National Small Business Network

Balanced Tax Policy Corrections

June 2024

These recommendations are suggested as part of a balanced program of both tax policy and budget policy corrections to restore a sustainable Federal fiscal process and stable economic growth.

There is a clear need for both tax system reforms and for added tax revenue to reduce fiscal deficits and the unsustainable growing debt. Because of the tight distribution and split control of the 118th Congress, any effective fiscal or tax policy changes will also need to be very balanced, bi-partisan, and evidence based. We suggest these basic tax reform principles, tax code corrections, and broader tax reform recommendations be included in future tax or budget legislation.

Reality Number One:

There is a clear need for additional tax revenue as well as fiscal control.

The primary Constitutional responsibility of Congress is to pass a budget of necessary expenditures for the needs of the country. The Congress also has the Constitutional responsibility to collect the taxes to pay for those programs. In FY 2023, Congress spent 22.7% of GDP, but collected only 16.5% of GDP. The GAO and CBO have both concluded that “The federal government is on an unsustainable fiscal path”. The latest CBO projections show deficits will average $2.1 Trillion or 5.7% of GDP over the next 10 years, even under current law. In effect, this means essentially all of our expected GDP growth, is just borrowed ahead from future years, and future generations. The total “Publicly Held” national debt is now projected to equal our total annual GDP in less than 5 years. Most economists believe that continuing deficits, added to our $34 Trillion national debt, will reduce long-term economic growth, and are a very real threat to the future sustainability of our economy.

We agree with the CBO and GAO warnings, and those of other research organizations. And, the real situation is even worse. The “discretionary budget” deficit excludes the pending bankruptcy of our key social support programs, Social Security and Medicare, as well as growing deficits in infrastructure replacement and climate damage preparation. The bottom line is that we must increase our overall tax revenue to at least equal average federal expenditures. The $4.2 Trillion CBO projected cost of extending all the 2017 TCJA tax cuts is not rational, and they should not be approved without offsets. Congress is the cause of the growing deficit, and only Congress can correct it.

Basic Taxation Principles for Economic Growth:

· Tax policy should incentivize direct long-term investment in businesses, buildings, and equipment that create new jobs, rather than short-term speculative transactions which create no new economic activity or jobs.

· It should promote domestic investment and job creation to the greatest extent possible within the limitations of international agreements by focusing tax incentives on domestic investment.

· It should maintain U.S. international business competitiveness, while also reducing the ability of multi-national corporations to avoid taxes by shifting profits to low tax countries.

· It should provide equitable tax incentives for the growth of small businesses which provide over half of all new jobs and are the greatest contributor to economic growth. These are predominantly pass-through entities which require separate and equitable treatment of business income in the personal tax code. That equity will end in 2025 without further Congressional action.

· It should stop trying to influence taxpayer behavior using only tax credits and deficit increasing revenue giveaways, It should instead put revenue raising taxes on behavior which conflicts with broader governmental policy objectives.

· It should be progressive in rate and application, because the impact of any specific tax rate has a much greater impact on the sustainability of small businesses, or on the personal security and financial stability of low income individuals.

· It should assure that any net tax reductions or federal expenditure increases are at least revenue neutral and provide adequate overall revenue to gradually reduce our national debt and restore long-term fiscal stability.

Targeted Tax Correction Recommendations for this Congress

Corporation Tax Recommendations:

1. Increase the base tax rate on large C corporations to 28%.

Even before the 2017 TCJA rate reductions, the percentage of total US tax revenue coming from corporations had declined significantly over the last 25 years. A recent GAO report found that the TCJA rate reduction cut the effective Corporation average tax rate by 22%. to only a 12.8% tax rate on average. in 2018. The GAO also reported that 33.9% of corporations with $10M or more in assets paid no corporate income tax. A 25% increase to a 28% base rate for large corporations, and a proportional increase in tax rates for pass-throughs, would restore some balance in business tax levels.

2. Correct the impact of a higher flat tax rate on small C corporation start-ups by re-instating graduated small corporation tax rates.

