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January 17, 1996 02:32 PM | Permalink |

The Kemp Commission’s loophole-ridden flat-rate tax proposal released on January 17, 1996 would balloon the budget deficit by hundreds of billions of dollars annually or require a tax rate in excess of 30 percent to break even, according to a preliminary analysis of the Commission’s report by Citizens for Tax Justice.

“Adding new upper-income loopholes to the tax code and slashing tax rates on the very rich is hardly the answer to the problems in our income tax,” said CTJ director Robert S. McIntyre. “The Kemp Commission report is an exercise in fiscal irresponsibility and grossly unfair tax policies not seen since the “rosy scenario” days of the early Reagan administration.”

Outline of the Kemp Plan

The Commission endorsed a single-rate tax to replace the current progressive personal and corporate income taxes. It also called for a vast array of new loopholes, including a 100% exemption for interest, dividends and capital gains, and outright repeal of the estate tax on very large inheritances.

The report suggests retention of most itemized deductions (for mortgage interest, charitable contributions, etc.) and calls for a new deduction for Social Security taxes paid. Corporate profits from new investments would be exempted from tax, and “transition rules” would “protect” profits generated from existing investments.

Although the Kemp Commission’s report makes no mention of new taxes on employee fringe benefits, Mr. Kemp later told reporters that employee health insurance benefits should be taxed, with the goal of encouraging employers to eliminate such benefits.

The Commission does not specify a tax rate or personal exemptions for its plan, but calls for a rate “as low as possible” and for “generous” exemptions against the wage portion of its tax proposal.

Revenue Losses of $300 Billion a Year–or a 30%+ Tax Rate

Recently, the Treasury Department estimated that the 17% Armey flat tax plan would reduce government revenues by $138 billion a year (implausibly assuming no transition rules and no changes in taxpayer behavior to avoid the new tax). Taking account of the additional write-offs, exclusions and transition rules recommended by the Kemp Commission, CTJ estimates that the Kemp plan would lose upwards of $300 billion annually at a 17% rate with family exemptions similar to the Armey plan’s. Alternatively, CTJ estimated that the Kemp plan would seem to require a tax rate in excess of 30% to break even.

The Commission disputes this mathematical logic by arguing that lower tax rates and more loopholes for the wealthy would “double the economic growth rate.” “This is the same discredited supply-side nonsense that was touted in the late seventies and early eighties,” McIntyre noted. “It didn’t work then, and it wouldn’t work now.”

Middle- and Low-Income Working Families Would Be Big Losers

“Since all but the very richest families are now in the 15% and 28% tax brackets, a break-even 30%-plus Kemp flat tax would obviously increase taxes by huge amounts on middle- and low-income working families,” McIntyre said. Previously, Treasury has estimated that a revenue-neutral flat tax such as Armey’s would increase taxes substantially on all income groups except those making more than $200,000 a year.

“If House Speaker Newt Gingrich and Senate Majority Leader Bob Dole are truly serious about balancing the federal budget, they should immediately repudiate the Kemp Commission’s budget-busting recommendations,” McIntyre concluded.

 

Gramm Plan: More Snake Oil

In a related development, Senator Phil Gramm (R-Tex.) called for a 16% flat tax on income. Gramm proposes new loopholes for capital gains, dividends and corporate depreciation write-offs, repeal of the estate tax, retention of itemized deductions for mortgage interest and charitable donations, and larger standard deductions and personal exemptions. Although Gramm’s plan is very sketchy, it also would appear to add hundreds of billions of dollars to the annual budget deficit–and ultimately lead to sharply increased taxes on most families or huge reductions in government services.

Citizens for Tax Justice is a non-partisan Washington, D.C. tax policy group.

 

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Kemp Commission Recommendations (quotes except bracketed items]:

[OVERVIEW: Calls for a flat-rate quasi-consumption-based tax with an exemption for investment income from old, as well as new savings and business investments.]

[Key Goal: The rich must pay a much lower share of the taxes than now:]

  if one taxpayer earns ten times as much as his neighbor, he should pay ten times as much in taxes. Not twenty times as much.

[Therefore, there must be a single, unspecified rate:]

the single rate [should] be as low as possible

[An unspecified personal exemption:]

a generous personal exemption

[No taxes on interest, dividends, capital gains or inheritances:]

the tax system must either let savers deduct their saving or exclude the returns on the saving from their taxable income. It must end double-taxation of businesses and their owners and permit expensing of investment outlays. . . . [I]t also must abolish separate taxation of capital gains. . . . It makes little sense and is patently unfair to impose estate taxes.

[No taxes on existing (old) capital either:]

there will . . . be difficult issues to address during the transition. In particular, policy makers must take care to protect existing savings, investments, and other assets.

[Additional retirement savings incentives (on top of exemption)?]

any tax system should encourage people to save for their own retirement.

[Keep mortgage interest, charitable and perhaps other existing deductions:]

[Deductions and exclusions] should be considered with an eye to their impact on the tax rate, the costs to the Treasury, and the consequences of change–and within the context of the values of the American people. For example, the home mortgage interest deduction has spurred home ownership in America . . . . And, at a time when America needs a renaissance of private giving . . . we need a system which encourages people [to give to charity] . . . . [Kemp later said he would keep deductions for state and local taxes as well.]

[Add a new deduction for payroll taxes:]

The Commission recommends that federal payroll taxes be fully deductible.

[Tax fringe benefits such as health insurance:]

[Although not mentioned in the Commission report, Kemp said on “Face the Nation” (Jan. 21) that employer-paid health insurance and other fringe benefits should be taxed under the flat tax. According to the Washington Post, he “agreed that the flat tax might lead to a decrease in employer-funded health care. . . . [But that was the goal, he said,] ‘What we’ve got to get rid of is third-party payments–government, business or union.'”]

[Making it add up:]

We believe the changes we propose will help double the rate of economic growth. . . . We recommend that Congress . . . use . . . “dynamic” scoring . . . . It is essential to avoid overly optimistic as well as overly pessimistic projections.

[To the critics:]

The defenders of the status quo will say that our recommendations for a new tax system will mean a tax increase on the middle class or a flood of red ink.

We strongly disagree. . . . Complainers fail to understand the new world that this new system will create. The tax reform we envision will create a different climate for economic growth. It will lift incomes. It will reduce interest rates. It will put people to work. It will reduce the use of tax shelters. It will reduce the need for social safety-net spending. It will foster millions of new businesses and jobs. In the process, the transition will help to pay for itself.

[RE: Implementation of recommendations–let’s have another commission!]

we urge President Clinton to appoint a . . . commission to bring the recommendations offered by this congressionally appointed commission to the next level of public debate.

[NOTE: With Kemp’s proposed increased exemptions and his new or retained deductions and exclusions, Kemp plan would appear to take a rate in excess of 30% to break even. At a 17% rate, such a Kemp plan would appear to lose over $300 billion a year.]

January 17, 1996

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July 27, 1995 02:22 PM | Permalink |

Citizens for Tax Justice, August 15, 1995

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June 1994:

Rep. Dick Armey introduces H.R. 4585, calling for a 17% flat-rate tax to replace all federal personal and corporate income taxes. The bill is patterned after a flat-rate consumption tax designed by Hoover Institution economists Robert Hall and Alvin Rabushka in 1983. Armey’s version, however, entails both a lower tax rate and much higher standard deductions against the wage portion of the tax. Armey claims his plan will lose $40 billion a year in revenues at its proposed 20% (two-year) temporary rate.(1)

September 1994:

In an article in the Washington Post (Sept. 25, 1994, p. C2), Citizens for Tax Justice director Robert McIntyre estimates that the Armey 17% flat tax plan, as drafted, “could cost in excess of $200 billion annually.” A few weeks later, CTJ provides a detailed outline of its analysis, which is based on the revenue-estimating methodology outlined by Armey’s mentors, Hall and Rabushka, in their 1983 book, Low Tax, Simple Tax, Flat Tax. CTJ pegs the revenue cost of the Armey plan at $220 billion a year at its proposed 17% rate. (Because of unresolved transition and compliance issues, CTJ calls the $220 billion revenue-loss estimate “optimistic.”)

Rep. Armey immediately challenges CTJ’s estimate. He repeats his claim that his bill will lose “only $40 billion”–but again at the plan’s temporary 20% tax rate, rather than its permanent 17% rate. Armey calls CTJ’s analysis “fundamentally flawed,” says that CTJ “manipulated data” and accuses CTJ of “outright dishonesty.” Although Armey offers no explanation of exactly what “major error” he found in CTJ’s figures, he calls CTJ’s analysis “discredited,” and falsely tells reporters that CTJ has “admitted its error.”

On September 21, 1994, a few days before McIntyre’s Post article appeared, the congressional Joint Committee on Taxation writes to then majority leader Richard Gephardt in response his request for an analysis of the Armey plan. The letter notes:

“Viewed in isolation, the effect of the [Armey plan’s] changes in the standard deduction, exclusion of investment income, and reduction in the top marginal tax rate could cause decreases in revenue in excess of $200 billion annually.”

Joint Tax’s letter goes on to say: “However, we cannot provide our normal revenue estimates for the bill’s impact on individuals for the following reasons: [basically, because Armey’s bill was too poorly drafted to answer some key questions about the tax base].” Joint Tax concludes that “we are unable to provide either a revenue or distribution analysis of H.R. 4585 [the Armey plan] at this time.”

Rep. Armey seizes on Joint Tax’s complaints about the poor drafting of his bill to argue that no one could possibly cite Joint Tax’s tentative revenue-loss estimate to buttress CTJ’s analysis.

October 1994:

The Treasury Department releases an extensive computer analysis of the Armey flat tax (relying heavily on Hall and Rabushka’s 1983 book for details that are lacking in Armey’s bill). In “An Analysis of a Flat-Rate Consumption Tax,” Treasury finds that at a 17% rate, Armey’s plan will lose $244 billion a year in revenues, assuming retention of the earned-income tax credit for the working poor, or $219 billion annually if the EITC is eliminated (as CTJ had assumed). Thus, despite a somewhat different estimating methodology, Treasury’s finding is virtually identical to CTJ’s September 1994 estimate.
Treasury notes that (obviously) it would take a much higher tax rate (25% to 26%) or much lower exemptions than Rep. Armey has proposed for his plan to break even. And under a revenue-neutral Armey flat tax, Treasury concludes, the vast majority of American families will pay much higher taxes, while the very rich will get enormous tax cuts.
Treasury’s distributional findings match previous conclusions by the authors of the Armey plan, Hall and Rabushka. In their 1983 book, they had conceded that their flat tax would “be a tremendous boon to the economic elite” (p. 67), and admitted:

“Now for some bad news. . . . [I]t is an obvious mathematical law that lower taxes on the successful will have to be made up by higher taxes on the average people.” (p. 58)

Rep. Armey responds to Treasury’s findings by calling them “garbage” and a “partisan assault by the Democrats.”
Armey offers no response, however, to the fact that 12 years earlier, Ronald Reagan’s Republican Treasury Department reached exactly the same conclusion. At a 1982 Senate Finance Committee hearing on various tax proposals (including an Armey-style flat tax plan), the Reagan Treasury testified that “any” flat-rate tax “would involve a significant redistribution of tax liability” away from the wealthy and onto average taxpayers.

