Strategy

What is a ‘Fair’ Tax System?


by FEI Daily Staff

All agree the U.S. tax system is virtually unworkable and practically and politically impossible to fix right now. But imagine starting with a new slate to design a tax system that is viewed as fair. Here are some insights on what such a system should comprise.

Americans don’t agree on much. But they agree about taxes. Unfortunately, the point of agreement is that the tax system is unfair, increasingly unworkable and politically nearly impossible to fix.

What’s fair? How close to unworkable is the current system? Ask anybody who’s read the 16,000 pages of the U.S. tax code and the essential 56,000 pages of Internal Revenue Service rulings on it.

And how likely is Congress to fix it? Imagine the congressional brawl over any significant tweak. Most disturbing — and dangerous — about this conundrum is that it’s happening in the world’s predominant economy, even as federal revenues fall far short of spending.  Corporations work with a statutory tax far above those of competitors in other countries, while some companies pay effective rates close to zero. And media sources say that half of the population pays nothing, while, according to financing guru Warren Buffet, secretaries pay more than their bosses. It all adds up to a disaster that isn’t waiting to happen. It’s here, and the nation must deal with it. And though the political situation isn’t encouraging, tax and financial professionals see feasible solutions worth thinking about.

Views Vary on Solutions Asked how he’d replace the tax code if a clean slate appeared, David Marron, director of the Urban Institute’s Tax Policy Center, offers a neat, clean, four-step process: Step 1: Impose taxes on major economic activities that create significant externalities and can be monitored well enough to be taxed, such as carbon emissions and petroleum use. Step 2: Impose user fees where appropriate, such as for highway use. Step 3: Impose a progressive consumption tax, sometimes known as an “X tax,” with parameters to hit revenue and distribution targets. Step 4: Decide what social and economic policies should be impacted by tax policy, and adjust Step 3 rates as needed to generate sufficient revenue.

Marron’s suggestions touch on some key principles of taxation. One is that taxation can be an effective way to nudge an economy in a different direction and encourage or discourage certain activities.

Another is the notion that taxes benefit an economy more (or hurt it less) if they fall on consumption rather than on labor and production. Political philosopher Thomas Hobbes figured that out four centuries ago, reasoning that a consumption tax most closely reflects the benefits a person receives from society. Unlike a production tax, such as an income tax, a consumption tax — for example, a sales tax — does not discourage the investment and savings that result in economic growth.

The X tax that Marron suggests, a variation of the value-added tax or VAT, is an example of a consumption tax. The standard VAT is based on crediting a percent of sales value on invoices all the way through the value chain, with the consumer paying the final tax bill. While it is simpler and easier to monitor than an income tax, a VAT is regressive in that the tax bill falls disproportionately on people of lower income.

The X tax, also known as the Bradford X tax, after the late Princeton economist David Bradford, turns a VAT into a progressive consumption tax. Workers are taxed on their wages, but dividends, interest and capital gains are exempt. Higher earners would pay a higher rate. Business would be taxed on their cash flows at a flat rate equal to the rate on the highest-paid workers.

William McBride, an economist with the Tax Foundation, advocates an X tax as part of an ideal, if politically unlikely, tax system.

“Ideally we should be taxing business under a different regime,” McBride says. “All businesses should be taxed under the same regime with the same rates and definitions of cost and receipts. It would involve scrapping the corporate code or the individual [income tax] code or both and starting over with some sort of universal tax code.”

That universal tax code, he says, would make taxation fairer by taxing individuals and companies at about the same level. It would avoid the unfairness of pass-through business income from S corporations, partnerships, sole proprietorships and farms, which end up being taxed at personal income levels rather than at capital gains levels. It would also allow the United States to lower its corporate tax rate, which is the highest in the world.

How high the U.S. actual corporate tax rate is, however, depends on several factors. The statutory rate is 35 percent, compared to an average of about 25 percent in other industrialized nations. Due to state taxes, that U.S. rate is generally closer to 40 percent. This puts American companies at a competitive disadvantage that cuts into their profitability and encourages them to move to lower tax jurisdictions.

The effective rate, however, is lower, and opinions differ as to the realities. The Tax Foundation figures it’s close to 26 percent (plus an average of four percent for state taxes, plus another three or so for companies paying foreign taxes).

And the nonprofit research and advocacy group Citizens for Tax Justice, using U.S. Treasury data based on “corporate surplus” instead of income, says that effective tax rates of 280 Fortune 500 corporations in 2008 through 2010 averaged 18.5 percent, and that 30 companies — including General Electric Co., The Boeing Co. and Wells Fargo & Co. — paid no corporate taxes in that period.

There are many legitimate ways for corporate taxpayers to pay less than the statutory rate, and GE’s in-house Internal Revenue Service accountants made sure the company was legitimately avoiding all income taxes. But calling those ways “loopholes” disparages their bona fide purposes.

