Critical tax reform decisions affecting middle market businesses
INSIGHT ARTICLE |
"Tax reform" means different things to different people and while both Republicans and Democrats have expressed an interest in reforming the nation's tax laws, they are far apart on what to do and how to do it. Middle market businesses need to watch this debate closely because, historically, debates over business tax reform tend to focus on the economic extremes, global multinational businesses and small businesses. Here are four critical decisions middle market businesses need to focus on.
Tax reform principles
The chairman of the Senate Finance Committee, Senator Orrin Hatch, has set out seven principles for tax reform: promotion of economic growth, fairness, simplicity, permanence, enhancement of international competitiveness, promotion of saving and investment and revenue neutrality. In response, the Democrats on the Senate Finance Committee set out their own principles. They agree with Senator Hatch on two (permanence and international competitiveness) but set out four other principles that they think should be paramount in any re-write of the tax laws: increased progressivity, reducing the differential between wage and capital income, growing domestic jobs and increasing the amount of tax revenue. It is not a good sign when the two sides can't even agree on a majority of the principles they think should be the focus of any initiative.
The first critical decision: The process
So far, the Senate Finance Committee has been more active than the House Ways and Means Committee setting up five working groups (individuals, business, international, saving and investment, and infrastructure and community development) that are expected to issue reports in late May. Hearings are underway in the House and Senate, and Congressional staff is hard at work laying the groundwork to move the process forward.
The first critical tax reform decision relates to process, specifically whether tax reform will move forward as part of budget reconciliation or as part of the regular legislative process. The Republican leadership on Capitol Hill has decided not to use the reconciliation process for tax reform. That means tax reform will very likely move forward at an unpredictable pace and will most likely drag into next year and probably beyond.
Three more critical decisions
Of the three remaining critical decisions on the road to tax reform, probably the most important to watch is the scope of tax reform. This has two aspects: (1) whether the focus is only business tax reform or both business and individual tax reform and (2) with respect to business reform, whether the focus is corporate reform or both corporate and pass-through tax reform. On the first question, having fought so hard as part of the fiscal cliff legislation for a higher individual rate for certain upper income individuals, the administration is reluctant to give that up as part of a broad tax reform effort so their stated focus is business only. A business reform only approach also avoids tough questions like what to do with popular tax deductions and the taxation of dividend and capital gain income. The Ways and Means Committee Republicans who control the committee have said they plan to do both. Second, with respect to business tax reform, many middle market and small businesses conduct business as so-called flow through businesses (proprietorships, partnerships and S corporations) and the earnings are taxed at individual rates. Corporate only reform means that corporations will see their tax rate reduced below its current 35 percent level while earnings of flow through businesses would continue to be taxed at rates as high as 39.6 percent. Not only that, if tax deductions and credits are reduced for all businesses to pay for corporate rate reductions, flow through middle market businesses could actually see their taxes go up. No consensus currently exists on any of these questions. The third critical decision is how to tax foreign earnings. Again, the two sides are far apart. Republicans want a territorial system and the administration wants to not only keep the current worldwide system but strengthen it with a minimum tax. The last of the major decisions to watch is whether tax reform will raise revenue or be revenue neutral. The Republican view is revenue neutrality and the Democrat's view is that it should raise revenue. This is not a difference that is easily bridged.
Even those most closely involved with tax reform admit that they do not know what will happen. Given the decision not to include tax reform as part of the budget reconciliation process, though, the road to tax reform is likely to be a long and torturous one filled with potholes for the middle market.