President Barack Obama laid the groundwork for reducing the corporate tax rate and simplifying the tax code in his State of the Union address. He also erected a political hurdle to these efforts as they could lead to higher rates for millions of businesses.
Obama said in the Jan. 25 speech that he wants to rid a “rigged” tax code of “loopholes” that allow some corporations to pay less than others, and would use the savings to reduce the top 35 percent corporate rate, one of the world’s highest. He also called for “millionaires to give up their tax break” after an extension of Bush-era tax cuts expires in 2013.
The administration insists a tax overhaul must raise at least as much in revenue as the government now collects.
Those parameters would divide the business community, analysts said. An estimated 1.9 million corporate employers would fight over which tax breaks to curtail, such as a deduction for manufacturing that helps such companies as General Electric Co. and Caterpillar Inc.
Six million other employers operate under tax laws that govern individuals and would lose deductions without gaining a lower rate. They include large hedge funds such as Renaissance Technologies Corp. and manufacturers such as McIlhenny Co., the Avery, Louisiana-based maker of Tabasco pepper sauce.
“The history of tax reform is you go through a cycle where everyone points fingers at each other and says ‘not my stuff, it’s your stuff instead,’” said Clint Stretch, a managing principal at the Washington consulting firm Deloitte Tax LP. “If you’re doing revenue neutral, you’re going to create winners and losers, and as soon as you create winners and losers the business community will fracture.”
Michigan Representative David Camp, a Republican who is chairman of the House Ways and Means Committee, said a rewrite of the tax code should tackle the individual tax system that Internal Revenue Service data shows generated $1.2 trillion in 2009, as well as corporate tax laws, which contributed $225 billion.
“Moving our economy forward and creating a climate for job growth requires a tax code that empowers all job creators, large and small,” Camp said.
Tackling the individual tax code would widen the partisan debate while threatening tax breaks such as the mortgage-interest deduction. It also would challenge Obama’s vow to avoid raising taxes on couples who earn less than $250,000.
Obama is likely to outline his proposals more concretely in coming weeks; he is slated to speak to the U.S. Chamber of Commerce Feb. 7 and the next week will release his budget blueprint for the fiscal year that begins Oct. 1.
The administration has framed the debate around eliminating tax breaks. Some are obscure, such as breaks for railroad companies to maintain their tracks. Others are widely used, such as a deduction for manufacturing products in the U.S., worth about $58 billion to companies over the next five years, according to the White House’s Office of Management and Budget.
Obama championed the biggest corporate tax expenditure in history -- the ability, for about 16 months, to fully deduct investments in the year they are made instead of depreciating them over as long as 20 years. That will be worth about $200 billion to U.S. businesses in 2011, the White House said.
Since taking office in 2009, Obama has supported some of the biggest corporate tax breaks and introduced legislation to rein in others. The administration’s previous budget proposals provide clues on potential winners and losers among companies and industries if rates are lowered and loopholes closed.
For instance, one proposal is to make permanent a tax credit for corporate research. That break is projected to cost the government about $8 billion this year and next, according to the Joint Committee on Taxation. Half the benefit accrues to 100 large companies, according to IRS data. Large beneficiaries include technology, pharmaceutical and defense companies like Boeing Co., which reduced its effective tax rate by nearly one-third to 23 percent in 2009 due to the credit, SEC filings show.
Many of those same companies benefit from provisions of the tax code that permit them to shift income to lower-taxed countries overseas, through a system known as “transfer pricing.” Google Inc. in 2009 reduced its overall effective tax rate to 22 percent largely with these transactions.
Obama has proposed changes that would tax overseas income generated by some transfer pricing maneuvers, which could hurt Google and drugmakers like Pfizer Inc. In recent years, Pfizer has shaved more than half off of its tax bill because of lower taxes overseas. A Google spokeswoman declined comment. A Pfizer spokeswoman did not respond to a request for comment.
The administration in 2010 called for repealing a “last-in, first out” accounting provision that allows companies to raise the cost of inventory sold, effectively increasing tax deductions. The Treasury Department estimated the repeal would raise $59 billion over 10 years.
The repeal would especially hurt oil companies like Exxon Mobil Corp., said Edward D. Kleinbard, a former chief of staff at the congressional Joint Committee on Taxation.
The administration has also proposed that oil and gas companies lose a special tax deduction for domestic production.
“When you raise energy taxes, you get less jobs, less economic activity and less energy security for the United States,” said Cynthia Bergman White, an Exxon spokeswoman. She declined to comment on specific tax breaks.
Eliminating the five biggest corporate tax breaks would generate about $300 billion over five years, according to OMB estimates. That would be enough to reduce the corporate rate to about 30 percent, based on calculations of estimated corporate tax receipts in fiscal years 2011 through 2015 by OMB and the Congressional Budget Office.
Many businesses organized under individual tax laws also claim those benefits. Their tax rate would increase if Congress fails to overhaul the individual code.
The top marginal rate paid by individuals is 35 percent, the same as for corporations. If current individual rates expire, the top income tax bracket would rise to 39.6 percent in 2013.
Combined with taxes imposed under the health-care law and the reinstatement of limits on personal exemptions and itemized deductions in 2013, the top tax rate faced by business owners that file as individuals would approach 50 percent, said Bill Rys, tax counsel for the Washington-based National Federation of Independent Business, which advocates for small businesses.
“That is going to have a very negative effect on capital formation and the ability of those businesses to reinvest,” said Rys, who estimates 75 percent of businesses with 500 or fewer employees file taxes as individuals.
Joel Slemrod, professor of economics at the University of Michigan, said a tax-code overhaul that results in a lower corporate rate and higher individual rates could end up increasing the deficit. That’s because many business owners who file as individuals might change to a corporate structure to take advantage of the lower tax rate.
“One has to take into account that there’s going to be revenue lost as businesses shift to the lower-taxed form of organization,” Slemrod said.
A similar lowered-rate-for-closed-loopholes bargain was struck as part of the Tax Reform Act of 1986, when Congress eliminated some tax benefits for corporations and began lowering the statutory tax rate from 46 percent to 34 percent.
Much of the anticipated revenue from eliminating tax breaks did not materialize, said Martin A. Sullivan, a former U.S. Treasury Department tax economist, and industry-specific tax breaks soon returned. For instance, Congress rolled back the ability of financial institutions to avoid tax on so-called “passive income” overseas, and then eventually restored it.
A repeal of that exemption -- estimated to cost about $5.8 billion in 2011 according to the OMB -- could have an impact on large financial firms, like General Electric Co.’s GE Capital arm, said Sullivan. GE declined comment.
“I favor lowering the rate and broadening the base” via closed loopholes, said H. David Rosenbloom, a tax attorney at Caplin & Drysdale in Washington, D.C. and director of the international tax program at New York University’s school of law.
“But the problem is that every time Congress does that -- and it doesn’t do it very often -- it quickly sets out undoing its work,” Rosenbloom said. “The ink isn’t dry on the page before they’re out there soliciting campaign contributions in return” for tax breaks.