Tax Reform: What to Expect From the New Congress

U.S. Capitol. Source: Wikimedia Commons.

When it comes to taxes, just about the only thing that gets bipartisan support is the idea that the existing tax laws need major reform. How those reforms will take shape, though, could help define not only what taxpayers have to deal with in the coming years, but also the political climate going into the 2016 presidential election. Now that Republicans control both the House and the Senate, the question many people are asking is whether the new Congress will take a different tack on some of the most controversial areas needing tax reform. In particular, three specific tax provisions are likely to get the most attention from a Congress seeking to move forward with its legislative agenda over the next couple of years.

1. Congress wants to find a way to lower corporate tax rates.
At first glance, the area where Congress would seem to have the greatest chance of achieving one of its primary goals is in corporate taxes. Both Republican Congressional leaders and President Obama have advanced proposals that would reduce the current top corporate tax rate of 35% by anywhere from 7 to 11 percentage points, helping to alleviate what is currently the highest corporate tax rate among the nations with the largest economies in the world.

The challenge, though, is reconciling how the proposals seek to lower corporate tax rates. The White House proposal would cut top rates to 28% while removing perceived loopholes that allow substantial amounts of corporate income to go untaxed, and it also seeks to favor domestic manufacturers with preferential tax rates of just 25%. Meanwhile, a proposal from House Ways and Means Committee Chair Dave Camp suggested a 25% rate to be phased in gradually over a five-year period, with intricate changes in the treatment of many different current tax breaks for businesses, ranging from the elimination of percentage depletion in the energy industry and the like-kind exchange gain-deferral rules to changing available accounting methods to spur greater recognition of taxable income. On its face, those two ideas sound similar, but the specific ways those and other proposals seek to keep their overall impact revenue-neutral are major potential sticking points.

Russell Senate Office Building. Source: U.S. Senate.

2. Congress would like to solve the international tax mess.
One of the reasons corporate tax reform has become so important is that the tax treatment of multinational corporations has become a huge issue. The upsurge in the number of tax-motivated transactions, especially the newly popular tax inversion strategy that many U.S. companies have used to shift their tax homes to more favorable foreign jurisdictions, has turned the foreign tax system into a patriotic debate. Companies as big as Apple (AAPL 0.64%) and Microsoft (MSFT 1.65%) have kept tens of billions of dollars in foreign subsidiaries rather than repatriating their profits and paying the resulting corporate tax, and policymakers would prefer to remove that artificial incentive and get more capital back into the U.S. for reinvestment.

Again, though, the tactics involved will pose a problem between Congress and the White House. One option is simply to grant another repatriation tax holiday, temporarily reducing the corporate tax rate on repatriated profits in order to spur companies to make one-time transfers back into the domestic side of their businesses. Yet even though several technology companies have pushed for exactly that result, a past tax holiday a decade ago showed how while such a move can temporarily alleviate the problem, it doesn't really address the core issue.

Source: Office of the Taxpayer Advocate.

To address tax reform head-on, lawmakers will have to decide whether it's better to seek to expand U.S. taxation to cover worldwide income of U.S. multinationals regardless of where subsidiaries are located, or to impose a territorial system whereby foreign income is entirely free of U.S. tax, but associated costs are also not deductible for U.S. tax purposes. The current hybrid system in some ways gives corporations the best of both worlds, but in combination with a corporate tax rate decrease, moving to a territorial system is more in line with the way most countries around the world have handled their foreign taxation. Whatever solution it chooses, Congress can expect plenty of opposition from those who'd be adversely affected by its provisions.

3. How Congress hopes to cut individual income taxes.
One of the key goals for a Republican Congress will be to restore the lower individual tax rates that expired at the end of 2012. With top-bracket taxpayers paying as much as 43.4% when you add in surtaxes imposed by the Affordable Care Act, restoring the Bush-era top tax rate of 35% would be a huge victory for Congress. Yet with increasing awareness of income inequality, the general population remains sharply divided on whether tax hikes or cuts are the better policy.

Source: John Morgan via Flickr.

Representative Camp's tax proposal seeks to simplify the individual tax code, with three brackets of 10%, 25%, and 35%. Higher standard deductions will help to keep taxes low for those at the bottom end of the income spectrum, but the proposal would eliminate huge swaths of existing deductions, including state and local taxes, medical expenses, and personal exemptions. It would also reduce eligibility for the mortgage interest deduction and cut maximum Earned Income Tax Credit amounts. Yet even Camp's Republican peers didn't seem enthusiastic about the proposals.

The big question for individual tax reform is whether lawmakers and the president can agree to the same grand compromise that resulted in the 1986 tax reforms. Those reforms used the same combination of lower rates and reduced tax breaks to spur both sides to the bargaining table. Given current popular opinion, Congress will have to convince many Americans that eliminating tax breaks for high-income taxpayers will at least offset any reduction in the marginal tax rates they pay on their income.

The new Congress has a tall order in facing tax reform. If it succeeds, though, then it will defy expectations of gridlock for another two years and restore confidence in the American tax system -- and perhaps help promote a strong U.S. economy along the way.