While some aspects of the agenda for the incoming Republican-controlled 114th Congress are still in formulation, there is no question that tax reform will be a top priority. Both the expected new Senate Majority Leader Mitch McConnell (R-Kentucky) and House Speaker John Boehner (R-Ohio) have repeatedly stated that tax reform is a fundamental part of their promise to move the country in a new direction. Also, in recent weeks, key Administration officials, including Treasury Secretary Jack Lew, have signaled that tax reform is a potential legacy issue for the President in his remaining two years in office.
The outcome of the elections suggests that voters were frustrated with a federal government, including the Congress, that appeared incapable of addressing the nation’s challenges. Republican leaders have identified the tax system as an impediment to economic growth at home and global competitiveness for US companies. Their challenge now is to show the American people that they have listened to the frustration and are ready and able to work with their Democratic colleagues and the President to reform a tax system that is badly out of date.
Although many of the details of tax reform have yet to be worked out, the basic structure, especially on the corporate side, has been debated in Congress in depth over the past few years and there is substantial bipartisan common ground as to the approach.
There is general agreement that two aspects of the current US corporate tax system have made American companies less competitive globally and inhibited economic growth – (i) the 35 percent rate (32 percent for manufacturers) – the highest among OECD member nations and (ii) the worldwide taxation base. Tax reform proposals advanced by Congressional Republicans over the past two years would reduce the corporate rate to 25 percent, while the President’s tax reform framework would reduce it to 28 percent. Republicans have proposed shifting the US to a territorial tax system, under which the foreign profits of US companies would be taxed by the US only when earned in very low rate jurisdictions (i.e., below 15 percent) or at a very low rate when brought back into the US. In contrast, Democratic tax reform plans have called for ending the deferral of US taxation on foreign profits, while imposing a lower corporate rate that would be offset for taxes paid to foreign jurisdictions.
There is also general agreement that tax reform should be revenue neutral, meaning that the potential loss of revenue resulting from the reduction in rates should be offset through the elimination of many current law tax expenditures. This approach is based on the assumption that Congress has traditionally created tax expenditures as a way to reduce rates, and that there is far less justification for them if rates are significantly lowered. The elimination of expenditures is also viewed as a way to simplify an increasingly complex tax system.
There is less common ground on the individual side of tax reform. The President took a hard stand two years ago in favor of allowing the highest individual tax rate to return to its pre-Bush Administration level of 39.6 percent (as opposed to 35 percent). Meanwhile, Congressional Republicans generally insist that given the fact that most American businesses are taxed at the owner level as individuals there would be a great deal of distortion (and complex tax planning) if a significant differential existed between the corporate and individual rates. Democrats appears more reluctant to eliminate tax expenditures on the individual side than on the corporate side, including the deduction for state taxes, home mortgage interest, and contributions to retirement arrangements, even if rates are also lowered.
Nonetheless, a number of potential compromises have been discussed on the individual side, including the concept of reducing individual rates with respect to income earned from self-employment and the concept of limiting deductions at higher income levels only.
A major factor that will drive serious consideration of tax reform in the next Congress is deep concern among lawmakers and the Administration over self-help measures that some major American companies have been taking to reduce their rates, most notably the announcements over the summer of corporate inversions (i.e., a US company shifting its domicile overseas to remove its future overseas profits from the US tax system). Both the current chairman of the Senate Finance Committee, Ron Wyden (D-Oregon) and the expected next chairman, Orrin Hatch (R-Utah) believe that unless Congress reforms the tax system in 2015, the pace of corporate inversions will accelerate. In fact, Senator Wyden has said that Congress cannot wait for the next presidential election to enact tax reform because by that time there will be no US domiciled corporations among the Fortune 500 and the US federal tax base will be irrevocably eroded.
Many policymakers are also concerned that the current tax system discourages American companies from bringing their overseas profits back into the US, where they will be taxed at a 35 percent rate, when those funds could be used to support badly needed infrastructure spending at home. Just in the past few days a number of Senators, including Rand Paul (R-Kentucky) have suggested that the President’s goal of increasing domestic infrastructure spending and employment could be met though aspects of tax reform that would facilitate capital repatriation, and the President indicated in his post-election news conference that he agrees with such an approach in principle.
The new Congress will convene the first week of January, but bipartisan tax reform discussions within the Senate Finance Committee have been ongoing since the summer and will now intensify. If they have not already done so, businesses should analyze how they are likely to be affected by a trade-off between tax expenditures and rate reduction, assuming a new corporate rate at 25 percent, 28 percent or 30 percent, as well as how they are likely to be affected by potential changes in the international tax system or by proposals to alter the taxation of partnerships and other passthroughs. Tax reform will be the product of compromise, and much of the lobbying in Washington will be over which tax expenditures should be retained even if rates are lowered.
The fact that the Senate will soon be controlled by Republicans makes tax reform more likely; although House Ways and Means Committee Chairman Dave Camp (R-Michigan) produced a comprehensive tax reform draft earlier this year, his leadership hesitated to move forward with it, fearing that the Democrats would not consider it. That concern will no longer exist.
Now is the time for companies to look at taking part in the legislative process around tax reform.