Congress has always said that they understand the critical importance of small innovative businesses to the economy. The TCJA change to a single tax rate, even at 21%, actually increased the tax rate on small startups by 40% by deleting the lower 15% tax bracket on the first $50,000 of income. Most high growth potential start-ups, who may become the base of future economic growth, have to be organized as C corporations because of the need to attract equity capital. Based on the most current IRS numbers available, over 560,000 small business are in this category and had their taxes increased by the TCJA. We recommend legislation to reinstate the 15% tax rate on C corporation income below $100,000 and provide graduated rates between $100,000 and $5M of corporation taxable income.

3. Continue to Reduce Multi-National Corporation Tax Avoidance.

We believe that Congress erred in 2017 by adopting a territorial tax system for multinational corporations combined with lower tax rates. The reduction of corporation tax rates by other nations has been a race to the bottom, with a significant loss of tax revenue from businesses for all countries. We support Treasury’s work on international agreements to reduce base erosion, and support the “Pillar 2” agreement. but believe more changes are needed. We recommend continued work with other nations to change the taxation of multi-national businesses (MNB) to a formulary allocation system based on a percentage of sales of goods and services, or assets in each country.

The current corporate income tax system allows multinational corporations, particularly those with high intellectual property values, to use inter-division accounting manipulations to shift taxable profits to divisions in lower tax countries where the earnings can multiply. This not only reduces US tax income, but also creates a tax incentive barrier to recognizing and re-investing those earnings in the US for domestic business growth. Adoption of a self-adjusting Value-Added Tax may also be a logical way to supplement business taxation.

4. Allow the phase-out, of 100% Bonus Depreciation, or expensing, of long-term capital investments.

Although accelerated expensing can be a useful tax tool during a recession, its use at the peak of an economic cycle, when the JCTA was passed, was not needed and significantly increased the deficit and growth of the debt. This also contributed to inflation which the Federal Reserve is now having to control. If extended or made permanent, the Congress would have few practical tax incentives left for stimulating the economy when we need it for the next recession.

CBO estimated cost to extend Bonus Depreciation is $3B over 10 years. Section 179 small business expensing should also be capped at $1M per year.

Individual Income Taxation Recommendations:

5. Increase the top marginal Individual Income tax rates progressively on income over $1Million.

Many of those who have become ultra-wealthy owe much of their success to the structure and systems of the US government and its patent, copyright, and general legal protections. It is appropriate that they share a greater percentage of their income to help pay for those protections. We support higher graduated tax rates on taxable income over $400,000, over $1Million, over $10Million and over $100Million. We do not, however, recommend the concept of a “wealth tax” on existing personal assets because of the complexity of calculation and the variability of valuing many asset types. Excessively high existing wealth is best taxed through the estate tax system.

6. Refocus Capital Gains taxation incentives to encourage longer-term, direct, economic investment and improve the incentive for long-term capital investment by increasing the long-term capital gains period to 5 years. But, also reduce taxation of the phantom gain from monetary inflation on business assets held more than 15 years, to properly reflect the true constant dollar value of any gain.

The current personal income tax code provides a lower tax rate for a “long-term capital gain” on an asset held for more than 365 days. This actually progressively penalizes longer-term investments that are held more than one year because of the failure to adjust for monetary inflation, over the investment life. The investments that America needs to build for a sustainable economy such as starting or growing businesses, and building business infrastructure, are not 366-day investments. True long-term business investments may not provide a capital return for 10, 20, 30, or 40 years or longer. Based on the last 40 years of inflation rates, which are significantly increasing again, the Federal Capital Gains taxes would actually exceed the total real economic gain on the sale of an asset after about 40 years at the 23.8% tax rate. Even owners of relatively small businesses will generally be in the maximum tax rate bracket in the year they sell their business or business property resulting in capital gains taxation of the inflationary gain at the maximum rate.

