What the Debt Limit Debacle Teaches Us About Tax Reform

By: Marty Sullivan

Tax reform will not be a part of the legislation that raises the debt limit. Congress and President Obama cannot even agree on the broad outlines of reform. And even if they could, the multitude of political problems and technical issues are too great and too complicated for legislation by August 2.

The fastest possible legislative path would involve circumvention of the taxwriting committees with direct floor action. After negotiators reached agreement on specific provisions for inclusion in the plan, staff would still have to hammer out non-trivial details, estimate revenue effects, and draft statutory language. Even with swift passage in the rule-constrained House, there would still be a contentious, time-consuming Senate fight with about 100 amendments. And subsequent to that, all the political problems postponed by cutting the taxwriting committees out of the process would ultimately manifest themselves in conference committee wrangling of unprecedented proportions. The last major tax reform took two years, and that was when Republicans and Democrats talked to each other. It is unrealistic to think we can do it now in two weeks or even two months.

Nobody knows what overall budget deal will emerge from the current debt limit talks. As of this writing, it is looking increasingly minimalist. To make up for the absence of substance, there will be much fluff. The final agreement will be light on actual deficit reduction and heavy on symbolic gestures. It will be a down payment. It will include Gramm-Rudman-like deficit targets that further postpone specific action. And there will be a vote on a balanced budget amendment — even though the magnitude of deficit reduction required to balance the budget, in the neighborhood of $1 trillion per year, is so out of reach it is laughable to even suggest it.

Finally, the debt limit deal could include a commitment to enacting major tax reform. The Committee for a Responsible Federal Budget has recommended this approach. And so have Sens. Ron Wyden, D-Ore., and Daniel Coats, R-Ind., authors of their own comprehensive tax reform plan. In a July 6 letter to Obama and congressional leaders, the senators wrote:

We recognize there is not enough time to pass comprehensive tax reform between now and the August 2 deadline for raising the debt limit, but there is no reason why any debt-reduction agreement should not include a timeline for enacting tax reform before the end of this year. Therefore, we believe it is vital that any debt-reduction plan you negotiate contain a commitment to comprehensive tax reform.

Both the Committee for a Responsible Federal Budget and the senators want tax reform completed within a year. Even that timeline may be a little too compact.
Another promise of renewed efforts at tax reform may disappoint those who had high hopes for something Reaganesque. But to realists there will be no disappointment. In fact, under the right conditions, it could be a very positive development.

What conditions are necessary for a productive fresh start? To avoid just another toothless blue-ribbon panel like the Bowles-Simpson commission, Obama — like Reagan in 1984 — must put the prestige and the technical expertise of Treasury behind the effort. But hasn’t Treasury been doing tax reform since the president’s State of the Union address? Yes, but it is all behind closed doors, so most of what undoubtedly is first-class staff work just accumulates in the files. There is no progress without actual proposals to which citizens and Congress can respond. There is no leadership. Some secrecy must be sacrificed. Some political capital must be expended. As in 2004 and 2005, Treasury needs to share its tax reform findings with the public. After all, we are paying for it.

More importantly, negotiators must clear the ground and provide direction on the fundamental structure reform should take. Until now, negotiators have used tax reform as a smoke screen for their failings as budgeteers. This is getting us nowhere. They have put the cart before the horse and, as the analogy suggests, made only the most awkward progress. There’s no use debating the repeal of particular tax breaks unless the overall reform is put into a budget context. Much of the Democrats’ support for tax reform is conditioned on an increase in revenue. Many Republicans want revenue-neutral reform or no reform at all. Congress and the president need to reach an agreement about revenue first and then proceed with tax reform.

For the overall revenue target there is a spectrum of possibilities. At one end there is revenue-neutral reform, as in 1986. But 21st-century tax reform does not have to follow the Reagan precedent. There can also be revenue-raising reform. Republicans might agree to that in exchange for expenditure cuts two or three times the amount of the revenue increase. Revenue-raising reform would also need to include rate cuts so it could still plausibly be called tax reform. The important thing is that there is agreement first.

