Testimony of Pamela Olson Assistant Secretary (Tax Policy)
Testimony of Pamela Olson Assistant Secretary (Tax Policy) United States Department of the Treasury before the Senate Committee on Small Business and Entrepreneurship
Madam Chair:
I appreciate the opportunity to appear before you today to discuss current tax issues affecting small business manufacturing in a global market.
Small business and the global market — two cornerstones of the U.S. economy in the 21st century. The millions of entrepreneurs who spend their time, energy, and resources pursuing ideas, taking risks, and creating value are instrumental to job creation and the growth of our economy. Globalization – the growing interdependence of countries resulting from increasing integration of trade, finance, investment, people, information and ideas in one global marketplace – has resulted in increased cross-border trade, and the establishment of production facilities and distribution networks around the globe. Technology will continue to accelerate the growth of the worldwide marketplace for goods and services. Firms in this global marketplace differentiate themselves by being smarter: applying more cost efficient technologies or innovating faster than their competitors. The returns are much higher than they once were as the benefits can be marketed worldwide.
Small business has been fundamental to the United States throughout our history, but only in recent decades has the global marketplace acquired the prominent role it now occupies in the U.S. economy. In 1960, trade in goods to and from the U.S. represented just over six percent of Gross Domestic Product (GDP). Today, trade in goods to and from the U.S. represents over 20 percent of GDP, a three-fold increase, while trade in goods and services represents more than 25 percent of GDP today. While large multinational corporations still dominate U.S. trade, in this era of globalization international markets are becoming increasingly important to small business as well. Even small manufacturers who are not themselves selling abroad are more frequently involved indirectly in the global marketplace by supplying their wares to larger businesses who are competing on the international stage.
U.S. tax policy has important effects on both small business and the U.S. role in world markets. In both contexts, the basic role of tax policy is to raise needed government revenue in ways that pose as little burden as possible on taxpayers and that keep distortions to private economic decisions to a minimum, based on the belief that individuals and businesses know better than the government how to make the most out of the limited resources at their disposal. To foster the small business economy, this Administration is committed to easing unnecessary restrictions, reducing taxes, and streamlining burdens. In international taxation, the ideal tax system should seek to minimize distortions to trade or investment relative to what would occur in a world without taxes. While it is impossible for the U.S. to level all playing fields simultaneously, we can ensure that our own rules minimize the barriers to the free flows of capital that globalization necessitates.
Small Business
With these principles in mind, the Administration, with the help of Congress, has taken significant steps to ease the tax burden on small businesses across the board, in manufacturing and in other industries, those producing for the world market and those focused on the local economy.
· In the past two years, personal income tax rates have been cut by 3 to 5%, relief has been provided for the marriage penalty, the 10-percent tax bracket broadened, and the child credit expanded. These changes have benefited 23 million small business owners, leaving them with cash for further investments and job creation. Because most small businesses are flow-through entities (S corporations, partnerships, or sole proprietorships) and pay taxes at the individual rates of their owners, these reductions in personal tax rates have also been, in effect, reductions in small business tax rates.
· Small business in all forms of organization can benefit from the expansion of small business expensing (section 179). The amount of investment that may be immediately deducted by small businesses was raised from $25,000 to $100,000, and the limit at which expensing phases out was lifted from $200,000 to $400,000, increasing the number of taxpayers qualifying for expensing.
· Lowering the dividend and capital gains rates reduces the role of taxes when small businesses are choosing the type of entity in which to operate their business. The partial relief from the double taxation of dividends will make the use of C corporations more available to small business owners.
· Phasing out the estate tax allows innovative entrepreneurs to pass their life’s work to their children, not to the government.
Unfortunately, all these initiatives are scheduled to expire by the end of 2010. Making them permanent would be one of the best things that could be done for small business. It would eliminate one area of uncertainty as small business attempts to plan for the future and keep the tax burden as low as possible on this productive segment of our economy. Madam Chair, your proposal that the deduction for small business expensing phase out at fifty-cents for each dollar of excess investment, rather than dollar for dollar as under current law, would also improve the provision by reducing the investment disincentive as the deduction phases out.
Although these legislative actions have provided much needed tax relief to small businesses, the complexity of the tax laws continues to plague small business owners. Our tax laws have become devastatingly complex in recent years. Many small business owners are unprepared to deal with this complexity and do not have the resources to hire sophisticated tax counsel to advise them. Tax law compliance drains the time, energy, and financial resources of small business owners and diverts their attention from the more important goal of building a business.
