Chairman Tiberi.  Now that we have finished our organizational meeting, I would like to call today’s meeting to order.  I want to welcome our witnesses to the hearing to discuss the taxation of small businesses and passthrough entities as part of a broader discussion on comprehensive tax reform. 

I believe there is a window of opportunity to enact comprehensive tax reform, and we must take advantage of it.  Last November, the American people sent a strong message to Washington.  They told Washington to stop putting off tough decisions, start making the decisions that will ensure future generations of Americans will prosper. 

Whether it will be reducing the national debt, ensuring entitlements will remain solvent, or reforming our Tax Code to encourage economic growth, saying it is too difficult isn’t an excuse anymore.  Our current system of taxation was written for an economy that was very different from the competitive global economy of today.  It is time to enact a Tax Code that is competitive with the rest of the world, that is fairer, and that is simpler. 

Small businesses must be included in comprehensive tax reform.  Reforming corporate taxes means only reforming roughly 10 percent of Federal revenues.  That is not comprehensive.  Many small businesses pay taxes under the individual income tax rates as passthrough entities, which we will hear more about today. 

The last thing we want to do as part of tax reform is create a situation where we are putting small businesses at a competitive disadvantage.  I fear leaving them out of tax reform will do just that.  Small businesses are the engine of economic growth in our economy.  As we move forward with tax reform, the question we must ask ourselves is how we reform the code in a manner that empowers small businesses to grow and create jobs. 

I look forward to hearing from our witnesses on those issues today. 

With that, I will yield to the ranking member, Mr. Neal.

Mr. Neal.  Thank you, Mr. Chairman. 

And I want to thank you for calling this hearing this morning.  I hope that it will be the first of many on the topic of tax reform. 

Earlier, I commented on how this subcommittee always hears diverse points of view, and certainly this morning is no exception.  We have one witness who is complaining that there are too many special provisions for small businesses and that the clutter is overwhelming.  We have another saying that these special provisions make for a code that favors small businesses over large, and yet another tells us that we need to lower income taxes on the upper‑income to save small businesses. 

But one thing that we can agree on is that the U.S. offers some of the most flexible rules on structuring your business in the developed world, offering limited liability without the requirement of a corporate‑level tax.  As one witness tells us today, we are second only to Mexico in the size of the unincorporated businesses as a total share of business, and that this self‑help integration is a step toward reform. 

While this hearing is intended to explore special tax issues on passthrough entities, much of the discussion will involve small‑business incentives.  We should note that the two are not necessarily the same.  As one witness tells us, less than 1 percent of all passthroughs are large businesses with more than $10 million in receipts but they accounted for almost 60 percent of the total revenues of all passthroughs.

Confucius noted that a journey of a thousand miles begins with a single step.  I want to thank you, Mr. Tiberi, for taking that first step this morning on the road to tax reform.  And we hope the journey does not take a thousand hearings. 

Thank you.

Chairman Tiberi.  Thank you, Mr. Neal. 

I ask unanimous consent that all Members’ written statements will be included in the record. 

Without objection, so ordered. 

Chairman Tiberi.  We will now turn to our panel of witnesses, whose bios are in your packages.  I will introduce them, and then we will begin after I have introduced them all. 

Dr. Robert Carroll is from Ernst & Young.  Ms. Patricia Thompson is a tax partner at Piccerelli, Gilstein & Company and chair of the AICPA Tax Executive Committee.  Mr. Dennis Tarnay is the CFO of Lake Erie Electric and a former board member of the Ohio Society of CPAs and from the great Buckeye State.  And Dr. Donald Marron is director of the Urban‑Brookings Tax Policy Center. 

Thank you all for joining us this morning. 

Dr. Carroll, you may begin your testimony. 

STATEMENT OF ROBERT CARROLL, PRINCIPAL, QUALITATIVE ECONOMICS AND STATISTICS, ERNST & YOUNG LLP, WASHINGTON, D.C.

Mr. Carroll.  Thank you, Chairman. 

Chairman Tiberi, Ranking Member Neal, and distinguished members of the subcommittee, I thank you for the opportunity to testify today regarding the taxation of flow‑through businesses and tax reform. 

I have had the opportunity to consider the taxation of flow‑through businesses from a number of different perspectives inside and outside of government in the context of broad reform of the code and narrow reform of the business tax system.  More recently, I have been analyzing the flow‑through sector in the course of preparing a report on behalf of the S Corporation Association.  Today I would like to share my perspectives and provide some preliminary results from the study on the flow‑through sector we are preparing for release in the near future. 

Flow‑through businesses, S corporations, partnerships, limited liability companies, and sole proprietorships play an important role in the U.S. economy.  The vast majority of businesses in the United States have chosen to organize as flow‑through businesses. 

Today, flow‑through businesses comprise more than 90 percent of all business entities, employ more than 50 percent of the workforce, and report more than one‑third of all business receipts.  Individual owners of flow‑through businesses report 40 percent of all business net income.  These individual owners also pay 43 percent of business taxes when filing their individual tax returns. 

The flow‑through sector in the United States differs markedly from other developed nations.  The business forms available in many other countries tend to push businesses toward the corporate form in pursuit of limited liability, whereas in the United States such limited liability is attainable through various organizational forms outside of the corporate sector. 

This has resulted in a flow‑through sector with considerable flexibility in how they organize and how they structure their operations.  Businesses can choose between several different organizational forms which may provide a better match to their management needs and capital requirements. 

The unincorporated business sector in the United States is also larger than in most other developed nations.  Of the countries responding to a 2007 OECD survey, the unincorporated business sector was larger as a share of the total number of businesses in the U.S. in all but one country. 

With the increasing prominence of flow‑through businesses, it is important to carefully consider how the flow‑through form fits into the U.S. tax system and how any particular reform might affect flow‑through businesses.

Flow‑through businesses are subject to a single level of tax on the income earned and allocated to their owners.  Thus, it is the tax rates faced primarily by individual owners of flow‑through businesses that affect decision‑making and the economic health of these businesses. 

In contrast, the income of C corporations is subject to two levels of tax:  first when income is earned at the corporate level and again when the income is paid out to shareholders in the form of dividends or retained earnings and later realized by shareholders as capital gains, hence the phrase, “the double tax on corporate profits.” 

The double tax affects a number of important economic decisions:  First, by increasing the cost of capital, it discourages investment and, thus, economic growth and job creation.  Second, it leads to a bias in firms’ financing decisions between the use of debt and equity.  And, third, it distorts the allocation of capital within the economy.  The flow‑through form provides an important benefit to the economy by reducing these economically harmful effects of the double tax. 

Recent focus on the need to lower the corporate income tax has also drawn attention to how flow‑through businesses might be affected by tax reform.  With substantial evidence that the U.S. corporate tax rate is out of step internationally, corporate tax reform is an important component of an overall approach to improving the current tax system. 

As with any such endeavor, however, it is important to keep in mind the potential for undesirable side effects.  Corporate reform that eliminates business tax expenditures would have the unintended impact of raising the taxes of businesses organized using the flow‑through form without offering the benefit of the lower corporate tax rate.  Flow‑through businesses would lose the benefit of widely used and longstanding provisions such as accelerated depreciation and the charitable‑giving deduction.  In total, flow‑through businesses use about 22 percent of the roughly $100 billion in annual business tax expenditures. 

Flow‑through businesses are a large part of the U.S. business sector and important contributors to the economic vitality of the U.S.  As reform progresses, it is important to understand and consider all of these issues with an eye toward bringing about the tax reform that is most conducive to increased growth and job creation. 

The path toward tax reform will need to take into account many features of our tax system and strike a balance between a number of sometimes conflicting and competing objectives.  This committee should be commended for holding this hearing to better understand the role that the flow‑through sector plays in the U.S. economy. 

I thank you, and I would be pleased to address any questions the subcommittee might have.

[The statement of Mr. Carroll follows:]

Chairman Tiberi.  Five seconds to spare.  Impressive.

Ms. Thompson?
 
STATEMENT OF PATRICIA A. THOMPSON, CHAIR, TAX EXECUTIVE COMMITTEE, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, TAX PARTNER, PICCERELLI, GILSTEIN & CO. LLP, PROVIDENCE, RHODE ISLAND

Ms. Thompson.  Good morning, Chairman Tiberi, Ranking Member Neal, and members of the subcommittee.  My name is Patricia Thompson.  I am a CPA and chair of the AICPA Tax Executive Committee.  My testimony today is based on my experiences with working with many small business clients.  I am tax partner at Piccerelli, Gilstein & Company LLP, a CPA firm in Providence, Rhode Island, and have been with the firm for over 32 years.  I would like to thank this subcommittee for the opportunity to appear today. 

Chairman Tiberi, I would like to start by thanking you for your work in trying to repeal the two 1099 provisions.  As noted in our written testimony, these are significant burdens on small businesses. 

Today’s hearing focuses on the special burdens that the tax law imposes on small businesses.  Business tax reform cannot merely change the corporate tax rates or other corporate provisions if the desired impact is to help small businesses, since many of them are not organized as corporations.  I understand the challenges inherent in drafting tax legislation and appreciate your diligence in trying to do the right thing for taxpayers. 

My full written testimony discusses several burdens and complexities facing small businesses.  In my brief time with you today, I would like to highlight just a few. 

