Tax reform Frank Capra style

With Republicans taking control of the Senate there has been talk of tax reform as a potential area where the Obama administration and the Republican controlled Congress can agree.  There is a widespread view that the Internal Revenue Code is in need of reform. Previous efforts at tax reform by Congress, however, have created a complex, inefficient and inequitable federal tax system.  

While past tax acts often are replete with reference to “tax reform” or nomenclature like “jobs creation,” they generally serve neither to truly reform the tax system or create many American jobs. One must therefore be wary of tax reform that would continue this pattern. Imagine, however, if the next round of tax reform were crafted by those who embody the ideals of Senator Jefferson Smith, portrayed by Jimmy Stewart, in the 1939 movie classic directed by Frank Capra, “Mr. Smith Goes to Washington.”  

{mosads}In the movie, Senator Jefferson Smith is an idealistic young senator who in an effort to establish a national boys’ camp takes on Jim Taylor, the corrupt businessman whose tentacles in Congress include those of the Senator Smith’s home state mentor, Senator Joseph Paine. The boys’ camp proposal endangers Taylor’s dam building graft scheme. Smith’s reputation is shattered by Taylor’s political machine but the movie has a happy ending when Senator Paine has a pang of conscience and confesses to the shenanigans. 

Business tax reform that a Senator Smith would approve would presumably be aimed at broadening the base, reducing the high statutory corporate tax rate as well as the complexity and inequity in the current Internal Revenue Code. Such tax reform would serve to increase efficiency, promote job creation in the United States, and use additional revenue to both rebuild our infrastructure and reduce the national deficit. 

This type of tax reform could include the taxing of all business income the same way, whether earned by a corporation, partnership or sole proprietorship at a relatively low rate of tax, perhaps 25%.  Currently generally only “C” corporations pay tax at the entity level. This kind of reform would broaden the base significantly and, among other things, simplify the current Byzantine system for taxation of partners. To address the fact that business income, other than that of “C” corporations, is generally currently taxed only once at the individual level, reform could encompass a recent proposal by Professors Michael Graetz and Alvin Warren to include some amount of shareholder credit for income tax actually paid at the corporate level. This would replace the low rate of tax currently imposed on “qualified dividends” that applies whether or not the corporation paying the dividend actually paid any corporate level tax. This credit should apply to all business income regardless of what type of entity is utilized. 

On the international side, instead of embracing a territorial taxation and/or a significant tax holiday on existing offshore foreign earnings, tax reform could include a provision taxing currently all income of businesses, with a potential foreign tax credit offset, to minimize or eliminate duplicative taxation whether earned in the United States or by a foreign subsidiary. This would replace the current approach of not taxing most earnings of foreign subsidiaries until if and when they’re distributed to their United States shareholders. There could be a small rate difference, e.g., 10 percent – 20 percent, for offshore earnings to help address the problem of U.S. multinationals not being competitive with foreign corporations headquartered in countries utilizing a territorial tax regime. Countries with a territorial tax system generally exempt non-home country income from tax.  

Alternatively, business tax reform in the international area could instead serve to strengthen the existing rules of subjecting passive and highly mobile earnings of certain foreign subsidiaries to current taxation. Under this system, earnings of foreign subsidiaries that pay a foreign income tax at less than a certain level, e.g.,  80 percent- 90 percent of the U.S. tax rate would be subject to immediate taxation. The legislation should also include provisions discouraging corporate tax inversions. These steps would serve to promote job creation in the United States and hinder further U.S. tax base erosion made possible through related party transfer pricing and otherwise. 

Life and tax policy is not as black and white as the movie, “Mr. Smith Goes to Washington.” Nevertheless the country will be best served by those in Congress who can be moved like Senator Paine to eventually do the right thing. 

Cohen is associate professor of Taxation at Pace University’s Lubin School of Business and a retired vice president-Tax & General Tax Counsel at Unilever United States, Inc.  The views expressed herein do not necessarily represent those of any institution that he is or has been associated with.