The Coming Tax Hike

Simplification is the stated goal of president Bush's tax commission. But the more likely outcome is a tax increase for business.
Don DurfeeApril 1, 2005

The U.S. tax code, as any politician will tell you, has some problems. First, it’s long: the code now weighs in at an impressive 60,000 pages, almost twice the length of the Encyclopaedia Britannica. It is also intricate. Completing tax forms consumes 6 billion hours of taxpayer time each year and causes large businesses to incur an estimated $40 billion in compliance costs.

It gets worse every time Congress passes a new tax bill. “Over time we’ve had a lot of changes and modifications to the tax code that have only made it more complicated,” says Peter Grabowski, CFO of Gevity HR, a human resources services firm based in Bradenton, Florida. “I believe it’s time for simplification.”

The Bush Administration has promised to do just that. Citing the burden of “an archaic, incoherent federal tax code,” the President has made tax-code reform a top domestic priority; in January, he appointed a panel to explore paths to a new system. The panel will make its recommendations this summer.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

What will this mean for business? While it’s impossible to say for certain, it isn’t too soon to make two predictions. One is that radical change—the adoption of a flat tax, for instance—won’t happen. The other is that incremental change will. And given the size of the federal budget deficit and the President’s plans to make his tax cuts for individuals permanent, such change could be very costly.

No Small Change

The last time Congress and the President managed to reform the tax code was in 1986. Ronald Reagan, with the support of a Democratic Congress, ended a variety of loopholes and credits for businesses in exchange for a lower tax rate for individuals. Most experts agree that it is time for another review. “We tinker with the tax code every year, but it’s healthy to ask what you would do differently if you were drawing on a clean slate,” says Ronald Pearlman, a professor of law at Georgetown University and a former Treasury official during the Reagan Administration.

Some argue that the only solution is to replace the tax code entirely with something simpler. But Bush has promised to keep popular deductions for mortgage interest and charitable deductions, which rules out a pure flat income tax or consumption tax. He also demands that any change be “revenue neutral”—dropping taxes in one area will require raising them elsewhere. That means any change will spark opposition, making big change even harder. “Everyone is in favor of reform and simplification until they realize that some people will pay more and some less,” says Michael Kelleher, a partner with McDermott, Will & Emery in Washington, D.C. And while the tax panel’s writ does not extend to fiscal policy, its recommendations cannot help but take into account their potential budgetary impact.

At first glance, many finance executives might welcome a simpler code, especially since governance reforms have made tax compliance more onerous. “The interaction of the tax code with Sarbanes-Oxley is creating very high compliance burdens for large companies like ours,” says Robert Busch, president of New Jersey­-based PSEG Services and CFO of its regulated electric utility. And as companies grow wary of tax planning and concentrate on compliance, they see simplicity as a benefit.

However, many companies profit from the code as it stands. For example, last fall’s American Jobs Creation Act contained scores of provisions that businesses lobbied for, and the beneficiaries will almost certainly battle to preserve them. Furthermore, any drastic change in the code would create transition problems, as they throw out 20 years’ worth of processes to adapt to new rules.

In fact, corporations have fared so well in Washington they may be vulnerable to a backlash. That’s especially true when it comes to tax shelters. “I think the failure of Congress to come to grips with the tax-shelter problem may motivate some change,” says Michael Graetz, a tax-law expert at Yale Law School. “Everyone recognizes that erosion of the corporate tax base is a serious problem.”

The issue can only gain currency as a result of the push for changes on the individual side. Pressure is building to fix the alternative minimum tax (AMT). Introduced in 1969, the AMT ensures that wealthy taxpayers pay some tax. But since the AMT wasn’t indexed to inflation and because of Bush’s tax cuts, it will snare 35 million taxpayers by 2010. According to many observers, if Congress does anything with the code this year, it will repeal or alter the AMT. Repeal would cost $600 billion in 10 years. While the money will have to come from somewhere, that somewhere probably won’t be individuals.

“If there’s any major change in the tax law, the political process will always favor individuals,” says Pearlman. “It happened in 1986, and I guarantee it will happen again. Businesses could end up paying the price.”

Changes affecting business seem most likely in four areas:

1. Credits.

An obvious target is incentives—the benefits Congress doles out to everyone from ethanol producers to sports-team owners. Economists complain that such incentives can distort economic decision-making and favor some businesses over others. “Our system creates an uneven playing field,” comments Charles Rossotti, a former IRS commissioner and a member of Bush’s tax panel. “Sometimes that’s deliberate—if you want to give incentives for synthetic fuels, for example—but often these things last for such a long time that no one remembers why they’re there.”

Even beneficiaries recognize the resulting mess. Says PSEG’s Busch: “These things rarely go away, so we wind up with layer upon layer of complex incentive structures that interact with one another.”