This is the task budget deal negotiators must complete if they want to set a productive tax reform project in motion. Once the parameters are established, Treasury and the taxwriting committees can get down to brass tacks. Otherwise we are back at square one.

On the Cutting-Room Floor

The need to give priority to setting budget targets is not the only thing we have learned about tax reform from the debt limit debate. It has caused habitually tight-lipped politicians to actually mention real revenue raisers. This gives us a glimpse of the future. Based on public statements (mostly from Democrats) and scattered press reports about recent negotiations, the following paragraphs list proposals that are likely to attract initial attention during the next round of tax reform.

Eliminate the LIFO method of accounting. Repeal of the last-in, first-out method was reportedly part of the $1 trillion tax increase proposed by Democrats during the week after the July Fourth holiday. It has also been included in the president’s budget. Senate Finance Committee ranking minority member Orrin G. Hatch, R-Utah, has excoriated the president for this proposal, complaining that “millions of Americans are out of work, and this White House is actually proposing an idea that would make things worse for our manufacturers.” The Congressional Budget Office estimates that repeal of LIFO (and another profit-cutting inventory accounting method known as “lower of cost or market”) would raise about $98 billion over 10 years. Most of this pickup is in the early years, because the proposal requires the recapture of LIFO reserves. The main beneficiaries of the availability of LIFO are the major oil companies.

Repeal oil company tax breaks. With gas prices at almost $4 a gallon, Obama and Democrats in Congress have been pushing hard to repeal many tax benefits for oil and gas producers. In addition to repealing LIFO, Obama’s most recent budget proposed repealing nine other tax benefits for oil companies. The largest of these include:

Percentage depletion. Under current law, percentage depletion is only available to independent producers, and the allowable deduction varies from 5 to 22 percent of gross income from a producing property. Percentage depletion costs the government about $1 billion annually.
Expensing of intangible drilling costs. Oil companies incur significant costs for preparing and drilling wells. These costs — mostly in the form of wages, fuel, supplies, and repairs — are investments that should be capitalized and deducted over the life of the well. But current law allows them to be written off immediately, except for bigger oil companies that must spread 30 percent of the costs over five years. Disallowing expensing of intangible drilling costs is estimated to raise $8.5 billion over 10 years.
Deduction for domestic production. The section 199 deduction is generally equal to 9 percent of profits, but for oil companies it is only 6 percent of profits. The repeal of the domestic manufacturing production deduction for oil companies is estimated to raise $15.9 billion over 10 years.

Limit the tax credits for foreign taxes on oil companies. The dividing line between royalties and creditable foreign taxes is a hotly contested issue. The administration proposes to limit creditable foreign taxes to taxes paid by all businesses in that country; special taxes on oil production would no longer be creditable. The proposal is estimated to raise $9.2 billion over 10 years.

On May 17 the Senate took up the issue of repealing these tax breaks for the five integrated majors — Exxon Mobil, ConocoPhillips, Chevron, Shell, and BP. To prevent the legislation from being killed, supporters needed 60 votes, but they got only 52 — most of them from Democrats. During the debt limit negotiations, Obama has repeatedly called for raising taxes on oil companies.
Eliminate graduated corporate rates. Congress in 1936 put a graduated rate structure in place for corporate taxes. Graduated corporate tax rates have no economic justification except as a poorly targeted benefit for small businesses. Requiring all corporations to pay a flat 35 percent rate is part of the Wyden-Coats tax reform plan, and it regularly appears in the CBO’s annual list of possible revenue raisers. Requiring all corporate profits to be subject to the 35 percent rate would raise about $2.5 billion annually.

Eliminate capital gains treatment of carried interest for fund managers. There is no need to get into a philosophical debate about the difference between capital gain and incentive fees for investment services. It is a tribute to the skill of hedge fund lobbyists and the power of their clients that in the midst of a deficit crisis immediately following a financial crisis, and in a nation where the distribution of income is becoming increasingly skewed, Congress cannot raise tax rates on multimillionaire managers to levels paid by wage earners. The Joint Committee on Taxation estimates the proposal would raise $21 billion over 10 years.

