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Annette Nellen
Annette Nellen

Real revenue sources for tax reform

Will the lower tax rates promised as part of revenue-neutral tax reform be “paid for” with mostly temporary or permanent changes?

January 16, 2014
by Annette Nellen, Esq., CPA

Today, talk of comprehensive tax reform focuses on international tax reforms and lowering the corporate tax rate (and perhaps also the individual tax rate) in a revenue-neutral manner. For example, with the release of a discussion draft for cost recovery changes, Senate Finance Committee Chairman Max Baucus, D-Mont., stated, “These reforms would also raise enough revenue from corporations in the long-term to finance a significant reduction in the corporate tax rate” (press release (11/23/13)).

A budget letter of March 2012 from the Republican members of the House Ways and Means Committee stated, “[T]he country is in dire need of tax reform that lowers rates, broadens the tax base, and addresses global competitiveness” (letter to Rep. Paul Ryan, R-Wis. (3/12/12)).

While no specific plan exists yet for a revenue-neutral rate reduction via base broadening, there have been both broad suggestions and a few specific suggestions. Broad suggestions typically call for eliminating “loopholes” and making the system more fair, with no specifics. More specific suggestions tend to call for eliminating provisions that affect only the timing of deductions, rather than any that would result in permanent tax increases. For example, suggestions have been made to repeal last-in, first-out (LIFO) and the lower-of-cost-or-market (LCM) accounting methods. Such changes do not generate revenue over the long term, though. These are timing rules, and the changes will just shift write-offs to later years, making them “revenue raisers” only over a short time period, such as the typical 10-year projection used for revenue estimates.

This article draws from government reports to identify income tax changes (other than rate increases) that would generate permanent revenues that might be used to pay for permanent rate reductions.

How much revenue is needed?

To put the revenue-raiser provisions in perspective, consider how much revenue is needed to lower the tax rate. In July 2013, the Joint Committee on Taxation estimated that, over a 10-year period (2014–2023), $1.234 trillion would be needed to lower the top corporate rate to 25% (letter from the Joint Committee on Taxation to Rep. Sander Levin, D-Mich. (7/30/13)).

Congressional Budget Office (CBO) suggestions

Periodically, the CBO issues a lengthy report described as “a compendium of policy options that would affect the federal budget.” The latest report, Options for Reducing the Deficit: 2014 to 2023, was released in November 2013. It presents 103 ideas for lowering federal spending or increasing revenues, including 36 “revenue options” involving taxation.

Selected items from the revenue options list that would yield permanent tax increases follow (the complete list is available at the CBO website):

Proposal Revenue
2014–2023
(Billions of Dollars)
Add a new 30% minimum tax on adjusted gross income (AGI) of high-income individuals (“Buffett Rule”) 76
Increase the rate for capital gains and dividends by 2 percentage points 53
Use an alternative inflation measure (“chained consumer price index”) for indexing tax provisions 140
Convert the mortgage interest deduction to a 15% credit 52
Eliminate the deduction for state and local taxes 954
Limit charitable contributions to those that exceed 2% of AGI 212
Limit the value of itemized deductions to 28% 135
Tax carried interests as ordinary income 17
Repeal the American opportunity, lifetime learning, and Hope scholarship credits, and phase out the deduction for interest on student loans 155
Impose self-employment tax on owners of passthrough entities if they materially participate 129
Repeal the Sec. 199 deduction for domestic production activities 192
Measure the foreign tax credit (FTC) on a pooling basis 44

President Obama’s suggestions

President Barack Obama’s annual budget proposal includes several suggestions that would be permanent tax increases. Some of the items match those of the CBO report, such as the Buffett Rule and pooling for the FTC. Selected items from the administration’s FY 2014 “Greenbook” follow:

Proposal Revenue
2014–2023
(Billions of Dollars)
Repeal expensing of intangible drilling costs 11
Disallow deduction for nontaxed reinsurance premiums paid to affiliates 6
Require mark-to-market for derivative contracts and treat gain or loss as ordinary 19
Deny deduction for punitive damages 0.4
Limit the value of itemized deductions and certain exclusions to 28% 529

Other suggestions

Some additional suggestions, which have been offered by members of Congress and others, are listed below:

  • Eliminate various exclusions, such as for prizes, foreign earned income, and meals and lodging furnished by an employer (S. 727 (112th Congress); Sen. Ron Wyden, D-Ore.).
  • Eliminate the new markets tax credit, Empowerment Zone incentives, and the historic preservation tax credit. Reform the mortgage interest rules by repealing interest deductions for home equity and a second home, and limiting the deduction to homes costing $500,000 or less ($187 billion raised over 10 years). Modify the exclusion for employer-provided health insurance (Sen. Tom Coburn, R-Okla., “Reforming Tax Expenditures & Ending Special Interest Giveaways” from his Back in Black report of July 2011).
  • Repeal or modify tax expenditures: The annual tax expenditure reports released by the Joint Committee on Taxation and the Office of Management and Budget (OMB) (FY 2014 report) identify tax provisions that result in reduced revenues permanently. Some examples of tax expenditures that could be modified or repealed to generate tax revenues include:
    • Reducing the exclusion for employer-provided health insurance.
    • Reducing the exclusion for gain on sale of a residence.
    • Taxing the step-up in basis of assets at date of death.
    • Taxing employer-provided meals and lodging.

Timing “revenue raisers”

Some of the proposals that would push deductions to later years have significant revenue estimates associated with them. Examples from the CBO revenue report and the president’s FY2014 budget proposal include the following:

Proposal Revenue
2014–2023
(Billions of Dollars)
Repeal LIFO 81
Repeal LCM 7
Extend the life of equipment and certain structures from 3, 5, 7, 10, 15, or 20 years to 4, 7, 9, 13, 20, or 25 years, respectively. 272
Modify depreciation rules for general aviation passenger aircraft 3

Looking forward

Lowering income tax rates through revenue-neutral base broadening will be a challenge. As described in this article, it may not be possible to find enough revenue from permanent changes (rather than only timing changes) to reach a 25% maximum corporate tax rate. Many of the revenue raisers in the reports referred to here concern the individual income tax. In the current political climate, it is unlikely that lower corporate tax rates will be paid for with individual tax increases. However, perhaps some tax preferences individuals use that are tied to corporations should be considered to be corporate provisions. For example, the exclusion for meals and lodging provided for the convenience of the employer directly benefits individual workers, but it is really based on a corporate practice or need. According to the OMB tax expenditure report, this provision has a significant cost. For FY 2014, it is estimated that this exclusion costs $6.6 billion in revenue. In contrast, the earned income tax credit (EITC) cost is $5.6 billion for the same time period (FY2014 Analytical Perspectives, page 254).

Changes to depreciation are likely to be a significant revenue source to cover the cost of a lower corporate tax rate. In 2011, the Joint Committee on Taxation estimated that about 70% of a 28% top corporate rate would be “paid for” by shifting from the modified accelerated cost recovery system (MACRS) to the alternative depreciation system (ADS) (Nellen, “The Rough Road to a 28% Corporate Tax Rate,” Corporate Taxation Insider (Nov. 10, 2011); and JCT report (10/27/11)). Yet, a depreciation change involves timing, not new revenues, to pay for a permanent lower corporate tax rate. The reality that there are no easy ways to permanently raise revenue may be one reason for the delay in seeing a discussion draft or proposal for how a lower corporate tax rate (and perhaps also a lower individual income tax rate) will be paid for in a revenue-neutral manner. Let’s see what happens.

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Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and a blog.