Effective tax rate test for reform

It turns out tax reform is alive after all. House Ways and Means Committee Chairman Dave Camp (R-Mich.) literally put the issue on the table recently when he unveiled a discussion draft of his plan to overhaul the nation’s tax code.  When the chairman of the House’s tax-writing committee puts his name on a major initiative like that, the proposal by definition is serious.

But the draft, by Camp’s own admission, is still a work in progress. That’s a good thing since it could certainly be improved. In particular, several of its provisions need to be revised with one overriding concept in mind: the effective tax rate.

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The effective tax rate is the amount that’s actually paid in taxes by an individual or a company. It is, therefore, quite literally the bottom line for tax reform.

To ascertain the winners and losers in any tax proposal all that’s needed is to calculate whether the total amount of taxes paid under the plan is less than or more than the amount that’s being paid under existing law. Going straight to the bottom line – the effective tax rate – is especially important with tax reform, which has a dizzying mixture of lower tax rates and reduced or eliminated tax preferences.

In the broadest sense, Chairman Camp’s plan is bold and welcome. It is, correctly, revenue neutral, meaning that it neither raises nor loses revenue compared to the current tax system. It is also comprehensive because it deals with both corporate taxes and the taxes paid by individuals.

In structure, his plan is exactly the kind of reform that can fix the broken tax code. It lowers tax rates by eliminating tax preferences. It also overhauls the laws that affect all types of businesses – both corporations and the far larger number of businesses known as pass-throughs that pay taxes using the individual tax-rate system.

The Camp draft goes a long way toward simplifying the corporate income tax and making it apply more fairly across different industries.

But it does not adequately address a glaring shortcoming of the current tax system: the disparities in effective tax rates paid by different types of businesses, especially pass-throughs. Why should two companies in the same business pay different effective tax rates simply because one is organized as a corporation and the other as a pass-through? They shouldn’t, for fairness’ sake.

The draft’s complicated set of exemptions, surtaxes and wide disparity between the top tax rate for pass-through businesses and corporations, in fact, would only exacerbate the already wide variance in effective tax rates paid by different industries.

For example, the retail industry, the second largest private-sector employer in the U.S., is taxed at an effective tax rate that is significantly higher than many other industries. Some retailers, even the largest of them, tend to have effective tax rates in the 30 percent range. This contrasts sharply with other industries whose effective tax rates are often in the teens or lower.

The Camp plan also creates brand new disparities between and among pass-through businesses. It gives a lower rate to manufacturing pass-throughs but not to other pass-throughs such as retail, wholesale distribution or service companies. Clearly, that’s unacceptable as well.

Such plan’s favoritism toward pass-through manufacturers adds complexity to a proposal that’s supposed to make the tax code simpler. The Camp proposal is rife with these new complexities.

The best and easiest way to make sure the next iteration of reform is a success is to view it through the lens of effective tax rates. Chairman Camp and other lawmakers need, in fact, to use effective tax rates as a chief way to achieve comprehensive reform for all types of businesses.

Reliance on the metric of effective tax rates will strengthen the economy by replacing today’s government-selected winners and losers with a leveler playing field. It will also bolster the effort to enact revenue neutral tax reform that broadens the tax base while lowering tax rates for corporations, pass through businesses and individuals alike.

Disparate and high effective tax rates – of the kind that the current code allows today – hinder job creation, economic growth and the competitiveness of American businesses. Simplifying the tax code in a way that reduces effective tax rates and narrows the effective rate disparity among industries and business types is the key to composing a reform that works for everyone.

Danner, president of the National Federation of Independent Business, is co-chair of the Coalition for Fair Effective Tax Rates.