Business tax reform needs a bipartisan, national consensus, but is absolutely necessary for the country to remain competitive in a global economy, according to Senate Finance Committee chair Chuck Grassley, R-Iowa."I think the consensus is there that the business tax system is in desperate need of reform," he told a recent hearing on the business tax system. "But we need to start building consensus on how to do it."
Dr. Robert Carroll, the deputy assistant secretary for tax analysis at the Treasury Department, who testified at the hearing, said at a Tax Foundation podcast that Congress would be a willing partner in tax reform.
"It's pretty clear that Congress is very interested in tax reform," he said. "At Treasury, we of course have a new secretary, and he's still working to develop his priorities, and the country faces a number of important challenges, not only on the tax front, but we also face very large fiscal imbalances in the future that need to be dealt with - entitlement reform, reforming Medicare and the Social Security system are both important to dealing with this longer-term problem. The administration will be evaluating over the coming weeks and months exactly what it should focus on over the next two years in office."
Carroll said that the tax system that we have today imposes costs on the economy both in compliance costs and economic costs. "The Internal Revenue Service estimates that those compliance costs total up to about $140 billion a year, spread between both individuals and businesses - about $100 billion borne by individuals, about $40 billion borne by businesses - in just compliance costs associated with the very vast complexity of the tax system," he said.
"The tax system also interferes with economic decision-making in very important ways," he added. "It interferes with the ways in which households make decisions, and the ways in which businesses make decisions, and those economic costs are very, very significant. Economists have estimated that a fundamental reform to the tax system could increase economic growth by some 2 to 10 percent."
Carroll said that in addition to the three broad objectives of simplicity, growth and fairness that President George W. Bush laid out when creating the Advisory Panel on Federal Tax Reform, there are principles that should be adhered to as approaches to tax reform are considered.
"One principle would be that the tax system should raise revenue with the least possible interference in business and household decision-making," he said. "Another principle would be that the tax system should have a broad base, with low tax rates. A third might be that the tax system should promote a strong economy by promoting savings and investment, and the tax system should be appropriately progressive, and provide equal tax treatment of similarly situated taxpayers."
The tax system also affects where businesses spend their money, according to Carroll.
"Domestically based multinational businesses and their foreign investment are very important; they help bring the benefits of global markets back to the United States by providing both jobs and income," he said. "Like all firms, multinational firms have to choose how much and where to invest, and the tax system is very important to those decisions. Multinational have to decide where to locate their headquarters, their intangible assets, their R&D, and their decisions often affect which countries are going to reap the benefits from the multinationals' operations."
Does one size fit all?
Jeff Johannesen of RSM McGladrey pointed out that midsized businesses organize their corporate structure in a different way than larger companies, and direct their resources to managing and developing their businesses and competing with larger and better-capitalized corporations. "They don't invest in increasing internal administrative resources to comply with complex public policies that really are not appropriate for them, but nevertheless cover them," he said.
As a result, "an organization with $500 million of annual revenue with little or no internal tax department simply cannot cope with the numerous federal, state and local filing requirement on a routine and regular basis," he said.
"These two points are important," he noted, "because midsized firms are often forgotten in the formulation of public policy. Large businesses actively participate in the development of tax policy. Congress often creates small-business exemptions to protect the smallest firms. Unfortunately, middle-market firms may not participate in policy development and are often left attempting to implement policies that don't fit their structure."
"In our experience, the presumption that companies with revenues of $25 million, $100 million or even $500 million can deal with laws and regulations with the same ease as companies with $25 billion or $100 billion in revenues is flawed," he said. "An organization with $500 million of annual revenue with little or no internal tax department simply cannot cope with the numerous federal, state and local filing requirements on a routine and regular basis."
As an example, Johannsen said that an RSM survey found that less than two thirds of midsized manufacturers are taking advantage of key tax credits and deductions that could benefit them. "For example, it would be a safe bet that nearly all Fortune 500 corporations take advantage of R&D tax credits ... but only about 60 percent of midsized manufactures responding to our survey do so."
A broken system?
Former IRS Commissioner Charles O. Rossotti said that he had experienced the terrible inefficiency of the tax system from both sides of the table, as both a tax administrator and a businessman, "and have often reflected to myself that America is indeed a rich and productive country if it can afford the monumental burden of such an inefficient tax system. But that begs the question of whether it has to be that way."
Rossotti offered four principles that he considered essential to making a simpler, fairer and more efficient system of business taxation.
First, he said, lower rates are better than special preferences. "Over the years, a large number of special preferences for particular kinds of business activities have been put into the code," he said. "Some of these, such as the R&D credit, are substantial in size and affect a significant percentage of businesses, and others are much smaller and affect only a few businesses. But each of this long list of preferences requires complex rules and regulations to define who is entitled to get these preferences; they are the source of enormous controversy and often confusion between taxpayers, the Treasury and the IRS; and they all have the effect of raising the rates for all businesses."
Second, said Rossotti, rules for small businesses should be and can be far simpler than those for large businesses. "It makes no sense to impose the complex rules needed to measure income in a multibillion-dollar global business on a local business with a few employees. Attempting to do so imposes large unnecessary costs on small business. It also impedes compliance by diverting IRS resources into technical issues at the expense of the major compliance problem with small business, which is to ensure that all income is reported."
Third, according to Rossotti, double taxation of businesses should be reduced or eliminated, but all business income should be taxed once at approximately the same rates. "Because businesses take different legal forms, some, but not all, businesses pay tax at the business level, while their shareholders also pay tax at the individual level. To mitigate this problem, the tax code now provides for lower rates on capital gains and most dividends."
As a result, he said, "this blunt method means that some business income may still be taxed twice, once at the 35 percent corporate rate and again at the capital-gain or dividend rate. On the other hand, it can also mean that some business income is taxed only at the lower capital-gain and dividend rates, even though it was taxed very little or not at all at the corporate level."
Fourth, he urged, the tax system should be updated to reflect the reality that a large fraction of business is now routinely done on a global basis. "Companies source their purchases globally, locate service as well as manufacturing operations where they can get the greatest efficiency, raise capital in markets around the world, and increasingly depend on intellectual property as a principal source of income," he noted.
"In this context, the tax code, which in principle taxes worldwide income of U.S. corporations, has grown to have so many exceptions and complexities that it raises very little revenue from this theoretically worldwide reach, but it does so at tremendous cost in the form of tax planning and compliance," he said. "Furthermore, this aspect of the code more than any other gives rise to the remarkable unevenness among businesses in the tax rate they actually pay."
Business and personal
Although the discussion of business taxes focuses on the corporate tax, a large portion of business taxes are actually paid by individuals, observed the Treasury's Carroll.
"One interesting fact that a lot of people should perhaps pay a little bit more attention to is about 35 percent of business taxes are actually paid by pass-throughs, S corporations, sole proprietors and partnerships, which are often small businesses. The owners of those businesses pay tax at the top individual rate, so keeping an eye on the top individual rate is very important," he said.
Businesses do not pay taxes, people do, concluded Carroll.
"Businesses organize capital and labor in the production of goods and services used throughout the economy and consumed by households," he said. "Businesses, however, are owned by individual investors, hire individual workers and sell to individual consumers. While corporations may remit tax to the federal government, it is individuals who bear the burden of business taxes. Investors pay business taxes through lower after-tax returns to their investments, workers pay business taxes through lower wages, and consumers pay business taxes through higher prices."
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