Rep. Armey also complains that Treasury had misunderstood some of the technical details of his plan. In particular, he says, Treasury failed to take account of the fact that his plan treats employer-paid Social Security taxes as taxable fringe benefits to workers.
Treasury responds that it is surprised to hear that Armey intends to tax employer-paid Social Security taxes. But even with Armey’s odd technical revisions, Treasury notes, Armey’s plan still loses $186 billion annually (assuming retention of the earned-income tax credit). Treasury also points out a distributional analysis of a revenue-neutral version of this restated Armey plan will almost certainly show the same harsh consequences for most taxpayers as the plan Treasury originally analyzed.

Rep. Armey then falsely declares that Treasury has “admitted” its October analysis of his plan was completely wrong!

April 1995:

Treasury puts out an update of its October 1994 analysis of the Armey plan, taking account of Armey’s proposed treatment of employer-paid Social Security taxes as taxable fringe benefits. As already noted, the cost of the plan is pegged at $186 billion annually. Treasury points out that for the restated Armey plan to break even, either its exemptions must be cut by about two-thirds or its rate must be raised to about 23%. Not surprisingly, Treasury also finds that the distributional effects of a revenue-neutral version of the restated Armey plan are virtually identical to those found earlier, i.e., the very rich get huge tax cuts, while everyone else pays much higher taxes.

May 1995:

Representative Armey announces to a Texas television audience that his plan will repeal both the earned-income tax credit for the working poor and the federal estate and gift tax on the wealthy. In combination, these offsetting changes cut the revenue loss from his plan by about $8 billion–thus to $178 billion annually at a 17% rate based on Treasury’s figures.
On the same television show, Armey again attacks Treasury’s and CTJ’s revenue estimates. He promises that “honest” estimates will soon arrive from the congressional Joint Committee on Taxation that will confirm his claims that the bill does not lose huge amounts of revenue.

Meanwhile in May, Armey’s gurus, Hall and Rabushka, publish a new version of their book, called The Flat Tax. In it, they say that a break-even flat tax will take both a higher tax rate and much lower standard deductions than Armey proposes.
In fact, once Hall and Rabushka’s calculations are adjusted to (a) fix a technical error, (b) include Armey’s newly-proposed repeal of the estate tax and (c) bring revenues fully in line with current law, their figures indicate that the flat tax rate would have to about 21 percent, even with standard deductions one fourth less than Armey proposed in his 1994 bill.(2)

July 1995:

On July 19, Rep. Armey (with Sen. Richard Shelby (R-Ala.)) introduces a revised version of his flat tax plan. It features standard deductions about a sixth lower than he had originally proposed–apparently to shave the plan’s revenue shortfall. Armey declares that this amended plan, too, will lose $40 billion annually at its 20% temporary tax rate–thus tacitly repudiating his earlier assertions about the cost of his original proposal.
Nevertheless, Armey continues vociferously to deny Treasury’s (and CTJ’s) estimates of the huge cost of his plan at its 17% permanent tax rate. Instead, he again claims that he has “asked the Joint Committee on Taxation to score our bill”–although the idea that the tax staff would have refused to respond to the majority leader’s alleged earlier request seems dubious.

On July 25, CTJ points out that Armey has not only explicitly backtracked on his earlier assertions about his plan’s revenue losses, but also has implicitly confirmed Treasury’s findings about the cost of his plan at its 17% permanent tax rate. In fact, CTJ notes, simple arithmetic shows that a plan that loses $40 billion at a 20% tax rate must lose $146 billion at a 17% rate.(3) (For more details, see CTJ’s “Notes on Dick Armey’s Revised ‘Flat Tax,'” July 25, 1995.)

August 1995:

On August 11, at a United We Stand America conference in Dallas, Rep. Armey tells deficit-conscious Ross Perot supporters that he “would ‘gladly’ adjust his [flat tax] legislation (HR 2060) . . . to ensure that it remains revenue neutral.”(4) Armey does not specify what adjustments he would “gladly” make, but instead emphasizes that his revised plan requires a three-fifths majority vote in Congress to raise its tax rate or reduce its standard deductions.(5)

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1. Thus, even from the beginning, Armey’s own figures seem to imply that his plan would lose close to $150 billion at his 17% proposed permanent tax rate. See July 1995 below.

2. Hall and Rabushka suggest a 19% rate for their plan at 1993 levels, assuming retention of the estate tax. In computing that 19% rate, however, they compared actual fiscal 1993 income tax revenues to calendar year GDP. Correcting for this error adds about 0.6 percentage points to their calculated tax rate. Taking account of Armey’s proposed repeal of the estate tax adds another 0.4 percentage points. And bringing their figures in line with current tax revenues adds still another 0.7 percentage points. That raises the total tax rate required to break even using Hall and Rabushka’s methodology to 20.8 percent. And even that rate may be too low. Hall and Rabushka also note: “Our estimates assume that the IRS will learn about all the . . . unreported income. [I]t is possible that our estimates of the base for the flat tax are a little optimistic. . . . We do not think we are far off, however.” See The Flat Tax (1995), pp. 57-58

3. Current personal and corporate income taxes and the estate and gift tax raise $747 billion at 1995 levels. If Armey’s plan loses $40 billion at a 20% tax rate, then it must raise $707 billion. If the rate is reduced to 17%, then Armey’s plan raises only $601 billion ($707 billion × 17/20ths). That leaves a revenue loss (at 1995 levels) of $146 billion a year. The difference between that figure and Treasury’s $178 billion estimate for the earlier version of the plan stems from Armey’s reduction in his proposed standard deductions.

4. BNA Daily Tax Report, Aug. 15, 1995, p. G-1.

5. At the same conference, “Armey also denied that the plan would exempt unearned income [such as interest]. He said the plan would tax unearned income the same as wages–at 17 percent with no exceptions.” Armey is quick to contradict himself, however. “He said the elimination of the [home mortgage] interest deduction would be offset by eliminating the tax on interest earnings.” BNA Daily Tax Report, Aug. 15, 1995, p. G-1.

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June 12, 1995 02:24 PM | Permalink |

Robert S. McIntyre

 

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Having attacked the liberal accomplishments of the Great Society and New Deal, congressional Republicans are preparing to eliminate a reform that stretches even further back into history: the progressive income tax. Republicans in both houses of Congress have introduced plans for a flat tax, claiming that its simplicity and fairness will be a boon to all. Majority Leader Dick Armey, presenting his plan, states that “millions of taxpayers are taken off the rolls entirely, and middle Americans receive a tax cut.”

The first part of that claim is largely true. Since Armey’s plan does not tax income from interest, dividends, or capital gains, those taxpayers who live completely off of investment income would be taken off the rolls entirely. The second part of the claim is, by any serious accounting, wrong. Armey’s plan has two parts: It replaces the progressive income tax with a flat tax, and it replaces business taxes with a consumption tax. Both elements would dramatically shift the tax burden from the wealthy toward the middle class and the poor.

If not for stunning misrepresentations, this would be obvious to everyone. Our personal income tax now starts with a zero effective rate on lower-income families (families of four currently earning up to about $23,200 pay no income taxes) rising to a 39.6 percent top marginal rate on the incomes of the richest 1 percent. Replace that with a flat rate of, say, 20 percent and clearly the rich will pay far, far less in taxes. That has to be made up somewhere.

Flat-tax advocates imply that the lower tax rate will be made up by closing loopholes for the wealthy and well-connected. In fact, the opposite is true. The complete tax exemption for personal investments replaces many small loopholes with one enormous loophole. Rather than alleviating the plan’s regressivity, this aggravates it: A large share of the income of the wealthiest Americans wouldn’t be taxed at all. That would leave middle- and low-income families holding the bag.

The flat-tax proposals currently in Congress are based upon a plan put forth by Robert Hall and Alvin Rabushka, two Stanford economists. In their 1983 book, Low Tax, Simple Tax, Flat Tax, they said that their flat tax “will be a tremendous boon to the economic elite.” They honestly delivered what they admitted was “some bad news”: “it is an obvious mathematical law that lower taxes on the successful will have to be made up by higher taxes on average people.” Hall and Rabushka calculated that their flat tax would raise taxes by $1,400 to $2,400 a year (in today’s dollars) on families earning between $25,000 and $75,000. But “the truly successful get a better and better deal,” they pointed out. “Families with incomes around [$285,000] receive tax breaks of about 7 percent of income, those with incomes of [$1.5 million] get 10 percent, and the handful with incomes approaching [$4 million] get 13 percent.”

 

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THE FULL PICTURE

The politicians who have embraced this plan are less candid about its effects. Armey, for example, tries to sell his flat tax by (a) talking only about the wage portion of his tax, while pretending that nobody pays the business sales tax part, (b) denying that his proposed 17 percent rate and high exemptions entail a huge revenue shortfall, and (c) nevertheless insisting that almost everyone will get a tax cut.

Let’s start with the first part. The business tax part of the plan would tax all corporate receipts, exempting investments in capital, with wages taxed separately. Economists call this a consumption tax. Armey delicately avoids the term. Calling it a “business tax” allows him to pretend that consumers don’t pay it, but Hall and Rabushka have failed to cooperate in this political charade. During a 1982 Senate Finance Committee hearing, Senator Bill Bradley asked Hall, “So you are advocating a consumption tax?” Hall responded, “That’s right, but we are careful not to label it as such.” In the revised edition of their book, they are not so careful. “The flat tax,” they write, “by expensing investment, is precisely a consumption tax.”

Although flat-tax backers seem to think that their business sales tax would be immune from political pressures, this is not the experience with value-added taxes in Europe, nor with sales taxes in the states (the closest existing approximations). On the contrary, lobbying for special exemptions and loopholes is rampant with those taxes, cheating is widespread, and administrative costs are generally as high or higher than for income taxes.

Even the introduction of this huge new consumption tax, however, would not make up for the huge losses of revenue brought about by the plan. Armey proposes a tax exemption of $13,000 for an individual, $26,200 for a married couple, and $5,300 for each child. “A family of four would have to earn $36,800 before it owed a penny of federal income tax,” explains Armey, declining once again to mention the effect of his consumption tax. Too good to be true? Of course.

Although it’s difficult to gauge what effect such a radical change would have on economic behavior, a study by the Treasury Department of the impact of Armey’s plan pegged the revenue shortfall at $186 billion a year. To make up the difference, Armey would have to drastically reduce his proposed exemptions for children, jack the rate up from 17 percent to about 23 percent, or some of each.

Once these changes are taken into account, Treasury’s analysis shows that the typical family would pay close to $2,000 a year in additional taxes under the Armey flat tax. Very rich people, however, would get tax cuts averaging more than $50,000 each.

More specifically, Citizens for Tax Justice (CTJ) has calculated the effect of the flat tax on a range of income groups. For simplicity, CTJ focuses on non-elderly couples with two children, based on actual tax return and Census data (adjusted to 1996 levels). The results are similar to those shown in the tables presented by the Treasury and by Hall and Rabushka in 1983. For example:

Family income: $25,000. Under current law, a family of four earning $25,000 pays essentially nothing in combined personal and corporate income taxes. Taxes that would otherwise be due are offset by the earned income tax credit, which Armey would repeal. Under the Armey plan, with its proposed exemptions but with a 22.6 percent break-even tax rate, such a family would typically pay $810 in taxes on its $3,600 in fringe benefits and $1,540 as its share of the business tax. Thus, its tax bill under the Armey flat tax would increase by about $2,400. Under the alternative scenario, with a 17 percent tax rate but lower exemptions, this family’s tax bill would increase by almost $3,700.

