Tax plans a step forward but 3 key flaws remain

The House has passed tax reform legislation, and the Senate is working through similar tax reform legislation. Both are a reasonable start, but both grapple with several deficiencies that need to be corrected to maximize economic effectiveness and maintain fair competition.

Proposed tax reform should seek to simplify the tax code while eliminating tax inequalities across sectors and within tax brackets.

{mosads}Tax reform is critical to bolstering potential growth, simplifying the tax code and increasing global competitiveness, while promoting job opportunity and productivity. Simplification can reduce compliance, enforcement and administrative costs, while limiting tax avoidance.

Tax and regulatory reform combined with spending reform is needed for broad fiscal reform to reduce the deficit by growing tax revenue faster. A federal budget that also reduces spending by $1.5 trillion provides for greater tax reform flexibility without increasing the deficit. Treasury debt of $20 trillion, now exceeding 100 percent of GDP, is unsustainable, particularly as interest costs begin to rise.

We recently wrote about 10 fundamental principles to reforming taxes in “What to Expect from Tax Reform.” The first principle is that income taxes should be assessed only on retained income. It is a conservative principle to avoid double taxation of levying tax by two or more jurisdictions on the same declared income.

Earnings to pay government taxes, including state and local income or property taxes (SALT) should be fully deductible from income. Why should earnings to pay income or property taxes be taxed again? Neither geography (high cost of living), nor state tax policies (split between income vs. property or sales tax), should matter.

A second principle trampled in proposed tax reform is maintaining equality between businesses, promoting fairer competition and lowering barriers to entry. Tax rate variances between large vs. smaller (S-corp. or pass through) companies already competitively disadvantage smaller companies, as well as increase barriers to entry, stifle innovation and encourage consolidation.

Both House and Senate versions materially limit or exclude tax cuts in different ways for at least 85 percent of pass-through businesses, even to the proposed higher 25-percent tax rate, while lowering large companies from 35 percent to 20 percent.

Corporate tax reform should apply equally, and effective tax rates should be similar for all businesses, irrespective of tax accounting choices or types of businesses (i.e., services versus manufacturing).

If tax reform drives a wider gap in tax rates between larger and smaller companies, then smaller companies that are the engine of job growth and opportunity will be competitively disadvantaged. A tradeoff of slightly higher tax rates than 20 percent for corporations is better than excluding so many businesses or delaying tax cuts.

We appreciate concerns of potential salary tax avoidance in income pass-through businesses, but this can be better addressed by imposing requirements for multiple revenue sources and material cost of goods sold, which provides evidence of qualified businesses.

A wide majority of small businesses can’t support tax reform because it adversely affects so many — 80 percent of American businesses are pass-through entities. Including more small businesses under the umbrella of corporate tax reform is consistent with tax reform objectives, and increase support.

Finally, a third principle is that our conceptualized “Repatriation Tax Curve,” suggesting an intuitive behavioral relationship between tax rates and repatriation rates, implies an optimal foreign earnings tax rate of 10 percent versus the current 35 percent, which should encourage rapid repatriation, thereby bolstering domestic investment, while raising revenue.

If after five years, unrepatriated earnings of $3 trillion have not diminished or corporate inversions not subsided, then reconsider even lower tax rates. More than 90 percent of earnings should repatriate given cost of capital and associated country or currency risk of predominately technology, pharmaceutical and industrial companies.

Loss of future tax-free foreign income costs $205 billion (over 10 years), or two-thirds of the cost for expanding the umbrella of small-business tax cuts. A permanent 10-percent repatriation tax would add ongoing tax revenue to offset including tax cuts for excluded small businesses.

All three of these deficiencies in fundamental tax reform principles should be adopted within final legislation. Tax reform under Presidents Kennedy, Reagan and Bush highlighted many economic lessons, including demonstrating increased potential growth and global competitiveness that drove higher tax revenue and limited inflation.

Experience also demonstrated the importance of permanent changes versus sunsets or phasing in policy changes. Simplifying the tax code also makes AMT irrelevant.

Thus, any resemblance to historically key fundamental tax reform principles should increase real potential growth by 0.5-0.7 percent and add 1-2 percent to long-term earnings growth. Broad tax reform has potential to add dramatically greater tax revenue than Congressional Budget Office scoring assumed.

David Goerz is CEO and chief investment officer of Strategic Frontier Management, LLC, which is a registered investment advisor focused on global asset allocation and investment strategy.