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CTJ's Tax Justice Digest, July 27, 2007

Welcome to CTJ's Tax Justice Digest, our regular survey of new and interesting trends in state and federal tax policy. Click here tobrowse through archived editions of the Digest.


Crunch Time for Congress
With a week left before Congress adjourns for its August recess, several important tax issues are being either rushed along or rescheduled for the fall.
Alternative Minimum Tax
Among those items pushed back to September is the Alternative Minimum Tax reform plan being developed by the House Ways and Means Committee. While no actual bill has been released, it is known that the House Democrats want to exclude families with incomes of up to $250,000 a year (or $125,000 for singles) from the AMT, reduce the AMT for those between $250,000 and $500,000, and pay for the reform with a surtax on those with incomes above $500,000. Anti-poverty advocates are excited that the plan would also include improvements in the child tax credit and Earned Income Tax Credit. While there is some question of whether or not the President would sign such a bill, it's possible the White House would find it risky to veto a bill that saves millions of middle-income taxpayers from the AMT (which is scheduled to expand its reach from about 4 million to 23 million this year if Congress does not act) in order to protect the very wealthiest Americans, who have received most of the Bush tax cuts.
The Senate Finance Committee is said to be interested in simply passing a one-year or two-year "patch," or temporary extension of the exemption that keeps most people from paying the AMT. This would cost around $50 billion just for one year. Finance Chairman Max Baucus (D-MT) has implied that he might increase the federal budget deficit by this amount rather than find revenue to pay for it. The Finance Committee has not tried to introduce a bill before the August recess.
Carried Interest Tax Loophole
The House Ways and Means Committee has pushed back its plans to hold a hearing on the tax loophole for private equity "carried interest" until September. The loophole allows private equity fund managers to pay only the 15 percent capital gains tax on carried interest, which is the majority of their compensation in many cases, even though they actually don't make capital investments. The result is that fund managers making millions, even over a billion dollars a year, pay a lower tax rate than middle-income people. A bill introduced by Sander Levin (D-MI) (H.R. 2834) would close this loophole and tax carried interest as ordinary income. The industry has begun a fierce lobbying and PR campaign to defend this loophole, and CTJ has issued its own response to the deceptive claims being made.  
The Senate Finance Committee is currently considering a more limited bill (S. 1624) that would affect those private equity firms that are publicly traded partnerships, requiring them to pay corporate taxes like other publicly traded companies. Finance Chairman Max Baucus and ranking member Charles Grassley (R-IA) have indicated that they are interested in exploring the possibility of passing another bill in the future along the lines of the Levin bill. The committee held a hearing on the issue on July 11 and will hold another on July 31. Baucus expects to pass S. 1624 in the fall and consider a broader bill sometime after that.
State Children's Health Insurance Program (SCHIP)
Democratic leaders in the House and Senate hope to bring an expansion of the State Children's Health Insurance Program (SCHIP) to the floor next week. The Senate Finance Committee has approved a $35 billion expansion that would be funded by a 61 cent increase in the federal tobacco tax (bringing the tax to a dollar per pack of cigarettes). Many have pointed out that cigarette taxes are regressive, but others have argued that this is the only funding mechanism that will produce anything close to bipartisan agreement in Congress.
The House Ways and Means Committee worked into Thursday night and Friday morning to approve a broader bill (H.R. 3162) that would include a $50 billion SCHIP expansion and a 45 cent increase in the federal tobacco tax. The House bill also would end the federal government's practice of paying more for people using Medicare Advantage (HMOs within Medicare that tend to attract healthier people) than it does for traditional Medicare. The House Energy and Commerce Committee, which has jurisdiction over SCHIP, was also working on the bill as of this writing.
The President has threatened to veto this legislation, saying it represents an expansion of the government that will "crowd out" private insurance. The Center on Budget and Policy Priorities has pointed out that most of the children who would get health insurance under the bills are those who already meet the eligibility requirements but are not enrolled, and that the majority by far are children who would otherwise not have health insurance.
A Lower Corporate Tax Rate?
Loopholes Turn Corporate Tax into Swiss Cheese
The U.S Treasury has been causing some business investors heartburn this week by suggesting that some cherished loopholes in the tax code could be closed and the resulting revenue used to lower the corporate tax rate. The argument was made in a report published by the Treasury and then discussed at a conference yesterday. Among the tax subsidies mentioned were the research credit, which Citizens for Tax Justice has criticized in the past, as well as several others that we noted last week in our "Hidden Entitlements in the Federal Tax Code" feature. The report finds that loopholes reduce the Federal corporate tax base by around 25 percent.
It's certainly true that there are plenty of business-oriented loopholes in the tax code that need to be closed. As the report points out, many of these are quite inefficient and result in business decisions based on tax reasons rather than cost-effectiveness.
But it's not at all clear that the revenue generated by closing loopholes should be used to lower the corporate tax rate. If federal revenue is not increased at some point, Congress may have to cut public services that Americans from all walks of life depend on. Further, if the corporate rate falls far below the top personal income tax rate, this may encourage wealthy people to use corporate entities to avoid the personal income tax.
International Tax Avoidance Also a Major Issue
But the report does not address another factor that is seriously eating away at corporate tax revenue: tax avoidance associated with multinational firms involving transfer pricing. Transfer pricing is basically the accounting that must take place when divisions of a corporation that are based in different countries "sell" and "buy" products or services to and from each other. In theory, if an American division of a company buys something from its division in another country, then that purchase can be deducted for American federal tax purposes. The foreign division has revenue and may have a profit, but in theory, the foreign government will tax that profit.
The problem is that a multinational corporation can exploit this system. For example, it may transfer its patents and trademarks to a division in a low-tax foreign country with little transparency (a tax haven) and then have that division "charge" the American division for the use of these "intangibles." The accounting can be done in such a way that the American division appears to have no profits after making these payments, and all the profits appear to go to the division in the tax haven.
A recent report from the Hamilton Project of the Brookings Institution explains the inefficiencies in this system and cites a study finding that a 35 percent reduction in corporate tax revenue results. The report argues that the United States and its major trading partners should switch to a system in which a company's total global expenses and profits are calculated and then tax is apportioned to the various countries where it does business based on sales in each country.
The problems with the current system are evident. The New York Times recently reported on how drug companies are particularly likely to take advantage of transfer pricing. Eli Lilly, for example, only paid about 6 percent in U.S. federal taxes on its profits of around three and a half billion dollars last year.
State Tax Justice News

