The Tax Policy Blog

Just before 5:00 AM on Saturday, the U.S. Senate passed a budget for the first time in four years in a 50-49 vote. (Sen. Frank Lautenberg (D-NJ) stayed at home on doctor's orders.)

The budget blueprint, opposed by all Senate Republicans and four red-state Democrats facing re-election in 2014, sets a level of $3.7 trillion in federal spending for fiscal year 2014. Over a ten year timeframe, the budget cancels $1.2 trillion in planned spending cuts, substitutes $975 billion in reduced projected spending, and raises taxes by $975 billion.

The budget vote sent Washington scrambling because of the "Vote-o-rama" that comes with it: every senator is able to propose amendments that the entire Senate will vote on. Lots of ideas have been sitting un-voted on after four years of no budgets, so 572 amendments were filed. The Senate methodically worked through them, one by one, into the wee hours, ultimately doing 43 roll call votes and a number of voice-only votes and unanimous consent approvals. Because the budget would need to be meshed with a House version to become law (which is unlikely), the amendments were considered by all to be non-binding in nature.

Among the tax-related votes included approving 79-20 the repeal of the "Obamacare" medical device tax, approving 51-48 the inclusion of dynamic scoring analysis in revenue estimates, rejecting 46-53 the repeal of the federal estate tax, and approved 80-19 a separate amendment to repeal or reduce the federal estate tax in a revenue-neutral manner.

The Senate also approved 75-24 a modified version of the Marketplace Fairness Act, a proposal to authorize states to collect sales tax on Internet and catalog transactions between their residents and out-of-state retailers. Presently, state tax authority over retail transactions extends only to retailers with a physical presence in the jurisdiction (just as one must have a physical presence in the jurisdiction to receive state services). The hotly controversial amendment has been pushed by an alliance of big-box retailers and state officials, and opposed by some Internet retailers and conservative groups.

I'm writing a piece for later this week on what's missing from the Marketplace Fairness Act, omissions that could threaten interstate commerce and economic growth unless remedied.

Here's the vote breakdown on the Internet sales tax vote (Enzi Amendment 656):

Note: Blog updated to correct the medical device tax vote.

NBC may be a successful, profitable company but that's not stopping New York legislators from offering them taxpayer subsidies to lure The Tonight Show back to 30 Rockefeller Plaza from California. NBC is rumored to be replacing Jay Leno as host of the late night mainstay with comic Jimmy Fallon.

The New York Daily News first reported on a carefully worded provision inserted into the state budget that can only mean The Tonight Show:

The provision would make state tax credits available for the producers of “a talk or variety program that filmed at least five seasons outside the state prior to its first relocated season in New York,” budget documents show.

In addition, the episodes “must be filmed before a studio audience” of at least 200 people. And the program must have an annual production budget of at least $30 million or incur at least $10 million a year in capital expenses.

In other words, a program exactly like “The Tonight Show.”

Aides to Gov. Andrew Cuomo (D) denied to the Daily News that the provision was written with The Tonight Show in mind.

Altogether, New York provides $420 million in tax subsidies each year for the film and television industry, one of the highest levels of taxpayer support in the country.

It’s not often that state lawmakers agree on tax reform, but Rhode Island seems to be an exception. Governor Lincoln Chafee (I) has proposed lowering the state’s corporate income tax rate from 9 percent to 7 percent, phased in over three years. The measure would make Rhode Island’s rate the lowest among its neighbors and in the greater New England area. Revenue losses would be offset by closing or reducing certain carve-outs, such as the Jobs Development rate reduction.

In 2010, the state enacted a significant income tax reduction measure that flattened the state’s five individual income tax brackets into three and brought the top rate down from 9.9 percent to 5.99 percent. Certain progressive and labor groups have rallied to raise taxes on high-income earners this legislative session, however, by means of a new top bracket (HB 5196, HB 5751, HB 5805, and SB 527). All await action in the each chamber’s respective finance committee. 

Despite the pushback on the former tax changes, the legislative leadership seems to be in favor of keeping the cuts. Senate President M. Teresa Paiva Weed (D–District 13) has voiced reluctance at raising individual income taxes. According to the Providence Journal, she “repeated her opposition to changing the state income tax so close on the heels of the 2010 revisions lawmakers made,” making the important point that “businesses need predictability and consistency in tax policy.” The chair of the Senate Finance Committee, Daniel Da Ponte (D–District 14), noted that the new system was “a simpler, fairer tax formula.” House Finance Committee Chair Helio Melo (D–District 64) was one of the sponsors of the 2010 legislation.

