October 4, 2011 9:42 pm

US tax system: A return to reform

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Across the political spectrum, pressure is building for a taxation overhaul that could boost the economy and win back the confidence of investors – but a discordant Congress remains divided on details

Ron Wyden, a Democratic senator from Oregon, does not try to conceal his disgust. It is not at the salad on which he chomps from a plastic box or even the rain streaming down the windows of the Dirksen office building on Capitol Hill. The object of his ire is, however, something that has come to be just as fundamental to life as food and the weather.

“Our current tax system,” he says, “is an anti-growth mess.”

Mr Wyden has been fighting for years for a dramatic overhaul of the tax code, a main pillar of America’s economic structure. But now, he argues, the case for making big changes is more powerful than ever, with the recovery close to stalling and both fiscal and monetary policy either exhausted or severely constrained.

“It is the one tool in the economic tool shed that hasn’t been tried,” says Mr Wyden. “Permanent tax reform will change behaviour in US markets.”

That may be an ambitious goal, but Mr Wyden’s mission is gaining traction in Washington and in corporate America. Scorn towards the tax code seems to be growing by the day, with politicians and executives attacking it from all angles and ideologies.

Warren Buffett, chairman of the Berkshire Hathaway conglomerate, in August criticised the code’s lack of fairness, saying something must be wrong if he is paying a lower effective rate than his employees. Calling for the wealthiest to pay a bigger share of the revenue pie to help pay down the federal deficit and stabilise the country’s debt, he said: “My friends and I have been coddled long enough by a billionaire-friendly Congress.”

Muhtar Kent, chief executive of Coca-Cola, in September framed the question in terms of competitiveness, arguing that China is becoming a more business-friendly environment for multinationals than the US. America’s corporate tax rate is the second-highest in the Organisation for Economic Co-operation and Development club of rich nations. Unlike most countries, the country taxes profits earned by its companies overseas.

“I believe the US owes itself to create a 21st-century tax policy for individuals as well as businesses,” Mr Kent told the Financial Times. Edward Rapp, chief financial officer of Caterpillar, the maker of earth-moving equipment, was even more blunt: “We need to do a tear-down of our corporate tax structure.”

Federal receipts charts

A well-judged overhaul could aid the American recovery if it incites businesses to invest and hire more, and boosts consumer confidence. It would also show that the political system is able to address effectively the country’s most glaring defects – including its dire long-term fiscal position – after partisan fighting brought the US within days of a devastating default on its debt in early August.

Yet the prospect that sweeping reform will be enacted by Congress before the 2012 presidential election is mired in uncertainty.

There is a veneer of bipartisanship on the need for reform – and even on part of its shape. President Barack Obama and John Boehner, the Republican speaker of the House of Representatives, last month called for it in speeches on the economy within a week of each other. The two political leaders, often found feuding on fiscal issues, both said that any changes would have to involve lower rates for individuals and businesses – and should be funded by limiting the proliferation of deductions now worth $1,000bn every year.

The objective of reform efforts – which have been the subject of a series of congressional hearings this year – is to create a series of incentives for economic activity while promoting a simpler system that reduces distortions.

But there is fierce disagreement on the details. Tax policy remains one of the most divisive issues in American politics, a critical battleground between Republicans and Democrats arguing over the size and role of the government – which makes it harder for either side to make concessions in the run-up to next year’s election.

“The problem is to go beyond the generalities and dig in to the specifics,” says Sander Levin of Michigan, the most senior Democrat on the House ways and means committee, which has jurisdiction over tax policy in the lower chamber. “That’s where it becomes more difficult.”

“Will we get this done? We’ll have to see but I doubt it,” says Orrin Hatch of Utah, the most senior Republican on the Senate finance committee, which oversees taxes in the upper chamber.

For Democrats, reform represents a serious opportunity to address decades of rising income inequality, and at least 15 years of median income stagnation, by making the wealthy shoulder a heavier burden. They also want it to raise money for the government and contribute to deficit reduction in the next decade.

“Look, we need to reform our tax code based on a simple principle: middle-class families shouldn’t pay higher tax rates than millionaires and billionaires,” said Mr Obama in Denver last month, as he argued for his own deficit reduction plan. “A quintessentially American idea is that those of us who’ve done well should pay our fair share to contribute to the upkeep of the nation that made our success possible.”

Republicans have a very different starting point. They argue that the code is already sufficiently progressive – and that making it more so would reduce rather than improve the incentives for job creation. Conservatives also insist reform should not generate net tax increases for individuals or businesses, and that deficit reduction plans should be confined to cuts in what they see as the sole source of America’s fiscal woes: runaway government spending. “Everybody knows that you can tax the rich every dime that they make and it still wouldn’t be the solution to our problems right now,” says Mr Hatch.

In the meantime, even as chief executives clamour ever more loudly for reform, many of their business lobbyists are limbering up behind the scenes, preparing to defend their industry’s protections in the tax code. Defenders of their frantic campaigning say it is simply an attempt to shape any legislation, but others fear that their arguments could prove so powerful that they end up killing it off – at least for the time being. The oil industry, for instance, is battling very hard to preserve tax breaks in its favour that have been harshly criticised by the White House.

In the short term, hope for reform resides in a panel of 12 lawmakers – split evenly between Republicans and Democrats – charged with identifying by November 23 at least $1,200bn in deficit reduction measures in the next 10 years.

At best for proponents of reform, given the short time-frame, the panel would set out a process for an overhaul – with specific targets for tax rates and tax break reduction – that the House ways and means committees and the Senate finance committee could consider next year. Changes to the corporate side may advance faster than those affecting individuals, especially if the Obama administration releases the plan for corporate tax reform on which it has been working this year. At worst, however, there will be no progress.