The first is tax simplification ‑‑ depreciation is the best example.  Methods to compute depreciation are different for tax and financial accounting purposes.  Depreciation rates can vary depending on the method.  There are special types of depreciation, such as bonus, special straight line, and Section 179.  Plus, there is a different method for AMT.  So businesses have to maintain several different books of depreciation and update them annually for each individual asset. 

Let’s say a client places several pieces of equipment in service throughout the year.  To determine the best depreciation method, they need to run a complex analysis:  When was it purchased?  Was it new?  Was it used?  What was the total amount purchased?  Depending on the purchase date, they may be entitled to 50 percent depreciation; maybe it is 100 percent.  If they purchase too much equipment, Section 179 isn’t available.  If they don’t earn enough money, Section 179 is limited.  The best depreciation method may not be clear without extensive analysis. 

My second point is uncertainty in the tax law.  Many of the changes passed last year were designed to help employ more workers, help small businesses improve cash flow, and improve the economy.  For example, the HIRE Act that passed last March provided an incentive to hire unemployed workers.  This legislation was time‑sensitive.  If taxpayers did not know of the new incentive, the tax‑saving opportunity was permanently lost. 

The increased use of temporary provisions has also created some uncertainty.  While some measures may be appropriate for the short term, temporary tax provisions and incentives have become far too common.  Often they are allowed to expire, then they are revived after much debate, but only for another temporary period.  It is inefficient and ineffective to make longstanding tax policy utilizing temporary provisions. 

Additionally, when changes occur late in the year, small‑business owners have little time to evaluate the impact of those changes on their businesses.  It is even harder to plan when the new tax law takes effect in the same year that it is issued.  In that case, a small‑business owner can’t do long‑term planning for growth, business development, or new hiring.  It can be difficult to change course in response to a new, short‑term expiring tax provision. 

The third issue I would like to highlight is the need to consider expansion of corporate provisions to help noncorporate entities. 

The Small Business Jobs Act passed last September expanded an existing provision to allow 100 percent gain exclusion on the sale of small‑business stock if certain conditions were met.  There are several requirements to qualify for this exclusion.  It must be a C corporation of a qualifying business.  The stock cannot exceed a certain value and must be held for more than 5 years. 

The key here is that this provision only benefits C corporations, so it excludes many small businesses that are conducted as sole proprietors or passthrough entities.  This is an excellent example of a provision that was intended to help small business that will likely not have the desired impact. 

One final note:  I would encourage you to review two of our recent publications, one on alternatives for tax reform, and the other is our report on penalty reform.  Both are available online, and links are provided in our written testimony. 

Thank you again for the opportunity to testify, and I will be happy to answer any of your questions.

[The statement of Ms. Thompson follows:]

Chairman Tiberi.  Thank you.  Thank you, Ms. Thompson.  And you came in under time, as well. 

Mr. Tarnay, welcome.

STATEMENT OF DENNIS TARNAY, CHIEF FINANCIAL OFFICER, LAKE ERIE ELECTRIC, INC., CLEVELAND, OHIO

Mr. Tarnay.  Chairman Tiberi, Ranking Member Neal, and members of the subcommittee, thank you for inviting me to appear before you today to discuss the issue of fundamental tax reform, particularly as it relates to small businesses. 

I am the chief financial officer and a minority owner of Lake Erie Electric, a position I have held since 1987, and a former board member of the Ohio Society of Certified Public Accountants.  I am speaking today on behalf of both Lake Erie Electric and the OSCPA. 

Lake Erie Electric, based in Cleveland, Ohio, is an electrical contracting company that was first formed as a C corporation in the 1950s to primarily serve industrial customers in the automotive and steel sectors of the Midwest. 

My company has seen many changes since its inception, both in terms of its corporate structure and business strategies.  In 1987, we modified the corporate structure of the company to a passthrough Subchapter S corporation through the Federal tax law changes that occurred at that time and because it was a better fit for us.  When Cleveland’s industrial base contracted, we transitioned our customer base to be more heavily weighted to commercial businesses and the health‑care sector. 

The main message I want to deliver to you today, gentlemen, is that simplifying the Tax Code for small businesses means creating jobs in places like Cleveland, Ohio.  Predictability and stability within the Tax Code provides businesses, particularly small businesses, which typically have tighter profit margins, the necessary lens with which to make decisions regarding growth, investment or reinvestment of capital, and expanding new employee job opportunities. 

Further, a simpler Tax Code means small‑business owners can spend less time on costly and burdensome compliance activities and invest more of their time on innovation and growing their businesses.  Simplicity also helps to minimize taxpayer confusion over exactly what liability is owed and help with financial planning for the future. 

Tax reform for small business is about one thing in America:  jobs for all business sectors. 

Subchapter S corporations are structured so that net income or losses to the business are distributed to the shareholders of the company and are reflected on the individual’s Federal, State, and even local income tax returns.  The tax is assessed at their individual income tax rates, meaning legislators should be conscious that discussions of assessing higher tax rates on individuals at the $200,000 level and families at the $250,000 level will have a direct impact on the ability of many small‑business owners to reinvest in their businesses and keep or grow their workforce. 

In addition to Subchapter S corporations, other forms of passthrough entities that will be similarly impacted are limited‑liability companies, partnerships, limited‑liability partnerships, and sole proprietorships.  Roughly 75 percent of small businesses are passthrough entities.  As we know, the primary reason there are so many passthrough entities is because double taxation is eliminated, first at the entity level as earnings and then again at the individual level as dividend payments to shareholders. 

This data leaves little doubt that, in order for a significant economic recovery to take place, there must be a tax structure in place that will give small businesses the incentive to hire and thrive. 

Tax law does matter to small‑business passthrough entities because they modify business practices to adjust for law changes.  In recent years, tax‑law changes have become a political tool, with revisions occurring far too often, sometimes more than once a year and sometimes so late in the year that it is retroactive in impact, causing business owners to be confused and uncertain on how to proceed. 

The frequency of tax‑law changes affects small businesses in particular because the unpredictability often slows or discourages the hiring or rehiring of employees or investing in new capital or other products and services.  While certainly businesses of all sizes are impacted by the frequency of tax‑law changes, they have a far greater impact on small‑business decisions because so many of them operate on very tight profit margins. 

Predictability helps to keep costs down, as fewer changes equate to fewer compliance costs associated with changing practices and procedures that, in many cases, are longstanding and successful from a cost‑benefit standpoint.  Lower cost equals greater ability to reinvest in company and future growth. 

The current structure of passthrough entities, such as Subchapter S corporations, provides flexibility and control to small‑business owners and should be maintained in any tax reform proposal.  Going forward, tax reform should help small business by reforming issues such as:  simplifying compliance rules regarding E‑Filing and E‑Verify; shifting the burden away from being the watchdog for various government entities on its employees; reforming the timing requirements for S‑corporation formations; increasing the amount a small businesses may expense on the Federal tax returns; reasonable independent contractor rules. 

Gentlemen, the alternative minimum tax should be eliminated.  If it can’t be eliminated, enact a more reasonable and consistent threshold for the alternative minimum tax. 

In a related matter, I do applaud your efforts to address the expanded 1099 requirements currently on schedule to become effective January in 2012.  From a small‑business perspective, this is the classic example of a compliance cost on both businesses and the Internal Revenue Service outweighing the benefits derived.

Chairman Tiberi.  Mr. Tarnay, if you can wrap up ‑‑

Mr. Tarnay.  I am right now. 

Chairman Tiberi.  Thank you. 

Mr. Tarnay.  Meaningful tax reform that focuses on simplicity, predictability, and fairness that includes an emphasis on the related cost and compliance burden to small businesses is critically important so that we, as small‑business owners, do our part to grow the economy. 

On behalf of both Lake Erie and the Ohio Society of CPAs, I appreciate the opportunity to share my concerns and would welcome any questions you have.

[The statement of Mr. Tarnay follows:]

Chairman Tiberi.  Thank you. 

Mr. Marron?
 

STATEMENT OF DONALD B. MARRON, DIRECTOR, URBAN‑BROOKINGS TAX POLICY CENTER, WASHINGTON, D.C.

Mr. Marron.  Chairman Tiberi, Ranking Member Neal, members of the subcommittee, thank you for inviting me to appear today to discuss the tax system and small business.

America’s tax system is needlessly complex, economically harmful, and often unfair.  Because of a plethora of temporary tax cuts, it is increasingly unpredictable.  And it fails at its most basic task, which is raising enough money to pay our government’s bills.  For all those reasons, the time has come for fundamental tax reform. 

Such reform could have far‑reaching effects on every participant in the economy, including small businesses.  To provide a foundation for thinking about these effects, my testimony discusses basic facts about the relationships between tax policy and small business. 

I make six main points. 

First, today’s Tax Code generally favors small businesses over larger ones.  Provisions such as Section 179 expensing, graduated corporate tax rates, and special low capital gains taxes benefit businesses that are small in terms of investment, income, or assets. 

Second, many small businesses also benefit from the opportunity to organize as passthrough entities.  S corporations, limited‑liability companies, partnerships, and sole proprietorships all avoid the double taxation that applies to income earned by C corporations. 

