Federal Tax Reform as “Seinfeld”

As our 2017 tax panel discussed, the ongoing federal tax reform debate features convoluted story lines, awkward situations, and outrageous characters, and may well end up being a show about nothing.  From the September-October 2017 edition of Fiscal Focus.

The good news: with the recent release of more elements of the federal tax reform plan, there is now about nine times more substance as there was in the blueprint released a couple months ago.  The bad news: federal tax reform now totals nine pages instead of one.  And that is generous.  Like a third-grader’s book report featuring massive margins and paragraph spacing to meet a teacher’s minimum page expectations, one of the most distinguishing features of the updated reform plan is its copious amount of white space.

Nevertheless, the dearth of new information did not prevent an engaging discussion on federal tax reform by our distinguished 2017 annual meeting tax panel.   Moderated by former revenue Commissioner Ward Einess, participants explored the prospects for reform, the politics surrounding it, and the potential implications for Minnesota.  Panelists included Commissioner Cynthia Bauerly, Minnesota Department of Revenue; Doug Lindholm, President and Executive Director, Council on State Taxation; Max Behlke, State Budget and Tax Director, National Council of State Legislators; and Joe Crosby, Principal, MultiState Associates.

Reform in the Eye of the Beholder

Starting from a big picture perspective, panelists were asked if the proposal seems to meet tests of true tax reform.  Can it be described as potentially game changing in terms of addressing needs and remedying problems that plague the tax system in its current design?  Panelists commented that while ideas that would qualify as true reform certainly exist in the plan, they are lost in a sea of ambiguity making it impossible to answer that question.  The current reform proposal, said Doug Lindholm, is “a moving target – sometimes ephemeral, sometimes non-existent.”  He cautioned against paying attention to ideas that appear to be reform features but due to their lack of detail are really nothing more than aspirational.  Joe Crosby noted that territoriality in corporate taxation and the hints of a third tax system for pass through businesses could certainly be qualified as true reform, but in both cases considerable uncertainty remains surrounding the interpretation and actual implementation of these ideas.

Max Behlke discounted the idea of reform on more pragmatic grounds – doubting that this Congress could ever implement it.  He noted the same dynamics that killed the health care bill are at work in tax reform and therefore any successful effort will place heavy emphasis on simple tax relief – making reform ideas much more difficult to implement.  All this is compounded by perceptual issues like the 70%-plus of Americans who don’t think corporations and rich people pay enough in taxes.  Some rate reductions, he maintained, could certainly be an outcome but that is a very low bar for defining tax reform.  Commissioner Bauerly concurred, observing that high profile and heralded reform goals are being undercut by details that have leaked out.  For example, she noted, simplification has been trumpeted as a primary reform objective, but as the list of “will not touch” deductions and exemptions grows, it becomes more difficult to see how any meaningful simplification can be realized.

However this effort may turn out, everyone agreed it bears little resemblance to federal tax reform efforts of the past.  Lindholm offered an interesting comparison and contrast of the current effort to the Reagan tax reform of 1986.  He noted that reform took three years to come to fruition and included literally hundreds of Congressional hearings.  “Anytime you undertake bipartisan tax reform,” he observed, “somebody has to make tough choices, somebody is going to get their ox gored and the only way you get past that is if somebody has your back.”  President Reagan, he said, provided the necessary cover for lawmakers to take the tough votes and redirect any political blame.  Notably, nothing like that exists today.  “There is no sense of loyalty.  Rather, everybody thinks they will be thrown under the bus for their vote… The dynamic is really ugly.”

Moreover, Lindholm continued, even if legislators could reach closure on basic reform details and structures, the real work and heavy lifting would only be beginning.  “What takes all the time in tax reform,” he emphasized, “is the transition rules.”  He noted that in tax reform the transition process is where lobbyists earn their keep because the details can have such a big impact on both revenue projections and taxpayers.  An accelerated timeline for bipartisan tax reform is essentially impossible because transition rules can’t be written until there is an endpoint and negotiators are currently nowhere near that.

What’s missing from the current reform proposal, he continued, are the tough choices.  As an example, Lindholm pointed to the much-publicized reduction in business pass through rates.  Lurking within this issue is the need for anti-abuse rules specifying what is business income and what is wage income (which is taxed at a higher rate and also subject to Social Security and Medicare).  Tax writers can respond by crafting something clear and predictable that nobody is going to like, or something more flexible, permissive – and incredibly expensive.  This has huge implications because so much more business is being done now in pass-through entities.  For these reasons, he argued extreme skepticism about tax reform by the end of the year is not negativity, but realism.