Hopefully Rhode Island can add to its past tax reform success. The House Finance Committee is set to discuss the governor’s budget recommendations next week, but business leaders have already testified in favor of the corporate rate reduction. Governor Chafee had the right idea when he asserted that lowering the corporate rate would promote business growth and investment. One of the reasons Rhode Island scores poorly on our State Business Tax Climate Index (it ranks 46^th overall) is its high top corporate income tax rate—lowering it would most certainly give the state a competitive edge

More on Rhode Island here.

According to OECD data on Non-Targeted Corporate Income Tax Rates, in 2012 the United States had an adjusted central income tax rate of 32.77% and a sub-central corporate income tax rate of 6.36% for a combined effective tax rate of 39.13%, for the second highest rate in the OECD. Although this number is relatively high today, historically, the corporate income tax rate is lower than in previous years. In 1981, the adjusted central government corporate income tax rate was 42% and the sub-central corporate income tax was 6.9% for a combined rate of 48.9%. However, in today’s world of increasing globalization, our comparatively higher rate puts the United States at a disadvantage.

Though corporations consider many factors when making decisions about where to locate and how to allocate their profits, but they increasingly consider the corporate tax rate of a country compared to other similar countries. In order to remain competitive and to enhance growth, many OECD countries have reformed their corporate income tax by decreasing the rate and broadening the base. The United States reduced rates as part of the 1986 Tax Reform Act. Germany responded in 2000 and 2008 by reducing their statutory corporate income tax rate from 45% to 25% to 15%. Similarly, the United Kingdom has lowered their corporate income tax rate gradually from 52% in 1981 to 24% in 2012 The corporate income tax rate will continue to fall in the United Kingdom to 21% in 2014 and then to 20% in 2015.

In general, a lower rate decreases the distortion and deadweight loss created by the corporate income tax rate. Distortion arises when businesses opt to remain as sole-proprietors, partnerships, or S-corps in order to avoid the corporate tax instead of expanding and structuring themselves as a corporation. Deadweight loss results from the increase in the price and the reduction in the quantity of goods or services produced by corporations below the welfare maximizing market equilibrium. The cost of the taxes can be passed on to consumers through higher prices and fewer goods and services, to the employees through lower wages or fewer jobs, or to capital holders through lower rent or returns on property, stocks, bonds, dividends etc. Thus, society, as a whole, loses.

This graph shows that the United States combined corporate income tax rate has not fallen as drastically as other OECD countries.  The combined corporate income tax rate for the United States has only fallen by 10.57% from 1981 and 2012. Given that the United States already had a high corporate tax rate in 1981, the United States corporate income tax rate remains substantially higher than comparable OECD countries.

Although the OECD adjusted combined corporate income tax rate of 39.54% for Japan was slightly above the United States’ rate in 2012, the Japanese Ministry of Economy, Trade, and Industry estimates that their state’s statutory corporate income tax reduction from 30% to 25.5% will lower their effective combined corporate tax rate to 38.01% and then to 35.64% in 2015 after a temporary surtax.

Thus, with the highest effective corporate income tax rate among comparable countries, the United States will need to address whether the excess revenue gained (if any) from maintaining the highest corporate income tax justifies the losses incurred to society from lower employment and wages, lower capital investment and returns, higher prices and lower quantity of goods, and slower economic growth.

See also: Japan’s New Rate

The House of Representatives is about to vote on a series of Budget Resolutions.  One will be the Paul Ryan budget proposal and other will be the Senate budget plan proposed by Senator Murray.

Budget Resolutions specify a revenue floor and a spending target for each budget area, but cannot dictate to the various Committees exactly how they are to hit their targets.  Therefore, modeling the economic results of a budget proposal is problematic.  In this instance, we have a fairly detailed list of tax changes proposed in Representative Ryan’s blueprint for restoring a balanced budget.  The plan is less specific on spending reductions.  The Murray plan is more vague, on both sides.  Nonetheless, one can make a broad comparison of the two approaches. 

The Ryan plan would reduce tax rates and spending significantly.  The Murray plan would have far smaller reductions in spending and would raise taxes significantly.  History and sound economic theory tell us that a smaller government and lower tax rates mean a larger private sector and larger overall level of GDP.  A larger government and higher tax rates mean a smaller private sector and total GDP. 

