House blueprint for tax reform pushes consumption taxes onto center stage: shifting away from 1986-style reform, the drama is definitely in the details.

• Author: Zarlenga, Lisa M.
• Position: Tax Reform

[ILLUSTRATION OMITTED]

On June 24, with much fanfare, House Republicans laid out the framework of a new tax reform proposal, frequently called a "blueprint" for tax reform. To date, most of the focus of tax reform discussions and the major Congressional committee and Obama administration efforts on tax reform have involved so-called 1986-style reform, that is, modifying the income tax system to lower the tax rates and broaden the tax base in the same manner as the last major tax reform in 1986. Conceptually, the new blueprint represents a significant move away from this 1986 model toward a consumption-based system. Although consumption taxes have their supporters, lawmakers have generally been ambivalent about them, (1) and the blueprint makes clear that it does not propose to add a new consumption tax: "Movement toward a consumption-based system need not involve a shift to an explicit consumption tax, such as a retail sales tax, but instead could result from reforms which exclude certain features of the income tax base." (2)

Although perhaps not a full-throated endorsement of a consumption tax, the blueprint does represent a shift in the discussion away from simply attempting to replicate 1986 reforms and an elevation of the role of consumption taxes among mainstream tax reform efforts. The cost to reduce rates is astounding: $102 billion over 10 years to reduce the corporate rate by one percentage point and $689 billion over 10 years to reduce the individual rate by one percentage point. However, unlike in 1986, when significant pay-fors, such as the passive activity loss rules and the repeal of the investment tax credit, were available, politically viable pay-fors are more difficult to come by today. That means comprehensive 1986-style tax reform that is revenue neutral will continue to be an uphill battle.

Previous Major Tax Reform Efforts

Congress and the executive branch have been developing tax reform proposals for more than a decade, and many have grown skeptical of the possibility for action in the near future. The rollout materials for the blueprint indicate that the House Ways and Means Committee will begin developing legislation based on the blueprint, with a goal of being ready for legislative action in 2017. Before exploring the blueprint, however, it is helpful to review some of the most recent efforts at tax reform.

Camp Draft

The most recent prior House tax reform proposal, the so-called "Camp Draft," came from former Ways and Means Chairman Dave Camp (R-MI) in February 2014. It is by far the most comprehensive recent proposal and illustrates well the tradeoffs necessary to accomplish a 1986-style revamp of the income tax code. Under the Camp Draft, corporations would be taxed at a top rate of 25 percent. Many of the corporate tax credits and deductions would be modified or eliminated, such as accelerated depreciation, last in, first out (LIFO) accounting, and the domestic production deduction; only a few, like the R&D credit, would be retained. Passthroughs would continue to be taxed through the individual tax system, although domestic manufacturing income would be taxed at a maximum rate of 25 percent.

On the international side, the Camp Draft would move to a territorial system, with a 95 percent exemption for dividends received by U.S. corporations from their foreign subsidiaries. Foreign intangible income would be subject to a 15 percent rate, and previously untaxed foreign earnings would be subject to a one-time tax at 8.75 percent for cash assets and 3.5 percent for other assets. The Camp Draft would also limit net interest expense deductions for U.S. companies with respect to debt with foreign subsidiaries. Specifically, the draft would limit interest deductions based on domestic leverage relative to the worldwide group or a percentage of taxable income.

For individuals, the Camp Draft would create two income tax brackets of 10 percent and 25 percent with an additional 10 percent tax on certain high-income taxpayers. Dividends and capital gains would be taxed at ordinary income tax rates with a 40 percent exclusion from income, resulting in a top rate of 24.8 percent. As with corporate taxes, many individual tax credits and deductions would be modified, reduced, or eliminated. For example, the mortgage interest deduction, the Earned Income Tax Credit (EITC), and the charitable contribution deduction would be scaled back, while the deduction for state and local tax payments would be eliminated.

Senate Working Groups

In the Senate, Chairman Orrin Hatch (R-UT) and Ranking Member Ron Wyden (D-OR) of the Finance Committee formed five bipartisan tax reform working groups, focusing on (1) business income tax, (2) community development and infrastructure, (3) individual tax, (4) international tax, and (5) taxes on savings and investment. Each of the five groups produced a report in July 2015 with options and recommendations for the Finance Committee to consider as it worked toward reforming the tax system.

The report of the Business Income Tax Working Group acknowledged broad support for a substantially lower corporate tax rate, but advised that business tax reform must ensure that passthroughs are not ignored in an effort to reduce the corporate tax rate. The report considered several options to ensure equitable treatment, including (1) a business equivalency rate, (2) targeted tax benefits for passthroughs, and (3) a new deduction for active passthrough business income. The report also urged the committee to further consider corporate integration to eliminate double taxation of corporate income, although it did not recommend a particular approach. (3) The Business Income Tax Working Group also discussed ways to promote investment and savings through moving to a consumption tax base.

The report of the International Tax Working Group called for an overhaul of the United States' current system of international taxation as necessary to stave off additional tax inversions and to prevent base erosion. The report recommended a dividend exemption regime in conjunction with base erosion rules, net interest limitations to stop disproportionate leveraging, and a one-time tax on previously untaxed foreign income. The working group also explored a minimum tax on certain foreign earnings.

Administration Framework and Budget

The White House has focused largely on business tax reform, releasing the Framework for Business Tax Reform in February 2012 (and an update to that framework in April 2016). The framework would lower the corporate tax rate from 35 percent to 28 percent while eliminating certain tax expenditures and implementing other reforms. Certain reforms are specifically recommended, such as repealing LIFO accounting and oil and gas preferences, whereas other reforms are offered as part of a "menu of options" to be considered as ways to lower the rate to 28 percent. These options include eliminating accelerated depreciation and creating greater parity between the taxation of corporations and passthroughs (for example, an entity-level tax on large passthroughs). The report also recommends establishing a new minimum tax on foreign earnings (the specifics of which are not described in the report, although it would allow U.S. companies to exclude costs associated with foreign investments, effectively creating a type of territorial system) and a one-time tax on unrepatriated earnings.

The Obama administration's FY 2014-17 budget proposals have elaborated on the business tax reforms by reserving revenue associated with particular...