Third, the benefits of organizing as a passthrough are not limited to small businesses.  Some large businesses adopt these forms, as well.  Although these large firms account for a tiny share of passthrough entities, they represent a substantial fraction of passthrough economic activity.  For example, only 0.3 percent of S corporations had revenues above $50 million in 2005, but they accounted for more than a quarter of S‑corporation income.  The situation is even more extreme with partnerships.  Only 0.2 percent of partnerships had revenues above $50 million, but they accounted for 57 percent of partnership income.  Lawmakers should therefore take care not to assume that all passthroughs are small businesses. 

Fourth, small businesses face disproportionately high costs in complying with the Tax Code.  They are also more likely to understate their income and underpay their taxes.  High compliance costs thus disadvantage responsible small businesses, while the greater opportunity to evade taxes can advantage less responsible ones. 

Fifth, an ideal tax system would collect enough revenue to pay for government services while minimizing distortions to economic activity.  To the extent possible, economic fundamentals, not tax considerations, should drive business decisions about organizational structure.  By treating passthroughs and C corporations differently, our current tax system deviates from that ideal. 

Sixth, and finally, in discussing reform proposals, it is important to distinguish between businesses ‑‑ a broad category that includes passthroughs ‑‑ and corporations, which generally means C corporations.  Many tax reform proposals would reduce business tax preferences and use the resulting revenue to cut corporate income tax rates.  Such revenue‑neutral reforms could lessen the disparity in tax treatment between passthroughs and C corporations.  Passthroughs would see their tax burden increase since they would lose some tax preferences but not benefit from the rate reduction, while C corporations would, on average, see their taxes decline. 

Thank you.  I look forward to any questions.

[The statement of Mr. Marron follows:]

Chairman Tiberi.  Thank you. 

Mr. Tarnay, in your written testimony and briefly in your verbal testimony, you mentioned a couple of things I would like you to expand on, if you could.  You mentioned simplifying compliance rules regarding E‑Filing and E‑Verify.  And you also mentioned shifting the burden away from small businesses to be the watchdog for government on their employees. 

Can you expand on both of those issues? 

Mr. Tarnay.  E‑Verify ‑‑ in our business sector, since our labor force comes from the unions, we have employees that come and go during the course of the year.  And every time they come on, we have to E‑Verify. 

So you can have an employee, an electrician, for example, that comes on the payroll for, let’s say, 3 weeks, 4 weeks, 3 months, and then goes back to the labor force because we don’t need that employee anymore.  Well, the next time he comes on, we once again have to go through the E‑Verify process, and we have to do that within 3 days of him being on the payroll.  But when we do that, and since we have roughly 400 or 500 electricians and they rotate, we could have that same employee being E‑Verified 3 or 4 times a year.

It is time‑consuming, and it takes away from other opportunities.

Chairman Tiberi.  And the other issue? 

Mr. Tarnay.  E‑Filing?  We haven’t had much to do with E‑Filing.  But I know for small businesses it can be very difficult, simply because many of the small businesses are not that, I am going to call it, technologically ‑‑ have those technological abilities.

Chairman Tiberi.  And your point about being a watchdog, small businesses being a ‑‑

Mr. Tarnay.  Well, that isn’t just at the Federal level.  That is at all levels of government.  Garnishments, withholdings ‑‑

Chairman Tiberi.  1099s.

Mr. Tarnay.  ‑‑ child support.  It goes throughout.  It is a tremendous burden.

Chairman Tiberi.  Thank you. 

Dr. Carroll, if Congress decides to reduce business tax expenditures and cut the corporate tax rate, what are some ways that we could mimic a corporate tax rate cut for noncorporate businesses? 

I would note, and I know you are aware, for example, that the House Republican Pledge to America proposes a 20 percent deduction for small‑business income, which would, I believe, be a similar rate cut from 35 percent to 28 percent for small businesses. 

Can you give us some thoughts on that? 

Mr. Carroll.  Yeah, sure.  I think there are a couple of ways that that could be accommodated in our current tax system.  One approach would be to put in place a separate rate schedule, similar to dividends and capital gains.  Another approach would be to put in a deduction for a certain fraction of flow‑through income. 

One of the complexities in extending a deduction or a lower rate to flow‑through income might be trying to split up the return to labor and return to capital associated with that income. 

For S corporations, it is fairly ‑‑ it is more straightforward, I would say.  S corporations are required to pay the owners a reasonable level of compensation.  But for other organizational forms, such as, you know ‑‑ one would have to address that issue.  Some of the Nordic countries have tried to split up the return to labor and return to capital, but they have come up with very, very complicated approaches for that.

Chairman Tiberi.  Last question, if you could all just comment on this.  Some have said that if we can lower the rate and broaden the base and get rid of some of the other stuff within the Tax Code to simplify it ‑‑ Ms. Thompson, starting with you ‑‑ what would be a ballpark figure that you think you could lower rates for passthrough entities and get rid of some of the things that might benefit some passthrough entities but not all? 

Ms. Thompson.  The AICPA actually doesn’t take a position on the best alternative to come up with.  But what they have is the report talks about reform alternatives for the 21st century. 

And what they think about when evaluating the tax reform proposals, they would want to look for simplicity within the measure; whether it is fair; whether it has economic growth and efficiency; its neutrality; whether it is transparent to everybody; whether or not it is minimizing the noncompliance, because we all know that that is a significant issue, and the easier you make something, the more compliant people will be; whether it has the ability to have cost‑effective collection and the impact on the government revenues; whether there is certainty in it; and whether there is payment convenience. 

So the AICPA really, at this point, doesn’t have a position, to answer your question, on it.  But as proposals come up, we could take a look at them and see what ‑‑

Chairman Tiberi.  We could probably move your bill right now, actually.  I think everyone agrees with what you have said. 

Mr. Tarnay? 

Mr. Tarnay.  Simplicity and predictability for a small business is essential so that they know what to do, moving forward.  As we all know, in small businesses, it is usually the owner that leads it, and he is not necessarily the key in financial decision‑making.  That is why, many times, the CFO is known as an “OFO,” the “only financial officer.” 

If you make it simple and predictable, a small‑business owner begins to understand it, and he can make decisions in his structure, in his decision‑making, so that he can expand his business.  It is as simple as that.

Chairman Tiberi.  Mr. Marron? 

Mr. Marron.  I was quite impressed with where the President’s fiscal commission came out.  I served on the parallel Domenici‑Rivlin commission. 

Both of those did full‑scale tax reform, individual and corporate at the same time.  And in both of those, they came out in roughly the same place, saying that we should aspire to a system where both the top corporate rate and the top individual rate are the same and begin with a “2,” and it is 27, 28, somewhere in there.

Chairman Tiberi.  Thank you. 

And, finally, Dr. Carroll? 

Mr. Carroll.  Just following on Mr. Marron’s comments, both the fiscal commission and the Rivlin commission got down to about a 27, 28 percent.  They would eliminate most, if not all, business tax expenditures, depending on the plan.  They kept a few things. 

If you go back to the 2007 Treasury competitiveness report, we were able to get the rate, at that time, down to about the same.  If you eliminated all business tax expenditures, you could get the rate down to about 27, 28 percent.  And that includes getting rid of provisions like accelerated depreciation, and so some provisions that are longstanding and, certainly, widely used. 

And one of the things I think you need to also consider is, when you add in the State rates, even if you got the business rate down to 28 percent for corporations and for flow‑throughs, when you add in State rates you would still have a rate on the order of about 33 percent, combined rate, for the U.S., which would still place us at a rate above the OECD and the G‑7.

Chairman Tiberi.  Thank you.  Thank you all. 

I will yield for questioning to the ranking member, Mr. Neal.

Mr. Neal.  Thank you, Mr. Chairman. 

Dr. Marron, both you and Dr. Carroll discussed the problem with eliminating business tax preferences as part of an effort to lower the corporate rate.  In fact, Dr. Carroll’s testimony highlights the annual cost of these preferences and which ones are used equally by both corporations and passthroughs. 

Since base‑broadening, though, seems to be the best way to accomplish reform, how do you think that Congress should address this real concern? 

Mr. Marron.  I would start with broad principles.  And from the security of being a think‑tank economist kind of guy, the number‑one principle I start with is a leveling the playing field.  That the first order, the goal of our tax system should be not to play favorites among different types of activities, different organizational forms.  And that when you have business tax preferences that are clearly skewing the field in one direction or another, that those are ones that ought to get close attention. 

A second one ‑‑ and this one I want to highlight just because it doesn’t come up as much.  We often talk about a strategy of rolling back tax preferences, and lowering rates as a strategy for doing corporate reform and business reform.  There is another strategy, which is to keep favorable depreciation policies, possibly even move toward expensing, but then pay for that by walking back the deductibility of interest. 

And an attraction ‑‑ I would recommend that as a strategy to keep in mind, because the attraction of that is that it would eliminate some of the distortions in our current system that favor leverage and favor debt.  And, in principle, it could be a way that it would have favorable business incentives but in a paid‑for way.

Mr. Neal.  Uh‑huh.

Dr. Carroll? 

Mr. Carroll.  Yeah, I think the challenge is ‑‑ there has been some discussion of corporate reform focused on trying to bring the corporate rate down, primarily due to the pressures from abroad, with the corporate rates coming down quite a lot over the last couple of decades among our major trading partners.  And I think, you know, tax reform ‑‑ I think business tax reform needs to be somewhat more broadly considered. 

I think it is very hard to lower the corporate rate and pay for that by repealing all business tax expenditures or some set of business tax expenditures for both flow‑throughs as well as C corporations.  I think one needs to pursue not just reform of the corporate income tax but, more broadly, reform of the business tax system and look at that in a more holistic fashion. 

