Treasury Secretary Jacob Lew proposed administrative rules this week that would limit the benefits of tax inversions, where companies move their headquarters overseas for tax reasons. The rules target abusive practices where deals were often structured solely to skirt U.S. tax law. They eliminate some incentive for companies to invert, but many of the basic incentives to invert will remain until fundamental tax reform passes Congress and is signed by the President.
Recent months have seen a wave of actual and proposed corporate "tax inversions," where U.S. companies merge with a foreign corporation to move their headquarters overseas and avoid the high statutory U.S. tax rate on corporate income. Inversions are estimated to cost about $20 billion in lost corporate tax revenue over the next ten years. The Obama Administration had been pushing for legislation to address the issue, but after Congress left town for campaign season without addressing the issue, the Treasury Department moved forward in areas where they believe they have clear legal authority.
While the proposal reduces some benefits to inversions and may cause some companies to rethink their plans, inversions are a small symptom of an outdated tax code.
A new paper suggests that tax cuts that add to the deficit provide little boost to economic growth and may actually hinder it. Last week, the Tax Policy Center (TPC) put out a paper entitled “Effects of Income Tax Changes on Economic Growth,” summarizing the academic literature. According to the authors, Bill Gale from Brookings and Andrew Samwick from Dartmouth, the net economic impact of a deficit-financed income tax cut is either small or negative, with the negative effects of additional debt likely overwhelming the economic benefit of lower rates, particularly over the long term.
Tax cuts have the potential to grow the economy, but their benefit depends on how they are structured and financed. For tax changes to promote growth, changes should encourage work and investment through lower rates, efficiently encourage new economic activity (rather than providing a windfall for previous investments), reduce economic distortions, and create minimal (if any) increases in the budget deficit.
The key question is, how do you pay for tax cuts? If tax cuts are deficit-financed, the negative economic effects of debt will crowd out investment, which can outweigh any positive growth impact from the tax cut. CBO has found that an “Alternative Fiscal Scenario” representing roughly a $2 trillion increase in deficits over ten years would lead to a 7.5 percent smaller economy in 25 years, while a deficit reduction plan of $4 trillion would increase the size of the economy by 2 percent. Increased revenue has been a key part of many bipartisan plans for deficit reduction, including Simpson-Bowles and Domenici-Rivlin.
Importantly, however, the lack of growth from deficit-financed tax cuts is distinct from the effects of either tax reform, which pairs rate reductions with base broadening, or tax cuts that are financed through simultaneous spending reductions to reduce government consumption. Using base broadening to pay for lower rates avoids crowding out other investment, but would likely temper the economic gains because some base broadening can push up effective marginal tax rates on taxpayers who were taking advantage of the closed loopholes.
Earlier in the week, we highlighted a portion of CBO Director Doug Elmendorf's presentation at Cornell University highlighting the increased resources going to health care, Social Security, and interest spending to the detriment of the rest of the budget. In addition, the slideshow contained other helpful charts showing how the federal budget could change over the next decade, the choices policymakers face to alter the trajectory of debt, and a further look at the impacts of the Affordable Care Act. Here are some of the more interesting charts from that presentation.
Putting Debt on a Sustainable Path Requires Significant Changes
With debt set to continue to rise as a percent of GDP, simply maintaining the status quo will require significant changes. Keeping debt stable at its current elevated level of 74 percent of GDP for the next 25 years would require $2 trillion of savings over ten years, twice as much as the savings in the President's budget. Getting debt close to its historical average of 40 percent of GDP in 25 years will require $4 trillion in ten-year savings.
Individual Income Tax Revenue is the Only Growing Revenue Stream
CBO's ten-year projections show only a modest rise in revenue as a share of GDP over the next decade, from 17.5 percent to 18.2 percent, and in fact from 2015 to 2024 revenue will remain roughly flat.
House Republicans plan to vote this week on a jobs package combining bills that would "build a robust economy and foster job creation." While promoting economic growth should be a top priority after a lackluster jobs report and a slow recovery, policymakers should also be fiscally responsible. Unfortunately, the House Republican approach would make the debt much worse. We've compiled the cost estimates for the various bills, and the package would cost more than $570 billion over ten years, before interest.
The package includes a combination of tax, spending, and regulatory changes, many of which could help to spur short or long-term economic growth. The majority of the costs in the legislation come from permanently extending and expanding a few expired tax provisions which focus on promoting research and investment. Unfortunately, the legislation would include over $570 billion of costs, but only $400 million worth of savings. Without offsets, the package will add substantially to the debt.
This increase in debt isn’t only bad for the fiscal situation; it also works against the exact purpose of the bill. As CBO has noted, a high national debt creates drag on economic growth by crowding out private investment, reducing output, and increasing interest rates. The package's care-free attitude towards increasing the debt will dampen any economic growth that would occur from the legislation.
