Business Gives Cold Shoulder To Baucus 'Tax Cut'

A senator who proposes to cut the corporate tax rate probably expects praise from corporate leaders. When, instead, he finds them among his most vocal critics, the senator should consider the possibility that his plan needs more work.

So it is with Sen. Max Baucus, D-Mont., whose corporate tax proposal has few fans among the businesses it would affect.

One reason is that, as business lobbyists have pointed out, Baucus' plan would add complexity and vagueness to the existing tax code, which is more than amply complex and vague to begin with. The bigger reason, however, is that in order to make the plan revenue-neutral, the proposal would slow business' ability to write off investment costs.

That is exactly the opposite of what a sensible tax policy - one that seeks to encourage and expand economic activity - ought to be doing. Yet tax writers like Baucus (chairman of the Senate Finance Committee) who are looking for revenue often seek to defer the ability of businesses to deduct expenses. In the short term, this makes the budget numbers work out, even though in the long term it does not actually produce any net revenue. In fact, by reducing business investment and the future economic return on that investment, such policies actually reduce government revenues in the long run.

To repeat, this is the opposite of sensible tax policy.

Baucus' proposal would benefit old business investments and hurt new ones. Thanks to lower rates, a business that continues to see benefits from an investment it wrote off years ago will face lower taxes on its returns going forward. However, a business that makes an investment under the new rules will only get the lower rate at the cost of slower write-offs. Old and established companies would, for years after Baucus' plan was implemented, enjoy benefits that startups could not touch.

Companies need cash to invest in plants and equipment, to conduct research, to build their brands and to pay their workers. Uncle Sam demands that taxes be paid in cash too. If the corporate tax rate is 35 percent and a company that has made $200 turns around and spends $100 on capital investments, then that company only has $100 left to use for other purposes, including paying taxes. But if the government, instead of allowing the company to deduct the full $100 spent that year, only allows it to deduct $50 right away and demands it deduct the other $50 later, it effectively taxes $150 of "profit," even when the company only has $100 in ready cash to pay those taxes. This means a larger slice of that $100 pie has to go to the Treasury, leaving less for other needs.

If the government really wants to encourage corporate investment, it should allow companies to write off their investments as quickly as possible, rather than forcing them to stretch out the deductions over a long period. In fact, this was the approach that President Ronald Reagan and Congress took in 1981 with the Economic Recovery Tax Act, which sparked the major investment boom that lasted through that decade. American productivity gains increased sharply through the remainder of the 20th century, partly as a result.

Baucus also wants to slash the business expense deduction for advertising, which has not won the plan many friends on Madison Avenue. Currently, all of a business' advertising costs can be treated as a deductible expense immediately. Baucus would halve that, with the half not immediately expensed amortized over the following five years. This move seems especially reactionary when one considers the pace at which modern advertising moves.

"This stuff used to happen over months and years. It now happens over minutes and hours," Jim Davidson, the executive director of the Advertising Coalition, said in response to the proposed change. (1)

In the case of advertising, there's an old saw that says half of advertising dollars are wasted; the problem is that you can't know which half. The IRS has always felt that advertising creates a long-term benefit by building brand equity and, as a result, that it should not be deducted up front. But companies that spend dollars to build brand equity can't pay those same dollars to the government in the form of taxes. The government, like the companies, ultimately benefits if and when advertising results in greater profits. This means the government, like companies, will lose when punitive tax policy pretends that companies can spend dollars on advertising and still use those dollars to pay the government simultaneously.

Baucus' bill would be harmful, but I am not terribly worried about it. The prospect of a major tax bill passing during this Congress is virtually nonexistent. With any luck, a more business-friendly Congress - and possibly a more business-friendly administration - will take up the issue after the 2014, or more likely after the 2016, elections.

By Larry M. Elkin

Avoiding More Self-Inflicted Harm

By permitting passage of a "fiscal cliff" compromise that most of them detested, House Republicans took the only sensible path available. It was an unfamiliar route.

Less than two weeks earlier, those same Republicans rejected House Speaker John Boehner's "Plan B," which would have allowed tax rates to rise for taxpayers earning more than $1 million a year. Passing Boehner's bill, which had no Democratic support, would have placed the onus on the Democrat-controlled Senate to act in time to prevent the broad and substantial tax increases and spending cuts that technically took effect yesterday, before the Jan. 1 legislation canceled them.

Passing Boehner's plan also would have kept House Republicans, who wield their party's only legislative instrument of power in Washington, at the negotiating table in the critical final days as details of the inevitable compromise were worked out. Instead, the Republicans marginalized their leader and, as a result, themselves. The House GOP could only watch as Senate Republican Leader Mitch McConnell, whose party has just 47 of the Senate's 100 seats (a number that will drop to 45 when the next Congress is sworn in this month) hammered out terms first with his Democratic counterpart, Harry Reid, and later with Vice President Joe Biden.