And the tax system is very intertwined.  There are a lot of interrelationships between, as I have discussed in my written testimony, between C corporations and the flow‑through sector, but also in the taxation of investor‑level income, in the form of capital gains and dividends.  You have the part of the double tax on corporate profits. 

These things are very interrelated, and I think it is very difficult to take a small piece of the Tax Code and try to reform that in isolation.  I think pursuing it in a much broader way is more constructive.

Mr. Neal.  Uh‑huh.

Off‑script for a moment:  But a few moments ago in your comments, you spoke to depreciation allowance.  While I think, in my own instance, having rejected the idea, the theology that tax cuts pay for themselves, I do subscribe to the notion, as Chairman Tiberi offered at the outset, that the use of the NOL last year was very important, further suggesting that, at certain times, some tax cuts are better than others. 

And I think there is some evidence over the years that acceleration of depreciation allowance has worked, in terms of changing behavior in an economic downturn.  Are you prepared to suggest that that ought to be eliminated as a possibility? 

Mr. Carroll.  Yeah, I am not really here to suggest what should be eliminated or kept. 

With respect to accelerated depreciation and expensing, I think it is a pretty common view among economists that expensing and accelerated depreciation are constructive provisions that help encourage investment.  Both in times of economic downturns ‑‑ the bonus depreciation and 100 percent expensing enacted in late December can be very constructive to help stimulate business investment during periods of economic weakness ‑‑ but it is also, I think, very helpful in terms of longer‑term tax policy.  Accelerated depreciation and expensing help to reduce the tax on capital income in the economy, which can help encourage capital formation and promote growth in the longer term.

Mr. Neal.  And, Ms. Thompson, it was dizzying just to read your client scenarios with all the complex depreciation options, but I am sure you understand that Congress was trying to help small business, even though the result was a patchwork of generous rates and confusing expiration dates. 

And I share the argument that the four of you seem to be unified around, with respect to the need for predictability, in our tax rules.  That is a given.

But since you mentioned how tax accounting here differs from financial accounting, is conformity a recommendation that you would make? 

Ms. Thompson.  We are not really saying that the tax rules need to be the same as the financial accounting rules.  But what we are thinking is that it is just one area that could be analyzed to see if it can be made easier and it can be more predictable.  Because, as we had said, during 2010 there were quite a few tax provisions that came in and actually were changing depreciation.  So it just adds to the complexity of it. 

I don’t think that anybody is opposed to accelerated depreciation; my small‑business clients aren’t.  But they would like to know ahead of time so that they could have time to plan for it.  So that is really what they are asking for.

Mr. Neal.  Just lastly, Rep. Phil English and I, at one time, worked on that, as you know.  And there was substantial evidence that it was an effective approach.  And, certainly, tax receipts were up, based upon that initiative.

Chairman Tiberi.  Thank you, Mr. Neal. 

Mr. Heller is recognized. 

Mr. Heller.  Thank you, Mr. Chairman.  And I appreciate your comments and holding this hearing. 

I appreciate all of you being here. 

I am from Nevada.  So when you think of Nevada, a lot of times you think of gaming properties, and I can understand that.  But I think the fact remains that small businesses make up almost 96 percent of the employers in Nevada. 

And just some other statistics, only because I think Nevada is a microcosm of what is going on economically in the country as a whole.  In 2004‑2005, it created nearly 68,000 new small‑business jobs.  In 2005 to 2006, we created 77,000, so an increase of nearly 10,000.  But in 2006‑2007, going from 77,000, it was reduced to 40,000 new small‑business jobs.  And, clearly, economic factors have everything to do with it. 

In 2009, Nevada averaged 3,300 new small‑business startups each quarter.  The down side is that we averaged 3,700 small businesses being closed each quarter.  So, clearly, those that are closing are unfortunately outpacing those new jobs that are being created. 

In the Obama fiscal year 2012 budget, he raises taxes on small businesses.  He does it in three ways:  He raises the top 2 individual income tax rates from 33 percent to 36 percent and then from 35 percent to 39.6 percent.  He reinstates the personal exemption phaseout and the Pease limitations on itemized deductions.  And, finally, he raises taxes on dividends and long‑term capital gains, hoping to raise in his budget $709 billion. 

Now, the theme ‑‑ and I appreciate Mr. Tarnay’s comments about what businesses need ‑‑ and I think it has been a theme for all of you, and that is predictability, stability, and simplicity. 

I guess my question, Ms. Thompson, since you alluded to these issues and the importance of planning, long‑term planning, as you know, last year we extended the 2001‑2003 tax cuts for only 2 years.  And you were talking about the ability of a small business to be able to plan long‑term, a 5‑year plan, a 10‑year plan. 

With these potential increased taxes of $709 billion and the extension for only 2 years, the 2001‑2003 tax extension, how does a small business today put together a 5‑year plan or put together a 10‑year plan? 

Ms. Thompson.  They don’t.  Or, they can’t.  Because you are absolutely right, it was very helpful that the 2001 tax rates were extended for a 2‑year period.  But what we would like to see is to know either this year or as soon as we can what the rates are going to be beyond 2012 so it will help that small‑business owner know what his tax liability is going to be in the future.  Because if he knows that his taxes are going to increase, it is going to have an impact on his cash flow.  If it has an impact on his cash flow, there is going to be potentially cuts in other areas, and, unfortunately, that might be workers.  It is hard to say. 

But they will definitely need to know what their tax liability is going in the future to make business decisions now. 

Mr. Heller.  Mr. Tarnay, since those were your words, “predictability, simplicity, and stability,” how does a business today plan under the current tax rates that we have? 

Mr. Tarnay.  I would agree it is very difficult, because for years, for decades, it used to be we understood what the tax rates were, what the law was moving forward, accelerated depreciation, the whole nine yards.  Then I would say, in the past 10 to 15 years, laws changed annually, sometimes retro.  It is very, very difficult for small businesses to do that.  They have to bring in their experts, their tax advisors, and that is costly. 

If small‑business owners understood what it is going to be for a 5‑year period, a 10‑year period, they can plan.  That is what they are good at.  That is what we need.

Mr. Heller.  The President’s deficit‑reduction commission, is there anything that you disagreed with?  There was a lot of tax structural changes talking about deductions and removing ‑‑ Dr. Marron, you are talking about moving forward with a different type of tax structure. 

What in the President’s deficit‑reduction commission ‑‑ were there any principles in there that you agreed or disagreed with?  You said you sat on a similar commission yourself.

Mr. Marron.  Yes.  So, in terms of things agreed with, I very much endorse the idea that, if you are going to do reform, A, it makes sense to do the whole tax system at once, if you possibly can politically, to take into account all of the interactions.  That there are a lot of tax preferences out there that really look a lot like spending programs; they have just been dressed up to appear as tax cuts.  And that, as a result, if someone is interested in making the government smaller, there are actually some things you can do that will be recorded as tax increases that actually are functionally the reduction of spending, from any sort of economic or budget point of view.  And that, as a result, there are ways, basically, to increase revenues that, you know, are not that troubling, frankly. 

I am very much encouraged by the idea of bringing down rates, kind of broaden the base, lower the rates.  As Dr. Carroll mentioned, a little bit of concern that the plans do raise dividend rates and capital gains rates.  And so there is an issue that, while for the corporate form you are reducing rates with one hand, on the other hand you are raising rates on the other hand, and you are not getting as much of a net incentive for investment as you might get with a slightly different form. 

Mr. Heller.  Thank you. 

I have run out of time.  Thank you, Mr. Chairman.

Chairman Tiberi.  Thank you. 

Mr. Roskam is recognized for 5 minutes. 

Mr. Roskam.  Thank you, Mr. Chairman. 

Well, the good news is we all agree on something, and we all agree that the status quo has to change.  There is no voice here on this panel and there is no voice among the witnesses that says, let’s stick with the status quo.  And that is, actually, good news.  I mean, there is this shared premise that we can move forward from. 

What I am interested ‑‑ you know, we are all products of our environment, and we are all reflecting our districts today.  Mr. Heller talked about Nevada.  I am from suburban Chicago, and my district has an extraordinary number of manufacturers, small manufacturers, tool‑and‑die types that are selling into foreign markets and are selling around the world, selling to the Caterpillars of the world and so forth. 

Illinois has a unique dynamic that I am concerned about.  It is nothing that we are going to do anything about today.  It was a bad decision, I think, that was made.  But it is having an impact on this larger conversation about passthroughs. 

Let me just give you a couple of quick facts on Illinois.  Illinois just raised its taxes, right?  So the individual rate went from 3 to 5 percent, a 67 percent increase.  The corporate income tax rate went from 7.3 to 9.5, a 30 percent tax increase.  Illinois now has the fourth‑highest combined national‑local corporate income tax rate.  And according to The Tax Foundation, we have dropped from 23 to 36 in the country among States. 

Now, that is not your problem; that is my problem, because I am an Illinois resident.  But it is also the problem of a lot of companies and businesses that I represent. 

So if we are making changes at a macro level, in terms of U.S. tax policy, that have an impact on driving more businesses into a corporate structure, you see what that does to the employers that I represent.  They are jammed, right?  They have to go into this position.  And what we don’t want to do is move them so that they have to go that route. 