As we've argued many times, if something is worth having, it is worth paying for. The fact that a package has the potential to promote growth does not mean we should allow it to add to the debt over the long run. In the past, we’ve suggested numerous offsets to pay for unemployment insurance, highway spending, extending tax provisions, veterans health care, or the Medicare "doc fix." Any of those, or any number of others, could be attached to this package to make it more fiscally responsible.
|Provisions in the September 2014 House Jobs Package
|Policy||Ten-Year Costs, 2015-2024
|Expand and make permanent bonus depreciation||$269 billion|
|Expand and make permanent the research & experimentation tax credit||$156 billion|
|Expand and make permanent 2013 levels of small business expensing (Section 179)||$73 billion|
|Change the definition of full-time employment from 30 to 40 hours/week||$46 billion|
|Repeal medical device tax||$26 billion|
|Make permanent two expired tax breaks relating to S Corporations||$2 billion|
|Exempt from the employer mandate servicemembers and veterans who already have health insurance||$1 billion|
|Codify standards for regulations that create private mandates||< $0.1 billion|
|Require agencies to submit a monthly report of proposed and final regulations||< $0.1 billion|
|Require major regulations to get Congressional approval||"significant"|
|Exempt most private equity financial advisors from SEC registration||negligible|
|Exempt certain merger & acquisition brokers from SEC registration||negligible|
|Streamline the process to obtain permits to extract critical and strategic minerals from public land||negligible|
|Permanently ban states and localities from imposing taxes on internet access||$0|
|Increase timber production on federal lands||- $0.4 billion [savings]|
|Total, House Republicans Jobs Package||$572 billion*|
Senators Chuck Schumer (D-NY) and Dick Durbin (D-IL) have introduced legislation that would reduce the benefits to companies that choose to "invert," or move their headquarters overseas for tax reasons. The bill is very similar to a proposal included in last year's President's Budget, which would save about $3 billion over ten years by limiting tax deductions. It targets "earnings stripping," when companies with large amounts of cash borrow purely for tax reasons.
Recent months have seen a wave of corporate "tax inversions," where U.S. companies merge with a foreign corporation to move their headquarters overseas and avoid the high statutory U.S. tax rate on corporate income. Inversions are estimated to cost about $20 billion in lost corporate tax revenue over the next ten years.
Schumer and Durbin's proposal targets what they call “one of the most egregious practices of corporate inversions,” known as earnings stripping. This practice involves a foreign parent company lending to its U.S. subsidiary. Then, the U.S. subsidiary can send its profits to the parent company as interest. While this paper transaction doesn't change the company's overall financial position – it has the same income and debt levels as before – the loan provides two tax benefits. First, the U.S. subsidiary will have greater interest payments, which can be deducted as a business expense. Second, more of the company's income is "booked" outside the United States, where companies do not have to pay U.S. tax unless they repatriate the funds back to the U.S.
With the economy recovering slower than originally anticipated, the government now expects to collect significantly less revenue this decade than it did just two years ago. The most recent budget projections from the Congressional Budget Office (CBO) show the government taking in $1.8 trillion less over a ten-year period than was projected in February 2013.
Growing entitlement spending is the primary source of growth in the federal budget, but this growth would not lead to higher debt if revenues kept pace. Despite the savings from the widely noted $900 billion slowdown in health care spending since March 2011, federal revenues are set even faster, widening the deficit. Over the same 2013-2021 time period, revenue projections have fallen $1.2 trillion since February 2013 and net health care spending has fallen $780 billion since March 2011.
February 2013 was the first budget baseline after the fiscal cliff law, which allowed certain tax cuts for high earners to expire while permanently extending most of the 2001/2003 tax cuts. In that baseline, revenues were expected to climb to 18.5 percent of GDP, both in the immediate future and by the end of the decade. Over the last two years, though, CBO has continually revised these revenue projections downward, particularly in their February baseline of this year. The last month's projections showed revenue staying under 18.2 percent of GDP throughout the period.
Half of the $1.8 trillion is due to decreases in individual income tax revenue. Payroll taxes experienced a similar but smaller decline. Corporate tax revenue is expected to be much lower than expected in the near term – projections for 2016 dropped over 15 percent – but only slightly lower over the long term. Excise taxes are the only exception to the decline, with projections that have slightly increased over the last two years.
Many policymakers have expressed concern about "tax inversions," transactions where American companies move their headquarters overseas in order to pay a lower tax rate. The inversions are estimated to cost about $20 billion in lost corporate tax revenue over the next ten years. Yet even as Congress and the Administration debate whether to stop inversions, there is bipartisan agreement on a series of tax breaks that could cost 35 times more. Reviving the tax extenders continually over the next 10 years will cost about $700 billion (about $400 billion in corporate tax breaks, and about $300 billion for other businesses and individuals).
