The Coming Storm: How Business Can Prepare for Federal Income Tax Reform
By Clint Stretch
Illustration By Jonny Mendelsson 
The current system is too complex, but many specific complexities are vigorously defended by those whose tax bills are lowered as a result. Closely related to the U.S. tax system’s inability to raise revenue in a sustainable fashion is its unacceptable complexity. Most all of the complexity comes from one of three sources: • The desire of Congress to give, and taxpayers to receive, better tax treatment than would occur under a theoretically pure system. These provisions include broadly utilized rules such as choices in inventory methods, the research and development credit, capital cost recovery rules, and deferred compensation provisions. They also include a host of narrowly available or industry-specific exceptions to general tax rules. • The desire to provide taxpayers with choices. For example, the U.S. system provides at least 18 different savings vehicles explicitly focused on retirement. • The necessity to provide consistent tax answers for economically equivalent transactions. This is the source, for example, of rules for the taxation of interest-free loans and original issue discount. Demographic changes will require re-examination of key tax assumptions. Changes in population demographics will also create pressures for change in the current system. By 2050, 35 percent of the U.S. population will be retirement age. This change is coming relatively rapidly, starting in just a few years as baby boomers begin to retire. These shifts will call into question current tax policies. For example, present law provides “marriage penalty” relief for most married couples. The necessary result of these rules is that the tax on a single person is substantially higher than that on a married individual earning the same income. As the population ages, an increasing number of widows and widowers may begin to question a perceived bias in favor of young married couples at the expense of the elderly. Similarly, declining numbers of families and smaller family size could reduce political support for child credits and education subsidies. The income of these retirees typically is composed of a relatively larger share of investment income, which is currently subject to favorable rates. To the extent that the system continues to favor investment income, shifts in relative tax burdens within income classes and between income classes and an inherent erosion of the tax base will occur. At the same time, of course, these retirees will bring with them significantly increased demand for health care and other federal, state and local services. Not Your Father’s Tax Reform Many seem to expect that when Congress and a new administration address these pressures on the tax system, they will look to another 1986-style reform in which lower rates were exchanged for a significant broadening of the tax base. We do not think that can happen. The conditions that allowed the Tax Reform Act of 1986 to occur do not exist. In 1986, the formula of lower rates and a broader base without a tax increase or decrease was broadly accepted. Today, we have none of those core agreements from which to build. Conservatives, moderates and liberals are far apart in their views about both the size of the federal government and the revenue needed to support it. They are similarly far apart on what kind of tax system ought to produce whatever revenue the government needs. While some would completely replace the income tax with a national sales tax or a consumption tax, others would institute a comprehensive income tax with virtually no preferences, incentives, or special exclusions. In addition to the philosophical splits that exist, even pragmatic reformers are troubled by the reality that the 1986 reform did not survive. After 1986, rates went up and significant new incentives were introduced. Although the case is probably overstated, one must be sympathetic with those who say the Internal Revenue Code is worse today than it was in 1985.  “By 2050, 35 percent of the U.S. population will be of retirement age. This change is coming relatively rapidly starting in just a few years as
baby boomers begin to retire. These shifts will call into question current tax policies.” When we draw back from the details of the coming debate, we believe that a likely outcome will find taxes restructured in three distinct pieces. For individuals, tax rates — including capital gains and dividend rates — are likely to increase, but not significantly above the levels that existed at the end of the Clinton administration. Top ordinary tax rates have not exceeded 40 percent since 1986. The tax rate on capital gains has been 25 percent or less for 42 of the 63 years that have passed since the end of World War II. We believe that a majority consensus has emerged in support of a ceiling on tax rates no higher than those historical levels. For business, income tax rates will come down substantially to bring the United States in line with other major jurisdictions. That said, total taxes on business are more likely to increase than decrease. Congress will look both at repealing important existing incentives that economists say distort economic choices and at perceived abuses in international tax that some say favor investment offshore. After all the politically achievable modifications to individual and corporate income taxes are made, Congress likely will not have enough revenue to do all that we ask of the federal government. That will force consideration of an additional federal levy in the form of some kind of a consumption tax. The question will be whether the tax will be a broad-based consumption tax burdening the purchase of most goods and services or whether it will be more narrowly focused on specific forms of consumption such as consumer goods, energy or carbon. What Does This Mean for Global Business Leaders? Although looking straight ahead at the tax and spending challenges of the next decade is sobering, there is some cause for optimism. If the United States moves quickly to address these issues, the impact on global business will be positive. Moreover, the United States is not alone in its challenges. The other more developed nations and China all face sharp increases in the share of their population that is age 65 or older. By 2050, half of the population of Europe will have reached retirement age. If the United States can move quickly and effectively to address its budget outlook, then U.S. businesses stand to reap the rewards of a relative advantage. This potentially dramatic level of change creates both risks and opportunities that business leaders must manage effectively. These risks and opportunities may arise in any of three areas of the business — tax, operations or sales — and during any of three episodes of reform — short-term PAYGO-related reforms, active consideration of comprehensive reform, and implementation of new or modified tax regimes.  “...efforts to increase revenue from individuals would necessarily involve attacking enormously popular incentives such as the mortgage interest deduction, state and local tax deductions, and exclusions for employer-provided medical insurance.” Although it may be tempting to wait until the options are clearer before starting to manage this process, delay would likely be a mistake. Previous major tax restructurings and reforms have happened relatively quickly. The 1986 reform started in earnest with a May 1985 Treasury report and ended in October 1986 when President Reagan signed the new law. Businesses that wait for the threat to emerge will find that even an 18-month legislative process effectively forecloses many of their options. The first step in assessing risks and opportunities will be a solid understanding of those key aspects of present law upon which the business relies to minimize tax liability or to drive sales. Obviously, therefore, effectively managing risks and opportunities will require involvement from more than the tax department. Business unit leaders throughout the organization — from HR to product design to procurement — may have important contributions to make. Attachments
The Coming Storm (380 KB) 
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