Limiting the benefit of itemized deductions to 28 percent. In all three of his budgets, Obama has proposed limiting itemized deductions for high-bracket taxpayers so the tax benefit of those deductions does not exceed those available for taxpayers with a 28 percent rate. This proposal also has been reported to be part of a $1 trillion tax increase proposed by the president during recent negotiations. It is similar to the Pease phaseouts of itemized deductions. But it could return in 2013 if the Bush tax cuts are not further extended. The president’s proposal, like its predecessor, has the phony (yet politically attractive) virtue of increasing taxes on upper-income households without explicitly raising tax rates. It is vehemently opposed by the charitable sector and the housing industry. The JCT estimates the proposal would raise $293 billion over 10 years.

Close tax haven loopholes. Declaring that “people are sick and tired of tax dodgers using offshore trickery and abusive tax shelters to avoid paying their fair share,” Sen. Carl Levin, D-Mich., reintroduced the Stop Tax Haven Abuse Tax Act of 2011 on July 12. Levin’s prior versions of the bill were the foundation of the Foreign Account Tax Compliance Act enacted in 2010. In a July 11 floor statement, Senate Budget Committee Chair Kent Conrad, D-N.D., said the budget plan to be released by Senate Democrats will include proposals to crack down on tax havens. Levin and Conrad hint that $100 billion or more could be raised each year if tax haven loopholes are closed. But this is not an official estimate, and the actual figure is likely to be a fraction of the suggested amount. Still, there is no good reason why Obama and Democrats cannot add the proposals in this legislation to their list of populist tax increases.

Impose corporate tax on large passthrough entities. In its list of possible tax reform options, the President’s Economic Recovery Advisory Board in 2010 included proposals that would require publicly traded partnerships to pay corporate taxes and that would require businesses above a specific size to be subject to corporate tax. And in mid-2011, rumors abounded that Treasury, as part of its effort to lower corporate tax rates, would impose corporate tax on all businesses with more than $50 million of receipts. In 2007 Finance Chair Max Baucus, D-Mont., and Finance member Chuck Grassley, R-Iowa, introduced legislation that would tax as corporations publicly traded partnerships that provide investment advice. Obama was one of the three cosponsors. And at a May 4 Finance hearing, Baucus chimed in: “We’re going to maybe have to look at passthroughs — say they’ve got to be treated as corporations if they earn above a certain income. It’s one possibility.”

Extend the depreciable life of corporate aircraft to seven years. Obama mentioned the tax benefit for corporate jet owners six times during his June 29 press conference. Presumably he is referring to the preferential treatment corporate aircraft receive relative to commercial aircraft. Under the modified accelerated cost recovery system enacted as part of the Tax Reform Act of 1986, aircraft used in the commercial carrying of freight or passengers are depreciated over a seven-year recovery period. If aircraft are used for other qualified business purposes, they are depreciated over a five-year recovery period. This is estimated to raise $3 billion over 10 years.

Repeal the 45-cent-per-gallon tax credit for corn ethanol. The Tea Party sees the ethanol tax break for what it really is: a subsidy from big government to special interests. Three cheers for them! This type of thinking is revolutionary for Republicans, and it is why the Senate on June 16 voted 72 to 23 to repeal the ethanol subsidy. This will raise about $6 billion a year.

Repeal the deduction for domestic production activities. In the world of big corporate tax breaks, the deduction for domestic production activities is the new kid on the block. Created in 2004, it is hardly simple. There are complex rules for determining the activities that qualify for domestic production. Income from roasting and packaging coffee beans qualifies, but income from sales of brewed coffee does not. On top of definitional issues like this, domestic manufacturing income that qualifies for the deduction must be distinguished from foreign manufacturing income that doesn’t qualify. Repeal would raise receipts by about $15 billion annually. Of all the big corporate tax benefits — the research credit, accelerated depreciation, tax-exempt interest, and the low-income housing credit — it would be the first to go.

None of these proposals is a shoe-in. Impossible, some will say. But if Congress ever is going to reform the tax code, these loopholes will likely be among the first to be closed.