We have modeled the economic consequences of tax changes roughly consistent with the two policy proposals.  We do not model the economic effects of the proposed government spending reductions.  Government transfer payments add nothing to production and national income, and, through the disincentive effect of promising benefits without people having to work and save for them, probably reduce output.  Government spending on goods and services is part of GDP, but does not add to it.  It diverts resources from private to public use, and displaces private production and consumption.  On balance, it probably reduces the value of national output by diverting it to products the public would not normally favor.  Government spending would add to GDP primarily in those limited cases of infrastructure investment that adds more to productivity and GDP than private investment would do.  These are a small fraction of the federal budget.

The Ryan plan:

We have modeled the following Ryan proposals:

• Lower the 15% Statutory Individual Income Tax Rate to 10%
• Lower all higher Individual Income Tax Rates to 25%
• Repeal Obama Care HI Surtax
• Repeal Obama Care Investment Income Surtax
• Repeal AMT
• Cut the Corporate Income Tax Rate to 25%

The Ryan tax reductions would raise GDP and labor income by a bit over 6% after all adjustments (about five to ten years after full implementation).  That is roughly equivalent to 8 million additional full time jobs at current wages.  GDP would rise by $6.20 for each dollar of net tax increase (saving the taxpayers $7.20).  Over half of the assumed revenue loss would be recovered from increased GDP and employment.  To be clear, the growth calculated for the Ryan plan assumes the residual revenue losses (after feedback from the added economic growth) are covered by restraining spending, or by reducing tax preferences that are unrelated to incremental economic effort and would not discourage capital formation, hours worked, or labor force participation.

The static distribution of the tax cuts would be skewed toward the upper income, in large part because the plan repeals the Obama Care tax increases and some of the fiscal cliff tax hikes that were skewed toward the upper income.  (Relative to the 2012 tax system, the tax changes would be much more uniform across income levels.)   The static distribution table does not include the corporate tax rate changes, which are more broadly distributed throughout the economy.  After accounting for the positive economic changes, including the increased work hours and wages, after-tax income rises substantially across all income classes under the Ryan proposal.  See tables below.

The Murray plan:

We have modeled the Murray tax plan as a limitation on the benefits of itemized deductions to 15% of the amount, as if they were applied solely against income in the 15% tax bracket.  This in the spirit of a proposal in the President’s FY 2012 budget submission.  In addition to tax increases on the upper income, Murray also recommends extending a number of refundable credits.  These have limited economic effects, and are not modeled.  The deduction limitation raises about as much revenue on a static basis as is needed to cover the stimulus proposals, sequestration repeal, refundable credits, and net revenue gains in the Murray plan.  Note that there are many alternative ways in which the tax committees could achieve the revenue targets.

The tax increase would reduce GDP and labor income by a bit under 1% after all adjustments.   That is roughly equivalent to a loss of a million full time jobs at current wages. GDP would fall by $1.60 for each dollar of net tax increase (costing the taxpayers $2.60).  Over a quarter of the assumed revenue gains would be lost to reduced GDP and employment.

The static revenue estimates show the Murray tax increase falling mainly on people in the upper income brackets.  After adding in the negative economic effects, including the reduced work hours and wages, it can be seen that after-tax income would fall at all income levels (excluding refundable credits). See tables below.

Conclusion

The economy would be stronger under the smaller government and lower tax rates of the Ryan Budget than under the Murray budget.  Congress should be aware that the health of the economy is enhanced as the federal budget is reduced (certainly from the historically high levels that have existed since 2009).  The idea that a larger federal sector is good for economic growth was a mistaken lesson dating back to the Great Depression.  It is time we moved on.

*Spending here reflects how tax changes affect federal workers' wages.  It does not include the spending proposals by Ryan or Murray.

It is March 20th, 79 days since Obamacare’s medical device tax went into effect, and firms are still not sure if they are in compliance, according to Tax Analysts (subscription required):

John Seabrook of Deloitte Tax LLP said he thinks there are still many manufacturers that have not made deposits (of the tax). "Some companies are putting a lot of time and effort into compliance, but many more are still struggling," he said. "Companies should be making deposits now," he added, saying that he thinks failing to make deposits would not be considered a good-faith attempt at compliance.

Lew Fernandez of PricewaterhouseCoopers LLP said some manufacturers will probably overpay the tax in the early going, in part because it is hard to calculate some items that should be deducted from the tax base, such as rebates, price adjustments, warranty costs, and training provided by the manufacturer. Overpayments can be claimed as credits against the tax or refunds.

This is even after the IRS has published guidance twice to manufacturers on the tax in late 2012, assuming they would have enough time to prepare.