. . .

So while the stage for reform is being set, its structure is likely to be fought out in the looming election campaign, with the winners of the White House and congressional majorities likely to take it up on their terms in 2013.

But can the US afford to wait so long? Some economists and policy analysts in Washington believe the benefits are being overplayed and that changes would have only a marginal impact on the country’s economic trajectory. For those increasingly loud voices arguing that the tax system imposes a significant restraint on the stuttering recovery, however, the answer is probably no.

The last time the US made huge changes to its tax system was in 1986 – in legislation that is widely considered one of President Ronald Reagan’s biggest domestic achievements.

After months of tortuous negotiations with a Republican Senate and a Democratic House – immortalised in the best-selling political thriller, Showdown at Gucci Gulch – Reagan was able to declare the US had put in place the most “modern” tax system in the developed world – “one that encourages risk-taking, innovation, and that old American spirit of enterprise”.

A quarter of a century on, that no longer stands. According to the White House, the code is now 10,000 pages long. If all the volumes were stacked, they would stand 5ft tall, forming a bloated set of rules often incomprehensible to all but the most expensive accountants.

“We are certainly far from the frontier of what a well-designed tax system would look like,” says Donald Marron, director of the Urban-Brookings Tax Policy Center, a Washington think-tank. One big shortcoming, he argues, is the number of temporary provisions created by Congress to last only for a number years. These range from tax cuts created under George W. Bush and scheduled to expire at the end of 2012 to a one-year reduction in the payroll tax, which runs out in January. Those create uncertainty for both the government and the private sector about forthcoming levels of taxation.

But arguably the most damning feature is the plethora of tax breaks injected into it since the 1986 law, which some say are costly, unnecessary or targeted at the wrong areas. “We run social policy and industrial policy through the tax code and it doesn’t make any sense to do that,” says Pamela Olson, a tax lawyer at Skadden Arps, a global law firm, and former tax official at the Treasury during the George W. Bush administration.

However, there is nothing simple about finding savings from tax breaks – even if they distort economic activity. Many benefit vast reaches of the public and economy, and cutting them would prove gut-wrenching for the Obama administration and for individual members of Congress who want to protect preferences for industries and interests in their districts. But some say all these should be open for review. “Nothing in our laws should go without questioning on a regular basis,” says David Kendall of Third Way, a centrist Democratic think-tank.

Getting to that point will not be easy – but apostles of tax reform, who see it as a medicine for the US economy that is simply gathering dust on the shelf, are hopeful. “All of the signals indicate that this is a path to job creation and turning around the psychology now,” says Mr Wyden.


Speed read

● Overhaul overdue. The last time the US made big changes to its tax system was in 1986 under Ronald Reagan. It took months of tortuous negotiations with a Republican Senate and a Democratic House of Representatives.

● Voluminous variations. The code is now 10,000 pages long, a bloated set of rules often incomprehensible to all but the most expensive accountants.

Exemptions big and small are numerous.

● Electoral exigencies. A veneer of bipartisanship exists on the need for reform but tax policy remains divisive, with the two parties arguing over the size and role of the government. That makes it harder for either side to make concessions ahead of the 2012 elections.


Whaling and moaning

What do Nascar racetracks, dog and pony shows, tree planting, fishing tackle boxes and Eskimo whaling captains have in common? Each benefits from special protections in the US tax code. Those are attracting scrutiny, and some derision, as the debate over tax reform heats up.

But the larger tax breaks can be profoundly popular. On the individual front, they include the exclusion of employer health benefits from taxable income, the deductability of mortgage interest and charitable giving and a preferential treatment of capital gains. On the business side, there are big incentives for debt issuance, domestic manufacturing and the depreciation of equipment.


Republican proposals: Different ways to slice the fiscal pizza

Tax reform fever is gripping not only Washington itself but also the 2012 presidential campaign trail.

Herman Cain, the former chairman of Godfather’s Pizza – and of the Federal Reserve Bank of Kansas City – is a very long shot to clinch the Republican nomination. But he has made headlines in the past few weeks, and inched up in the national polls, by capitalising on the itch among conservative voters for tax changes.

Mr Cain’s proposal – the 9-9-9 plan – is dramatic. It would scrap the current system, replacing it with a 9 per cent income tax, a 9 per cent consumption tax and a 9 per cent corporate tax. Further, it would scrap the estate tax, the capital gains tax, the double taxation of dividends and the payroll tax, which funds the social security retirement scheme.

Jon Huntsman, the former Utah governor, has released his own tax reform proposal and Mitt Romney, ex-governor of Massachusetts and a leading contender in the race, has chimed in too. One of Mr Romney’s proposals is to exempt Americans earning less than $200,000 a year from paying capital gains and dividend taxes, in order to spur investment.

The Republican plans do not aim to raise more revenue, even though the government generates only about 15 per cent of gross domestic product in receipts, the lowest ratio since 1950. As the economy improves, however, that figure is expected to climb – to 20 per cent by 2014 – above the long-term postwar average of 18 per cent.

Republicans say this is sufficient to nourish what should be much reduced federal operations and programmes. Democrats say an ageing population means that would not be enough to sustain the kind of society companies and individuals have come to expect.

Another common feature of Republican tax reform plans is to shift the US to a territorial system that does not tax foreign profits – a change for which multinationals have been clamouring. “Our taxation of overseas income and our recognition of global income is really out of sync with the rest of the world,” says Caroline Harris, chief tax counsel for the US Chamber of Commerce.

Meanwhile, the US has neither modified nor permanently extended incentives for companies to do research and development. “Countries like China and India are offering significantly stronger R&D incentives,” Ms Harris says.

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