Dr. Carroll, I am interested in your perspective.  A lot of times, when we talk about corporate tax rates and, sort of, corporate tax conversations or general tax reform, we tend to shun passthroughs as a little bit of a sideshow. 

You mentioned three key points, and I just want to yield you some time.  Could you go through those key factors on the distortions within the marketplace, the debt equity distortions and so forth?  Because I think that is an important part of the calibration that this subcommittee needs to take into consideration as we move forward.

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Mr. Carroll.  Yeah.  As I mentioned in my oral statement and explained in some detail in the written testimony, one of the major differences between the taxation as a C corporation and as a flow‑through is the double tax on corporate profits, the notion that a dollar investment in the corporate sector, the return to that investment is first subject to the corporate income tax and then taxed again at the individual level, either when it is paid out as a dividend or if the return is retained then it would be taxed as a capital gain eventually when the shareholder disposes of the stock.  So when you combine those two levels of tax you wind up with a double tax, and that distorts economic decision‑making in a couple of ways. 

Dr. Marron had mentioned that economic fundamentals should drive decision‑making, not tax considerations.  One of the things that the corporate tax does, because it is tax on equity financed investment, interest expenses are deductible but dividends are not, and so it is tax on equity finance investment which creates a bias or adds to the bias for debt finance investment, increases the overall leverage within the economy to the extent that firms are more highly leveraged.  Because of this tax bias, they are going to be more susceptible to financial distress during times of economic weakness.  So that is one of the distortions.  The tax bias for debt finance, the tax bias for greater leverage, that is an issue.

Another issue is you have a different treatment of investment in the corporate sector versus elsewhere in the economy, in the noncorporate, in housing, other sectors in the economy, and that causes a misallocation of capital within the economy.  Again, you have investment decisions throughout the economy being made for tax considerations, not economic fundamentals.  When you have that misallocation of capitol, the capital stock will not be allocated to its best and highest use, and that is going to reduce economic growth.

And then, third, it raises the cost of capital.  The double tax and corporate profits, you know, it is another layer of tax on capital formation, that that higher cost of capital discourages capital formation and investment and, again, would reduce the overall growth rate of the economy.

Mr. Roskam.  Thanks, Dr. Carroll. 

Thanks, Mr. Chairman.

Chairman Tiberi.  Thank you. 

Mr. Thompson, you are recognized for 5 minutes.

Mr. Thompson of California.  Thank you, Mr. Chairman.  Thanks for holding this hearing and thanks to all the witnesses for being here.  I concur with everyone else who said that this is an issue that we all agree on.  We just need to figure out how to get there. 

Just a real quick question, Ms. Thompson.  On the 1099 issue that you raised, do you have any suggestions on how this Congress should deal with the underlying issues that brought the 1099 matter to the forefront?  And that is, the $30 billion or $25 billion worth of tax evasion that is going on, how do you address that? 

Ms. Thompson.  I think that would probably be on enforcement side, which the IRS does have the ability to ‑‑

Mr. Thompson of California.  But they don’t have the data.  You can’t put an IRS person at every point of purchase.

Ms. Thompson.  I think that the existing rules that are in place cover services, and I don’t think that everybody is even in compliance with that one.  So we might start working on that area first. 

I think the way the legislation is written right now it is covering goods and it is covering corporations, and that is not realistic on how you are going to solve the problems.  The example that everybody is talking about is if a small business owner goes into Staples and purchases their office supplies and they happen to spend more than $600 in a year, they are going to be required to send a 1099 to Wal‑Mart and Staples, and it just doesn’t seem like it is the right target that you are looking for.

Mr. Thompson of California.  A couple of you have raised the whole issue of complexity, and for those of us who were in the meeting that we had in the full committee when we got a briefing on the U.S. tax structure it is pretty hard to argue that the system isn’t just overwhelmingly complex. 

In another life, I chaired a tax committee in the State legislature in California, and I had business people tell me just, you know, lower the heck out of our taxes.  We understand things need to be revenue neutral, and that you need money to do all the things that government does.  But the lower our tax rate is, the more people we will hire, the higher wages we will pay, the better off everybody will be.  Get it at the employee.  We are paying them well.  They should pay taxes.  Do you think that is a pretty accurate approach? 

To any of you, do we have too many tax options for business?  I think Mr. Neal said it earlier, that everything that is there that makes it complex was there to address a certain issue or, in most cases, to help business.  Do businesses have too many tax options on the table? 

Mr. Tarnay.  The answer is yes.  Also, the answer is, if it can be done so that the law is something that people can understand for a significant period of time, as opposed to things changing year‑to‑year or less than 5 years, people can plan that.  I can plan it.  My company can plan that.  We understand that.  We can move forward.  Okay?  That is the difficulty that we have.

And the other thing is, simply law changes that are retroactive.  When you hear that, you don’t do things because you don’t know when that retroactive application is.  If we knew that, we can plan.  That is what we need.

Mr. Thompson of California.  So if there were fewer options, if you didn’t have the LLC, didn’t have the corporate election, and you had just a business tax? 

Mr. Tarnay.  Well, I am not saying the type of entity.  I am saying within that type of entity that you understand what the law is.  It is simple.  It is fair.

Mr. Thompson of California.  I get that part.

Mr. Tarnay.  That is it.

Mr. Carroll.  I guess I would say that I think one of the distinguishing features of the U.S. business tax system is we do afford businesses with different choices on how to organize themselves, and I have always thought of that as a virtue.  It allows companies to make the choice that best fits and suits their capital requirements and their management needs.  It is probably one of the many distinguishing features of the U.S. economy in comparison to our major trading partners.  That flexibility probably adds to the dynamism of the U.S. economy.

Mr. Thompson of California.  To follow up on that, Dr. Carroll, are there certain anti‑avoidance measures that would have to be put in place if you were to devise a system that pushed the rate down and lessened the options? 

Mr. Carroll.  Yeah, that is a very, very interesting question, and it is kind of an extension of your earlier question in some sense in terms of how tax rates affect decision‑making. 

Typically, from an avoidance or a compliance perspective, one would think higher tax rates would encourage greater avoidance and noncompliance activity.  Because the benefit of avoiding and the benefit of not complying to the taxpayer is greater with the higher rates.  So one of the benefits of lowering rates generally would be that you would help mitigate and reduce avoidance behavior.

Chairman Tiberi.  The gentleman’s time has expired. 

Mr. Thompson, just a side note we tried to find Grandma Thompson to come testify.  When we couldn’t, we had Ms. Thompson instead.

Mr. Thompson of California.  That is why I cautioned you, you better lay off the Grandma Thompson jokes today.

Chairman Tiberi.  Mr. Paulsen is recognized for 5 minutes.

Mr. Paulsen.  Thank you, Mr. Chairman.  It is nice to be having a hearing that is focused on small business entities, and I appreciate your testimony here today.

Knowing that we are in a very globally competitive economy, absolutely, and, you know, today we have to have a Tax Code that has not only the predictability in the long‑term thinking, but, I mean, I really do believe it also has to spur innovation, spur the whole idea of entrepreneurship, and also capital formation and investment.  I think there are a lot of staff people in the administration or even Members of Congress that don’t understand the allocation of capital, and that is really what this is about, how you allocate capital in the global environment. 

One of my concerns with the administration’s proposal on tax reform is that it is centered more on the corporate tax side, at least in the President’s State of the Union proposal, and he talks about having a revenue‑neutral basis for corporate tax reform.  I want to make sure that is not going to be an expensive trap for small business entities and pass‑through entities such as S corps, LLCs, sole proprietorships, partnerships, et cetera. 

If that is the track that is ultimately pursued and a lot of our Nation’s employers are going to see tax increases because we eliminated certain tax business, the expenditure side like deductions for depreciation, et cetera, which you talked about, you know, what would be some of the ramifications of that from the standpoint of ‑‑ while there might be not be any offsetting benefit, in essence, for small employers ‑‑ and, on top of this, we also heard Secretary Geithner actually, just last week I think, float the idea of having some pass‑throughs be pushed more into the C corporation model, actually, ensuring they would also be hit with this inefficient double tax. 

So let me ask Mr. Carroll first maybe, if the purpose of tax reform is to actually make the U.S. government more competitive or our economy more competitive, I should say, and encourage job creation, does it make sense to push more people into the C corporation tax model? 

Mr. Carroll.  My view is that that is problematic.  As I already discussed, we have a double tax on corporate profits.  It distorts decision‑making in some fairly fundamental ways.  It is kind of widely recognized among economists in the policy community that the double tax on corporate profits is a significant problem.  It contributes to the leverage among businesses.  It misallocates capital, and it raises the overall cost of capital for the economy.

Most other developed nations have provided some relief from the double tax on corporate profits in some way.  They have shifted a little bit in the last 10 years in how they do that, whether they do it at the shareholder level, whether they do it at the corporate level, the mechanism in which they deliver it.  But the U.S. tends to have fairly ‑‑ even after the lower rates on dividends and capital gains were enacted in 2003, we still have a fairly high double tax on corporate profits such that a dollar of investment in the corporate sector that is paid out as dividends is taxed pretty highly relative to most other things. 

I think that is a problem.  It kind of complicates ‑‑ and I think it really complicates if you try to redraw the line between the flow‑through sector and the C corporation sector.  To raise more revenue to lower the corporate rate, I think it would make the double tax problem larger, not smaller.