Last fall’s tax bill provided generous tax breaks to “manufacturers”—including movie studios and coffee roasters. Eliminating those credits would provide an additional $76.5 billion over 10 years. “Corporate tax expenditures and tax shelters are a very ripe target to finance the repeal of the AMT,” comments William Gale, a senior fellow at the Brookings Institution.

2. Depreciation.

Capital investments are also under scrutiny. Conservatives have long advocated the immediate expensing of investments for tax purposes to encourage capital spending and shift the tax system’s focus to consumption from savings and investment. Expensing would effectively be a tax cut on investments and would force Congress to increase taxes elsewhere.

Changes over the past few years have already brought the code close to immediate expensing—companies can now deduct R&D expenses immediately and may use accelerated depreciation schedules for other investments. But full expensing may bring a less-welcome change—the loss of deductibility for interest payments. The reason, says Pearlman, is that allowing both expensing and interest deductibility would effectively allow businesses to recover more than their cost of investment and create massive tax-shelter opportunities.

Economists contend that interest deduction encourages companies to artificially favor debt over equity and to cheat, since many shelters take advantage of interest deductions. But the change would not be easy. Capital-intensive businesses could probably make up the loss from the interest-deduction side on the expensing side, but banks and other services could see a tax increase.

Grabowski argues that such a change would limit a company’s growth options. “Companies have different reasons at different times for wanting to borrow or raise equity capital,” he says. “And taking away the interest deduction removes a viable way to grow your company.”

3. International.

A third change could affect what many consider the most bewildering area of the code: the rules around which overseas income can be taxed and when. Today, corporate income is taxable whether it is earned in the United States or abroad, but, with some exceptions, companies can avoid tax on overseas income as long as it isn’t brought home. And they can take a credit against their U.S. tax for any taxes paid to foreign governments.

One change the tax panel will likely consider is whether to switch to a “territorial” system that would tax only income earned domestically. This would clear out a tangle of rules and encourage companies to repatriate overseas income. Such a system would probably yield a net increase in revenues for the Treasury.

Not everyone thinks that additional revenue would necessarily end up funding a tax cut for individuals. Says Graetz, “There’s no reason why it would have to be a tax increase for businesses. In fact, it might make sense to use that money to fund a reduced corporate rate.” That could make U.S. corporate rates competitive with those of other countries.

In any case, Grabowski sees a territorial system as both a simplification and a source of greater fairness. “Depending on how international your business is, you have more opportunities to manage your tax than purely domestic companies,” he says. “A territorial system puts everyone on a more level playing field. And if the objective is to simplify the tax code, it’s a step in the right direction.”

4. Tax-book conformity.

The fourth move would close the gap between financial statements prepared for tax purposes and those presented to shareholders. “Basing taxes more closely on what businesses already report for financial purposes would be an enormous simplification, and one that would entail fewer transition costs,” comments Rossotti. It would also combat tax shelters, since many involve loss-producing transactions that companies wouldn’t undertake if they had to be reported the same way to shareholders as to the IRS.

That’s not so simple, says Pearlman. “For example, for financial-accounting purposes, companies can’t deduct anywhere near what they are allowed to deduct for federal-income-tax purposes.” Unless Congress allowed complete expensing of investments, lawmakers would be under great pressure to allow exceptions for various businesses.

Reform or Retreat?

Skepticism over meaningful changes abounds. Social Security “reform” efforts might sap Congress’s energy. A new crisis abroad would be a distraction. And proposals could fail as businesses scramble to defend their own breaks. “How they will ever change over to a simpler system is beyond me,” says Walter Van Dorn, a partner with Kirkpatrick & Lockhart Nicholson Graham LP in Boston.

But the tax reforms of the 1980s show that change isn’t impossible. “No one likes our complex tax code, but there is a feeling of inevitability, that that’s just the way it is,” comments Rossotti. “But every once in a while, that isn’t the way it is. Nobody thought they would come up with tax reform in 1986, but they did. And it simplified things—at least for a while.”

Don Durfee is research editor at CFO.

A Half Century of Reform

This is not the first time Congress has considered wide-ranging changes to the tax code. It has done it three times before: in 1954, 1969, and 1986.

Internal Revenue Code of 1954

  • Codified and simplified tax rules
  • Reduced individual tax rates
  • Allowed accelerated depreciation for businesses
  • Cost: $1.4 billion

The Tax Reform Act of 1969

  • Introduced the alternative minimum tax
  • Cut the top marginal tax rate for individuals from 90% to 50%
  • Added tax credits for low-income groups
  • Cost: $15 billion

The Tax Reform Act of 1986

  • Reduced the number of tax brackets to two
  • Cut the top tax rate for individuals from 50% to 28%
  • Reduced the corporate tax rate from 50% to 35%
  • Broadened the tax base
  • Cost: Revenue neutral