Tax Reform Options: Incentives for Innovation

Comments for the Record

United States Senate Committee on Finance

Tax Reform Options: Incentives for Innovation

Tuesday, September 20, 2011, 10:00 AM

215 Dirksen Senate Office Building

By Michael Bindner

Center for Fiscal Equity

Chairman Baucus and Ranking Member Hatch, thank you for the opportunity to address this topic. As you know, the Center for Fiscal Equity suggests a four part tax reform, which form the basis of our analysis. The key elements are:

• a Value Added Tax (VAT) that everyone pays, except exporters,
• a VAT-like Net Business Receipts Tax (NBRT) that is paid by employers but, because it has offsets for providing health care, education benefits and family support, does not show up on the receipt and is not avoidable at the border,
• a payroll tax to for Old Age and Survivors Insurance (OASI) (unless, of course, we move from an income based contribution to an equal contribution for all seniors), and
• an income and inheritance surtax on high income individuals so that in the short term they are not paying less of a tax burden because they are more likely to save than spend – and thus avoid the VAT and indirect payment of the NBRT.

The incentives to innovation in the current tax code are only relevant to the extent that wages and profit are taxed separately through income and payroll taxes. Such incentives are difficult, though not impossible to preserve in tax reform to the extent that tax reform eliminates the Corporate Income Tax on profit and replaces it with reforms such as a Value Added Tax and a VAT-like Net Business Receipts Tax (which tax both labor and profit). As Value Added Taxes never contain offsetting tax benefits, we will confine our remarks to offsets to Net Business Receipts Taxes.

One of the virtues of an NBRT is that offsets are possible, which is not the case with a VAT or the FairTax. The challenge arises, however, when the existence of such subsidies carry with them the very justified impression that less well connected industries must pay higher taxes in order to preserve these tax subsidies. Worse is the perception, which would arise with their use in a business receipts tax, that such subsidies effectively result in lower wages across the economy. Such a perception, which has some basis in reality, would be certain death for any subsidy.

One must look deeper into the nature of these activities to determine whether a subsidy is justified, or even possible. If subsidized activities are purchased from another firm, the nature of both a VAT and an NBRT alleviate the need for any subsidy at all, because the VAT paid implicit in the fees for research and exploration would simply be passed through to the next level on the supply chain and would be considered outside expenditures for NBRT calculation and therefore not taxable. If research and exploration is conducted in house, then the labor component of these activities would be taxed under both the VAT and the NBRT, as they are currently taxed under personal income and payroll taxes now.

The only real issue is whether the profits or losses from these activities receive special tax treatment. Because profit and loss are not separately calculated under such taxes, which are essentially consumption taxes, the answer must be no. The ability to socialize losses and privatize profits through the NBRT would cease to exist with the tax it is replacing.

The last question concerns repatriation of overseas profits now taxable under the corporate income tax. The answer to this question depends on the tax impacted. Clearly such repatriations would have not impact on VAT collection, as VAT would have been collected where the item is sold. If the item were made in the USA and exported, the returning funds would be tax free. Indeed, collecting such funds would be tantamount to a constitutionally prohibited export tax.

The NBRT would not be border adjustable because it is designed to pay for entitlement costs which benefit employees and their families directly, so that it is appropriate for the foreign beneficiaries of their labor to fund these costs. Additionally, the ultimate goal of enacting the NBRT is to include tax expenditures to encourage employers to fund activities now provided by the government – from subsidies for children to retiree health care to education to support for adult literacy. Allowing this tax to be zero-rated at the border removes the incentive to use these subsidies, keeping government services in business and requiring higher taxation to support the governmental infrastructure to arrange these services – like the Committee on Finance.

The NBRT is collected based on where costs are incurred and dividends paid. Therefore, if foreign profits are repatriated and used to finance American research and development activities and distribution of dividends to American shareholders (or foreign shareholders based in the United States), NBRT would be due on researcher salaries and dividends paid out. Finally, dividends paid out to individuals responsible for paying the income and inheritance surtax would be fully taxable under that levy as if they were paid out from American operations.

Thank you again for the opportunity to present our comments. We are always available to discuss them further with members, staff and the general public.