Mr. Paulsen.  And, Ms. Thompson, I am just curious, what would happen to your clients if they got pushed into a C corp model? 

Ms. Thompson.  I think it is really too early to say what would happen if they moved into the corporate form because it hasn’t been worked out on what all the details of that are.  Are there going to be changes to the expenses?  Is there a going to be a double tax?  So it is really too early to answer that question.

Mr. Paulsen.  Mr. Chairman, I follow up in a different angle to what Mr. Carroll ‑‑ I know that you looked at the economic issues that are associated with S corporations and with the subset of S corporations, namely, employee owned or ESOP S corporations, in particular.  These are companies essentially that are employee owned and they fared much better in tough economic times in terms of actually growing their companies during these trying times and also putting people back to work, providing retirement security, actually, for their employees.  If the administration’s proposal to move and eliminate some of those pass‑throughs on S corps became a reality, for instance, what would this mean for privately employee‑owned companies potentially?  Who would be affected by such changes within those organizations? 

Mr. Carroll.  Yeah, I think the S corp ESOP structure is very interesting.  The employee ownership aspect is very interesting, and the performance of those companies based on some work that I have done suggest that those companies performed better during the economic downturn than the rest of the economy in the sense ‑‑ although it is not a huge segment of the economy, they did in effect provide, in some sense, a backstop during the economic downturn.  They tend to pay their workers higher average wages, and they tend to provide a fairly high level of retirement security.  So the ESOP provides that benefit as well.

Mr. Paulsen.  Thank you, Mr. Chairman.

Chairman Tiberi.  Thank you. 

Mr. Berg is recognized for 5 minutes.

Mr. Berg.  Thank you, Mr. Chairman.  I appreciate you being here. 

As a small businessman, it is kind of over the years going through the 1986 tax reform and everything else, small business tends to make decisions, first of all, on the economics, but they are really influenced by the taxation.  And it seems to me ‑‑ I enjoyed the OFO, only financial officer.  I think that is what a lot of these small businesses are. 

And when there is laws that are passed, they are either convoluted or complicated.  They are trying to look at that and figure that out.  And the point of having a third party analyze this for the business, I mean, those are things that, again, specifically help at little moments in time but I think overall really cause a lack of focus in what maybe a small business should be focused on.

So one of the things that I heard you saying that potentially when you eliminate some of the accelerated depreciation and other things that you could probably bring the rate down to 28, 27 percent.  I wonder if you ever looked at just the silo of pass‑through entities.  If you said just looking at this group of pass‑through entities, if we eliminated, again, or changed this to simplify it, what could that overall rate be brought down to?  Would that be the 28 percent?  Whoever would like to ‑‑

Mr. Carroll.  I think if you were looking at just the flow‑through sector by itself, I haven’t done the calculations in terms of how low the rate could be brought down.  As I mentioned, flow‑through entities use about 22 percent of the business tax expenditures, and they report about 40 percent of the net income and pay about 43 percent of the business taxes.  So, in that sense, the C corporations kind of make somewhat greater use of business tax expenditures.  So that might give you some sense of kind of the relative reduction of the rates.

But I would point out that if one tried to just do corporate reform and tried to draw a line in the various business tax expenditures or business tax provisions so that they would only be reduced or eliminated for C corporations or did the same for pass‑throughs, I think that would be a very, very complex, complicated system.  Trying to make those distinctions on something like accelerated depreciation that is probably available to all business forms in trying to have one system for C corporations and another system for flow‑throughs I think would be an extraordinarily complex system.

Mr. Berg.  Ms. Thompson, you had mentioned the 100 percent gain exemption, and that was a little bit new to me.  Could you explain that briefly and how that could benefit if it were implemented for pass‑through entities? 

Ms. Thompson.  The provision is that if you have a gain on the sale of a small business stock you can exclude 100 percent as long as you purchased the stock between September, 2010, and December, 2011; and starting in January, 2012, it is going to drop down to 50 percent gain exclusion. 

But what happens with that provision right now is it is only available to C corporations; and, as we had talked about, most of the small businesses are running as pass‑through entities.  And so if that is a C corporation provision, it automatically excludes everybody who has been running this small business as a pass‑through entity.  The value has to be less than $50 million, and it has to be in certain types of businesses, and it can’t be any type of personal services.  It can’t be restaurants, hotels, motels, those types of things.  So it is really very narrow, and it is even more narrow because it is only C corporations, which most of the small businesses aren’t.

Mr. Berg.  Thank you. 

The other issue that has come up time and time again is the uncertainty and unpredictability.  I mean, I think whatever our tax rates were, whatever our deductions were, if they were set in stone for 15 years, that would be a good thing for small business and probably all business, as long as it is competitive.  And so I guess looking at that ‑‑ and I am asking myself ‑‑ what are the taxes out there that are on like a short‑term trigger that need to be renewed that create this uncertainty out there?  In our current Tax Code, as it relates to the pass‑through entities, what are those either deductions or what are those things that you are aware of that creates that uncertainty that could be addressed in this Congress? 

Again, I am not, I guess ‑‑

Ms. Thompson.  The first one could absolutely be the tax rate.  Because we do know that they are set until the end of the next 2 years, through 2012.  But then once you get beyond that depreciation we do know that this is a business incentive that you put in place more when the economy isn’t really good.  But having that come in and out as frequently as it does, that is causing quite some challenges.

Mr. Berg.  Thank you. 

So tax rates and depreciation.  Is there anything else? 

Ms. Thompson.  From the small business perspective, I think those are the major ones that we come across.

Mr. Berg.  Dr. Carroll.

Mr. Carroll.  I think if you look broadly at the tax system, you have a large fraction of the Tax Code that is really in flux from year to year.  You have the sunset of the Bush tax cuts at the end of 2012 which raises a considerable uncertainty, and you also have the various expiring provisions, including the R&D credit that is used by small businesses as well as large businesses, and that expires periodically.  There is a long list of expiring provisions.  All of these things create a lot of uncertainty and instability in the Tax Code and make it very, very difficult for both individual and business taxpayers to make decisions.

Mr. Berg.  Thank you.

Chairman Tiberi.  Thank you.  Thank you, Mr. Berg. 

Dr. Boustany is recognized for 5 minutes.

Mr. Boustany.  Thank you, Mr. Chairman, and thank you for holding this hearing.  This is a very important hearing. 

Some time ago, I was back home doing a town hall meeting and I was talking about American competitiveness and the need to lower the corporate tax rates so we could compete in the global economy.  And after some lengthy discussion about all of that, I had a small business owner who I had happened to know, a gentleman by the name of Paul Fontana, who owns an occupational therapy business, and he stood up and he said, what about me?  What does this get me?  And it got me to thinking and I said, well, you know, you are right, because you have a pass‑through entity.

And as we go through this discussion it becomes apparently clear to me that we really have to focus on our small businesses and pass‑through entities as we do tax reform.  Otherwise, I think we will be negligent in the approach. 

Dr. Carroll and Dr. Marron, the administration is talking about reducing the corporate tax rate, which I think we all agree we need to do, and we are looking at targeting it down into the 20s, you know, 20, 25 percent, if we can get it down that low, to be really competitive.  But, at the same time, the administration is talking about raising the top level for pass‑through entities, the top rate for pass‑through entities and individuals to almost 40 percent.  So what is going to be the economic consequence if that is allowed to go through?  Dr. Carroll.

Mr. Carroll.  Yeah.  I think our corporate tax system is very much out of step in the global economy.  Most other developed nations within the OECD have lowered their corporate tax rates significantly over the last ‑‑ certainly since the mid‑1980s, and we now have the second highest corporate tax rate exceeded only by Japan.  Japan is likely to reduce their corporate tax rate in April, in which case we will have the highest.  So that kind of provides a backdrop for why there is an interest in corporate tax reform.  You know, we want the U.S. to be able to compete in a global economy, and the world has really changed.  It is very different now than it was.

Mr. Boustany.  What is the economic consequence here in the U.S. with this disparity if we have a top rate of almost 40 percent for our pass‑throughs and for individuals as we lower the corporate tax rate? 

Mr. Carroll.  I think it is a very problematic.  I think it is very problematic.  The flow‑through sector, as I said, is a very large segment of the economy, employs 54 percent of the private labor workforce, and to have a very different treatment of pass‑throughs relative to C corporations is a problem.

Mr. Boustany.  Thank you. 

Dr. Marron.

Mr. Marron.  Again, I would go back and reference what the fiscal commission came up with, the Domenici‑Rivlin Commission came up with.  There was a reason they chose in the end to try to have the top rates on the individual side and the corporate side be the same, and one of those key reasons is to avoid all the distortions that would arise.  If you have one rate that is 40 and you have another that is 25, you have created a gigantic incentive for creative people to think about how do I exploit this to best advantage, and that is thinking that would be better deployed doing something else in the economy. 

So if you can do fundamental reform of the entire system, that means touching all sorts of other tax preferences that are purely on the individual side and have nothing to do with business, much better to end up with rates being ‑‑ you know, they don’t literally have to be identical but close to each other.

Mr. Boustany.  Close.  Thank you. 

One of the common refrains I hear from small business owners is about the issue of accelerated depreciation, and we saw this after the hurricanes.  It was probably the single most important thing Congress did to spur the Louisiana economy after hurricanes Katrina and Rita; and I appreciated your comments earlier, Dr. Carroll, about both the short‑term and long‑term consequences that are positive with this type of approach.