Family income: $45,000. This family would currently owe about $3,800. Under the Armey plan, its taxes would increase by $1,740 to $4,200 a year, depending on the version.

Family income: $85,000. Current personal and corporate income taxes on this family would typically amount to $11,140. Under the Armey plan, wage taxes alone would be $10,400 to $11,650. When taxes on fringe benefits and the business tax are added in, this family would owe $4,600 or more a year in additional taxes.

Family income: $500,000. Under current law, this family would pay $154,000 in combined personal and corporate income taxes. Under the Armey plan, the family’s tax would be slashed by half or more for a tax cut of between $78,000 and $93,000 annually.

 

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SUPPLY-SIDE REDUX

How, then, does Armey conclude that his plan will cut everyone’s taxes without losing revenue? He relies upon Hall and Rabushka’s estimate in their book that the new incentives brought about by the flat tax will lead to a $1,900 increase in per capita income by 2002. This is just a leap of faith. There is no basis for this claim other than supply-side economics, the notion that lowering taxes on the wealthy will cause an explosion in economic activity whose riches trickle down to everyone. History has not been kind to this view.

Supply-side proponents of the tax-shift policies adopted during the Carter and early Reagan years confidently predicted that their approach would produce an investment-led economic boom. But despite the rosy scenarios, the supply-side experiment failed. After the 1978 capital gains tax cut was enacted, for example, the gross domestic product (GDP) dropped by 1 percent over the next year and a half, after having grown by 5.8 percent the previous year. The 1981 supply-side tax-loophole bill was followed by the deepest recession since the 1930s.

After several years of weak business investment, rampant tax-sheltering, and huge budget deficits, President Reagan himself switched gears. The supply-siders were banished and Reagan helped lead the charge for the loophole-closing 1986 Tax Reform Act. The result was a fairer, more efficient tax code that treats income more equally, regardless of how it is earned or used. And to the consternation of supply-siders, productive investment surged dramatically after the loopholes were closed and business tax avoidance was curtailed. As former Reagan Treasury official, J. Gregory Ballentine, told Business Week: “It’s very difficult to find much relationship between [corporate tax breaks] and investment. In 1981 manufacturing had its largest tax cut ever and immediately went down the tubes. In 1986 they had their largest tax increase and went gangbusters [on investment].”

More recently, our economy has enjoyed an investment-led economic rejuvenation following the increases in the top tax rates on corporations and the best-off people in President Clinton’s 1993 deficit reduction act — defying the tocsins of doom sounded at the time by Armey, Gingrich et al. Indeed, from the third quarter of 1993 (when the deficit reduction act was approved) through the end of 1994, real GDP rose by 5.7 percent, led by real business investment growth of 18.4 percent. The stock market is at a record high. Indeed, the economy has done so well since 1993 that the Federal Reserve has taken repeated steps to try to slow it down.

The current flat tax plans dwarf all previous tax change battles. President Clinton had to wage political holy war to win a slight increase in the highest tax bracket. The flat tax would cut it by more than half. While Congress has fiercely debated lowering the capital gains tax by a few points, this plan would drop it to zero. Liberals are shocked that the Republican Congress now seeks to cut the earned income tax credit by a tenth. Armey’s plan would eliminate it entirely.

The irony is that the flat tax is coming into political favor at a time when the economics undergirding it have never been less credible. Worse, at a time when Americans face a long-term rise in inequality and a decline in middle-class wages, Congress is considering solutions that would throw gasoline on the fire. Fortune magazine recently ran a cover story, “Get Ready for the Flat Tax,” as if it were a fait accompli. The message for anyone who cares about the future of economic justice in America couldn’t be any clearer: Get ready to fight the flat tax flat out.

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May 17, 1995 02:20 PM | Permalink |

Statement of Robert S. McIntyre
Director, Citizens for Tax Justice
Concerning Proposals for a Flat-Rate Consumption Tax
Before the Joint Economic Committee

May 17, 1995

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I appreciate the opportunity to testify before the Committee on behalf of Citizens for Tax Justice. Our coalition of labor, public interest and grassroots citizens groups represents tens of millions of middle- and low-income Americans, who have a vital stake in fair, economically sound tax and budget policies.

According to Chairman Mack, “The purpose of this hearing is to explore how the implementation of a flat tax would impact economic growth in the United States.” In other words, the question before the Committee today is the following:

How would very large tax increases on middle- and low-income families, coupled with huge tax cuts for the very rich, affect the economy?

We believe the answer to this question is quite clear. Higher taxes on average American families to pay for tax cuts for the wealthy is a terrible idea, both unfair and bad economics. That so-called “supply-side” policy was tried in the Carter and early Reagan years, and failed so miserably that President Reagan himself rejected it. We should not repeat those mistakes again.

 

1. The Great Middle-Class Tax Hike

There is little or no disagreement among serious analysts that replacing the current, progressive income tax with a flat-rate tax would dramatically shift the tax burden away from the wealthy–and onto the middle class and the poor.

(LATEST DISTRIBUTIONAL TABLES AVAILABLE @ctj.org)

Indeed, it seems hard to deny this obvious fact. Right now, our personal income tax starts with a zero effective rate (or less) on lower-income families (up to about $23,200 for a family of four) and goes up to a 39.6 percent top marginal rate on the incomes of the best-off one percent. Replace that with a flat-rate tax of, say, 20 percent and clearly the rich will pay far, far less in taxes. This effect would be compounded by the fact that the leading flat-rate plans (from Rep. Armey and Sen. Specter) are based on a plan put forward by Robert Hall and Alvin Rabushka that is designed to tax only consumption rather than income. (1) (This result would be achieved by allowing immediate deductions for tangible business investments and by exempting interest, dividends and capital gains from individual taxation.) Thus, not only would the flat tax rate on the wealthy be much lower, but a large share of the wealthy’s income wouldn’t be taxed at all. That inexorably would leave middle- and low-income families holding the bag.

At a 1982 Senate Finance Committee hearing on various tax proposals (including an Armey-style plan), the Reagan Treasury Department testified that “any” flat-rate tax “would involve a significant redistribution of tax liability” away from the wealthy and onto average taxpayers. More recently, the Treasury Department has undertaken a detailed analysis of Rep. Armey’s specific flat-tax plan.(2) Once Rep. Armey’s proposed exemptions are adjusted downward to avoid the huge revenue losses the plan would otherwise entail, Treasury’s analysis shows that the typical family would pay close to $2,000 a year in additional taxes under the Armey flat tax. Very rich people, however, would get tax cuts averaging more than $50,000 each. (3) Treasury’s findings have been confirmed by the authors of the original Armey and Specter-style flat tax. In their 1983 book, Low Tax, Simple Tax, Flat Tax, Hall and Rabushka noted that their flat tax “will be a tremendous boon to the economic elite.(4) They honestly delivered what they admitted was “some bad news”: “it is an obvious mathematical law that lower taxes on the successful will have to be made up by higher taxes on average people.”(5) In fact, much like Treasury, Hall and Rabushka calculated that their flat tax would raise taxes by $1,400 to $2,400 year (in today’s dollars) on families earning between $25,000 and $75,000. But “the truly successful get a better and better deal,” they point out. “Families with incomes around [$285,000] receive tax breaks of about 7 percent of income, those with incomes of [$1.5 million] get 10 percent, and the handful with incomes approaching [$4 million] get 13 percent.”(6)

To be sure, some flat-tax advocates have been less than fully candid about the effects of their plans. Representative Armey, for example, tries to sell his flat tax by (a) denying that his proposed 17% rate and high exemptions entail a huge revenue shortfall, (b) nevertheless insisting that almost everyone will get a tax cut, and (c) talking only about the wage portion of his tax, while pretending that nobody pays the business sales tax part (even though it would apply to everything from groceries to health care to new homes) or his tax on fringe benefits.

To supplement Treasury’s analysis, we have prepared some detailed examples of how the Armey flat tax would affect typical families, focusing for simplicity on non-elderly couples with two children, and based on actual tax-return and Census data (aged to 1996 levels). Our results are similar to those shown in the tables presented by the Treasury and by Hall and Rabushka in 1983. For example:

 

• Family income: $25,000. Under current law, a family of four earning $25,000 pays essentially nothing in combined personal and corporate income taxes. (What taxes would otherwise be due are offset by the earned-income tax credit, which would be repealed under the Armey plan, and apparently by Sen. Specter’s plan as well.) Under the Armey plan, with its proposed exemptions but with a 22.6% break-even tax rate, such a family would typically pay $810 in taxes on its $3,600 in fringe benefits and $1,540 as its share of the business tax. Thus, its tax bill under the Armey flat tax would increase by about $2,400. Under the alternative scenario, with a 17% tax rate, but lower exemptions, this family’s tax bill would increase by almost $3,700.
• Family income: $45,000. Under current law, this family’s tax bill would typically be about $3,800. Under the Armey plan, its taxes would increase by $1,740 to $4,200 a year, depending on the version.
• Family income: $85,000. Current law personal and corporate income taxes on this family would typically amount to $11,140. Under the Armey plan, wage taxes alone would be $10,400 to $11,650. When taxes on fringe benefits and the business tax are added in, this family would owe $4,600 or more a year in additional taxes.
• Family income: $500,000. Under current law, this family would pay $154,000 in combined personal and corporate income taxes. Under the Armey plan, the family’s tax would be slashed by half or more–for a tax cut of between $78,000 and $93,000 annually.

(LATEST TABLE OF EXAMPLES AVAILABLE @ctj.org)

2. How Would Raising Taxes on the Middle-Class and the Poor –to Pay for Tax Cuts for the Rich–Affect the Economy?

The notion that shifting the tax burden away from the rich and onto the middle-class and poor will help the economy is not a new idea. Often referred to (even by proponents) as “trickle-down” economics,(7) this approach had its most recent major test in the so-called “supply-side” tax bills of 1978 and 1981. In the Carter administration, the 1978 Revenue Act sharply reduced taxes on capital gains and expanded corporate tax breaks. Then Ronald Reagan’s 1981 tax act slashed taxes on corporate profits and personal investment income. Meanwhile, as taxes plummeted on the affluent, inflation and rising payroll taxes led to higher and higher effective tax rates on nine out of ten American families.

“Supply-side” proponents of the tax-shift policies adopted during the Carter and early Reagan years confidently predicted that their approach would produce an investment-led economic boom. But despite the rosy scenarios, the supply-side experiment failed. After the 1978 capital gains tax cut was enacted, for example, the GDP dropped by 1% over the next year and a half.(8) Likewise, adoption of the 1981 supply-side tax-loophole bill was followed by the deepest recession since the 1930s.

After several years of weak business investment, rampant tax-sheltering and huge budget deficits, President Reagan himself switched gears. The supply-siders were banished and Reagan helped lead the charge for the loophole-closing 1986 Tax Reform Act. The result was a fairer, more efficient tax code that treats income more equally, regardless of how it’s earned or used. And to the consternation of the supply-siders, productive investment surged dramatically after the loopholes were closed and business tax avoidance was curtailed.

