Senators Max Baucus (D-MT) and Orrin Hatch (R-UT), titans of the Senate Finance Committee, have laid down a tax reform gauntlet for the other 98 senators. One could paraphrase their intent this way: “Let’s start tax reform with a blank slate, eliminate all tax preferences, and use revenue from a broader tax base to cut statutory tax rates. Senatorial colleagues, please work within that framework and justify any tax preferences that you think should be kept in the Internal Revenue Code.”
Editorial writers from both the left and the right—the Washington Post to the Wall Street Journal—fell over themselves applauding the blank slate. They love the idea of putting lobbyists and special interests on the griddle to defend their tax preferences, known in journalistic parlance as tax loopholes. What they all miss is the most basic conceptual question how to define and recognize a tax preference. Is it like pornography—”I know it when I see it,” as Supreme Court Justice Potter Stewart famously said in Jacobellis v. Ohio (1964)? Or is there a more objective standard?
Baucus and Hatch evidently adopted, as their standard for defining tax preferences, the Estimates of Tax Expenditures,which is compiled annually by hard-working bureaucrats in the Treasury Department.1 Many items identified as tax expenditures for individuals, such as the “child credit,” “deductibility of mortgage interest on owner-occupied homes,” and “exclusion of employer contributions for medical insurance premiums and medical care” seem like obvious tax preferences.
But when the spotlight turns to business tax expenditures, the picture gets very fuzzy. The conceptual problem is that contours of a “normal” business tax system have changed radically since the 1960s, when Assistant Secretary for Tax Policy Stanley S. Surrey first conceived the tax expenditure schedule. (I was a young Treasury consultant at the time.) The most dramatic change is that the corporate income tax is no longer the workhorse of business taxation around the globe. Rather the load is now carried by the value added tax, which is used as a major source of revenue by nearly every country except the United States. But the Treasury does not even recognize that the landscape has changed—buffalo are no longer roaming across the Dakotas, and the corporate income tax no longer serves as the principal means of collecting revenue from business firms.
Even within the confines of the classical corporate income tax (piled on top of the individual income tax), the contours are very different today than in the 1960s. It’s worth pointing out a few of the changes and what they mean for the identification of tax preferences:
- The territorial system of taxing income earned by a multinational corporation outside its home country has become the global norm. Yet the Treasury’s tax expenditure tables are keyed off the yesteryear of a worldwide system, and misleadingly tell Senators Baucus and Hatch, as well as 98 other senators, that ending deferral would end a tax preference, and raise $220 billion over five years (2014–18). Under the tax deferral rule, earnings of foreign subsidiaries of US multinational companies (MNCs) are taxed only when they are repatriated as dividends to the US parent corporation. For reasons spelled out elsewhere,2 ending deferral would not raise anything like that amount, but more importantly, using a sensible contemporary definition, deferral is not a tax preference.
- The immediate deduction of exploration and development costs for finding new sources of energy, such as shale oil and gas, is characterized as a tax expenditure ($2 billion revenue cost over five years), but nowhere in the Treasury’s tables can a tax expenditure be found for expensing other forms of research and development costs. Energy exploration is just like other R&D—sometimes it succeeds, often it fails, but even failures provide valuable knowledge to the business community at large.
- Many line items characterize immediate or rapid expenditure of investment in plant and equipment as tax expenditures. Hence, under the Baucus/Hatch approach, all must be defended as worthwhile tax preferences. This puts the burden the wrong way around. Modern fiscal analysis says that all investment outlays should be immediately expensed, so that firms do not lose the time value of money, or bear the financial cost of future inflation. This is especially important when, as now, the US economy is struggling and needs all the productive investment it can get. Treasury should reverse its presentation: expensing should be viewed as the “normal” method of business taxation, while depreciation over the life of the asset (at best a speculative guess) should be entered as a tax penalty in the tables.
- A curious omission from the tax expenditure schedules deserves special notice, not least by Senators Baucus and Hatch. The schedules simply fail to identify, as tax expenditures, the exclusion of so-called “pass-through” entities—partnerships, Subchapter S corporations, LLCs, LLPs, Master Limited Partnerships, cooperatives, REITs—from the burden of paying the corporate tax.3 This is Hamlet without the Prince of Denmark. Back in the 1960s, these pass-through entities were a small part of the business landscape. Now they account for around half of business activity in the United States. To be consistent, either corporate income tax on Subchapter C corporations should be characterized as a tax penalty, or the absence of corporate income tax on pass-through entities should be characterized as a tax expenditure. Could political expedience, and especially pressure from the private equity sector, have something to do with Treasury’s inconsistent view of a “normal” business tax system?
These and other anomalies point to two recommendations as Senators Baucus and Hatch move forward with their blank slate approach. First, they should hold hearings to review the definition of a “normal” tax system for business firms. They should then introduce legislation instructing the Treasury to update its antiquated standards. Second, for this round of tax reform, the titans of the Senate Finance Committee should simply scratch from the list of preference items the ones mentioned here, and several others of a similar character.
1. US Office of Management and Budget. Budget of the United States Government, Fiscal Year 2014, April 2013, (Table 16-2).
2. Gary Clyde Hufbauer and Martin Vieiro, Corporate Taxation and US MNCs: Ensuring a Competitive Economy [pdf], Policy Brief 12-9, Peterson Institute for International Economics, April 2013.
3. The pass-through entities ascribe all their income to the individual beneficial owners, where the income is taxed. This treatment means that pass-through income does not bear the extra burden of the corporate income tax.