It’s been a whole career since tax reform last passed (1986). But on Sept. 27, 2017, the House Ways and Means Committee got the ball rolling by releasing its Unified Framework for Fixing Our Broken Tax Code
. A lot has been said about lowering the rates and broadening the tax base. Kevin Hassett, chair of the Council of Economic Advisers, has been a proponent of lowering the rate and broadening the base. The concept here is tax elasticity – the degree to which the economy responds to a change in the tax rate. The framework, in essence, calls for lowering the corporate and individual tax rates for the purpose of stimulating the economy.
The phrase “to create jobs” is ubiquitous among the proponents of stimulating the economy. As of this writing, the September unemployment figure of 4.2 percent is below what is commonly defined as full employment: 5 percent. To follow through on the logic, if we stimulate the economy to create more jobs, who will fill those jobs? The baby boomers are retiring, and the demographic trend points to fewer workers, not more.
When a stimulated economy creates growth and new jobs, but enough workers are not available to accommodate the demand, traditional economics says inflation in labor costs will happen as employers bid up the cost of labor. We should then expect some inflation with this scenario.
In some industries without enough people to fill jobs, employers may use available cash to invest in automated production capacity to meet demand without hiring. That investment in productive capacity will be further incentivized by a planned 100 percent expensing of investments in productive capacity called for in the House Ways and Means framework. The concept of 100 percent expensing is important, because the tax shield of depreciation is instant. The result is the tax shield becomes a component of the financing of the investment. Normally, depreciation is spread out over five or seven years. By expensing capital investment all at once, the tax shield comes home to roost in lower estimated payments and tax bills in the year of investment. So, if you spend $1 million at a 35 percent tax rate, you really only have to finance $650,000, or 65 percent. That shield drops to 20 percent if the proposed tax rate reduction for corporations is enacted.
Another high-profile provision of the tax proposal is the repatriation of foreign earnings. According to the framework, two rates may be applied to the amounts deemed repatriated – one for earnings and profits invested in liquid assets and one for illiquid assets. That provision must have corporate international tax directors quaking, because they will have to reconstruct foreign earnings and profits, and then apply whatever liquid vs. illiquid test that is drafted to those earnings and profits. That’s considerable work for a multi-national with a lot of foreign subsidiaries.
One of the proposal’s objectives is to get companies to repatriate some of the trillions of foreign earnings that are parked offshore. Proponents say it will provide an infusion of tax revenue to the government that can be spent on infrastructure. According to the framework, a reduced rate of tax will apply to the repatriated earnings, and the act of bringing cash back in the future won’t be taxable due to a 100 percent exclusion of foreign dividends paid to U.S. parents who own at least 10 percent of the foreign subsidiary.
A detail that is lacking is how the foreign tax credit will work. Let’s say a company has $100 of foreign taxable income and it pays $22 of foreign tax on that income. That leaves $78 that could be repatriated. If the U.S. repatriation tax rate is 20 percent, here is how the math works: $78 x 20% tax rate = $15.60 in tax.
The $78 carries “deemed paid tax” with the dividend deemed repatriated, so the $15.60 in tax is erased by the foreign tax credit. That results in zero tax revenue to the government and maybe some carry-forward foreign tax credit to boot. If the foreign tax credit is limited in the repatriation, then the effective tax rate on the foreign earnings is increased, not reduced. The example ignores the dividend gross-up under IRC Section 78 for simplicity.
What if the foreign tax credit is limited in the tax legislation that is ultimately drafted? Companies still may not pay any tax because of the use of domestic net operating losses. If the company was successful in earning foreign income, rather than domestic income, the company is likely to have domestic losses and foreign profits. Again, the companies may end up paying little if any taxes, and there will be no windfall to the federal government.
A rarely discussed consideration in this repatriation idea is whether companies actually are parking the money offshore for tax purposes. The reason why companies are not required to provide U.S. federal income tax on foreign earnings within their tax provision is the “permanent reinvestment” assumption. That means companies leave cash offshore because offshore is the location of future growth. One company likes to talk about its next billion customers. Those customers are not in the United States. If companies leave cash offshore because that is where their future markets are, companies may not repatriate cash.
One very important item to note is the U.S. government’s deficit spending and the growth in its insolvency. With $3 trillion in assets and roughly $22 trillion in liabilities, the government’s insolvency has risen to a level of strategic weakness. That debt number doesn’t include the present value of the social funds liability, which is in the $50 trillion to $80 trillion range. Whichever tax reform plan is eventually adopted, it must not make the insolvency of the U.S. government worse.
A big stretch is coming if Congress shows a willingness to bet on tax elasticity, particularly in light of the fact that there are not enough workers to make the growth assumption work. The Washington sales machine will say the proposal will help working families or will fund the replacement of substandard infrastructure. But as CPAs, we must look past the pitch and analyze the unbendable numbers.
Edward R. Jenkins Jr., CPA, CGMA, is an instructor of accounting at Pennsylvania State University in University Park, a tax consultant for Boyer & Ritter LLC in State College, and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.