June 23, 2016 | Backgrounder on Taxes
The House of Representatives is drafting a tax reform blueprint through its tax reform working group. The Senate Finance Committee is working separately on a plan to integrate part of the corporate tax system with the individual system to reduce the double taxation of corporate income (i.e., the practice of taxing a corporation’s earnings and, when the corporation passes the earnings to stockholders as a dividend, taxing the stockholders on that dividend income). The House and Senate efforts will aid tax reform. Congress should also work on the vitally necessary technical aspects of tax reform this year. If it does, it will greatly increase the chances of tax reform’s success.
The U.S. economy is currently operating below its potential. High taxes on capital and labor, as well as the reduction in the labor force of prime age workers, are keeping the economy from growing faster. Tax reform, by reducing penalties on work and capital formation, allows the economy to grow in size. Under a less complex tax code, valuable resources become available for more productive uses.
Tax reform is not going to happen overnight and its many problems will not be solved in a short amount of time. The House of Representatives, through its tax reform working group, is putting together a tax reform blueprint. The Senate Finance Committee is working on a plan to reduce the double taxation of corporate income by partially integrating the corporate system with the individual system. These efforts will help move tax reform forward. Congress also needs to focus on more technical issues that can bog down tax reform. If it addresses those issues in 2016, it will significantly increase the chances of tax reform succeeding.
The attention-grabbing parts of tax reform are the rates families and businesses will pay, how many brackets there will be, how much revenue the new system will raise, and how progressive it will be. Despite the attention these issues attract, they are relatively easy to address legislatively.
Tax writers should take time this year to focus on the more technically difficult aspects of tax reform. These issues include:
Anti-base Erosion and Profit-Shifting Policies. A vital part of tax reform is establishing a territorial system that taxes businesses only on the income they earn domestically, which is the system most other developed nations use. It would replace the current U.S. system of taxing U.S. businesses on both their domestic and foreign income. By putting U.S. businesses on equal footing with their international competitors, a territorial system would allow U.S. businesses to substantially increase efficiency and investment domestically, which in turn would boost domestic job creation and wage growth.
A territorial system needs to be paired with a robust set of policies to prevent erosion of the U.S. tax base and to prevent evasive shifting of profits offshore. These policies define what is U.S. source income and therefore taxable in the U.S. They include better transfer pricing policies, especially as they pertain to intangible income, as well as policies that limit the amount of debt a U.S. business can accumulate from its foreign subsidiaries.
Without such policies, businesses could move income abroad that should remain in the U.S. Under a territorial system, once a business moves income out of the U.S., that income is no longer subject to U.S. tax. This would erode the U.S. tax base and necessitate a higher tax rate on families and domestic-only businesses to raise a given amount of revenue. Higher rates are anathema to the aims of tax reform.
Congress should start crafting workable policies now. There is no perfect answer when it comes to this problem. Congress should pick a set of policies and then commit to evaluating them periodically to determine how well they work and how Congress should improve them.
Financial Issues. Taxing financial flows correctly is a vital component of tax reform because such flows directly impact saving and investment. Congress needs to decide whether to have a system that taxes interest income and provides a deduction for interest expenses, or one that does not tax interest income and therefore does not offer a deduction for interest expenses. Either system can work. However, exempting interest while still providing a deduction for interest expenses would create a subsidy for borrowing. Conversely, taxing interest and denying a deduction for interest expense would create a bias against borrowing.
There are other issues that Congress needs to address which arise with financial products. For example, Congress needs to take great care to ensure proper treatment of the life insurance industry, especially as it pertains to the deductibility of life insurance reserves.
Transition Rules. When a new tax reform law is enacted, the law must contain provisions to ensure a smooth transition from the old tax system to the new one. The transition from the old to the new tax system is especially critical in driving the success of reform. If the transition is done poorly, tax reform could hurt the economy. As long as Congress handles the transition properly, there will be little disruption to the economy.
For example, Congress should establish a window of time during which businesses can use deferred tax assets (like net operating losses, foreign tax credits, and depreciation deductions). Once a transition period expires, businesses would not be able to use those deferred tax assets to reduce their tax bills.