And, Ms. Thompson, in your testimony you highlighted a number of the complexities, the varying in rules and everything else, which I read with great interest; and I am going to look at the report that you all have as well.  But how could tax reform simplify some of these rules related to capital investment that would allow for small businesses to actually see capital formation? 

Ms. Thompson.  I think the best thing you could do with the depreciation is have it for a longer period of time and put it in place prior to the time that you are thinking about it. 

For example, if you wanted it to be effective January 1, 2011, put it in place, if you could, in 2010 and don’t have it just for a 1‑year period, have it for a much longer period of time.  Then that gives the ability to the small business owner to plan their investments better, their purchases, and that would really add a lot to the simplification of the system because everybody does like the accelerated.  It is just that it comes in too frequently at various times during the year.  It is just challenging.

Mr. Boustany.  Does anyone else want to comment on the issue of depreciation versus expensing and, you know, the concerns about debt financing before we conclude this? 

Mr. Marron.  If I could just second something I said before, is I am sympathetic to approaches that would move towards expensing if at the same time you think about walking back the deductibility of interest.  Otherwise, you accidentally end up in a system where, if interest is deductible, you can have a situation in which we effectively have negative tax rates on capital investment, which I think is going too far.  But if you, you know, keep accelerated depreciation and move towards expensing but then think about rolling back interest deductibility, you can have a system that reduces that debt equity distortion and provides incentives for investment.

Chairman Tiberi.  Anybody else care to answer? 

The gentleman’s time has expired.

Mr. Boustany.  Thank you.

Chairman Tiberi.  Ms. Berkeley, recognized for 5 minutes.

Ms. Berkley.  Thank you very much, Mr. Tiberi, and thank you for holding this hearing.  I thank all the witnesses.  I have learned a lot this morning, and I appreciate that. 

I agree with my colleagues that reforming the tax system is critical to the long‑term health of our economy.  I don’t think you need to be a genius to figure out that the tax code is bloated and it is very complex.  It adds unnecessary costs to business operations and distorts business investment decisions. 

That the Code is unnecessarily complex is a complaint that I hear often from my constituents in Las Vegas, and I worry that it poses an additional hurdle to my district getting back on its feet economically.  We are in a world of hurt in Nevada, particularly in Las Vegas, which is the community that I represent.  Half of the businesses ‑‑ although I know everybody thinks of Las Vegas as the glitz and the glitter and the big hotels, and in fact that is part of our persona and has served us well until the latest economic crash ‑‑ about half of the people that are employed in the State of Nevada are employed by small businesses.  So what we are talking about today is very important.  I know that this is the beginning of a very long process. 

In the State of Nevada, pass‑through entities outnumber C corporations by almost three to one.  So what we are talking about here today is very important to the people I represent. 

There are a number of questions that I have.  The first one is just some musings.  I know that we are all talking about budget neutrality and if we could bring down the corporate rates to 27, 28 percent across the board, get rid of all the tax extenders, the tax breaks, the tax credits, it would add to predictability and simplicity, which everybody believes would be better for small businesses.  If you know what is happening, what you can plan for 10 years from now, 5 years from now, obviously, it impacts on your business decisions and gives you an opportunity to make better ones. 

But having been through the tax extender debate and having everybody that I knew that owned a business of some kind coming into my office and asking for an extension of their tax break, no matter what business they are in, if it is propane gas or speedways throughout the United States, I am wondering how willing businesses are going to be to give up these tax breaks that we have extended over the years? 

And I would imagine that if we lowered the tax rate ‑‑ and I agree with you, when you look at our tax rate on paper in comparison to other industrialized countries, it seems very, very high.  But when you factor in all the tax breaks, tax credits, tax extenders, I think it generally lowers our overall corporate tax rate dramatically. 

I can tell you in my congressional district, without naming names specifically, I have one gaming company that pays overall about 8 percent after they take advantage of all their tax breaks, and I have another that pays over 30, and they are both pretty big companies.  Now, I wonder how the company that is now paying about 8 percent of their taxes is going to feel when we pass legislation that kind of stabilizes everybody at around 27, 28 percent while eliminating the tax breaks.  Can you comment on that? 

Mr. Carroll.  Yeah.  A lot of points that you have raised there that are all I think very important.  One point is, you know, how do we compare to other nations?  And there are different ways of measuring that.  We do have a high statutory corporate tax rate.  We also have a high ‑‑ what economists call a marginally effective tax rate relative to other nations.  There is a recent study that was released by an academic in Canada, Jack Mintz, that makes that point. 

We also have a very high effective tax rate and measured on a financial statement basis based on some work by an academic, Doug Shackleford down in North Carolina. 

There are a number of ways of thinking about effective tax rates or tax rates generally, and which tax rate you look at really depends on which question you are asking.  But by a number of different metrics the U.S. looks like it is pretty out of step relative to other countries.  So that is I think one point to keep in mind.

Ms. Berkley.  Mr. Marron, you pointed out in your testimony the connection between the complexity of the Code and the tendency of small businesses to underpay their taxes.  Can you share with us some areas of the tax code where simplification would have the highest effect on boosting compliance? 

Mr. Marron.  Well, in my remarks I was very careful to use ‑‑ what was the word I used ‑‑ responsible and irresponsible just to distinguish small business as a whole, vast array of different kinds of firms, some of which face very high compliance burdens and try to pay the taxes they do; and then, unfortunately, there are other ones who are able to avoid.

You know, unfortunately, I don’t have any good recommendations for you.  I mean, again, some of these things have to do with, you know, cash transactions which are hard to monitor.  It is just sort of a fundamental nature of some of these transactions that they are going to be more difficult to reach to. 

There was the effort with the 1099 which has gotten a lot of understandable pushback, and that is that the burden it placed on folks seems to be disproportionate to the additional revenue it is going to raise. 

Maybe some of my colleagues have some suggestions for you, but I do not, sorry.

Chairman Tiberi.  The gentlelady’s time has expired, but any of the other witnesses care to answer her question? 

Ms. Berkley.  So no suggestions on how we can, in fact ‑‑ what we can do with the Tax Code where simplification would have the highest effect on compliance?  No help? 

Chairman Tiberi.  The gentlelady’s time has expired. 

We are going to one more round, if the witnesses would care to indulge us, for just one question from each of the members, if they wish.  I will start out by asking all four of you ‑‑ well, two of you ‑‑ a question; and then I will follow up with the other two. 

Earlier this week, in a publication called Tax Notes, an article, a gentleman by the name of Marty Sullivan, who the minority actually invited as a witness a couple of weeks ago on tax reform, argued that double‑taxing on corporate income is bad economic policy; and let me quote what he wrote in the article:  We should recognize that the movement from double taxation to flow‑through taxation is a step in the direction of sound policy.  Tax reformers and professors will tell anyone who will listen that all business income should be taxed on a flow‑through basis. 

I would like to get opinions from Dr. Carroll and Dr. Marron on Dr. Sullivan’s point that double taxation on business income is bad for jobs and the economy, and good policy means moving toward taxing business income once.  Do you agree or disagree or and why? 

Mr. Carroll.  I do agree with that.  As I have already alluded to or stated in my comments, the double tax on corporate profits distorts economic decision‑making in a number of very important ways.  It leads to a higher degree of leverage in the economy, which is problematic; it leads to a misallocation of capital throughout the economy, which is problematic; and it raises the cost of capital, which discourages capital formation.  That is also problematic. 

Using something Donald said earlier, you know, economic fundamentals, not tax considerations, should drive decision‑making, and the double tax I think violates that principle.

Chairman Tiberi.  Thank you. 

Dr. Marron.

Mr. Marron.  I agree as well.  There are lots of plans over time that said, you know, if you could go back to the beginning and redesign a tax system from scratch, how would you want to design it?  And there are different ways of doing it, but they all have this feature that you eliminate the double tax.

Chairman Tiberi.  Mr. Tarnay, if you were forced to go and become a C corp, how would that impact your ability as a CFO to create jobs from your current tax system? 

Mr. Tarnay.  I think it would diminish it greatly.  A small business owner thinks one way:  I made a dollar.  I should pay tax on that dollar.  Not a dollar and then, after I get some money from it, then pay tax at the individual level.  This is how they think.  One‑time tax on that earnings.  Flow‑through entities allow for that.

Chairman Tiberi.  Ms. Thompson, you had mentioned that you do tax returns for a variety of clients, a lot of small business owners.  How would a majority of your clients be impacted if we forced all businesses to pay at a C corp rate? 

Ms. Thompson.  Without knowing all of the details of the tax reform and if you were purely to say everything is going to stay in place except you are now going to be corporations and you are going to need to double‑tax employees, they would be hurt tremendously.  I have had clients who have been C corporations in the past who, when they went to sell their business, they end up paying more than 50 percent in taxes, and it was overwhelming to them.  So it would really hurt them significantly if they had to go a C corp level tax and pay double.

Chairman Tiberi.  Thank you. 

I will yield time to Mr. Neal. 

Mr. Neal.  Thank you, Mr. Chairman. 

Dr. Carroll, you mentioned that ESOP entities tended to do better in the recession in terms of retirement savings, and you know that is something I have in interest in.