 

Annual Rates of Change In Business Investment in the 1980s (Real Private Non-Residential Fixed Investment)
	1981-86	1986-89
All Business Investment	+1.9%	+2.7%
Structures	-0.7%	+0.2%
Industrial buildings	-6.8%	+8.0%
Commercial buildings	+6.8%	-1.3%
All other structures	-3.4%	-1.4%
Equipment	+3.5%	+4.1%
Industrial equipment	+0.1%	+4.0%
Computers & office equip.	+22.6%	+8.8%
All other equipment	+2.8%	+3.2%
Addendum: Ind. equip. & build.	-2.0%	+5.1%
Source: U.S. Dept. of Commerce, Bureau of Economic Analysis, Mar. 1992

Real business investment grew by 2.7% a year from 1986 to 1989. That was 43 percent faster than the paltry 1.9% growth rate from 1981 to 1986. Even more significant, while construction of unneeded office buildings tapered off after tax reform, business investment in industrial machinery and plants boomed. As money flowed out of wasteful tax shelters, industrial investment jumped by 5.1% a year from 1986 to 1989, after actually falling at a 2% annual rate from 1981 to 1986. As former Reagan Treasury official, J. Gregory Ballentine, told Business Week: “It’s very difficult to find much relationship between [corporate tax breaks] and investment. In 1981 manufacturing had its largest tax cut ever and immediately went down the tubes. In 1986 they had their largest tax increase and went gangbusters [on investment].”

More recently, our economy has enjoyed an investment-led economic rejuvenation following the increases in the top tax rates on corporations and the best-off people in President Clinton’s 1993 deficit reduction act. Indeed, from the third quarter of 1993 (when the deficit reduction act was approved) through the end of 1994, real GDP rose by 5.7%, led by real business investment growth of 18.4%. The stock market is at a record high. Indeed, the economy has done so well since 1993 that the Federal Reserve has taken repeated steps to try to slow it down.

One might have thought–or at least hoped–that the soak-the-poor-and-the-middle-class tax-shift theories of the discredited supply-siders would have been laid to rest by the events of the past two decades. But sadly, that does not appear to be the case. The expensive new corporate and high-income loopholes included in the House-passed “Contract with America” tax bill are essentially an attempt to repeat the failed loophole-based tax policies of the Carter and early Reagan years. (The bill even includes a “Trojan Horse” of children’s tax credits to divert attention from the sharp reductions in capital gains and corporate taxes that are the true centerpiece of the plan.)

The Hall-Rabushka flat-rate consumption tax and its variants are an attempt to go much further. Among other things, the corporate income tax would be entirely repealed–replaced with what amounts to a modified value-added tax. Interest would be taken entirely out of the tax base. Dividends would no longer be taxed, nor would most capital gains. In short, the flat-tax proponents want to consolidate the current special tax breaks for income from capital into one giant, all-encompassing loophole. Then, on top of that, graduated tax rates would be abandoned in favor of a single flat tax rate.

The unreconstructed supply-siders who promote these regressive tax changes offer fanciful predictions about how their plan to shift the tax burden away from the rich and onto the middle class and the poor would supposedly boost economic growth. But they have been consistently wrong in the past, and they are wrong once again. Indeed, the flat-tax plan is so poorly worked out, that it would produce a major, negative upheaval in the economy that could take years to overcome.

 

3. Conclusion

Proposals for a flat-rate consumption tax would move our tax system in exactly the wrong direction, for both our economy and for tax fairness. Rather than expanding tax entitlements for corporations and the well off and lowering their tax rates, we should seek real tax reform. In our view that means that existing loopholes should be curtailed, tax laws simplified, and graduated tax rates maintained.(9)

 

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Appendix: The structure of the Armey-Specter-Hall-Rabushka flat tax.

The Hall-Rabushka flat tax, and its Armey and Specter variants, would replace the current personal and corporate income taxes with a new tax that is conceptually identical to a “subtraction-method” value-added tax, a version of a national sales tax, with two major modifications: First, imports would be exempt from the flat tax, while exports would be subject to tax. Second, to mitigate the regressivity of the VAT, cash wages, pensions received and other cash earned income would be taken out of the VAT base (i.e., deducted by businesses) and taxed directly to individuals, with exemptions. Thus, structurally, the flat tax is exactly equal to a value-added tax with an import incentive, an export disincentive and a personal rebate based on a percentage of a capped amount of cash wages, pensions and other earned income.(10)

The “business” tax: Although the corporate income tax would be repealed, its structure and most of its complexity would be retained in order to collect the modified value-added tax that is the centerpiece of the flat tax plan.

The flat-tax’s business tax form, which would be filed by corporations, self-employed people, partnerships, unincorporated companies, investors in rental properties, and anyone else engaged in business activities, would retain most of the trappings of the current corporate income tax (including the numerous, necessary rules defining gross receipts and allowable deductions) with the following modifications:(11)

 

• Capital investments in tangible property (such as machinery, buildings, land, inventories, etc.) would be expensed, rather than depreciated or amortized over time. This is consistent with the stated goal of taxing only personal consumption, and is intended to produce a zero tax rate on profits from new capital investments.
• Non-cash wages (i.e., non-pension fringe benefits such as employee health insurance) would not be deductible, and thus (unlike current income tax law) would be taxed. This is consistent with the treatment of wages generally under a normal value-added tax, but can also be seen as a withholding tax on employee fringe benefits.
• Interest income would be exempt from tax, and business interest expenses would not be deductible.
• Banks and other financial institutions would include in gross receipts the value of services provided to customers “for free” (i.e., “free” checking accounts, loan services accounted for by higher interests rates, etc.).
• Business entertainment outlays would be fully deductible (rather than only 50% deductible as under current law).
• Businesses with an excess of deductions over receipts would carry over the excess, on which the government would pay interest when the amounts are eventually deducted.(12)

After a long and troublesome transition,(13) the long-term impact of the flat tax’s business tax is supposed to approximate a consumption tax (except for its odd treatment of imports and exports). As Hall and Rabushka note in the revised version of their book, “The business tax is not a profit tax.” (14)Instead, “The flat tax, by expensing investment, is precisely a consumption tax.”(15)

Although flat-tax backers seem to think that their business sales tax would be immune from political pressures, this is not the experience with value-added taxes in Europe, nor with sales taxes in the states. On the contrary, lobbying for special exemptions and loopholes is rampant with those taxes, cheating is widespread and administrative costs are generally as high or higher than for income taxes.(16)

Personal taxes: Individuals would pay taxes directly only on wages, pensions, unemployment compensation and certain other income characterized as “earned.” Individual business owners, partners, etc. could report their earned income on the “wage tax” form by paying themselves a salary (thereby taking advantage of the wage-tax exemptions), but they would have to file the business tax form as well.

Besides smaller type, consolidation of several lines into cryptic, hard-to-audit summaries and elimination of some anti-fraud provisions, the major changes that the wage-tax form entails from the current income tax form include:(17)

 

Personal Income:
• There would be a 100% exclusion for interest income.
• There would be a 100% exclusion for dividends.
• There would be a 100% exclusion for capital gains from selling stocks and other intangible assets.
• Business receipts, rents, royalties, partnership receipts, farm receipts and so forth would not be reported on the personal tax form, but instead on the separate business tax form.

   

Personal Adjustments, Deductions and Credits:
• None of the current adjustments, for self-employed pension contributions, IRAs, self-employed health insurance, FICA taxes, or alimony paid, would be allowed.
• Itemized deductions, for state and local income and property taxes, mortgage interest, charitable donations, extraordinary medical expenses, job-related expenses and so forth would be eliminated. Sen. Specter’s plan, however, would allow charitable deductions of up to $2,500 a year and mortgage interest on up to $100,000 in debt for all tax filers with such outlays, thereby greatly increasing the number of taxpayers itemizing deductions.
• The child-care credit, earned-income tax credit for the working poor, credit for excess social security taxes withheld, and all other tax credits would be repealed.

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1. Hall and Rabushka used to be very reluctant to admit that their plan was a consumption tax. At a Senate Finance Committee hearing back in 1982, Sen. Bill Bradley asked Hall: “So you are advocating a consumption tax?” To which Hall responded: “That’s right, but we are careful not to label it as a consumption tax.”

In their recent book, The Flat Tax (1995), Hall and Rabushka are less reluctant than confusing. They variously tout their plan, often in juxtaposed paragraphs, as (a) an “airtight tax on . . . income” that “achieve[s] the goal of taxing all income exactly once” and (b) “a tax on consumption” only. The Flat Tax, pp. 72-73. Obviously, however, their plan cannot be both an income tax and a consumption tax.

2. Rep. Armey has proposed a variation on the Hall-Rabushka flat tax, with a lower 17% tax rate and larger exemptions. He also proposes to repeal the earned-income tax credit for low- and moderate-income working families and the federal estate tax on very large estates (as do Hall and Rabushka).

3. See U.S. Treasury Department, Office of Tax Analysis, “A Preliminary Analysis of a Flat Rate Consumption Tax” (1995). Treasury’s figures have been slightly adjusted here to take account of Rep. Armey’s proposals to repeal the earned-income tax credit and the estate tax. With those changes, but before adjusting Rep. Armey’s exemptions downward, Treasury’s analysis indicates that the Armey flat tax would increase the budget deficit by $178 billion a year (ignoring transition issues).

Alternatively, if Rep. Armey’s exemptions are kept as proposed, but his rate is increased (to about 22.6%) to avoid revenue losses, the redistributional effects are similar, although less pronounced. Sen. Specter’s 20% flat-tax proposal, which has smaller exemptions than Rep. Armey has proposed, is intended to be revenue neutral, and would have redistributional effects approximately in the mid-range of Treasury’s estimates for the Armey plan.

4. “Robert Hall and Alvin Rabushka, Low Tax, Simple Tax, Flat Tax (1983), p. 67.

5. Id., p. 58.

6. Id., p. 59. Dollar figures put forward by Hall and Rabushka in 1983 have been adjusted to today’s dollars. In their 1995 revision of their book, Hall and Rabushka are considerably less forthcoming about the adverse distributional consequences of their plan, asserting that “There is no way to tell.” Robert E. Hall and Alvin Rabushka, The Flat Tax (1995), p. 92.

7. “Supply side is ‘trickle down’ theory,” Reagan’s OMB director David Stockman was quoted as admitting in The Atlantic, December 1981.

8. Over the 12 months prior to enactment of the 1978 capital gains tax cut, the real GDP had grown by 5.8%.

9. In CTJ’s recent publication, The Hidden Entitlements (1995), we outline the kinds of loophole-closing measures that could and should be adopted to simplify and improve the tax system to promote both fairness and economic growth. We also look forward to analyzing the major income tax reform measure that House Minority Leader Richard Gephardt has promised to introduce later this spring.