Recognizing the need for simplification, the Treasury Department has undertaken initiatives not needing legislative action to decrease burdens on small business. For example, last year, the IRS and Treasury issued a revenue procedure permitting certain businesses with gross receipts of less than $10 million to use the cash method of accounting. We expect that the revenue procedure will eliminate most disputes concerning the use of the cash method by small business taxpayers, allowing those taxpayers to focus on growth, not tax compliance. Another step taken last year was to exempt 2.6 million small corporations from filing Schedules L, M-1 & M-2, reducing burden by 61 million hours annually. [1] Treasury will continue to work with the IRS to find ways to reduce the burden of recordkeeping, filing, and complying with the tax laws.
Global Marketplace
On the international side, many areas of our tax law are in need of reform to ensure that our tax system does not impede the efficient, effective, and successful operation of U.S. companies and the American workers they employ in today’s global marketplace. The pending repeal of FSC/ETI and its replacement with one of the measures currently under consideration in Congress will bring the United States into compliance with the World Trade Organization’s ruling on export subsidies. It will not, however, ensure that our businesses, including small businesses that export, remain internationally competitive or that our tax system fosters efficient business structures and operations. To secure the future success of U.S. businesses on the world stage, we need to look beyond the current legislation and give careful consideration to the following areas.
Integration. The partial relief for dividends and capital gains enacted in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) represents an important step towards removing the double tax on corporate income and lowering the cost of corporate capital. Before JGTRRA, the United States was one of the few industrialized countries that failed to provide some form of integration of corporate and individual income taxes. With this partial integration, investment projects will be more profitable and better able to attract corporate equity capital. Nevertheless, taxes on equity investments in the corporate sector will remain higher than they would be under a fully integrated system. In the context of competitiveness, this may mean that a project that would otherwise be undertaken by a U.S. company, either at home or abroad, is instead undertaken by a foreign competitor. An additional concern is that the present relief from the double tax is scheduled to expire at the end of 2008. Making permanent the present relief from the double tax for dividends and capital gains would help ensure the competitiveness of U.S. companies.
R&D Credit. The President’s Budget proposes to make permanent the research and experimentation tax credit. Research is central to American businesses’ ability to compete successfully in the global economy. It results in new processes and innovative products that open up new markets and create job opportunities. American businesses can continue to compete only if they stay at the forefront of technological innovation. The research credit encourages technological developments that are an essential component of economic growth and a high standard of living in the future. A permanent research credit would remove uncertainty about its availability in the future and thereby enable businesses to factor the credit into their decisions to invest in research projects. The complexity of the credit creates another source of uncertainty. Taxpayers are often not sure whether particular activities will qualify for the credit, and significant taxpayer and IRS resources are needlessly consumed by controversy. Consideration should be given to simplifying the credit to create greater certainty for taxpayers.
Depreciation. The current system of tax depreciation merits reevaluation. Inappropriate depreciation rules can hinder the competitiveness of our businesses by tilting investment away from profitable areas into less productive endeavors. This can pose a particular burden, for large and small businesses, in capital-intensive industries such as manufacturing. The 2000 Treasury Report to Congress on Depreciation Recovery Periods and Methods identified a number of issues that represent potential avenues for improving the tax system, and may warrant further study.
One such issue is that the current system lacks a firm conceptual rationale. For example, it does not reflect inflation-indexed economic depreciation. This means that tax depreciation allowances can deviate significantly from those required to measure income properly and from those that would provide a uniform investment incentive for all assets. A second issue is that the current system is dated. The asset class lives that serve as the primary basis for assignment of recovery periods have remained largely unchanged since 1981, and most class lives date back at least to 1962. Entirely new industries have developed in the interim, and production processes in existing industries have changed. A third issue is that the current depreciation system suffers from an ambiguous system for determining each asset’s cost recovery period. This ambiguity contributes to administrative problems, makes it difficult to integrate new assets and activities into the system rationally, and inhibits rational changes in class lives for existing categories of investment. Finally, in addition to these broad issues, the existing system is hampered by a number of narrower controversies, including the proper determination of the recovery period for real estate, the possible recognition of losses on the retirement of building components, and the presence of cliffs and plateaus in cost recovery periods that distort the relationship between economic life and tax life.
Corporate AMT. The corporate alternative minimum tax (AMT) is known in some circles as the anti-manufacturing tax. It is an alternative tax system to the regular tax system. (Small corporations with gross receipts averaging less than $7.5 million are exempt from the corporate AMT.) When investments and other expenses are large relative to a company’s taxable income, alternative minimum tax may be owed. Corporate AMT payments represent a pre-payment of tax that the taxpayer will get back when and if the taxpayer returns to a sufficient level of profitability.