He concluded by saying many DC observers believe it would actually be easier to pass a bipartisan “60 vote bill” than a Republican-only “51 vote bill”.  That’s because even though many formerly strident deficit hawks have suddenly and magically kicked their federal debt concerns to the curb, some are sticking to principle.  And it only takes 3 of the latter to stymie party-line reform efforts.  Building bipartisan reform with some moderate Democrats and Republicans may turn out to be an easier reform path but is guaranteed to be longer, requiring negotiations that will string it out for years.

Just Sign Something…Anything

The current tax reform push comes on the heels of some very high profile political failures for the current administration.  So to what extent is reform by year-end a political “must have” driven by a sense of desperation to claim passage of any measure as a victory?

Crosby argued any optimism for tax reform in the near future is indeed predicated on the fact that the GOP have boxed themselves into a corner.  There is tremendous pressure on leadership to accomplish something.  The question is how much of this framework they will have to give away or negotiate away just to get something through.

Policy-wise, he continued, it would be easier just to do corporate reform on its own for the simple reason both sides recognize a need for it and deals may be easier to achieve.  The problem is a “corporate-only” focus is a political non-starter.  If something does get traction and pass quickly, it will be because a win is needed and quickly to temper the internecine battles within the GOP.  But the resulting reform would likely be modest like some rate reductions and related tweaks within the existing structure.

Commissioner Bauerly took exception to the idea that any majority-only supported bill pushed through for purposes of political necessity and expediency should ever be considered “tax reform.”  Harkening to the discussion earlier, real reform, she argued, requires bipartisan participation.  Based on her experiences working with Senator Schumer, she maintained the Republicans have a very willing partner if they are willing to negotiate.  She noted that if simply being able to take political credit for something is the real objective, addressing expiring popular individual income tax extenders might offer a “win” before the end of the year.

Max Behlke pointed out timing challenges, noting the House and Senate are scheduled to be in session for only 24 more days jointly this calendar year.  In addition, on December 8 the federal budget will run out which guarantees shutdown issues, and a continuing resolution will consume most if not all of the legislative oxygen at that point.   Then there’s the ever-present wildcard of “tweeting” which can instantaneously redirect legislative time and attention away to other issues.  That said, he agreed the GOP does desperately need a win, heightened by the fact that many Republican consultants believe if tax reform doesn’t materialize, the U.S. House might change hands.  For these reasons, Behlke believes a spring 2018 timeframe is the most likely scenario for any bill that might materialize.

State Ramifications Seasoned by “SALT”

Anything the federal government does in tax reform has, of course, potentially significant implications for states and their revenue systems.  States are concerned and frustrated with both the lack of input they have on these important decisions and their inability to plan given the uncertainty.  So what should states generally and Minnesota specifically be concerned about?

Lindholm began by noting if it’s any consolation, states are not alone in their frustration.  Hill staffers and their bosses are being besieged by every possible interest, but it’s proven difficult for anyone to draw conclusions about how a provision fits into the whole when no one has any idea what the whole will look like.

The major concern for states is the potential elimination of state and local tax (SALT) deductibility.  In Minnesota, nearly 1 million filers claimed $12.3 billion of state and local tax deductions on their federal returns in 2015 representing 34.7% of all Minnesota individual income tax returns (see sidebar).  It has taken center stage because it’s the last big “pay for” available for reform now that so many other provisions have been taken off the table.  According to Lindholm, many economists are saying if it’s not eliminated tax reform is not going to happen because it would blow the deficit out of the water.

Behlke noted the SALT deduction is a target because of its political convenience, not because it’s in any way a “worse” deduction than the many other tax expenditures getting a pass.  The primary policy argument offered for its elimination is to end the federal subsidization of high tax states thus equalizing the tax code across the nation.  The problem with this argument, Behlke continued, is that SALT is just one of many federal subsidies provided to states.  On the spending side, states differ dramatically in the various payments they receive from the federal government.  Minnesota receives only $.90 for every dollar it sends to the federal government and is one of only 13 states with a negative balance of federal payments.  Given the federal government’s reliance on a highly progressive income tax, those states featuring negative balances of payments are (unsurprisingly) also predominantly wealthy states that would be most impacted by eliminating SALT deductibility.  Rather than reduce unequal treatment among states, a SALT repeal would likely exacerbate these differences and cause wealthier states to subsidize poorer states to an even greater degree.