A good example of how this could work is the potential transition to a territorial system. Businesses have an estimated $2 trillion of tax-deferred income overseas. The businesses should receive a certain number of years to repatriate the money and pay tax on it so all foreign income is on the same basis once the transition is over. After that time elapses, if the businesses have not paid the tax, the income would be deemed deferred and would be taxed. The rate on the repatriated income should be lower than the current rate (which can be as high as 35 percent before the foreign tax credit is applied) because businesses did not necessarily plan to bring that income back to the U.S.—consequently paying tax on it—during the window set by the move to a territorial system.
Improve the Congressional Tax Policy Apparatus. Congress needs to make sure that the Joint Committee on Taxation (JCT) can adequately handle evaluating a complex tax reform bill, given the congressional practice of relying heavily on the JCT’s work. Congress needs to make sure the JCT’s quantitative models and methodology allow it to accurately assess the plan on a dynamic basis. To date, there is evidence that the JCT needs to improve its models.
Congress should consider changes to how it uses the Congressional Research Service (CRS) for theoretical and empirical tax analysis. Congress has JCT and the Congressional Budget Office to conduct those analyses. Congress should consider relying fully on those agencies for tax work which would allow the CRS to focus its resources on areas of analysis only it provides to Congress.
In addition to tax reform, Congress should put to rest the problem of having to enact a “tax extenders” law every year to extend expiring provisions of the tax code.
The 2015 tax extenders law finally made several expiring provisions permanent. In 2016, Congress should go through each of the remaining expiring policies one-by-one and preserve economically justified policies and eliminate the economically unjustified ones.
Congress should begin laying the groundwork for major policy advancements as soon as possible, with tax reform being a substantial part of that effort. Congress should spend 2016 doing the vital technical work leading to pro-growth tax reform. Success in this effort will greatly increase the chances of pro-growth tax reform becoming a reality.—Curtis S. Dubay is Research Fellow in Tax and Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.
 Congressional Budget Office, “The Budget and Economic Outlook: 2016 to 2026,” January 2016, https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51129-2016Outlook.pdf (accessed January 31, 2016).
 John H. Cochrane, “Here’s What Genuine Tax Reform Looks Like,” The Wall Street Journal, December 22, 2015, http://www.wsj.com/articles/heres-what-genuine-tax-reform-looks-like-1450828827 (accessed January 11, 2016).
 See Curtis S. Dubay, “The Proper Tax Treatment of Interest,” Heritage Foundation Backgrounder No. 2868, February 19, 2014, http://www.heritage.org/research/reports/2014/02/the-proper-tax-treatment-of-interest, and Curtis S. Dubay, “An Alternative Way to Treat Interest Properly in Tax Reform,” Heritage Foundation Issue Brief No. 4465, September 30, 2015, http://www.heritage.org/research/reports/2015/09/an-alternative-way-to-treat-interest-properly-in-tax-reform.
 KPMG, “The Camp Proposal: U.S. Corporate Tax Reform and the Insurance Industry,” p. 4, https://www.kpmg.com/US/en/industry/insurance/Documents/insurance-tax-camp-report.PDF (accessed March 2, 2016).
 A deemed repatriation as part of a move to a territorial system is different from a repatriation holiday. Under a holiday the worldwide system remains in place. During a holiday, overseas income could be either deemed repatriated or business could voluntarily bring the money back.
 See Curtis S. Dubay, “JCT Should Not Predict Federal Reserve Actions in Dynamic Scoring,” Heritage Foundation Issue Brief No. 4501, December 22, 2015, http://www.heritage.org/research/reports/2015/12/jct-should-not-predict-federal-reserve-actions-in-dynamic-scoring, and Curtis S. Dubay, “JCT Dynamic Score of Bonus Depreciation: Highly Flawed,” Heritage Foundation Issue Brief No. 4478, November 3, 2015, http://www.heritage.org/research/reports/2015/11/jct-dynamic-score-of-bonus-depreciation-highly-flawed.
 J. D. Foster, “Eliminating Partisan Analysis from Congress’s Support Agencies,” Heritage Foundation WebMemo No. 3059, November 15, 2010, http://www.heritage.org/research/reports/2010/11/eliminating-partisan-analysis-from-congresss-support-agencies.
 Protecting Americans from Tax Hikes Act of 2015; P.L. 114-113.
 Curtis S. Dubay, “The Senate Can Use Tax Extenders as an Opportunity to Improve the Tax Code,” Heritage Foundation Issue Brief No. 4437, July 28, 2015, http://www.heritage.org/research/reports/2015/07/the-senate-can-use-tax-extenders-as-an-opportunity-to-improve-the-tax-code.