Those terms included an explicit rise in tax rates for individuals earning more than $400,000 and couples earning more than $450,000. They also included a phaseout of personal exemptions and itemized deductions beginning at $250,000 for single filers and $300,000 for married couples, which effectively raises taxes, by a smaller amount, at those income levels too. The gift and estate tax rate rises from 35 percent to 40 percent on transfers above a lifetime exemption of $5.1 million, an amount that is indexed to inflation.

From the Republican standpoint, the results could have been worse. The estimated $600 billion in increased taxes over the coming decade is much less than the $1.6 trillion that President Obama originally demanded, and is even less than the $800 billion that Boehner originally offered in his aborted negotiations with the president. (Boehner, however, proposed to raise the revenue by restricting deductions and credits, rather than by raising rates.) Democrats did not love the deal that McConnell struck with Reid and Biden.

But the tilt toward the Democrats' priorities was evident in last night's House vote. Democrats supported the compromise 172-16, while Republicans opposed it, with 85 GOP members voting in favor and 151 against. This was in sharp contrast to the bipartisan 89-8 majority with which the compromise passed the Senate in yesterday's predawn hours. Unlike their House counterparts, Senate Republicans saw little point in asking their leader to negotiate for them and then rejecting what he got.

The final outcome was not clear until just a couple of hours before the vote. For much of the day, the question was whether House Republicans would allow the Senate compromise to reach the floor. They could have amended the Senate bill to reflect their own tax preferences - in all likelihood, reverting to Boehner's Plan B or something close to it. Or they could have accepted the Senate's tax terms but added spending cuts. Many Republicans complained throughout the day that rather than closing the national spending spigot, the compromise actually increased spending, via such Democratic priorities as a one-year extension of "emergency" unemployment benefits that are now four years old. The $30 billion cost of that extension will, by itself, absorb half the revenue from income tax increases in the coming year.

But amending the Senate compromise would have put the legislation on ice for days or weeks, if not longer. In that time, nearly every American household would have faced a major tax increase that both parties wanted to avoid, but for which House Republicans would have taken the sole blame. It is the sort of thing that might cost the GOP its House majority in the 2014 elections - an outcome that President Obama, for one, would welcome.

At the last minute, House Republicans recognized that by rejecting the Senate compromise, they would have simply played into the president's hands.

Sometimes, in a long war, you have to concede that certain battles are not winnable. Leaders who fail to recognize this find themselves participating only in short wars. We are in the midst of a long political war over the scope and role of government in American life.

Republicans want, or at least they say they want, a smaller, less costly, less indebted government. Democrats want to maintain and expand social spending in spite of, and in fact largely because of, an aging population whose projected costs for pensions and health care have no visible means of support. Obama and congressional Democrats have made clear that they will tax and borrow as much as they can to sustain those commitments as long as possible. Obama himself, in a premature victory rally, promised to fight future cuts in such spending, at least until he can extract still more tax increases to mitigate them.

The next battles are not far off. The Senate compromise merely postponed the deep and ill-devised federal spending cuts of the fiscal cliff for two months, and the Treasury reached its $16.4 trillion debt ceiling on Dec. 31. Treasury officials can juggle the books for, perhaps, the same two months, while Congress and the president continue to arm-wrestle over spending.

With the threat of unwanted broad-based tax increases behind them, Republicans are in a much better position to take a hard line on spending, using the debt ceiling as leverage. The administration will raise the specter of "default," which technically would be the failure to pay interest or principal on the federal debt, as an unthinkable but unavoidable consequence of failing to raise the debt ceiling. But default would come only if the government chooses it; if the administration correctly places honoring our financial commitments first in line, it will be other bills that that don't get paid. Failing to raise the debt ceiling is a back-door way to accomplish something many Republicans say they want: requiring Uncle Sam to balance spending with revenue.

The president sees the battle coming and is already trying to fortify his position. He warned Republicans last night not to use the debt ceiling as a negotiating tool. "I will not have another debate with this Congress over whether or not they should pay the bills that they've already racked up through the laws that they passed," the president said after the House voted on the tax compromise. (1)

The president will have that debate, however, whether he wants it or not. He cannot avoid it. Americans like their government benefits, and they like the idea of having other people pay for them, but the periodic review of the debt ceiling is a valuable reality check. Without it, we could go on pretending that we are not relying on other people - private citizens, foreigners and, most of all, future generations - to pay for the stuff we demand today but fail to finance ourselves.

The debt ceiling forces Democrats to reconcile their spending with its ultimate cost. It forces Republicans to reconcile their commitment to low taxes with the real-world bills our government incurs. It forces the very debate that the president does not want to have.