The current law also provides the same tax treatment for individuals who invest in speculative secondary market investments such as traded stocks. Less than 1% of total traded stock purchases are for new or IPO stock that actually provides business capital for economic growth. Most traded stock purchases contribute no more to economic growth than gambling. Ironically, secondary economic investments like stocks currently have a greater tax benefit because they can be easily sold after 1 year when the tax benefit is greatest. Where the asset is a business or investment property, this short tax incentive peak also encourages the owners to focus on short-term “paper” profitability and the potential for resale, rather than long-term growth and sustainability. The 366-day incentive peak also encourages financial speculators to purchase and sell off asset rich businesses, rather than operating and growing them.

7. Maintain a Federal Estate Tax exemption of at least $10M to simplify estate planning, and protect mid-size family businesses and farms from forced sales.

The current estate tax exemption of about $13 Million per person, adjusted for inflation, which would currently end in 2025, is probably adequate to protect 95% of small family businesses and farms from a federal estate tax impact. However, the estate tax is still an important business continuity issue for faster growing mid-size businesses and larger farms because of rising land values and should not be allowed to revert to previous low exemption levels. However, the Estate tax should also not be repealed. Without the re-valuation of assets at death, family members who inherit small businesses and farms would be hurt by high capital gains taxes when they later have to sell. We also suggest adding progressive graduated rates above the exemption amount starting at 20% and going to 70% for very large estates, rather than the current flat rate which is inequitable for smaller estates.

8. Re-authorize the personal deduction for employee business expenses, which was eliminated by the TCJA.

With the pandemic and changes in technology and the workforce, more employees are working outside of a conventional business location. They are being required by employers to fund more of their own expenses for equipment, technology, transportation and home-office work space. Since these job related costs reduce their effective income, they should be deductible against their wage income, at least over a 2% of AGI threshold, and with a reasonable cap, as would be allowed if they were an independent contractor. To enable deduction of home office expenses, Congress also needs to change the outdated requirement for “exclusive” business use to “primary” business use with cost limitations, and allow for electronic based business transactions.

9. Immediately act to remove the wage cap on FICA Social Security taxes to extend the default date for the program.

More complex changes will be needed to provide long-term sustainability to the Social Security program, but Congress needs to move quickly to adopt the easiest and most logical correction.

10. Increase the general State and Local Tax deduction limitation to $20,000 and allow deduction of up to $100,000 of state income tax specifically paid on QBI small business pass-through income.

The TCJA $10,000 state and local tax deduction limitation was particularly harmful to small business owners. Most small business are pass-through entities and have to pay the state income tax on their business income, which can be as high as 10% in some states, in addition to the taxes on their personal income and property. This often makes all of the state tax on their small business income non-deductible. We recommend that the overall cap on personal state and local taxes be increased to $20,000. In addition to any general cap, small pass-through entity business owners should be allowed to deduct up to $100,000 of state income tax paid on their net active business income at the state’s maximum income tax rate. The “work-around” business entity tax alternatives that have been adopted by some states have just added more confusion and complexing to the tax system.

Small Business Pass-Through Entity Tax Corrections:

11. Maintain tax equity and predictability for small pass-through businesses by

Reenacting a Qualified Business Income credit for pass-through business of 15% to match the 25% increase in corporation tax rates.

We believe that tax rates and tax incentives should be as equitable as practical for all types of businesses. To provide equitability, The 2017 Tax Cuts and Jobs Act (TCJA) reduced taxes on both corporations and on pass-through entities, which is how most small businesses are taxed. For bill scoring reasons, the matching pass-through rate reduction and other provisions were only done to 2025, 6 months away. To make business planning and investment decisions, pass-through businesses need longer term certainty of the tax structure before the end of this Congress.

12. Provide a better definition of Qualified Business Income that better separates personal services income, which should be taxed at regular rates, from true return on business investment.

a. Remove the Specified Service Industry exclusions from the section 199A 20% Qualified Business Income adjustment on pass-through entities. Section 199A of the TCJA, though well intentioned, created a large amount of complexity, uncertainty, and inequity for many pass-through businesses who pay their business taxes on their personal tax return. One of the most inequitable provisions was the exclusion or phaseout of income from certain designated business sectors from the rate reduction on Qualified Business Income.

