Beware of a Tax Reform Revolution

Tax reform proposals made by politicians should be scrutinized carefully and implemented gradually.
Philip G. CohenJuly 13, 2016
Beware of a Tax Reform Revolution

It is somewhat ironic that many politicians, including numerous ones who refer to themselves as conservatives, espouse radical changes to our tax system. They claim our tax system is broken and requires a drastic transformation. I’m skeptical of following their guidance. Many of them and their predecessors helped create the system that they now profess is shattered. I’m wary of panaceas promised from politicians, including replacing the corporate income tax with a value-added tax (VAT) or quasi-consumption tax. We should resist taking extreme measures that could make our budget problems as bad as those of Greece and/or create other havoc in our economy.

Philip G. Cohen

Philip G. Cohen

We are not, thankfully, in the Depression of the 1930s, during which the government needed to take major and immediate action to try to address substantial unemployment and other dire consequences. What is needed today, instead, is careful tinkering to improve our income tax system using the scalpel, not the sledgehammer.

There is no question our system requires reform. The corporate statutory tax rate is excessive. The Internal Revenue Code is byzantine, filled with provisions designed to benefit campaign contributors or other special interests. There is a major tax gap between what is legally owed and what is actually collected.

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We also have a budget deficit that needs addressing. Our infrastructure requires rebuilding, and we must create more well paying jobs. Previously, I advocated that the corporate tax base be broadened, the statutory rate be lowered, and the tax law’s complexity be reduced. I also recommended that all business income be taxed the same way, whether earned by a corporation, partnership, or sole proprietorship, and that steps be taken to further reduce double taxation for C corporations.

I’m still a believer in those steps. Changes should, however, be more evolutionary than revolutionary, done so as to allow carefully monitoring of the impact of the alterations on our economy. We must make sure “reforms” help fix rather than further fracture our system for funding the government.

A 39-page “blueprint” by the House Republicans released on June 24 contains a number of proposals for changing the federal tax system. Among their ideas affecting businesses, the plan would lower the current progressive rates for C corporations from a maximum rate of 35% to a flat rate of 20% with an immediate expensing of capital expenditures, excluding land.

The plan would replace the current system of taxing corporations on worldwide income to a territorial system with unclear safeguards to address base erosion and profit shifting. The proposal would eliminate the deductibility of net interest for businesses. There would be border adjustments taxing imports and exempting exports. Further, small businesses organized as S corporations, partnerships, and sole proprietorships would pay a top tax rate of 25% on their active business income. Most business credits and what are referred to as “special-interest” deductions would be eliminated.

Individuals would be taxed at just half the regular individual tax rate on both dividends paid on corporate shares and capital gains recognized on dispositions of corporate shares. Carried interest and inversions are not specifically addressed.

While some of the ideas merit consideration, others should be rejected or significantly modified.

Why not, at least initially, limit the reduction of the corporate tax rate to no lower than 25% for manufacturing income and 28% for other income? Strong consideration should be given to addressing the revenue reductions caused by the statutory corporate rate reduction, at least in part by immediately taxing income earned outside the United States, albeit at a lower rate than domestic source income, perhaps 22%.

If enough revenue is collected, rates can be reduced further over time. The interest expense deduction should be capped, perhaps based on a percentage of adjusted taxable income, but not eliminated entirely. The system for capital cost recovery should be simplified and made more investment friendly, but should be retained.

Some pruning should be given to many deductions and credits. We do need to reduce the burden of double tax on C corporation income, and we should substantially lower the rate on dividend income to individuals from the current 23.8% maximum to perhaps 15%, assuming adequate revenue offsets. Finally, we need to address the carried-interest and inversion problems.

“Trust but verify,” Ronald Reagan said about what the U.S. policy should be regarding the former Soviet Union. Tax reform proposals made by politicians need to undergo similar scrutiny and are better implemented with gradual, rather than radical, steps.

Philip G. Cohen, a retired vice president of tax and general tax counsel at Unilever United States, is currently an associate professor of taxation at Pace University Lubin School of Business.