State of the Union: Focus on Corporate Tax Reform

President Obama identified a number of economic policy priorities in this week’s State of the Union Address. The speech presented a general theme of improving U.S. economic competiveness. The following observations highlight those portions of the address that pertain to the housing industry, as well as explain the difficulties in achieving revenue neutral corporate tax reform.

  • The president endorsed the concept of corporate tax reform, with an aim toward reducing corporate tax rates by eliminating business tax deductions and credits. However, the president did not in general identify tax rules that would be curtailed or eliminated to achieve a revenue neutral transformation, with the one exception of carving back existing rules for the oil/gas industry.
  • With respect to last year’s health care reform law, the president indicated that the new, onerous 1099 reporting requirement should be repealed. The new tax law requires all businesses with at least $600 in transactions with any corporation must file a 1099 information reporting return, significantly increasing small business administrative costs, and is set to come into force in 2012. A separate 1099 requirement which applies to independent landlords is in effect for 2011.
  • While distancing himself from some of the recommendations of the deficit commission, President Obama noted a willingness to work with the Congress on some issues involving individual income tax reform, but no specifics were provided. 
  • No mention was made of proposals regarding Fannie Mae and Freddie Mac. The administration will be late in publishing such recommendations, with a proposal expected in early to mid-February.
  • No mention was made of the upcoming vote on raising the federal government debt limit.

Given the focus on corporate tax reform, it is important to note that the word “corporate” does not mean “business.” In general, corporations (C Corporations) pay the corporate income tax, with a top rate of 35%. However, most businesses in the U.S. are organized as pass-thru entities, such as S Corporations and LLCs. Such businesses pass through net business income to their owners, who pay business income tax on their individual income tax returns. Separating corporate tax rules from individual income tax issues will thus be a difficult technical challenge.

For example, within the construction sector, according to 2007 IRS data (the most recent available), there were approximately 781,000 businesses organized a C Corporations with aggregate net income of $82 billion. 

However, in 2007 there were 2.9 million sole proprietorships in construction, with $41 billion in net income. And there were approximately 209,000 partnerships (including LLCs) with aggregate net income of $9.3 billion. Finally, there were 569,000 S Corporations with net income of $55 billion. 

Would a revenue neutral corporate tax reform effort, with a goal of lowering corporate income tax rates, limit elimination/weakening of tax provisions for C Corporations alone? Or would it require reducing general business tax benefits, that affect pass-thru entities as well as C Corporations to reduce tax rates for just C Corporations?

Examining tax expenditure data from the Congressional Joint Committee on Taxation (JCT) provides some guide. The JCT publishes a report on tax expenditure estimates each year, and splits those estimates between corporate and non-corporate taxpayers. Using this information, we were able to aggregate the estimates for certain large corporate tax expenditures.

For example, for the 2011-2014 period, those tax expenditures totaling more than $30 billion over the four-year period include:

  • Deferral of active income from controlled foreign corporations: $58 billion
  • Corporate holdings of State and local tax exempt bonds: $38 billion
  • Section 199 deduction for domestic activities: $36 billion

Taken together, a set of large corporate tax expenditures might total about $250 to $300 billion over four years. It is important to note that a tax expenditure estimate is not a revenue estimate. A revenue estimate is the expected increase/decrease in federal revenue that would result from changing the nation’s tax laws, once microeconomic behavior is accounted for (macroeconomic effects are held constant). And as a technical matter, summing individual tax expenditures involves some double counting, so the total above can be thought of as an upper bond estimate. 

If we assume that perhaps 2/3 of the tax expenditure estimate is equal to applicable revenue estimate, this suggests that perhaps $160 to $200 billion could be raised over the 2011-2014 period by completing eliminating these tax expenditures. This is of course impossible to accomplish because most of these provisions would require transition rules that would reduce the revenue gain. 

But even with this optimistic revenue pickup, it would be difficult to reduce corporate tax rates much. The CBO baseline for corporate tax receipts over the same period totals $1.05 trillion.  Thus, roughly, these cuts could reduce the top corporate tax rate from 35% to perhaps 30% to 28%. 

This raises the question of raising taxes on small businesses to provide deeper corporate tax rate cuts.  For example, while the tax expenditure for the section 199 deduction is $36 billion for corporations for 2011-2014, another $17 billion will be gained on individual income tax returns from pass-thrus and sole proprietorships.  I would argue it would not be revenue neutral to raise taxes on one kind of taxpayer to pay for rate cuts on for a different set of taxpayers. 

And then there’s the question of what happens if the top individual income tax rate differs from the top corporate rate.

Taken together, these numbers and issues suggest that these policy efforts are easier said than done.



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