The designated business sector exclusions selected by the bill drafters were a carry-over from prior code provisions for special tax incentives, including Sec. 1202 small business investment incentives, and the old Section 199 domestic manufacturing – exporting incentives. However, Section 199A was not intended as a special incentive, but was simply intended as a way to provide some equitable rate reduction for pass-through businesses to balance the rate reduction the bill made in corporation taxes.

b. Add Guaranteed Payments made to partners with less than 2% ownership to the definition of wages for the Sec. 199A wage-asset test. The use of the term “W2 wages” for the wage-asset test of QBI discriminates against partnership entity partners who receive their compensation as “guaranteed payments” which are subject to self-employment taxes, but are not “W2” wages

Congress needs, to define a better test to separate true business income from personal wage and investment income. A better set of criteria for “reasonable compensation” for personal services by owners of an S Corporation business should also be developed to assure that personal service income is taxed as wages for employment and income taxes

13. Restore annual deductibility of business Research and Experimentation costs, for smaller businesses with under $5M in assets.

Research and innovation are vital to US economic growth, and should be incentivized. CBO estimates the true cost of returning to annual expensing for all businesses is only $6.3B after full phase in. The original 10-year scoring does not accurately reflect the continuing potential revenue from the change to amortization. Annual expensing is particularly important for small innovative businesses who do not have the cash assets, or borrowing capability, to withstand having to amortize a significant part of their R&E costs over 5 years. SBA research found small businesses did over $70B of R&D in 2019 employing over 500,000 workers. For small technology based businesses, R&D expenses are often the majority of their total expenses and cash flow. If the cost of full repeal of the amortization requirement cannot be justified, at least restore same year expensing for small businesses with under $5M in total assets.

14. Correct the excessive reduction in the 1099K “payment processor” reporting threshold and correct the original error in basing the reporting on gross payments, rather than net payment income.

We strongly support logical and efficient reporting of payments to both businesses and individual service contractors because of the positive impact on tax compliance. However, the reduction of reporting threshold from $20,000 to $600 was too much for existing reporting technology. Such a low reporting threshold, without clearer ways to separate out non-taxable payment transactions, will result in an excessive number of false income reports that will be costly for both businesses and the IRS to resolve. We suggest correcting the reporting threshold to $10,000 or 100 transactions per year, and developing better, clearer electronic reporting processes. At the same time, It is also important to correct the error in the original reporting requirements which specified gross payments to businesses, rather than net payments, after return credits, fees, and cash advances.

15. Permanently equalize the deductibility of worker health insurance at the entity level for all forms of businesses including the self-employed.

Changes in the economy accelerated by the pandemic have caused many people who were formerly employees to become self-employed contractors out of necessity. As employees, they usually received group health care that was tax deductible for their employer. As an independent self-employed worker, however, they cannot deduct the cost of their insurance from the business income, and have to pay the 15.3% self-employment tax on the income they use to purchase it. This often means they can’t afford the cost of insurance for themselves and their family. The self-employed should be allowed to deduct insurance premiums up to the average ACA coverage cost at the business tax entity level.

Strategic Tax System Recommendations

16. Assure that a deeply divided Congress, and a highly political process, can stop the growing debt, and allow time for strategic tax reforms to generate adequate revenue , by adopting a Bi-Partisan Deficit Control Surtax Act.

Because of the very high level of division and partisanship that exists in Congress, it will be very difficult for either party to take any leadership in balancing the budget by increasing taxes or reducing major expenditure programs. The only possible way to get agreement to increase revenue may be through a bipartisan pre-agreement on an “automatic” deficit control process similar to prior “pay-go” and budget sequestration legislation. They weren’t perfect, but they helped control deficits without either party having to take the political “blame” for the necessary actions. Congress should always first try to balance expenditures with adequate tax revenue using regular order, but that will take time. As a “Fail-Safe” to prevent increased deficits, except in times of true national economic emergencies, we suggest the Congress adopt a provision which would provide for an automatic income tax surtax necessary to offset any prior budget year deficit.