Many if not most are well-intentioned incentives that benefit the nation or its economy — write-offs for energy efficiency, research and development, pollution control, continued domestic manufacturing and so on.

Granted, a few remain from the beneficence of Congresses past, incentives that no longer serve a purpose. But in general, the tax policies that account for the difference between the statutory and effective tax rates can be considered tools that strengthen the economy and the companies that drive it.

Ronald Dickel, vice president, Global Tax and Trade, Intel Corp. and FEI member, defends incentives for R&D and for anything else that will keep manufacturing companies from seeking shelter offshore.

“Everyone pretty much agrees that you want to keep that kind of activity in the states because that’s what makes the U.S. economy strong and keeps the brainpower here,” Dickel says.

“You need to have some kind of incentive, be it R&D credits or a patent box [that shelters revenue from production under new patents] or allowing you to expense or even double-expense R&D. Where you do your R&D is becoming increasingly mobile. The U.S. does not have a monopoly on good schools and good scientists. A few decades ago, we did. We don’t anymore,” adds Dickel.

Mel Schwarz , director of the Washington National Tax Office of Grant Thornton LLP, recognizes that the tools of incentives have their place, but at the same time, he believes, they inevitably burden business with a certain inefficiency. To take advantage of tax breaks, companies have to allocate resources where they otherwise wouldn’t.

“If you don’t collect enough taxes, you’ve got a problem, and if you collect too many taxes, you’ve got a problem,” Schwarz says. “And you want to avoid collecting taxes the wrong way, such as when you create a situation where you get artificial allocations of capital for tax purposes rather than business efficiency, or if you need to make a change but the transition is too jarring.”

U.S. Rep. Dave Camp (R-Mich.) expressed a similar thought in his opening remarks to a House Committee on Ways and Means hearing on the treatment of closely held businesses in the context of tax reform. Calling for a simpler tax regime and lower business taxes, he pointed out that an organization’s most fundamental decision is often based more on taxes than on doing business.

“In addition to the many tax rules a business must contend with, it is the first tax-related decision that businesses make — the manner in which they should organize themselves — that will affect all other tax decisions they make from that day forward,” Camp said.

“Whether a business organizes as a C corporation, an S corporation, a partnership or some other form of business entity, that decision should not be driven by tax considerations. Instead, it ought to be driven by what form of organization best suits that business and its needs.”

Worldwide vs. Territorial Global Tax Systems Regardless of subsidies and incentives, virtually every financial officer in the country believes American companies, and America, would be better off if the statutory corporate tax rate were closer to the global average.

But it isn’t that simple. David Heywood, vice president, Taxes and General Tax Counsel, Lockheed Martin Corp. and FEI member, says that while a reduction of the statutory rate is necessary to make the U.S. competitive, the nation also needs to change from a worldwide system of taxation to the territorial system that other economically advanced nations use.

Under the worldwide system, the U.S. taxes offshore earnings as soon as they are repatriated. Companies can take a credit for taxes paid in a foreign country (with significant limitations), but they owe the difference to Uncle Sam. Under a territorial tax regime, offshore earnings can come home without facing another tax bite.

Simply dropping the rate to 25 percent under a worldwide system, Heywood says, would not make the U.S. tax system fully competitive. The lower rate would help, but worldwide taxation of U.S. companies puts them at a disadvantage when they compete with foreign-based companies, whether operating in the U.S. or abroad.

Likewise, he says, “If you keep the 35 percent rate and switch to a territorial system, there would be more incentive for companies to move or generate income offshore,” where taxes would be lower. “But if you reduce the statutory rate to 25 percent or some number that’s globally competitive in a territorial system, then the incentive to move offshore disappears.”

Heywood says that lowering the statutory rate and eliminating many tax incentives and subsidies would broaden the tax base, which economists generally agree is a desirable ideal in any tax regime. More sources of taxes reduce the negative effects of weakness in any of those sources.

Eliminating loopholes, deductions and incentives would be one way to broaden the base and allow a lower statutory corporate rate. Heywood says it may be time to shake up the system, though in the end any change would have to be revenue-neutral.

“The corporate tax community is uniquely willing to accept base-broadening for the sake of lower rates,” he says, “even recognizing that some of that broadening would hurt various companies. I think we’ve reached the point where everybody’s willing to share a little bit of the pain.

And of course there’s going to be a little pain, and there’s going to be jockeying to see who shares how much.

That’s the normal political process, Heywood notes, “but in the jockeying, people are able to maintain the perspective that overall there’s going to be a benefit to the economy, and a strong economy is in the end what makes all of us successful.”

The United States has never considered itself a “can’t-do” country. It’s unlikely that the nation has met its match in its own tax structure. That structure has grown unworkable, inefficient and yes, unfair, but it is not beyond hope.

Business has the tools and talent to hammer out a new regime and individuals are willing to consider anything closer to simple and just. And when business and people are in agreement, the politics of democracy should eventually catch up.

This article first appeared in Financial Executive magazine.