The Future of the Corporate Income Tax
If there is such a dire need for tax reform and so much time and paper devoted to it, why does Form 1120 look the same every year?
October 25, 2007
by Annette Nellen, CPA/Esq.
Two great concerns leading to calls for tax reform are (1) that changes in the world economy are reducing the likelihood that the U.S. will be assured of a dominant role and (2) inordinate complexity that leads to disrespect for the tax system, economic inefficiencies and increased costs of tax compliance. Yet, despite numerous calls for tax reform, the major changes we have seen to the system recently have actually increased its complexity. Examples include the addition of Schedule M-3 for large corporations and the IRC §199 manufacturing deduction. Why? This article summarizes the primary reasons for tax reform discussion, some of the proposals and the obstacles.
President’s Panel on Income Tax Reform
In 2005, President Bush’s Advisory Panel on Federal Tax Reform noted the “unacceptable state of our current tax system” and that “America needs a better tax system.” Big picture problems noted by the Panel included: Complexity and its costs, lack of integration of business and personal taxes, incentives that distort economic investment and are subsidized by higher taxes paid by those not entitled to the incentives, failure to recognize that the primary purpose of taxes is to raise revenue for the government and frequency of change resulting in increased volatility and economic distortion.
The Panel particularly criticized the numerous tax preferences in the law and their adverse effect on the economy. The panel further noted that tax preferences can lead taxpayers to make “inefficient choices” that “divert resources from their most productive use and reduce the productive capacity of our economy.” Per the Panel, taxpayers help the economy best when they consider economics in making decisions rather than being swayed by tax preferences. Distorted decision-making can “waste economic resources, reduce productivity and, ultimately lower living standards for all” (see Final Report (PDF), page 36). These are strong statements that support the Panel’s proposals to broaden the income tax base, eliminate tax credits and lower tax rates.
Panel examples of how the tax law distorts decision-making and hurts the economy include the following (see Panel’s Final Report (PDF)):
Example 1: For federal income tax purposes, employer-provided health insurance is generally tax-free for employees yet deductible by the employer. This system is not only costly to the federal government, but results in increased cost of health care because the tax law has eliminated incentives for employees to control the costs of their health care. Higher health care costs result in increased insurance costs for individuals without employer-provided insurance and thus, many people not buying insurance.
Example 2: High technology companies often replace equipment within three years, yet a five-year recovery period is required for tax purposes. This life is based on that of government typewriters from the late 1970s. The tax law does not provide a mechanism for ensuring that the depreciable life assigned is appropriate given changes in technology.
Example 3: Double-taxation of corporate earnings results in a tax preference for debt over equity.
The Panel recommended two different plans to replace the current income tax: the “simplified income tax plan” and the “growth and investment tax plan.” The simplified plan is based on our current income tax while the growth plan is closer to a consumption tax that would lessen the tax on savings. Both plans call for significant changes affecting both individuals and businesses. The details of each plan are too numerous to cover in this article (a summary and additional information on tax reform, including a link to a 2005 AICPA report, can be found at the author’s tax reform Web site).
Significant provisions of the proposals include elimination of the AMT, expensing of some assets, movement to an integrated corporate and individual tax system, elimination of worldwide taxation and repeal of tax credits and several other tax preferences.
The Panel issued its report to the Treasury Department in November 2005. Specific proposals have not yet been issued by Treasury and little discussion has been generated by the Panel’s report. The report’s low profile is likely due to the significance of the proposed changes, particularly the elimination or reduction of popular tax preferences, such as the home mortgage deduction. A significant educational effort is needed to convince the public of the Panel’s findings that a broader base and lower rates will improve economic efficiency and fairness and have a positive effect on taxpayers.
While not directly related to the Panel’s report, in July 2007 the U.S. Treasury Department issued a background paper and held a conference entitled, Business Taxation and Global Competitiveness, discussed next.
The Treasury report notes that our current tax system distorts many business and investment decisions to the overall detriment of the economy. Some tax provisions, such as those benefiting home ownership, tend to lead to over-investment in such assets and thus, under-investment in others. The report also questions whether current tax rules written many years ago that treat income from foreign and domestic investment similarly still make sense today when the U.S. no longer dominates the world marketplace. Treasury estimates that if tax preferences, such as credits and the §199 deduction were eliminated, the top corporate tax rate could be lowered from 35 percent to 27 percent while at the same time raising the same amount of revenue and improving the economy.
Other tax law distortions noted in the report include double taxation of corporate income, failure to adjust depreciation deductions for inflation, favorable treatment of intangible assets relative to tangible assets and taxing human capital more favorably than physical capital.
Treasury also compared the U.S. tax system to that of our trading partners. The report notes that the combined federal and state income tax rate in the U.S. (39%) is the second highest among industrialized countries and other countries tend to be lowering their corporate rates.
The Treasury report does not make suggestions for reform. Treasury Secretary Paulson stated that Treasury’s next steps would be to “develop specific follow-up steps in the coming months to build support for the need to improve our business tax system and ideas for doing just that.”
A variety of proposals have also been offered by legislators, think tanks and presidential candidates. These range from changes that would allow for repeal of the great revenue-generator — the AMT, to flat rate systems that also reduce tax preferences. Proposals also include addition of a carbon tax, lower corporate tax rates, elimination of tax havens and replacement of most federal taxes with a national sales tax and even elimination of the IRS as it currently operates.
While there is little argument among policymakers that the federal income tax system is broken, reform seems elusive. Tax preferences add complexity, but each one has its band of supporters. The President’s Panel, Treasury and many others have made strong cases for reform. However, until there is strong political will for major reform and broader public understanding of the problems and remedies, Form 1120 will continue to be a familiar document.
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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.