inventories, a proposal that has been opposed by certain industry groups.
Territorial system. The Simpson-Bowles plan would gradually move the U.S from a worldwide system of taxation to a territorial system of taxation. Under a territorial system, income earned by foreign subsidiaries and branch operations would be exempt from U.S. taxation. The taxation of passive foreign-source income, however, would remain unchanged.