10. Businesses compute a typical “subtraction-method” value-added tax by adding up their taxable gross receipts and subtracting the cost of previously taxed items. Thus, in computing the VAT, businesses deduct their purchases from other businesses, whether for supplies, services, machines, land or whatever. (In another, more common form of a value-added tax, known as a “credit-invoice” VAT, businesses get a tax credit for taxes paid on purchased items. In general, this produces the same result as a “subtraction-method” VAT.) Ultimately, the total tax base for a VAT is equal to retail sales of taxable items, and a VAT is thus equivalent to a retail sales tax. As noted, however, the flat tax base differs from a usual VAT, however, in that wages are deducted by businesses, and taxed at the personal level.

11. The business “postcard” tax form is a fraud, since it includes virtually none of the detailed information required for taxpayers to compute their taxes or for the IRS to audit them.

12. Hall and Rabushka argue that their plan will raise more revenues from “business” than does the current personal and corporate income tax. Since they also assert that their plan ultimately taxes only personal consumption, this seems disingenuous on its face. In fact, any added tax revenues that might be collected from businesses under the flat tax appear to reflect a combination of short-term transition revenues that will decline sharply over time and new taxes on workers, rather than any actual increase in taxes paid by businesses and their owners. Although Hall and Rabushka assert that their business tax will somehow bring in lots of currently untaxed business receipts, they offer little or no evidence for this claim. As noted in the text, in terms of the business-filed tax forms, Hall and Rabushka’s business tax base would be much like the current system (with similar underreporting of receipts and overstating of expenses), with the exceptions noted in the text. As for some of those notable exceptions:

• Currently, corporations report considerably more overall taxable interest income than interest expenses, while individuals report somewhat less in taxable interest than they deduct (mainly for mortgage interest). Whether making interest totally tax-free would gain revenues seems highly doubtful.
• Allowing business investments in tangible property and inventories to be deducted immediately, rather than depreciated or amortized (or, in the case of land, non-deductible), would be a huge reduction in the tax base (compared to the current income tax), cloaked in the short-term by the fact that Hall and Rabushka suggest wiping out all remaining depreciation and amortization deductions on existing assets.
• Employer-paid fringe benefits would no longer be deductible. But Hall and Rabushka expect that the burden of this tax change would not be borne by businesses, but would be quickly shifted to employees.
• Employer-paid social security taxes would no longer be deductible. But again, Hall and Rabushka correctly expect that this tax change would be borne by workers, not by businesses.

   

13. Hall and Rabushka seem to prefer that there be no transition rules to deal with, for example, depreciation deductions for existing equipment and interest deductions on existing loans. Under this scenario, they say, for example, that General Motors’ tax bill would increase by a staggering $2.6 billion a year in the early years of the flat tax (considerably more than GM’s total profits), due to lost depreciation and interest deductions. In contrast, they say, Intel’s tax bill would plummet by almost $1 billion because of fortuitous differences in the timing of its recent investments. See Robert E. Hall and Alvin Rabushka, The Flat Tax (1995), pp. 64-66.

Alternatively, Hall and Rabushka suggest a transition rule that would allow depreciation deductions on past investments, paid for by higher tax rates (primarily on wages and fringe benefits). Id. p. 78-79. They also suggest a possible transition rule for interest that would essentially require renegotiation of all existing loans, and is premised on the unsupported prediction that interest rates would immediately fall by a fifth upon adoption of the flat tax. Id. p. 78-79.

14. Robert E. Hall and Alvin Rabushka, The Flat Tax (1995), p. 64.

15.Id. p. 71

16. For a detailed discussion of the many problems with European value-added taxes, see Citizens for Tax Justice, No Sale: Lessons for America from Sales Taxes in Europe (1988).

17. Neither the personal nor the business tax form includes a line for self-employed people to pay their Social Security taxes. This may have been an oversight, or, like the consolidation of wages, pensions, IRA distributions, etc. onto one line, it may have been necessitated by the goal of fitting the tax form on a large index card.

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May 3, 1995 04:46 PM | Permalink |

Click here to download this analysis in PDF format.

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I appreciate the opportunity to testify before the Committee on behalf of Citizens for Tax Justice. Our coalition of labor, public interest and grassroots citizens groups represents tens of millions of middle- and low-income Americans, who have a vital stake in fair, economically sound tax and budget policies.

The issue before the Committee today involves the Alternative Minimum Tax, which was adopted in 1986 to try to put an end to the spectacle of highly profitable corporations and high-income individuals paying little or nothing in federal income taxes. Recently, however, the House has passed a bill that, among many other egregious provisions, would entirely repeal the Alternative Minimum Tax on corporations and gut the AMT as it applies to individuals.

The House plan is a direct attack on the principles of the 1986 Tax Reform Act. It could reasonably be called a slap in the face to Chairman Packwood, Sen. Bradley, former President Reagan, and all the others who worked so hard to pass the 1986 reforms. The designers of the House plan make no bones about the fact that they want to return to the bad old days of widespread corporate tax freeloading. We urge the Committee to reject the House’s outrageous AMT repeal proposal and instead to take measures to strengthen the minimum tax.

Why the Corporate Minimum Tax Was Adopted

A 1986 CTJ survey of 250 of the nation’s largest and most profitable corporations found that 130–more than half the total–managed to pay absolutely nothing in federal income taxes in at least one of the five years from 1981 to 1985.(1)

These 130 companies, ranging alphabetically from Aetna Life & Casualty to Xerox, earned a combined total of $72.9 billion in pretax domestic profits in the years they did not pay federal income taxes. But instead of paying $33.5 billion in income taxes, as the 46 percent statutory federal corporate tax rate purportedly required, they received $6.1 billion in tax rebates–for a “negative” tax rate of -8.3 percent.

• Of this group of 130 corporate tax freeloaders, 73 had at least two years of paying nothing in federal income taxes from 1981 to 1985.
• 42 of these companies paid nothing–or less–in total federal income taxes over the entire five years.

Congress rightly found this situation intolerable. “The committee believes the tax system is nearing a crisis point,” said the December 1985 House Ways and Means Committee Report on what became the Tax Reform Act of 1986. “Many firms have made use of tax provisions to reduce their tax liability to zero, and, in some cases corporations with substantial book income obtain tax refunds.”

Likewise, the Senate Finance Committee’s May 1986 report on the same bill stated: “The committee finds it unjustifiable for some corporations to report large earnings and pay significant dividends to their shareholders, yet pay little or no taxes on that income to the government.”

In response to the egregious level of corporate tax avoidance, the Tax Reform Act of 1986 closed many business loopholes and adopted the Alternative Minimum Tax. The AMT was designed to assure that all profitable corporations pay at least some reasonable amount in federal income tax. The official summary of the Tax Reform Act of 1986 states:

“Congress concluded that the minimum tax should serve one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits. . . . It is inherently unfair for high-income taxpayers to pay little or no tax due to their ability to utilize tax preferences.”

The Structure of the Alternative Minimum Tax

The “alternative” feature of the AMT works like this. Most companies pay the 35 percent regular corporate tax rate on their profits less amounts sheltered by various remaining tax preferences, such as accelerated depreciation (200%-declining-balance over short periods) and special breaks for oil, gas and mining. Alternatively, companies must pay the 20 percent minimum tax on profits computed without some of the loopholes–if the AMT is higher.

Minimum taxable income is usually higher than regular taxable income for several reasons. Depreciation write-offs, for example, are less accelerated under the AMT. Investments in mining exploration and development must be amortized over 10 years rather than deducted immediately. And tax “losses” (NOLs) left over from prior years that are attributable to certain tax preferences (such as accelerated depreciation and a portion of certain oil tax breaks) cannot be used to offset the AMT.

In addition, if “adjusted current earnings” exceeds minimum taxable income as otherwise defined, then the AMT applies to three-quarters of the difference. In computing adjusted current earnings, certain tax preferences are further scaled back and tax “losses” from previous years are not allowed.(2)

How the Minimum Tax Has Worked in Practice

Since their adoption, the 1986 reforms, including the corporate Alternative Minimum Tax, have curbed many of the worst corporate tax avoidance problems. In fact, the number of no-tax giant corporations in CTJ’s last comprehensive survey (in 1989) dropped sharply–to only seven in 1988.(3) Although not all firms disclose in their annual reports whether they paid the minimum tax, in our 1987 corporate tax survey we were able to identify 11 profitable companies that would have paid no tax at all without the minimum tax.(4) As a 1991 IRS paper noted, “in the case of large companies with regular deferrals of tax liability, AMT may cause them to experience a new phenomenon: paying taxes.”(5)

That’s not to say, however, that the Alternative Minimum Tax is paid by very many corporations. According to the IRS, from 1987 through 1991 the corporate AMT was paid by about 28,000 corporations a year–only 1.2 percent of all active corporate filers. By major industry, the percentage of corporations paying the AMT (in 1988-91) ranged from 4.3 percent in mining down to 0.7 percent in wholesale and retail trade.

Overall from 1987 through 1992, the AMT directly increased total corporate income tax payments by a net of $21.6 billion. That’s only 3.8 percent of the total amount that corporations paid in income taxes over that period. As a share of taxes paid, the biggest direct tax effects from the AMT were in the historically low-tax mining and oil & gas extraction industries, where the AMT amounted to about a fifth of total income taxes paid from 1987 to 1991.

Some 83 percent of the total 1987-91 net AMT was paid by corporations with assets greater than $250 million. That’s noticeably more than 71 percent of total corporate income taxes (after credits) paid by these giant companies. The AMT’s share of total taxes on giant companies was 4.7 percent.

Corporate Complaints about the Minimum Tax

So if the AMT is paid by so few corporations and amounts to such a small share of total corporate income tax payments, why is there so much corporate complaining about the AMT? There are two primary reasons:

First of all, the most important effect of the AMT is not the revenues it directly produces, but the tax avoidance that it stops in the first place. In other words, without the AMT corporations would find it profitable to engage in a plethora of economically wasteful tax avoidance activities that they now eschew in favor of productive endeavors. For example, it would be easier for companies to buy and sell excess tax write-offs. Oil companies would use loopholes they now sometimes forego. Insurance companies and banks would shift into more tax-exempt debt. That’s why the official Joint Tax Committee estimates of the cost of the House-passed AMT repeal–about $3 billion a year–are ridiculously low. In truth, if the House measure were enacted, the actual revenue cost would be at least three times those official estimates.

Second, direct AMT payments are a big deal for the few companies that actually pay the AMT. Overall, the AMT amounted to about 45 percent of the income taxes paid by the few corporations that paid it in 1988 through 1991 (in the years that they paid the AMT). Without the AMT, those corporations that paid it would have had very low, or even zero effective tax rates, as the examples further on in this testimony illustrate.

Corporations who favor eliminating the AMT contend that it has caused dire problems for the companies affected, raising their “cost of capital” and hurting their ability to compete internationally. But this argument verges on being silly. The AMT rate is only 20 percent–far below the corporate tax rate in any other major Western nation. Indeed, the regular U.S. corporate tax rate of 35 percent is also below the rate in most other countries. How can paying taxes at a 20 percent rate (or a 35 percent rate, for that matter) put American companies at a disadvantage compared to foreign corporations that generally pay much higher tax rates?

The United States already has very low corporate income taxes by international standards. In fact, at only 2.3 percent of gross domestic product (from 1989 to 1991), U.S. federal and state corporate income taxes are 40 percent below the 3.8 percent of GDP weighted average for the 22 other OECD nations. Japan’s corporate income taxes, for example, were 6.8 percent of GDP in 1989-91, the United Kingdom’s were 3.9 percent of GDP, and Canada’s were 2.6 percent.