Mr. Carroll.  Yeah.  In a number of different metrics, based on some analysis that I have done, it looks like the ESOPs did fare better during the recession than ‑‑ S corp ESOPs fared better during the recession.  They grew at a faster rate.  They added more jobs.  Generally, they have higher average wages; and, generally, they have a greater retirement security.

Mr. Neal.  Let me follow up on the point Mr. Thompson was making to you about anti‑abuse rules.  You pointed out that if the corporate tax was significantly lowered, that the lower rates don’t usually foster abuse, I think what he was trying to get at was that abuse might arise if the corporate rate was at 15 percent and the highest individual rate was at 35 percent.  In this scenario, would you see some movement of earnings to the corporate form? 

Mr. Carroll.  Oh, there is movement between ‑‑ at a high level, there is movement between the flow‑through sector and the C corporation sector, depending on the relationship of the individual tax rate and the corporate tax rate.  We saw that after the 1986 Act with the repeal of the general utilities doctrine and as well as the change in the relationship of the rates, we saw a movement that, some research that I did a while back, ascribed to the change in the rates.  Austan Goolsbee has done some research in the area as well that has found that the number of businesses or the level of activity within each sector is sensitive to the relative taxation.

Mr. Neal.  Thank you, Mr. Chairman.

Chairman Tiberi.  Thank you. 

Mr. Paulsen is recognized.

Mr. Paulsen.  Thank you, Mr. Chairman. 

And maybe I will just follow up with Mr. Tarnay.  I didn’t get to ask you a question before, but you listed several items as a part of your testimony that were important for tax reform to be in consideration.  And, you know, we all agree tax reform is necessary.  You have got the corporate component, you have got the pass‑through entities which we are talking about today, but can you just discuss in greater detail a couple of the items or maybe the top handful of the most important issues that should be focused on that would be the best ‑‑ I mean, the absolute best, actually, to help spur economic growth and capital formation and investment, if there is just sort of a top wish list that should absolutely be focused on.

Mr. Tarnay.  I think the timing in the requirements of an S corporation, because it is complex because of the levels of ‑‑ if you have certain stock structures, you can’t be an S corporation, certain number of shareholders, you couldn’t be ‑‑ I think that could be simplified.  I don’t agree with the alternative minimum tax, but I think that if you can’t take it away then I think it needs to be revised and simplified.

Mr. Paulsen.  Okay.

Mr. Tarnay.  Those are the two.

Mr. Paulsen.  Do you have any idea how many small business entities end up falling into sort of the alternative minimum tax because of their pass‑through income?  And maybe, Mr. Carroll, you may know.  You kind of nodded your head.

Mr. Carroll.  I actually don’t know the answer to that question, but it is a very interesting question.

Mr. Paulsen.  Okay.  Well, Mr. Chairman, if we can somehow have tax staff to look into that, too.  Because I know the alternative minimum tax is something that keeps trapping more and more people, and a lot of these people ‑‑ small businesses that pay also under the individual rates obviously would get trapped in that.  So I yield back.

Chairman Tiberi.  Thank you. 

Mr. Berg is recognized.

Mr. Berg.  Thank you, Mr. Chairman. 

We have seen a lot of statistics that show our corporate rate relationship to other countries across the world.  My question is, tell me about the pass‑through entities in these other countries; and, again, maybe, Dr. Carroll, you could start.

Mr. Carroll.  Yeah.  A lot of other countries push businesses into the corporate form in pursuit of limited liability.  That is one of the distinguishing features I think between the U.S. and other countries, is it is much easier to get limited liability in this country because of the flow‑through form and the various organizational forms in that sector.  And so that is one of the reasons we have a much larger flow‑through sector than most other nations. 

You know, I think that is ‑‑ one could also do a comparison of the kind of the tax rates that the flow‑through income received by individuals in the U.S. is subject to as compared to other nations.  I am less familiar with those statistics.

Mr. Berg.  Mr. Chairman, my question, kind of here in America we are trying to keep those two rates pretty close.  I argue that we should look at the net rate and not the gross rate.  But my question related to other countries, is their pass‑through rate similar to their corporate rate or is there a disparity in these other countries that we are aware of? 

Mr. Carroll.  I think there does ‑‑ without having looked at the data in detail, my sense would be that there tends to be some disparity.  The corporate tax rates tend not to be particularly high relative to individual tax rates.  There are a few countries that have tried to apply, in a sense, separate tax systems, particularly in the Nordic countries where they treat partnership income, you know, very differently than the income of wage earners in order to coordinate the corporate sector tax and the flow‑through sector tax.

Mr. Berg.  Let me, Mr. Chairman, wrap up just ‑‑ my question, when that nets out to the individual, the stockholder, where we are competing with another country that has a low corporate income tax, are they paying a very high personal income tax so that net that that person is paying, you know ‑‑

Mr. Carroll.  Yeah.  So looking at it a different way, if you look at kind of the net after‑tax amount received for a dollar invested in the corporate sector abroad, you know, kind of what is the sum total of the double tax on corporate profits, for a dollar paid out as dividends, that tax bite when you look at both levels, the corporate and individual level, tends to be higher abroad than here.  The U.S. tends to have a higher level of tax on a dollar invested in the corporate sector and paid out as dividends than our major trading partners.  And if the rate were to go up, the dividends and capital gains rates were to go up, then that difference would become fairly substantial.

Mr. Berg.  Thank you.  Thank you, Mr. Chairman.

Chairman Tiberi.  Thank you, Mr. Berg. 

Ms. Berkeley is recognized.

Ms. Berkley.  Thank you, Mr. Tiberi. 

I kind of caught something, Ms. Thompson, that you said, and I just wanted to make sure that I understand it completely.  Secretary Geithner has suggested that some pass‑through entities are ‑‑ in fact, very large firms, not the traditional small businesses, at least I think of it ‑‑ these large firms have revenues in the tens of millions of dollars.  Mr. Paulsen, I think, asked you what the impact of being taxed as a C corporation would be on your clients.  Could you share with us what percentage of your clients are of the size that Secretary Geithner was referring to? 

Ms. Thompson.  That is not the level of my clients.  My clients are very small businesses.  They have probably four to six members and revenues are probably ‑‑

Ms. Berkley.  You mean employees or members? 

Ms. Thompson.  No, owners of the company.  So you are talking about either C, S, or pass‑through entity owners.  There is probably four to six of them.  So they are very small from the measure of owners.  As far as revenue, they are probably, I am going to say, $25 million or less.

Ms. Berkley.  Okay.  So the comments that Secretary Geithner made would not ‑‑

Ms. Thompson.  It is not typical of my firm.

Ms. Berkley.  All right. 

And, Mr. Marron, in your opinion, what percentage of pass‑throughs are of the very large size that Secretary Geithner was referring to? 

Mr. Marron.  It is a very small percentage of the population but a significant fraction of the economic activity.

Ms. Berkley.  Please say that again.

Mr. Marron.  If you do it by counting the number of firms or the number of businesses, the number that are in that size range appears to be very small.  But because they are large, they account for a fairly large fraction of the economic activity, whether it is assets or revenues or income that are accounted for by pass‑throughs as a whole.

Ms. Berkley.  All right.  Thank you very much.

Chairman Tiberi.  Thank you. 

Dr. Boustany is recognized.

Mr. Boustany.  Thank you, Mr. Chairman. 

Dr. Marron’s testimony talked about partnership activity conducted through large partnerships and not small businesses, but aren’t many of these large partnerships actually joint ventures whose partners happen to be corporations themselves?  Dr. Carroll.

Mr. Carroll.  Yeah.  There is a significant fraction of partnership income where ‑‑ stated a different way, the owners of partnerships can be individuals or corporations, unlike, say, an S corporation where there is a restriction.  Only individuals can own an S corporation.  A sole proprietor, by definition, is an individual.  But for partnerships, based on the statistics I have seen, roughly 50 percent of partnership income results from partnerships that have corporate owners.  So you could think of two companies that engage in a partnership, a joint venture to do something, build a project, and then they distribute the income to the two corporate owners.  So about half of the partnership activity seems to be owned by corporations.

Mr. Boustany.  So if we were to tax those entities, those large partnerships or joint ventures like C corps, then in effect we are subjecting them to triple taxation; is that correct? 

Mr. Carroll.  Yeah.  If you did that, there is a long tradition of having flow‑through treatment of partnerships for that very reason that, you know, if they are owned by the other businesses, just as if a C corporation owned another C corporation, then you wouldn’t want to kind of have multiple layers of tax in the same activity.  There is usually a dividends‑received deduction associated with income that flows from one part of a complex business unit to another.

Mr. Boustany.  So, in effect, a joint venture is being taxed, the corporate partners are being taxed, and then the shareholders of the corporate partners would be taxed.  So, in effect, really triple taxation.

Mr. Carroll.  Right, that was the change.

Mr. Boustany.  Thank you.  I yield back, Mr. Chairman.

Chairman Tiberi.  Thank you, Dr. Boustany. 

Thank you all, all the witnesses who are here today; and members are advised that members may submit written questions to our witnesses.  Those questions and the witnesses’ answers will be made part of the record of today’s hearing. 

Again, thank you to the four of you for appearing today.  It has been an educational discussion, and I hope just the beginning, and it is hopefully helpful in moving the conversation forward on comprehensive tax reform.

This hearing is adjourned. 

[Whereupon, at 10:42 a.m., the subcommittee was adjourned.]

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