Elimination of SALT deductibility does face some major political hurdles.  Panelists highlighted the fact that it would only take 25 House Republicans from high income states with high marginal income tax rates to kill any attempt to eliminate it.  Crosby noted that this is not just an income tax issue – a conservative, high property tax state like Texas also benefits significantly from SALT deductibility and is also one of the 13 state “subsidizers” of the rest of the nation.  Commissioner Bauerly noted this is a topic of great concern to Minnesota and pointed out that in a couple Republican-held congressional districts, nearly half of households take advantage of the SALT deduction.

State ramifications extend beyond the simple politics of policy winners and losers.  Commissioner Bauerly highlighted several practical administrative implications inevitably accompanying federal reform that should not be overlooked.  Whatever policies might be adopted are almost sure to raise new conformity matters and accompanying administrative challenges with respect to filing state returns.  They may trigger other administrative needs like the enforcement of new anti-abuse provisions and establishment of anti-fraud protections.  The theoretical appeal of a simple postcard sized return may sound wonderful, she posed, but in an era of identity theft, the dark web, and an IRS stretched to the limit, “what would it take to ensure the “postcard” is really me and not a criminal?”

Will Sales Tax Godot Finally Arrive?

States have not-so-patiently waited for federal action on e-commerce legislation for a very long time.  The question was posed – is there any way to tie federal e-commerce legislation into federal tax reform activity?

Crosby argued there is “zero chance” of taking up any state and local issues as part of tax reform because from a federal perspective this is a commerce issue and procedurally there is no sense in adding another committee jurisdiction.  Behlke agreed that tax reform is not the vehicle for federal action.  He noted the e-commerce issue concerns state, not federal, revenues and the idea of offsetting a reduction in state spending or paying for a SALT elimination with the states’ own money is “just ridiculous.”

Panelists had some differences of opinion as to the broader question of whether federal action can be expected any time soon.  Behlke thought there was a better chance that Congress would take up e-commerce this year than tax reform (although he said the odds aren’t great for either).  Crosby disagreed for several reasons.  First, he said, a Supreme Court decision to hear the South Dakota Wayfair case would give Congress an easy out to wait for the Court to do something.  In addition, the political landscape is balkanized.  He estimated that among Republicans one-third want to take up an e-commerce bill, one-third don’t want a bill, and one-third “want to stick their head in the sand“ so they don’t have to take a position.  Finally, some states have been quite successful in their own e-commerce laws and don’t want federal help out of fear it will place greater restrictions on their authority.  Lindholm pointed out the electoral risk supporting a standalone bill creates.  It would be irresistibly easy to build a primary challenge to incumbents on accusations of supporting a bill to “tax the internet” even though the statement would be untrue.

Even though e-commerce will not be part of federal tax reform, the issue elevates the stakes for states with respect to any federal tax reform fallout.  Behlke pointed out e-commerce has been growing at 15% for the past 6 years and now constitutes 11% of all retail sales with the mobile sales segment now realizing growth rates of 50%.  States are already seeing how this is impacting sales tax receipts and forcing them to look for revenues elsewhere.  Combine the SALT deduction with this trend and the state revenue raising challenge becomes that much more difficult.

Magic 8 Ball Reform – Ask Again Later

So what does the crystal ball say?  Two things appear to be working in favor of a reform bill.  From a policy perspective, there is genuine, bipartisan agreement that the corporate income tax as structured creates a disincentive to invest in the United States and needs attention.  From a political perspective there is a powerful desire and pressing need to enact something and declare a political victory.

But panelists highlighted several obstacles which by themselves make reform difficult and in combination could scuttle the effort entirely.  They include time constraints, the impact on the deficit, the exceptionally difficult politics behind the “pay fors,” the absence of any bipartisan collaboration, the optics of business tax relief without individual income tax relief, and elevated levels of attention deficit disorder in D.C.  The general consensus seemed to be that despite the obstacles political necessity will triumph sometime in early 2018 resulting in some dramatically scaled down tweaks and rate adjustments that will nevertheless be marketed as the grandest and most amazing tax package in the nation’s history.

What also seems clear is that states are largely an afterthought in this whole debate.  As Commissioner Bauerly argued, “state interests and state economies are served by thoughtfulness, not speed.”  Yet any reform will almost assuredly present states with some challenging tax policy decisions of their own.  Whether or not, as Joe Crosby reflected after the meeting, the whole effort turns out be Seinfeld – “a show about nothing” – remains to be seen.   The next several months does carry the prospects for some great observational comedy – except for the fact that the issues and needs at stake aren’t exactly a laughing matter.