It’s very hard to believe that the AMT–a low-rate tax that directly affects only one percent of all corporations and directly raises only a few billion dollars a year–could possibly be guilty of the crimes it is alleged to perpetrate. Instead, the AMT actually works to level the business playing field, avoiding the inevitable economic distortions that result when certain industries and companies enjoy low-tax status, while others must pay significant taxes.

Notably, after the 1986 Tax Reform Act was adopted, business investment picked up markedly from its weak performance over the 1981-86 loophole era. Real business investment grew by 2.7 percent a year from 1986 to 1989, 42 percent faster than the meager 1.9 percent annual growth rate from 1981 to 1986. Leading the way was a resurgence in investment in industrial plant and equipment, which grew rapidly after actually falling from 1981 to 1986.

Some companies complain that the AMT can be tough on them in bad years. For example, suppose a company “normally” makes $500 million in pretax profits, and that after various special tax write-offs, its taxable income is $250 million. Such a company would “normally” pay 35 percent of that, or $88 million, in regular taxes–a 17.5% effective tax rate that would be unlikely to trigger the alternative minimum tax. But should the company’s pretax profit temporarily fall to, say, only $250 million (due to an short-term downturn in sales), while its special tax write-offs remained constant, then its taxable income would go to zero, and the AMT would probably be triggered.

Why this is perceived to be a problem, however, is hard to understand. After all, the company in this example still earned $250 million, and the approximately 10 percent tax that it would be likely to pay under the AMT hardly seems excessive. Moreover, assuming that the company returns to its “normal” profitability in subsequent years, it will get a credit for the AMT it paid.

Thus, as the real world evidence outlined in the next section of this testimony (and appendix 1) illustrates, the primary corporate complaints about the AMT come from companies that absent the AMT would pay little or nothing in federal income taxes year in and year out. Such companies simply don’t want to pay federal income taxes, hardly a sympathetic position.

The sometimes ludicrous nature of the corporate complaints about the AMT were inadvertently illustrated in a recent series of Mobil Corp. advertorials, which bemoan the fact that under the regular tax, a steel mill can be written off over 7 years, but under the AMT the write-off period is 15 years. How long does Mobil think a steel mill actually lasts?

Finally, some academic economists have argued that in a perfect world, we would not need an alternative minimum tax. It would be preferable, they say, if the regular tax were improved by closing the loopholes whose excesses the AMT is designed to curb. Maybe so, but the choice on the table today is not whether we should reform the regular tax rather than keeping the AMT. Instead, it is whether, an admittedly imperfect regular tax system needs an AMT backup to curb abuses. The AMT may be only a second-best solution to corporate tax avoidance, but that’s far better than no solution at all. In addition, academic economists who argue that we should have “one set of tax rules for everyone” ignore the complicated real world we live in–where one size does not always fit all. For example, current accelerated depreciation rules may provide “only” a significant subsidy for equity-financed corporate investment. But in the case of even partially debt-financed investments, the regular depreciation rules can often lead to outright negative tax rates. Thus, we need a backup AMT, with (among other things) less generous depreciation allowances, to deal with those cases where even generally “reasonable” tax rules lead to subsidies that are far, far larger than anyone would want them to be.

A Return to the Days of Corporate Tax Freeloading?

At bottom, the real purpose of various proposals to weaken the minimum tax has nothing to do with sound economics. As Ways and Means Chairman Bill Archer (R-Tex.) has happily admitted, the result of the House alternative minimum tax repeal would be to allow some highly profitable companies “to pay no tax.” He’s right. If Congress weakens the minimum tax by restoring tax preferences, it can be confidently predicted that the specter of large, profitable “no-tax corporate freeloaders” will return.

In particular, some of the companies that are lobbying hardest for repeal of the minimum tax paid very low–or no–federal income taxes prior to adoption of the Alternative Minimum Tax, and even today they pay low effective rates.

CTJ’s previous corporate tax reports covering 1982 to 1985 include 16 of the 26 corporate members of a so-called “AMT Working Group,” which was set up in 1993 to lobby for reductions in the corporate minimum tax. Over those four pre-tax-reform years, the average effective federal income tax rate on these 16 companies was a minuscule 1.4%. As a group, the 16 companies enjoyed a total of 22 no-tax (but profitable) years from 1982 to 1985.

• Thirteen of the 16 companies enjoyed at least one year from 1982 to 1985 in which they paid nothing (or less) in federal income taxes (despite considerable profits). Six companies enjoyed multiple profitable no-tax years.
• Six of the 16 companies paid a total of less than nothing in federal income taxes over the four years prior to tax reform.
• Only 4 of the 16 companies paid more than 10 percent of their profits in federal income taxes from 1982 to 1985.

More recent corporate annual reports from some of the “AMT Working Group” members show the effects of the current Alternative Minimum Tax. Many of them would pay nothing at all in federal income taxes without the corporate minimum tax. For example:

• In 1992, Texas Utilities paid a total of $19.6 million in federal income taxes on its $1 billion-plus in profits (for an effective rate of 1.9%). Without the AMT, Texas Utilities would have received a tax rebate of at least $18 million in 1992. The AMT also accounted for all the taxes paid by Texas Utilities in 1991 and 1990.
• In 1991 and 1992, FINA received tax rebates totaling $12.6 million on top of its $73 million in pretax profits. But without the AMT, FINA’s 1990-91 tax rebates would have been at least $8.2 million larger.
• In 1991, Union Camp paid $35.8 million in federal income tax on its $185 million in profits (an effective rate of 19.4%). Without the AMT, Union Camp not only would have paid no tax, but would have received an outright tax rebate of at least $3.7 million in 1991. In addition, the AMT cut Union Camp’s tax rebate in 1992 from $52.9 million to “only” $37.2 million.
• The AMT was the only reason why Champion International paid any federal income tax on its $346 million in 1990-91 profits. Without the AMT, Champion would have received $48.6 million in tax rebates over the two years. Champion paid only about 2% of its profits in federal income taxes from 1981 to 1987.
• From 1987 to 1991, the AMT accounted for all of the federal income taxes paid by Mitchell Energy Corp. Without the AMT Mitchell would have paid no federal income tax at all in each of those five years (as it did from 1982 to 1985), and would have received outright tax rebates in some years. In 1992, the AMT accounted for more than half of Mitchell’s federal income tax payment.
• LTV Corporation paid a 14.6 percent effective federal tax rate in 1990 and only 4.1 percent in 1989, most or all of which, according to LTV’s annual report, was the Alternative Minimum Tax.
• After paying no federal income taxes at all in the early 1980s, Texaco has been paying some tax in recent years. In 1993, however, Texaco’s federal income tax bill was only $5 million on $383 million in U.S. profits–an effective tax rate of only 1.3%.

We don’t need to lower taxes even further on these companies or others that pay the AMT in order to compete in world markets. On the contrary, the fact that these and other companies pay such low effect tax rates suggests that the AMT needs to be strengthened, not repealed. If the abuses that the minimum tax was designed to stop are recreated, the cost to the Treasury will be substantial, and taxpayer confidence in the integrity of the federal tax system will be damaged. It will then become even more difficult to raise the revenue the government needs to reduce the budget deficit and address our nation’s other problems. And if Congress fails to deal with those issues, the damage to American business and our ability to compete internationally will be severe.

We urge the Congress to reject efforts to weaken the corporate Alternative Minimum Tax, and instead to take steps to strengthen this important feature of our tax system.

AMT Reform Options

Although adoption of the corporate Alternative Minimum Tax was an important step in the direction of tax fairness, further reforms are still needed.

To make the Alternative Minimum Tax more effective, more loopholes and tax preferences should be disallowed in computing Alternative Minimum Taxable Income. Examples of changes that could be made to strengthen the corporate Alternative Minimum Tax include:

• Change accelerated AMT equipment depreciation to straight line over ADR lives.
• Treat all oil & gas intangible drilling cost deductions in excess of 6-year amortization as a tax preference.
• Disallow AMT deductions for business meals & entertainment.
• Disallow write-offs for “company cars” (with minor exceptions).
• Disallow interest deductions for payments to foreign lenders in tax havens. (This is a back-door compliance reform).
• Increase the corporate AMT rate from the current 20 percent rate, so that it is closer to the 28% individual AMT rate.

 

 

 

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January 25, 1995 05:42 PM | Permalink |

Testimony of Robert S. McIntyre
Director, Citizens for Tax Justice
Before the House Ways and Means Committee
Regarding Proposed New Tax Subsidies for Capital Gains and
Corporate Profits Designed to Gut the Tax Reform Act of 1986
January 25, 1995

I appreciate the opportunity to testify before the Committee on behalf of Citizens for Tax Justice. Our coalition of labor, public interest and grassroots citizens groups represents tens of millions of middle- and low-income Americans, who have a vital stake in fair, economically sound tax and budget policies.

The Republican “Contract with America” proposes an array of new tax breaks whose costs will be close to $100 billion a year once they take full effect. The bulk of these enormous revenue losses stem from two items: huge new tax breaks for capital gains and a major expansion in corporate depreciation write-offs. We strongly oppose these proposals. If enacted, they would undermine the gains in tax fairness and economic neutrality achieved in the 1986 Tax Reform Act. They would once again put Congress in the position of directing and allocating private investment, rather than leaving it where it belongs—in the hands of businesses and consumers. We would once again face rampant tax sheltering and outrageous high-income and corporate tax dodging. Ultimately, the price would be borne by average Americans, through higher interest rates and eventually, increased taxes. We therefore urge the Committee to reject these tax deforms, and instead to work to close remaining wasteful, economically harmful tax subsidies that benefit the few at the expense of most families.

Read the Full Testimony

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September 25, 1994 02:37 PM | Permalink |

By Robert S. McIntyre

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Remember a decade and a half ago, when supply-side Republicans promised they would cut everybody’s taxes and balance the budget at the same time? Remember how, as it turned out, most people’s taxes went up and the deficit skyrocketed–while the only thing that went down were taxes on the very rich?

Well, here they go again.

The Republican plan, due to be formally announced with much fanfare this week, is familiar in its cynicism. It promises large, unfunded income tax cuts–targeted to the well off–and enormous corporate tax reductions, bundled together with a constitutional amendment that will magically (and by implication painlessly) balance the budget. All across the country, Republicans are campaigning on this incongruous combination. The danger is not just that voters may respond favorably, but that President Clinton may let himself be pushed into a 1995 tax-cut bidding war that could undermine his hard-fought deficit reduction victory of 1993.

The collection of tax cut proposals to be unveiled on Tuesday could, when fully implemented, add $120 billion a year or more to the budget deficit. An even more radical plan, proposed by unreconstructed supply-sider Rep. Dick Armey (R-Tex.) and endorsed by numerous GOP candidates, could cost in excess of $200 billion annually.

Let’s start with the more far-out plan, Armey’s “Freedom and Fairness Restoration Act.” The plan would replace the progressive personal and corporate income taxes with what amounts to a 17 percent flat-rate national consumption tax.