The Congress would require the Congressional Budget Office to determine the amount of any net budget deficit for the prior fiscal year. Congress would then have one year to pass legislation for the current year either reducing expenditures, or increasing tax revenue which, by CBO projections, would be adequate to offset the prior year’s deficit. When special economic conditions justify a budget deficit for stimulus, Congress could override the requirement for a year by a majority vote of both the House and Senate. If Congress failed to act, CBO would be required to calculate a surtax rate, which when applied to all income tax categories, including corporations, pass-through entities, individuals, trusts, etc., would raise the amount of income needed to offset the prior year deficit. This surcharge would then be added onto the following year’s net tax due. Congress would still remain in complete control of the process, but as a last resort, the surtax would provide the needed revenue without members of Congress having to vote for any specific tax increase. The surtax would not change,

or complicate, the initial tax calculation for any taxpayer, but would simply apply a percentage to the final net tax owed. To let taxpayers, adjust to the potential surtax, it could be phased in over 4 years.

17. Increase the role of the Joint Committee on Taxation, Treasury Tax Policy and the IRS in assisting Members of Congress in the ongoing development of a simpler, more logical, and better-coordinated federal tax code.

Complexity makes it difficult for taxpayers, and even professional tax preparers, to understand and comply with the code. Complexity also increases the administrative burden on the IRS and makes it difficult for them to provide good taxpayer assistance and improve filing accuracy and taxpayer compliance. The Congress should direct JCT, Treasury and the IRS to develop a joint working group to identify existing code issues requiring better legislative clarity or coordination, and a process to develop legislation to resolve them. One key change would be to provide common definitions for special tax categories, and standard code wide system for inflationary adjustments.

18. Continue to fund and update the management and business systems of the Internal Revenue Service to provide better taxpayer assistance and an efficient and equitable administration process.

The IRS is the government’s revenue source. To properly and efficiently administer the tax code it needs continued improvements to vital business systems such as data processing and communication technology. The IRS has faced increased administrative responsibilities, such as the ACA, FATCO, and pandemic subsidies combined with declining budget allocations, and heavy turnover of key staff. This has resulted in declining levels of performance in many areas and increased burdens on taxpayers and return preparers. The combination of a complex tax code, low taxpayer assistance, inadequate IRS budgets, and reduced IRS training and staff levels will eventually threaten accurate and equitable enforcement of tax laws. If this happens, it will reduce collection of the revenue needed for all other Federal programs and services.

Congress and the Administration need to recommit to the goals of the 1998 IRS Reform and Reorganization process by continuing to provide adequate funding for better taxpayer assistance, support for improvements to technology systems, and stronger management emphasis on business process re-engineering for greater efficiency in the tax administration process. The IRS should also develop better on-line tax compliance assistance and provide free on-line filing for most taxpayers. The Administration and the Senate also need to revitalize the IRS Oversight Board to assist IRS management with continuing organizational improvements and improving communication with the Congress.

19. Evaluate supplementing Income Taxation with a Value Added Consumption Tax:

The size of the national debt and annual budget deficits in relation to current income tax revenues makes it unlikely that Federal corporate and individual income taxes could significantly pay down the debt, even if quickly returned to previous levels. The only additional revenue generator with the potential to stabilize and reduce the deficit in conjunction with the income tax is probably a Value Added Tax. During the 2017 tax reform debate, and again recently, many Republicans showed an interest in moving to a “consumption tax” that would exempt the tax on US exports, to promote international economic competitiveness. A VAT meets those requirements far better than previous proposals. Even at low rates, a VAT has the potential to generate significant revenue, with relatively low complexity and lower potential for tax avoidance in an increasingly less “traceable” and international economy. We recommend that the Finance and Ways and Means Committees, with the coordination of the Joint Committee on Taxation, start a bi-partisan review of value-added taxation as a potential supplement to the income tax. Because consumption taxes tend to be regressive in impact, some adjustment should be made to the income tax code to off-set the greater impact on lower income citizens.

Related Fiscal Policy recommendations and issue research are available on our website at www.NationalSmallBusiness.net

These recommendations were prepared for the National Small Business Network by Eric Blackledge and Thala Taperman Rolnick CPA. The National Small Business Network is a small non-partisan, nonprofit, group that evolved from the SBA Regional Tax Issues Chairs from the 1995 White House Conference on Small Business.

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