A significant problem with the AMT that is especially relevant today is that the AMT reduces the stabilizing property of the corporate income tax, raising tax liabilities just when the taxpayer is most troubled economically. In general, tax payments should help stabilize the economy by falling as the economy’s performance declines, thereby reducing the impediment taxes place on consumption, investment, and production. The AMT tends to impose an increased tax burden during an economic downturn, which prolongs periods of economic weakness by reducing business activity. During an economic downturn, companies that seek to maintain a constant level of investment and employment are more likely to pay AMT or pay larger amounts of AMT. This is because AMT adjustments and preferences will represent a larger portion of their taxable income than during periods of high profitability.
The AMT also limits the use of net operating losses (NOLs) which tend to increase during economic downturns. The Job Creation and Worker Assistance Act of 2002 temporarily waived the AMT limitation for NOL carrybacks arising in 2001 and 2002 as well as carryforwards to those years. In view of the slow pace of the economic recovery, the President’s Budget proposed waiving the AMT limitation for NOL carrybacks originating in 2003, 2004, and 2005, as well as for NOLs carried forward into those years. This change would provide appropriate tax relief for businesses in difficult financial straits.
Another aspect of the AMT is that it limits the use of foreign tax credits. Because the foreign tax credit is intended to ensure that foreign income of U.S. corporations is not double taxed, the AMT’s limitation on the use of foreign tax credits should be reconsidered.
Accounting. Current law specifies detailed and complicated accounting rules. Complying with these rules can be difficult and costly, especially for small businesses. To relieve compliance burdens (and perhaps reduce taxes as well), consideration could be given to simplifying capitalization rules and rules regarding long term contracts. These changes would provide significant benefits to the manufacturers who must expend resources to comply with these rules.
Simplification. It has been observed that “it is difficult to predict the future of an economy in which it takes more brains to figure out the tax on our income than it does to earn it.” That is the situation we face. Our tax laws are extraordinarily complex. A recent IRS study of the burden and cost of complexity to individual taxpayers put the burden well in excess of three billion hours per year and the cost well in excess of $60 billion per year. And that is just the individual side. The rules on the business side are even worse. While large businesses can grapple with them, many small and medium-size businesses cannot. The challenge for businesses trying to comply with the law – or for the IRS trying to administer and enforce it – is enormous. It is time for us to undertake a serious effort to simplify our tax rules. Treasury recognizes that broad simplification of the tax system will be difficult to achieve, but believes it important that Congress and the Administration remain vigilant against further increases in complexity. A $1000 tax break that costs a small business $3000 in accountants’ fees to obtain does no favor.
The complexity is nowhere more evident than in our international tax rules. A reexamination is needed, including of the fundamental assumptions underlying the current system. We should look to the experiences of other countries and the choices they have made in designing their international tax systems. Consideration should be given to fundamental reform of the U.S. international tax rules and to significant reforms within the context of the current system. Again, international simplification is important to small as well as large business. The notion of how to market abroad and how to comply with the tax rules of the country of interest is daunting enough to small U.S. firms seeking to take advantage of globalization without layering on the further complexities of our own country’s international tax laws.
In conclusion, Madam Chair, I want to thank you again for the opportunity to appear before you today and discuss the Administration’s views on tax issues affecting small business and the global marketplace. We believe it important to continue down the road to tax relief by making the individual tax reductions permanent. In addition we need to continue to simplify the tax rules for domestic and international business and consider other ways, including those I mentioned today, that would improve the global competitiveness of U.S. enterprises, large and small.
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[1] Other recently implemented burden reduction projects benefiting small businesses include:
· Reducing the number of lines on Schedules D, Forms 1040 and 1041, resulting in estimated burden reduction of 9.5 million hours for 22.4 million taxpayers. (January 2002)
· Eliminating the requirement for filing Part III of Schedule D (capital gains), Form 1120S for 221,000 S-Corporation taxpayers, reducing burden by almost 600,000 hours. (November 2002)
The IRS has also streamlined many of its procedures to make compliance less burdensome for small business taxpayers. A few examples include:
* The establishment of a permanent special group to work with payroll services to resolve problems before notices are issued and penalties are assessed against the individual small businesses serviced by these bulk and batch filers. (October 2002)
* Business filers can now e-file employment tax and fiduciary tax returns, and at the same time, pay the balance due electronically by authorizing an electronic funds withdrawal.
* Business preparers can now e-file their clients’ employment tax returns.
* The IRS has continued to improve its Web site to offer its customers the ability to both order, and in many cases, utilize its Small Business Products online.