To be sure, the part of Armey’s plan that calls for wiping out all loopholes and taxing all income equally has some surface attraction. But that’s not what his plan actually entails. Far from eliminating tax breaks that benefit the well-off at the expense of the rest of us, Armey would institute a giant loophole by exempting most capital income–interest, dividends, capital gains–from taxation entirely.

Under Armey’s plan, businesses would be taxed on their gross receipts minus the cost of the goods and services they buy from other producers who have already paid tax on them. But unlike a standard value-added tax, which taxes payments to workers at the employer level, Armey would allow businesses to deduct the cash wages and pensions they pay. Instead, such payments would be taxed as they are received by workers and retirees. This feature allows Armey to mitigate the regressivity of a standard sales tax by exempting the first $12,350 in wages for single people, $21,200 for a single parent with one child, and $34,700 for couples with two children. (Under current law, couples with two kids start paying income taxes when they make more than $23,200 in total income.) In effect, this feature offers families a rebate against their sales tax equal to 17 percent of their wages up to the exemption amounts.

That may sound generous, but in fact current law, thanks to the expanded earned-income tax credit, is already more generous for many low- and moderate-income families, who would face substantial tax hikes under the Armey plan. Still, Armey’s wage tax rebates would end up exempting over half of total wages from his new tax.

Which brings up the still larger flaw in the Armey scheme: it would add massively to the federal budget deficit. In fact, a reasonable estimate–just confirmed by the Joint Committee on Taxation–is that Armey’s proposal would cost the Treasury over $200 billion a year. That would multiply annual government borrowing as a share of the economy back to Reaganesque levels.

Look at it this way. According to the Congressional Budget Office, the best-off one percent of the population now pays just under a third of the total federal personal and corporate income tax bill–at a rate of about 31 percent of that group’s total income. Even if Armey’s tax applied to all of their income, they would still see their income taxes cut almost in half with his flat rate of 17 percent. But since Armey would exempt investment income from taxation, the tax cut for the well-off would be much, much larger.

Now, if Armey wants to cut income taxes on the wealthy by about three-quarters–and purports to cut taxes for the middle class as well–how does he expect to raise enough money to avoid skyrocketing deficits? The answer is, he doesn’t.

Armey’s mentors are Hoover Institution economists Robert Hall and Alvin Rabushka. Back in 1983, they calculated that for their plan to break even, it would need a rate of 19 percent and wage-tax exemptions only a third as large as Armey proposes (and far below those provided by the current income tax). In that case, they admitted, their plan would “be a tremendous boon to the economic elite”–while producing much “higher taxes on average people.”

The obvious problems with the Armey flat tax have not stopped many Republican political hopefuls from endorsing it. For instance, GOP Senate candidates from Michael Huffington in California to Chuck Haytaian in New Jersey have signed onto the plan. (Haytaian’s confusing platform combines a purportedly loophole-free flat tax with a call for keeping many existing tax breaks and adding a new one for health insurance.) Massachusetts’s Republican Gov. William Weld also has praised the Armey plan, as has conservative pundit George Will. Weirdly, Will is particularly fond of the fact that Armey’s plan would repeal tax withholding. Although this would require wage-earners to file 12 tax returns each year rather than one. Will see this as beneficial because it would make people angrier at government. So much, one might say, for tax simplification.

Perhaps recognizing that the Armey plan looks remarkably like the much-criticized flat tax proposed by Democratic presidential candidate Jerry Brown in 1992, GOP leaders in Congress have settled on a different set of tax cut proposals. The leadership plan includes these costly features:

• A $500 per child tax credit that would cost more than $26 billion per year.
• Repeal of the 1993 change that includes 85 percent of Social Security benefits in adjusted gross income at higher income levels. Under the GOP plan, at most half of Social Security would be subject to tax. This would cost about $5 billion a year.
• Reduced tax rates for married couples by widening the tax brackets and increasing the standard deduction for joint filers. The cost would be $30 billion a year.
• A huge capital gains tax cut. By excluding 50 percent of capital gains from taxation (on top of the current 30 percent exclusion for top bracket taxpayers) and by indexing gains for inflation, the Republicans would make about three-quarters of all capital gains tax-exempt–a $25 billion a year tax break mostly for the wealthiest people.
• Restoration of Individual Retirement Account tax breaks for upper-income people, with a long-term cost exceeding $12 billion a year.
• Eliminating all taxes on new corporate investments by allowing an immediate tax writeoff. The cost would quickly be tens of billions of dollars annually, and far more as time goes by.

The total losses of more than $120 billion a year would far more than wipe out the deficit-reducing benefits of the tax hikes adopted in President Clinton’s 1993 budget plan. How would Republicans make up the losses? Unsurprisingly, a GOP congressional aide told the Daily Tax Report that the Republican plan “will not be in the form of a fully funded, comprehensive package.” In other words, this is election-year pandering, pure and simple.

Voters may or may not be gulled by the GOP promises this fall, but Clinton–who has said he still would like to deliver on his 1992 campaign pledge of a middle-class tax reduction–may feel he has to match the Republicans’ promises. If he tries, one GOP House aide says, “the level [of the Republican middle-class tax cut plan] could increase to match or exceed any middle-class tax cut proposal President Clinton decides to offer.” The GOP promises may not be paid for; they may violate all the budget rules; but if Clinton tries to compete, he will find himself in a bidding war that, politically, he can’t possibly win.

Back in 1981, when President Reagan and Ways and Means Chairman Dan Rostenkowski locked horns over tax cuts, their back-and-forth competition for congressional votes quickly got out of control. As Rostenkowski sadly learned, trying to out-Reagan Reagan was futile. In 1981, there was simply no tax cut–whether breaks for oil companies, utilities, railroads or real-estate moguls–that Reagan and his supply-side-crazy Treasury Department wouldn’t cheerfully match and graft onto their own already excessive plan.

It took the hard fight for the loophole-closing Tax Reform Act of 1986 to curb the tax shelters and abuses that the 1981 act created. And it took the bitter battle for Bill Clinton’s 1993 budget act to bring taxes on the rich more in line with their ability to pay. The Republicans apparently think that they can attract voters by promising costless tax relief Maybe so. But if you’re one of those potential voters, keep in mind that unfunded tax reductions virtually guarantee higher taxes in the future. And when the two parties start trying to outdo one another in handing out tax breaks, in the end only the special interests really win.

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June 23, 1994 04:13 PM | Permalink |

Peter G. Peterson, as he cheerfully admits, is not a member of the middle class. He’s a rich
Republican Wall Street investment banker. But in his crusade against deficits and entitlements, he adroitly poses as a champion of the middle class.

Read the Full Article

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March 25, 1993 04:48 PM | Permalink |

March 25, 1993

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Multinational corporations, whether American- or foreign-owned, are supposed to pay U.S. income taxes on the profits they earn in the United States. But our tax laws often fail miserably to achieve this goal. As a result, our corporate tax base has been undermined, multinational businesses gain an advantage over their purely domestic competitors and the U.S. tax system subsidizes the foreign operations of multinational firms, sometimes at the expense of American jobs.

Our present system for measuring the U.S. income of multinational businesses is fundamentally flawed, both in theory and in practice. We need to overhaul our rules governing international allocation of profits, to protect our tax base and our workers. Specifically, we should abandon the complex and unworkable so-called “arm’s length” method of allocating profits among countries (which hopelessly asks the IRS to scrutinize hundreds of millions of intra-company pricing transactions) in favor of a formula approach similar to that used by American states (and by Canadian provinces) to allocate the taxable profits of multistate corporations. The pending North American Free Trade Agreement offers us a chance to begin the long overdue move to such a system.

The Defects of the Current “Arm’s Length” System

Currently, the IRS attempts to measure how much profit a multinational corporation makes in the United States using what is variously called the “arm’s length” or “transfer pricing” or “separate accounting” system. It was established in the 1960s, when trade accounted for only about 1/20th of our gross domestic product. After a long debate, our Treasury Department settled on the arm’s length approach (as opposed to a formula system), and then sold it to our trading partners.(1) Essentially, the present system requires multinational companies to assign “transfer prices” to each real or notional transaction between their domestic and foreign affiliates. In theory, these transfer prices are to be set as if the transactions had occurred between unrelated parties on an “arm’s length” basis.

Not surprisingly, in computing their U.S. income, multinational companies try to maximize their U.S. deductions and minimize their U.S. gross receipts. The standard mode of tax avoidance entails setting transfer prices that undercharge or overpay a company’s foreign affiliates when goods and services are exchanged or shared. It should be obvious that the opportunities for abuse of this system, under which the IRS is called upon to scrutinize hundreds of millions of transfer prices, are almost endless. In a recent study mandated by Congress, the IRS reported that “a significant section 482 issue may take eight or more years to resolve.”(2)

Today, as exports and imports of goods and services have each grown to more than a tenth of our GDP, the fundamental flaws of the arm’s length system have been magnified. The U.S. experience with the arm’s length standard over the past 25 years shows that it is not well-suited to resolving competing national claims to tax revenues from multinational corporations. Indeed, the complexity and incoherence of the current system encourages multinational firms to file U.S. tax returns that can be best compared to “low-ball opening bids” in a tax-avoidance game in which the companies hold most of the cards.

Once a multinational company makes its opening tax bid, the IRS must attempt to determine–through adversarial proceedings–what are the flaws in the multitude of transfer prices the company has assigned to its international dealings. The IRS must first try to recalculate the income of each corporate entity in a chain of related foreign and domestic companies under the arm’s length standard. It then must apportion the income so determined between U.S. and foreign sources under the source rules of the Code. Through this case by case process, the United States establishes its claims to tax revenue from transnational income. Those claims may and often do conflict with the claims of other countries. Some procedures are available under U.S. tax treaties to reconcile the competing claims, but those procedures are cumbersome and can only be used for a tiny fraction of transfer pricing disputes.

The practical failure of the arm’s length standard is by now beyond dispute. For example, most foreign-based multinationals report little or no American taxable income on their U.S. tax returns, despite conducting extensive sales and manufacturing activities in the United States. These companies are able to report such low profit figures by manipulating their transfer prices. Likewise, U.S.-based multinationals frequently employ creative transfer pricing strategies to avoid the bite of the foreign credit limitation rules and to shift income to low-tax countries. The IRS can monitor only a very small fraction of the hundreds of millions of transactions governed by the arm’s length standard. Even this limited scrutiny is enough, however, to generate tax deficiencies in the billions of dollars. By the end of this decade, the Tax Court’s backlog of section 482 cases may well exceed $100 billion in disputed taxes.(3)

When Treasury adopted the arm’s length approach in the sixties, its architects recognized its complexity, but thought it would be more “accurate” than the simpler formula approach that was also considered. But the truth is that the arm’s length system is widely recognized to be theoretically, as well as practically unsound.