Tax Trouble in Indiana

Emotions were running high this week in Indiana during the state legislature's public property tax hearing.  Hundreds of people showed up to protest in what some say is the beginning of a tax revolt.  Protestors were angry over what they see as the unacceptable rise in property tax bills this year. Many speakers called the current property tax system "broken" and advocated drastic cutbacks in school spending, or even a complete repeal of the property tax system.  Just this week, Governor Mitch Daniels ordered that property tax levies in four counties remain at their 2006 levels until reassessments are conducted and the list of counties where reassessments will be ordered is expected to grow. Governor Daniels has hinted at a calling a special session to deal primarily with property taxes. Expect this raging debate to continue.


Tax Talk-Back in North Dakota

"Americans for Prosperity", a national anti-tax organization, has been gathering signatures for an initiative petition that would, if passed, cut the state income tax by 50 percent and the state corporate tax by 15 percent. The group is aiming to put the measure before the people on the November 2008 ballot.  This week former North Dakota Lt. Governor Lloyd Omdahl published an editorial criticizing the initiative. Mr. Omdahl noted that North Dakota is already a low-tax state, ranking 37th nationally. More importantly he also pointed out that North Dakota has real education needs and cutting taxes certainly won't provide students with the resources they need to learn.  Mr. Omdahl's editorial is commendable for pointing out so succinctly the folly of what he terms a meat axe approach to tax reform. 


Turmoil in the Land of Lincoln
Lawmakers in Springfield are setting records that they certainly can't be proud of. The Chicago Tribune reports that Wednesday marked the 55th day the state has gone without a budget ("a modern day record"). The government is operating under a temporary one-month budget for July, but a long-term budget is fiscally and politically necessary. There was great hope at the beginning of the 2007 legislative session that this would be the year the state's school funding problems were solved, but now there's little hope that more than a business-as-usual budget will be eventually agreed to.
Senate Democrats are promoting a 75 cent cigarette tax hike. Illinoisans are interested in a fully funded pension system, health care reform, and fixing the state's school funding situation, but a cigarette tax hike would hand the bill to those least able to pay. Apparently, powerful Senate President Emil Jones has again come out in favor of an income tax increase for school funding, but according to this article the legislature may continue to put off this progressive solution.
Corporate Tax Reform in New Hampshire Friendlier to In-State, Mom-and-Pop Businesses

Late last month, New Hampshire adopted legislation that could serve as a model for other states seeking to modernize their corporate income taxes.  As part of their biennial budget process, Granite State lawmakers approved a change in the way they decide which multi-state companies are subject to the state's business enterprise tax, moving from a standard based on "physical presence" to one based on "economic presence." This change may sound esoteric, but it's important because the "physical presence" standard leads to all sort of strange outcomes, including advantages for huge out-of-state corporations that do business with state residents over the locally owned businesses that operate entirely within the state. 

Changing this standard (also known as "nexus") to one based on economic presence will help New Hampshire ensure that corporations that take advantage of the economic market the state fosters - its transportation infrastructure, judicial system, and educated workforce - will pay their fair share in taxes, even if they don't have offices or factories in the state.  In fact, as we previously noted in our Talking Taxes blog, the US Supreme Court earlier this year declined to hear two cases - Lanco and MBNA - in which New Jersey and West Virginia had subjected companies to business taxes because they had substantial economic presence in the state.  For more information on the "physical presence" standard and how it can harm state residents, see the ITEP paper on this topic.


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