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Reviewing the Tax Code

Posted by: Mark Marich on July 18, 2011 Source: Policy Dialogue on Entrepreneurship

PDE staff were on hand for a Joint Congressional Testimony of the House Committee on Ways and Means and the Senate Finance Committee on July 13. Our report of the hearing follows:

There is not an iota of doubt that the current tax code has serious problems, in the sense that it seems to favor more the issuance of debt, rather than the issuance of equity for businesses to raise capital. But what are some of these problems? A few of them came to light at a Joint Congressional Testimony of the House Committee on Ways and Means and the Senate Finance Committee.

What do the experts say?

The Joint Committee hearing saw experts in taxation testify on the current tax code—its problems, its implications for businesses, and finally, the way forward. The following were the witnesses before the Joint Committee:

  • Tom Barthold, Chief of Staff of the Joint Committee on Taxation
  • Pamela F. Olson, a partner in the law firm Skadden, Arps, Slate, Meagher & Flom, LLP. It should be noted that Ms. Olson stated rather unequivocally that she was making comments in her own right and not on behalf of the firm she worked for.
  • Victor Fleisher, an associate professor of law at the University of Colorado Law School
  • Milhir A. Desai, a professor of Law at Harvard Law School
  • Simon Johnson, a professor of entrepreneurship at the MIT Sloan School of management

Problems

All the panelists were unanimous in their assessment that the current US tax code, as earlier on mentioned, favored debt over equity. In fact, Johnson could not have put it any better when he stated, in his presentation that the US tax code creates a “debt bias that encourages borrowing by households, the nonfinancial sector, and financial firms.”

Causes of the “Debt Bias”

  • Barthold: According to Barthold, on the business side, there are “tax rules that create incentives to choose debt-finance over equity-finance.”
  • Olson: Ms. Olson reiterated Barthold’s point and further went on to state that the said incentives that make businesses choose debt-finance over equity-finance arise from the “interplay” of two features of the current tax system—“the double taxation of corporate income, and the tax deductibility of interest payments”
  • Desai: On his part, Desai mentioned that there were three developments that exacerbated the debt-equity distortion. These he mentioned as: the rapid globalization of firms and capital markets; the simple characterization of entity level taxation and taxable investors; & the fact that Corporate tax is now largely for public corporations.

Consequences/Costs of the Debt Equity Distortion

Fleisher’s testimony outlined the negative effects of the debt-equity distortions best, which also corroborated the negative effects outlined by the other witnesses. According to Fleisher, the debt-equity crisis had implicit costs, which he summarized as: risky managerial behavior; social cost from increased bankruptcy; and, wasteful tax planning.

The Way Forward & Implications for Small Businesses

Policy Recommendations

  • Olson: Olson outlined a number of reform measures to deal with the debt-equity distortion. According to her, a simple way to was “to lower the corporate tax rates, which will “reduce the value of interest deduction to corporations and thus, reduce the disparity in the taxation of debt and equity investments.” Furthermore, according to Olson, lowering the corporate rate will have the benefit of more closely aligning the rates with rates of other countries, which have fallen in recent years. Shifting away from lowering the corporate tax rate, Olson also mentioned that integrating the corporate individual tax systems along the lines of the Bush administration’s 2004 budget proposal was another reform proposal. This could be undertaken by “eliminating the shareholder level tax on corporate income distributed as dividends” since “the dividend exclusion proposal will eliminate the debt financing incentive associated with double-taxing the return to corporate equity investment.”
  • Fleisher: Fleisher, in his testimony, identified implicit and explicit costs of the debt-equity distortion, which he termed as “collateral damage of the debt-equity distortion.” For him, the best way of dealing with this collateral damage was to first and foremost “eliminate the underlying distortions in the tax code,” by engaging in a broader tax reform effort that will eliminate the debt-equity distortion altogether. He suggested eliminating the deduction for interests, and allowing the deduction for corporate equity as one of the ways of eliminating the distortion. In an attempt to give good counsel to Congress, Fleisher intimated that in the event Congress is interested in moving quickly on reforms, focus should be placed on financial institutions because they have the “most excessive leverage” and “the failure of a systemically risky financial institution imposes enormous social costs.”
  • Desai: For Desai, three approaches to the debt-equity distinction—regulatory, structural and rate solutions—should be deployed.
  • Johnson Johnson recommended that the tax of equity should be lowered, and that there should be a move to a new or more integrated system of corporate taxation to get a tax code neutral for debt and equity.

Small Businesses

The common theme that run through the opening statements of the both Chairmen and both Ranking Members of the two committees was the fact that there was the need for a tax code that enhanced economic growth. Taking special cognizance of the fact that the main drivers for economic growth in the US are small businesses, these policy recommendations on transforming the tax code should be carefully studied and acted on in a bipartisan manner by Congress to ensure that, as the House Ways and Means Committee Chairman, Dave Camp (R –MI) put it, it makes America “a more vibrant competitor abroad and a more attractive place to invest and create the jobs we need here at home.”

Partisan Spectacle

Obviously, with the current impasse in relation to raising debt ceiling, congressmen could not resist the temptation of introducing politics into this bipartisan matter. Admitting that his comments had no bearing to the discussion at hand, Rep Levin (Ranking Member, House Ways and Means Committee), in his opening statement, reacted to statements attributable to Senator McConnell in which the latter is purported to have said that he had little question that as long as “this President” (in reference to Obama) is in the Oval office, even after years of discussions, and months of negotiations, the real solution is probably unattainable.” According to Rep Levin, in his judgment, Senator McConnell’s pronouncements politicize, and could poison the will for tax reform in the near future. “It also flies in the face of basic facts,” Levin remarked. Coming to the rescue of the President, Rep Levin said: “Obama inherited a debt that had risen under President Bush from 5.7 trillion to 10 trillion, and he inherited a record 1.5 trillion deficit that had wiped out the record surplus inherited by President Bush. President Obama has said very clearly that we need a balanced framework to reduce the deficit now and in the future, while allowing for immediate investments to promote economic growth and job creation.” Rep Levin concluded his reaction by saying: “it is not helpful to walk away from the table; it is not helpful to insist on an ideological agenda that cannot become law.”

Interesting Fact

According to the Congressional Research Service, Wednesday’s hearing was first time since 1940 that there has been this combined meeting between the House Ways and Means Committee and Senate Finance Committee on Tax issues.

[Reported by Fertaa Yieleh-Chireh]

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