Tax Reform: Prospects and Issues for Manufacturing

There is considerable support in Congress, the business community and the Administration to revise the corporate income tax. The U.S. has a marginal rate which is the highest in the world. Tax complexity, a sluggish economy and international competition are driving the possibility of an update. However, the issues and the politics are very complicated.

Three broad areas have emerged to form a “triangle of reform”. The first side is the reduction of the corporate income tax rate. In conjunction with lowering the tax rate, the second leg how to minimize the loss of revenue to the government by examining the makeup of income and eliminating “tax expenditures”. Reduction of such expenditures is also seen as promoting tax simplification and reducing the importance of tax considerations in business decision-making. Lastly, as the third side of the triangle, there is the basis on which the United States taxes multinational corporations.

C corporations are taxed at statutory rates ranging from 15 percent to 35 percent. However, certain domestic production activities are effectively taxed at lower rates by virtue of a deduction equal to a percentage of the income from such activities. The deduction is equal to nine percent of the income from manufacturing, construction, and certain other activities specified by statute Thus, generally the maximum tax rate for a C corporation on its domestic production activities income is effectively 31.85 percent.

The legislative process for tax reform is being led by Senator Max Baucus (D-MT), the retiring Chairman of the Senate Finance Committee and Congressman Dave Camp (R-MI), Chairman of the Way and Means Committee. Each Committee has laid out in a semi-systematic way a program for putting some sort of starting point forward. Numerous hearings have been held. The Finance Committee has publish 10 papers on various options while the Ways and Means Committee has organized 11 subgroups to consider different areas of the tax law. More than 1300 comments have been submitted to the Ways and Means Committee.

There are three questions:

1. Can anything be done?

2. When will it happen?

3. What are the important issues?

The answer to the first question is: Given the state of the tax system, support for changes in its structure, and the investment of time and effort to date by the tax-writing committees, it is possible serious tax reform could proceed. Congress is not there yet and the opening of the window to do something is not all that big given the complexity of the issue, the political climate and the differing approaches of conservatives and liberals. One side is revenue hungry and the other side loathes new taxes. However, the gap is smaller on the corporate side than on taxing wealthy individual taxpayers.  Congress will likely drive corporate tax reform as the Administration has not made any real push,

Timing, of course, is everything. Senate Finance Committee Chairman Max Baucus has said more concrete proposals will be “coming out fairly soon.” He and Chairman Camp are going to make nationwide joint appearances across the country to generate support for tax reform. 

There are other issues that are somewhat interrelated with tax reform—increase in the debt ceiling and the budget. The Government will run out of options of getting around the debt ceiling sometime in late fall. This must be increased for continued funding the deficit and always offers an opportunity to attach legislation but also opportunity for mischief. Adoption of a joint Congressional budget remains in limbo due to political concerns by Republicans on tax increases and the vast differences in the approach taken by the House and Senate in their budget resolutions.  

It is not clear how the current “scandal” with the IRS will influence the process or the use of the IRS to enforce and monitor the new health care rules kicking in soon.

Let’s take a look at an important business sector—manufacturing. The manufacturing sector has enjoyed some growth or at least a lessen decline due to cheaper energy cost from natural gas among other reasons (not among them is reduced regulation). What are the important issues?

Rate will be the primary issue and as indicated support for a reduction is there. How low will depend on what structural changes are made with what offsets and  which reductions in tax preferences are enacted.

For manufacturing, as noted, businesses can deduct up to 9% of their income from domestic manufacturing and production (Section 199) thereby reducing the marginal and average tax rate for these qualifying businesses. Proposals to change, eliminate, target, and expands the deduction have all garnered support.  

Another less noticed area is capital formation. Most capital-intensive businesses, such as manufacturing, use some debt financing to reduce the cost of their investment. Some have suggested a change to the interest rules that would impose a limit on all corporate taxpayers’ interest expense. Indirectly, changes in the taxation of dividends and capital gains also effect capital formation, as do the rules on depreciation. Another potential issue for capital formation is inventory accounting.

While maybe less important to basic manufacturing, the favorable tax provisions for R & D will be closely examined.  Under current law, businesses can choose to immediately expense R&D costs or amortize such costs over 5 years or more.  In addition, businesses can claim a credit for incremental spending on labor and supplies used for research. The R&D credit has always been temporary and currently expires at the end of this year. 

Finally, expect the taxation on multinational companies to be seriously revised. The issues and consequences of this area were recently shown in a Senate Hearing involving Apple. Seems Apple did nothing wrong but does not pay much on income earned outside the U.S.  Due to the structure of the law it cannot bring the earnings back to the United States without being subjected to what the company considers excessive tax rates.

The United States employs a system of worldwide taxation, while the territorial system is now the international norm. This area is very contentious and views differ. It also affects hundreds of billions of yet untaxed but untouchable earnings. Chairman Camp has put forth a draft proposal on moving to a territorial system to allow for the free flow of capital back to the United States from foreign operations for reinvestment in the domestic economy. This would end the current “lockout” of earnings, effectively, because of the high rates, preventing them from being brought back to the United States. This approach is opposed by the Administration.

There most likely will be an effort to move legislatively on corporate tax reform but no certainly when. It is not necessarily a “must do” 2013 issue but the closer to midterms it goes, the more pure politics will get in the way.