The reason there is still so much confusion is that the medical device tax is very complex. It places a large burden on medical device manufacturers to calculate and determine their tax liability.

One of the biggest complexities in the law is the “constructive sales pricing.” Normally, firms will pay tax on the sale price of their taxable medical device. Constructive pricing is supposed to allow manufacturers that do not normally make sales to outside companies to “construct” a sales price in order to levy the tax based on fair market pricing and safe harbor rules. (I know- it already sounds confusing).

However, this is proving to be even more difficult due to the complexity inherent in the medical device industry: “Compared with other industries subject to similar taxes, the medical device industry is newer, is not as integrated, has complex distribution channels, and sells a wider variety of products.”

Firms will need to spend a lot of money and resources in order to just figure out on what price they must pay their taxes, making the total cost of this tax much more than the $29 billion dollars it is supposed to raise over the next ten years. The additional resources lost due to compliance are a loss to society that could have gone to more productive uses, such as research and development or hiring more workers.

As one could imagine, this complexity will have different burdens on different size manufacturers. Small firms that do not have the additional resources to hire accounting firms to navigate the constructive pricing regulations will be hit a lot harder as they have to shift more resources from production to compliance.  Indeed, the total cost of this tax is likely to exceed 100 percent of profits for many small companies.  As a result, medical innovation will take a hit.

Complexity is one costly aspect of tax policy that is often overlooked. If the cost of complying with the tax makes up a substantial portion of the tax’s total cost, there is something fundamentally wrong. Good tax policy should not have provisions that take more than 80 days for an industry of more than 12,000 companies to figure out.

In 2009, the state of Delaware passed a series of “temporary” tax increases in order to fill a state budget gap. These changes included an increase in the top individual income tax rate from 5.95 to 6.95 percent, in addition to higher gross receipts, franchise, and estate taxes. Though these measure are scheduled to sunset in the coming year, the state again finds itself in the face of a budget shortfall and must do something to balance their budget.

The state’s Governor, Jack Markell (D), has proposed keeping some of these temporary changes permanent. We’ve quipped in the past that there’s nothing so permanent as a temporary tax increase, and the situation in Delaware is a perfect example of this. In the face of year-to-year revenue fluctuations and spending obligations, states have few options to address budget gaps. Most are subject to balanced budget obligations, so if a state doesn’t have adequate savings in rainy day funds, it must turn to spending cuts or tax increases to meet short-run budget requirements.

The Governor’s tax package contains the following:

• Instead of allowing the current top individual income tax rate drop from its current level of 6.75 percent to the scheduled 5.95 percent, lowering it to only 6.6 percent;
• A 1.0 percent rate decrease in gross receipts tax, rather than allowing for the 2009 8 percent increase to fully sunset (as well as granting additional cuts to manufacturers);
• Fully lifting the sunset on corporate franchise and estate taxes (excluding certain farms).

House Republicans argue that the 2009 increases were only agreed upon because of the “understanding that the taxes would begin to go away this year.” Unfortunately, their solution is to again dub this year’s increase as “temporary.” Stability is crucial in a sound tax system. When tax laws fluctuate from year to year (or lawmakers have the reputation of changing laws frequently), it is difficult for taxpayers to engage in confident long-term financial planning.

Stability isn’t my only concern with the Governor’s plan. He proposes the state maintain reliance on gross receipts tax revenues. Gross receipts taxes are arguably one of the worst ways to raise revenue because of their lack of neutrality and simplicity. They lead to inefficient economic distortions. Further, the state is using higher-income taxpayers as a means to close a budget hole. This is problematic due to the volatile nature of these revenues. Individual income tax revenues are one of the most unstable sources of tax revenue.  

Delaware currently has the 15th highest top individual income tax rate in the country. Though lowering the rate to 6.6 percent is a move in the right direction, reducing it to pre-2009 levels would be more conducive to economic growth. The state would also do well to move away from taxes on gross receipts, as these are an inefficient, non-neutral, and overly-complicated way to raise revenue. Finally, enacting “temporary” tax measures makes it difficult for taxpayers to plan financially and gives them the impression that the state will raise taxes every time there is a budget crisis—not exactly the best way to foster confidence in the government’s ability to weather the business cycle. Instead, Delaware should design a tax system that is able generate adequate revenue regardless of the state of the overall economy and does so in an efficient, simple, and neutral way.

More on Delaware here.

Follow Liz on Twitter @elizabeth_malm.