“Separate accounting,” wrote Professor Jerome Hellerstein in 1983, “operates in a universe of pretense; as in Alice in Wonderland, it turns reality into fancy, and then pretends it’s in the real world. For the essence of the separate accounting technique of dividing the income of a unitary business is to ignore the interdependence of the operations . . . , and treat them, instead, as if they were separate, independent and non-integrated.”(4) Similarly, former assistant Treasury secretary Charles E. McLure, Jr. has written that “separate accounting cannot satisfactorily divide income of a unitary business.”(5)

Corporate executives have been equally critical of the arm’s length system. A 1981 GAO report, for example, cites a 1980 business survey, which found that:

“Although [multinationals are] composed of numerous legally separate entities, [a majority of the executives of such firms offering an opinion] reveal that their companies make most intercompany pricing decisions as though the organization is one economic unit. This basic difference in philosophy between the IRS and multinational corporations is central to [transfer-pricing disputes].”(6)

The GAO report goes on to relate that corporate officials have called outcomes under the arm’s length system “arbitrary” and have complained that “the analytical approach to determining arm’s length prices often leads to unreasonable results.”(7) A chorus of other experts echoes these conclusions.(8)

To be sure, the temporary and proposed regulations issued under Code section 482 at the close of the Bush administration will make it easier for IRS auditors to identify major transfer-pricing abuses. Those regulations will also close some of the loopholes opened in the old regulations by the courts. They will not do very much, however, to solve the fundamental problems with the arm’s length standard. Transfer pricing disputes will not diminish in frequency or in importance. They will be settled, in the appeals process or in the courts, on obscure or arbitrary grounds that will provide little or no guidance for avoiding or settling future disputes. Some companies will continue to avoid paying any significant taxes to any government by taking inconsistent tax positions with the U.S. and foreign tax authorities. Other companies may be subject to double taxation because of inconsistent positions taken by U.S. and foreign tax authorities.

The Better Alternative: Formulary Apportionment

If the arm’s length, separate accounting system is a failure, what then is the alternative? The best way for governments to resolve their claims to tax revenues from the income of multinational enterprises is through a mechanism that allocates the worldwide income of unified business enterprises by formula among the countries in which those enterprises operate. In a well-designed formulary apportionment system, companies would not go into battle with the tax collectors of each country. They would pay only to the government entitled to the tax revenue under an internationally accepted formula.

In essence, a formula or “unitary” approach would attribute a multinational corporation’s current worldwide income among taxing jurisdictions based on some objective measures of its economic links with those jurisdictions. For example, net income might be apportioned among taxing jurisdictions according to a weighted percentage of sales, payroll, and property within those jurisdictions. This is the system used by most American states and by the Canadian provinces.

Such a formula system would eliminate much of the complexity of the present arm’s length approach. It would also implicitly end what remains of tax “deferral” on international profits, since total current worldwide income would be included in the base for applying the formula. This would not only provide additional simplification, but would also address the “runaway plant” issue that Rep. David Obey and then-Rep. Byron Dorgan tried to deal with when they introduced H.R. 2889 in 1991.

Of course, the formula method will not yield perfect results in all instances. Nor will it solve all administrative and implementation problems.(9) But the formula method will produce consistent, fair outcomes–a far cry from the current arm’s length system. As one commentator noted:

“Perhaps the underlying reason for its superiority is that the formula approach makes no claims to achieve a perfect result. It recognizes, rather, that a perfect allocation is impossible. The unitary system seeks a reasonable division of income by formula. The arm’s-length standard strives for reasonable accuracy, but it fails to achieve it and its theoretical basis is unsound.”(10)

Although a formulary system is superior to an arm’s length system both in theory and administration, it will not be easy to put into place through the unilateral actions of a single government. Most of the major countries of the world must agree to become part of the solution.(11) Reaching consensus on formulas among the states of the United States has been a protracted process that is not yet completed. But while reaching agreement among the nations of the world will not come easily or quickly, it will not come at all unless the United States takes a leadership role in promoting formulary apportionment.

A First Step: Formulary Apportionment as Part of NAFTA

As an important first step toward worldwide adoption of formulary apportionment, we suggest that the United States work with the governments of Canada and Mexico to establish a formulary apportionment system for the North American Free Trade Zone. Business enterprises operating within NAFTA countries would file consolidated returns showing the total income from those three countries. That income would be allocated among the three member states by formula. We suggest, at least tentatively, that the formula apportion about half of the income from the manufacture and sale of goods to the country of manufacture and the other half to the country of sale.(12) Alternative formulas might be used for allocating income from natural resources and income from services.

To promote formulary apportionment under NAFTA, Congress should encourage the Treasury Department to renegotiate the U.S. tax treaties with Canada and Mexico to allow the use of formulas within NAFTA. The new treaties should also establish a united set of withholding rates, so that remittances from NAFTA to the rest of the world would bear the same tax without reference to the country from which the remittance was made. This uniformity would hugely simplify business operations in NAFTA and would substantially reduce opportunities for tax avoidance and evasion. It also would help generate the understanding and good will that are essential for the long-term success of the NAFTA experiment.(13)

The use of a formulary apportionment system under NAFTA would give a major boost to worldwide adoption of a formulary apportionment system. With the disintegration of borders within the European Community, the arm’s length standard will become increasingly unworkable for allocating income among EC countries. It is likely, therefore, that the EC would watch the successful implementation of formulary apportionment in NAFTA with great interest.

Conclusion

In the 1960s, the United States government made some important, and we believe mistaken, decisions about how to allocate the taxable income of multinational corporations. Today, with international trade growing ever larger as a share of our nation’s economy, we need to rethink those decisions. The pending North American Free Trade Agreement and integration of the European Community make replacing the discredited arm’s length system with a simpler and fairer formula approach both more necessary and more likely. We hope that these hearings will help move U.S. policy in that direction.

1. The regulations under section 482 were issued in 1968 in response to an invitation by the

Conference Committee Report on the Revenue Act of 1962 to “explore the possibility of developing and promulgating regulations under [the authority of section 482] which would provide additional guidelines and formulas for the allocation of income and deductions in cases involving foreign income.” H.R. Rep. No. 2508, 87th Cong. 2d Sess. 18-19 (1962) (our emphasis).

2. “IRS Report on Application and Administration of Section 482,” presented to the House Ways and Means Oversight Subcommittee, Apr. 9, 1992.

3. In April of 1992, then Chief Tax Court Judge Arthur L. Nims III stated that his court had a backlog of section 482 cases with an amount in controversy of $32 billion and that the amount had doubled in two or three years. These figures are the tip of an iceberg; according to the IRS, about 90 percent of contested section 482 adjustments are settled at the Appeals level without going to court.

4. Hellerstein, “The Basic Operations Interdependence Requirement of a Unitary Business: A Reply to Charles E. McLure, Jr.,” Tax Notes, Feb. 28, 1983, at 726.

5. McLure, “The Basic Operational Interdependence Test of a Unitary Business: A Rejoinder,” Tax Notes, Oct. 10, 1983, at 99. The theoretical weaknesses in the arm’s length approach are explained in Michael J. McIntyre, The International Income Tax Rules of the United States (1989, 1992), chapter 5/d. For additional references to the literature, see the bibliography at the end of that treatise.

6. Burns, “How IRS applies the intercompany pricing rules of Section 482: A corporate survey,” 52 J. Tax. 308, 314 (May 1980), paraphrased in Comptroller General, IRS Could Better Protect U.S. Tax Interests in Determining the Income of Multinational Companies, Report to the Chairman, House Committee on Ways and Means (1981), at 45.

7. GAO report cited in note 6, at 44. In its most recent report on transfer-pricing issues, the GAO praised the IRS for its recent efforts to improve administration of the arm’s length standard but predicted that “problems with arm’s length pricing can be expected to continue.” General Accounting Office, International Taxation: Problems Persist in Determining Tax Effects of Intercompany Prices (1992), at 56. That report discussed formulary apportionment as a promising option to the arm’s length method; it concluded, however, that international agreement on formulas could not be achieved in the near term.

8. See, e.g. Stanley Langbein, “The Unitary Method and the Myth of Arm’s Length,” Tax Notes, Feb. 17, 1986, pp. 625-681; Richard Bird & Donald Brean, “The Interjurisdictional Allocation of Income and the Unitary Taxation Debate,” 34 Canadian Tax J. 1377 (1986). Dale W. Wickham & Charles J. Kerester, “New Directions Needed for Solution of the Transfer-Pricing Tax Puzzle,” 5 Tax Notes International 399-425 (Aug. 24, 1992). The Multistate Tax Commission has recently circulated a draft report that recommends that the United States move toward an international formulary apportionment system. See Multistate Tax Commission, “Asking Global Corporations to Pay their Fair Share of U.S. Taxes–The Formula Apportionment Income Reporting–FAIR–Option” (Draft dated Dec. 16, 1992).

9. Some of the problems that may arise in the design of a formulary apportionment system are outlined and some solutions to those problems are suggested in Michael J. McIntyre, “Design of a National Formulary Apportionment Tax System,” 1991 NTA-TIA Proceeding, 84th Annual Conference 118-124. That article also explains the many potential advantages of switching to a formulary apportionment system.

10. Harley, “International Division of the Income Tax Base of Multinational Enterprise: An Overview,” Tax Notes, Dec. 28, 1981, at 1567. Similarly, Peggy Musgrave has pointed out: “Proponents . . . [have] suggested that the arm’s-length-separate-accounting method is inherently closer to establishing the true source of profits and therefore is less arbitrary than the unitary approach. Such is far from the case. . . . The use of the unitary method as implemented by a factor formula is not perfect, but it places less of a burden on administrative resources . . . , there is less danger of base slippage and discretionary profit shifting . . . and there are fewer items which have to be audited and checked.” P. Musgrave, “The U.K Treaty Debate: Some Lessons for the Future,” Tax Notes, July 10, 1978, at 27, 28.

See also Comment, “Multinational Corporations and Income Allocation Under Section 482 of the Internal Revenue Code,” 89 Harv. L. Rev. 1202, 1228 (1976): “The unitary entity theory has certain clear advantages. Principal among these is its theoretical superiority as a means for ascertaining the true income of various MNC [multinational corporation] components.”

See also Wickham & Kerester, cited in note 8 at 406: “The current Treasury regulation [under section 482] focuses attention on the wrong question; It asks, `What price is right for intercompany transfers?’ The right question is `What portion of the combined profits or loss derived by all participating units of an enterprise from an international transaction should be geographically sourced to each of the countries claiming jurisdiction to tax part of that income.’ “

11. Contrary to the position sometimes taken by the Treasury Department, agreement on a formula among all countries is not needed. Once a critical mass is reached, the members of the formula consortium could simply omit from their formula the sales, payroll and property of nonmember states. For discussion of this so-called “throwout” rule, see McIntyre, cited in note 9, at 121.

12. The formula used by most of the states of the United States apportions about one-third of the income to the country of sale and the remaining two-thirds to the state of production. The fifty-fifty split suggested here in the text could be achieved under the typical state formula by giving double weight to sales. We believe that a fifty-fifty split between the country of production and the country of sale (determined under a destination test) would have political appeal in the NAFTA countries.

13. The draft treaty with Mexico negotiated by the Bush Administration does nothing to promote the cause of tax reform or the long-term goals of NAFTA. The Treasury seemed to have had as a major negotiating aim the reduction of Mexican withholding taxes on interest payments to U.S. banks. The proposed reduction will do nothing for the United States or Mexico. It will simply give windfall benefits to a small group of American banks.

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October 11, 1989 04:50 PM | Permalink |

Tax reform is working. That’s the principal finding of this study, the fifth annual Citizens for Tax Justice report on America’s corporations and the taxes they pay -or don’t pay.

Read the Full Report

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