The only way we can sustainably get lower taxes and less debt is through less spending. The debt ceiling discussion favors the Republican side of this argument. By not crippling themselves on the tax vote, Republicans gave themselves a better chance to win the more significant battle, the one over how much the government spends, on another day.

By Larry M. Elkin

When Good News Is Bad News

Federal Reserve Chairman Ben Bernanke was full of good cheer as he stepped in front of the cameras recently to explain why our economic outlook is getting brighter.

From the way the financial markets reacted, you would have thought Bernanke's comments boiled down to "Your dog just got run over by a truck."

U.S. stock markets had their worst two-day stretch in more than a year on the Wednesday and Thursday following Bernanke's talk. Overseas stock markets were hit even harder. But the pain was not confined to stocks. Bond prices fell hard too; so did gold. Oil and other commodities slipped as well. The dollar strengthened, but not to the degree that other prices fell.

This is one of those moments when it is worthwhile to take a deep breath and consider what we know, what we don't know, and what we heard that we did not know before.

Bernanke and the Fed have been telling us for many months that they will begin to tighten the extraordinarily lax monetary environment once there are solid signs that the economy is picking up in a sustainable way. We knew well before Bernanke's speech that the Fed plans to cease its $85 billion in monthly bond purchases once unemployment drops below 6.5 percent (it stands at 7.6 percent now), as long as inflation stays below roughly 2.5 percent in the interim. Inflation is currently running well below that level, at around 1.4 percent. Bernanke has also signaled that the central bank will not begin lifting short-term interest rates, currently near zero, until after it has stopped the bond purchases and other so-called quantitative easing, or QE.

In other words, we will be in the current easy-money environment for quite a while. We knew this before Bernanke spoke. We still knew it afterward.

So what, exactly, did Bernanke tell us? For one thing, that the 6.5 percent threshold for ending QE is not automatic; it is simply a point at which the Federal Open Market Committee will consider ending the program. For another, he told us that weaning the economy off QE is likely to be a gradual process, perhaps beginning when unemployment falls to around 7 percent, but which could be halted or reversed if economic conditions warranted.

Translation: Don't worry. We won't apply the brakes too fast.

But Bernanke's calming message was largely ignored. Observers quickly concluded that the weaning process could begin as early as this fall and that QE might be history before the end of 2014. If this is true, it ought to be good news, since Bernanke's point was that the massive easing will end only if the economy is strong enough to stand on its own.

Financial markets were unwilling to take the chairman at his word. We need to ask ourselves why. I think there are several factors that contribute to the answer.

The first is that financial types mostly respect Bernanke and are not eager to see him go. But President Obama strongly hinted earlier last week, before the Fed meeting, that he has no intention of appointing Bernanke to a third term when his current posting expires next year. Bernanke, the president said, has already stayed "a lot longer than he wanted or he was supposed to." (1) So the president, whose economic savvy is not held in universally high regard on Wall Street (to put it kindly), will pick some unknown party to lead the global economy through the very delicate task of unwinding the current stimulus. Of course the prospect makes people nervous.

Another major factor is that, until Bernanke spoke, the United States looked like an island of relative calm in a particularly stormy world. China found itself in the midst of a financial mini-crisis - at least we can hope it is only a mini-crisis - when its central bank refused to supply the cash that its financial system desperately wanted.

Short-term interbank rates skyrocketed, and there is a growing risk that Chinese enterprises, especially smaller ones, may not be able to get enough capital to finance operations and expansions. Chinese growth was already slowing, and its banking system's coughing fit threatens to slow growth further.

Meanwhile, Europe continues to lag in making structural reforms that might help revive its stagnant economy. Japanese reform plans have also been a recent disappointment. And in the developing world, citizens of Turkey and Brazil have mounted massive demonstrations against their governments despite that fact that, until recently, they were among the feel-good stories of emerging economies.

So there were many reasons for the markets to be edgy when Bernanke spoke. His forthright acknowledgment that change might be on the horizon was just enough to push some people into full-scale panic.

There is one more thing to consider, and that is the hair-trigger mechanism in which many financial instruments are traded these days. Hedge funds and other rapid-fire traders are all eager to be the first ones in and the first ones out when the markets begin to move. A small movement can therefore snowball rapidly, until all the fast-money has raced to wherever it is bound to go next. I think of this as water sloshing in a bowl. Once disturbed, it moves back and forth until the energy dissipates and it finds its new equilibrium.

The simple fact is that the world of zero interest rates and massive central bank lending to the government cannot last forever. At some point, we will have to get from our current, highly abnormal position to a place approximating normal. Last week's panic was bound to happen whenever the first step approached. At least now it is out of the way.

Maybe things will calm down soon; maybe not. In the end, the bad news that the markets thought they heard last week is simply the product of a little bit of good news, which is that we might be getting closer to normal. I'll take that ride, even at the risk of a little motion sickness on the way.

By Larry M. Elkin