Since the beginning of the year, at least 14 companies have announced mergers or purchases of overseas companies that would result in an American headquarters moving overseas. Commonly called "tax inversions," these transactions often take place only on paper – no offices or employees move, but the company is considered foreign for tax reasons. By inverting, companies avoid the U.S. corporate tax rate of 35 percent on their overseas earnings, instead paying a much lower (or sometimes zero percent) rate that other countries charge on income outside their borders. This erosion of the corporate tax base is problematic, and there's several ways to address it. One suggestion, by CRFB President Maya MacGuineas, calls for a strategic pause where companies agree not to invert for nine months, paired with a fast-track procedure to encourage comprehensive tax reform.
Inversions are estimated to cost about $20 billion in lost tax revenue over the next 10 years, or about 0.5% of the $4.5 trillion that will be paid in corporate taxes during the same period. Legislation stopping them would raise enough to pay for about one-quarter of the $85 billion cost of continuing the extenders for two years, as the Senate Finance Committee would do. But the extenders have often been extended year-after-year. For example, the current Finance Committee bill continues 52 out of 54 provisions, and expands some tax breaks that were not in the original bill. If the package were continually extended, the provisions would cost $700 billion. (The House, on the other hand, has taken a much more expensive approach, expanding the package to cost over $1 trillion.)
Both the Government Accountability Office (GAO) and Senator Tom Coburn's (R-OK) office have released new reports on a tax credit that rewards banks for investing in low-income communities. Both reports raise questions about whether the money is being used as effectively as it could be. The GAO report raises some concern with the credit's complexity and effectiveness, finding certain cases where investors are receiving many sources of federal money for the same project. Senator Coburn's report goes farther, identifying several places where the credit has been used for questionable purposes and calling for the credit's elimination. As his report explains:
The federal New Markets Tax Credit program was created to steer taxpayers dollars into banks that would in turn funnel financial assistance to businesses and developers in low-income communities to help create jobs. Yet, virtually every neighborhood, from Beverly Hills to the Hamptons, could qualify for the program. The New Markets Tax Credit (NMTC) has subsidized wealthy investors in nearly 4,000 projects, including car washes, bowling [alleys], parking lots and breweries. Many of these are wasteful and not a federal priority – such as an ice skating rink and a car museum - while others are corporations in little need of taxpayers’ handouts – such as chain restaurants like Subway and IHOP.
Since 2000, the New Markets Tax Credit (NMTC) has given investors, mostly large banks and financial institutions, a 39 percent credit for loaning money to businesses in low-income communities. Investors claim the credit over seven years.
GAO notes the financial arrangements used to claim the credit have become much more complex.
Around this time of year, the Social Security Trustees usually issue their report on the status of the program over the next 75 years. In advance of that release, CBO has provided a report to Senate Finance Committee ranking member Orrin Hatch (R-UT) with options for making Social Security solvent over 75 years through payroll tax increases. If no action to address the insolvency is taken, Social Security will see a 23 percent across-the-board benefit cut in the early 2030s. Because CBO's own estimate of Social Security's shortfall is larger than the Trustees', it finds that larger increases would be required to keep Social Security solvent than the Trustees estimate.
Closing the 75-year shortfall through the payroll tax alone would require an immediate 3.54 percentage point increase in the payroll tax rate (to 15.94 percent), compared to the 2.7 percentage point necessary increase projected by the Trustees. CBO also evaluates increases in the cap on income subject to Social Security payroll taxes (the "taxable maximum"), which is currently set at $117,000 for 2014 and increases with average wage growth each year. The cap currently covers 83 percent of wages; raising it to 90 percent would close 30 percent of the funding gap, and eliminating the cap altogether would close 45 percent.
The report also shows that getting to 75-year solvency would require a 2.3 percentage point payroll tax increase in combination with the 90 percent option and a 1.6 percentage point payroll tax increase for the elimination option. There are a number of permutations of these options included in the report, which you can see below.
The House Ways and Means Committee just published its plan for a short-term fix to the Highway Trust Fund, which needs an additional $8 billion to fund highway construction through the end of the year. Unfortunately, it relies on a known gimmick called "pension smoothing," which technically raises revenue on net over 10 years but may cost money in future years. Lawmakers should not be using any gimmick, let alone a "pay-for" that may increase future deficits.
Since lawmakers have less than a month before disruptions occur, they may need to rely on a short-term patch while a long-term highway bill is being negotiated. To help, we published a list of options to offset a transfer of general revenue into the highway fund, which intentionally left off pension smoothing, even though it was used to "fund" the last highway bill, because it is a gimmick.
The Ways & Means plan raises $10.9 billion for the Highway Trust Fund: $6.4 billion from the pension smoothing gimmick, $3.5 billion from extending customs fees through 2024, and $1 billion transferred from an over-funded trust fund for leaking underground oil tanks. However, the pension smoothing money is entirely a timing shift that raises money upfront and transfers the costs beyond the 10-year budget window.