the meeting will come to order good morning and thank you for coming to this organizational meeting of the subcommittee on select revenue measures for the hundred twelfth congress i'll try to keep the meeting short so we can begin today's hearing and accommodate the schedule of our witnesses this meeting is up to the public and therefore will be an official transcript of the proceedings first i want to take it all with the thing to say thanks to all of you for being part of this committee forward to working with my good friend ranking member richie neal as chairman of the committee last session he set a high bar for making this subcommittee to select revenue measures subcommittee a bipartisan committee i enjoy the opportunity to work with him on a number of important issues in the last congress including but not limited to the net operating loss carry back for which rich he deserves a tremendous amount of credit for becoming law there's no doubt the subcommittee will tackle some tough issues like that in this congress including major tax reform my hope is and i look forward to working with him on some of those difficult issues going forward mr mayor would you like to make any opening remarks before you proceed thank you very much mr chairman i'm certainly honored to serve as the ranking member of the subcommittee and i share the goal that this subcommittee should and remain will remain bipartisan in the same spirit of last session we strive to have witnesses who represent diverse points of view and have representation of our members important to the greatest extent  was very pleased with the work that we did in the last session we held hearings on infrastructure financing tax exempt bonds taxes as part of the federal budget and to hearing highlighting how wealthy americans successfully hidden money in overseas banks which resulted in legislation that shut down an eight billion dollar loophole replanted porton role in vetting issues for the full committee and i look forward to continuing that role beginning with this hearing today one issue i hope that we can take up soon is the way that we might help to increase savings for tens of millions of americans who don't have access to workplace plans such as the ira proposal this hearing is about the new session of the congress but i did want to take a quick minute to acknowledge the morgan our staff assistants for the one hundred eleventh congress who all worked long hours to make us look good at the hearings we certainly wish them well and i want to thank the chairman for yielding thank you louisiana and i'll yield to ranking member neal massachusetts to introduce his members thank you mr chairman let me introduce the democratic subcommittee members some of whom will be new to the subcommittee and some are returning members first introduce our deputy webb who is also a member of our committee who's standing over there mr ross king of illinois and i too would like to thank a former staff member out in france who is no longer with me who provided invaluable counsel on issues dealing with tax policy for the last several years and welcome brad bailey who is here with us today and also introduce staff director for the subcommittee george callus and legislative assistant zack ok all right first take a moment to just hold on just a second here i think we are about ready to close up here would you like to introduce minority staff or you certainly would thank you mr chairman i do want to recognize the staff committee director and john young who was here and i thank you for to require both witnesses and members to adhere to the five minute rule for testimony questioning if needed we may proceed with the second round of questioning on occasion other members of the committee or other members not on the committee may join us at hearings i look forward to working with all of you in the months ahead with that the organizational meeting now that we finish our on as a show meeting i'd like to call today's hearing to order i want to welcome our witnesses to the hearing to discuss the taxation of small businesses and pass through 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 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 be reducing the national debt ensuring entitlements will remain solvent or reforming our tax code to encourage economic growth saying it's 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's time to enact tax a tax code that is competitive with the rest of the world that is fair and that is simple are small business and small businesses must be included in comprehensive tax reform reforming corporate taxes means only reforming roughly ten percent of federal revenues that's not comprehensive many small businesses pay taxes as under the individual income tax rates 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're putting small businesses at a competitive disadvantage if you're 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 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 that i will yield to the ranking member mr kneale thank you mr chairman of i want to thank you for calling this hearing this morning i hope that will be the first of many on the topic of tax reform earlier i commented on how the subcommittee always hears diverse points of views 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 other tells us that we need to lower income taxes on the upper income to save small businesses one thing that we can agree on is that the u s offer some of the most flexible the rules on structuring your business in the developed world offering limited liability without the requirement of corporate level tax as one witness tells us today we are second only to mexico and the size of the unincorporated businesses as a total share of business in the self help integration is a step towards reform while this hearing is intended to explore special tax issues on pastoral went to d c 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 one percent of all pasts are large businesses with more than ten million dollars in receipts but they accounted for almost sixty percent of the total revenues of all tasks confucius noted that a journey of a thousand miles begins with a single step one thank you mr barry for taking that first step this morning on the road to tax reform we hope the journey does not take a thousand hearings thank you thank you mr neale i ask unanimous consent that all members written statements will be included in the record without objection so ordered we will now turn and thank you chairman chairman and ranking member neal and distinguished members of the subcommittee and thank you for the opportunity to testify today regarding the taxation of lesser businesses and tax reform i've had the opportunity to consider the taxation  flow through businesses from a number of different perspectives and side and outside of government in the context of broad reform of the code and narrow reform of the business tax system more recently i've been analyzing the flow through sector in the course of preparing a report on behalf of the us corporation association today i would like to share my perspectives and provide some preliminary results from the study on flow through on the flow through sector we are preparing for release in the near future closer businesses s corporations partnerships limited liability companies  proprietorships play an important role in the u s economy the mat vast majority of businesses in the united states have chosen to organize this flow through businesses today flow through businesses comprise more than ninety percent of all business entities employing more than fifty percent of the workforce and report more than one third of all business receipts individual owners of flow through the flow through businesses report forty percent of all business net income these individual owners also pay forty three 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 of algal and many other countries tend to push businesses towards the corporate form and pursuit of limited liability whereas in the united states such limited liability is attainable through various organizational forms outside of the corporate sector this is 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 other countries responding to a two thousand seven o e c d 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 prom and so 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 face 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 burned at the corporate level and again when the income is paid out to shareholders in the form of dividends or retained earnings 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 closer businesses might be affected by tax reform with substantial evidence that the us 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 organize using the flow through form without offering the benefit of the lower corporate tax rate flow through benefits flow through businesses would lose the benefit of widely used and long standing provisions such as accelerated depreciation and the and the charitable giving deduction in total flow through businesses use about twenty two percent of the roughly one hundred billion in annual business tax expenditures closer businesses are a large part of the u s business sector an important contributors to the economic vitality of the united states as reform progresses it is important to understand it consider all of these issues with an eye towards bringing about the tax reform that is most conducive to increase growth and job creation the path towards tax reform will need to take into account many features of our tax system and strike a balance between a number of sometimes trying to repeal the two ten ninety nine provisions as noted in our written testimony these are significant burdens on small business today's hearing focuses on the special burdens that the tax law imposes on small business business tax reform cannot merely change the corporate tax rate 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 appreciate your diligence in trying to do the right thing for my full written testimony discusses several words and complexities facing small businesses in my brief time with you today i'd like to highlight just a few the first this 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 straightline section one seventy nine plus there's a different method for a m t so businesses have to maine several different books of depreciation and update them annually for each individual asset let's say a client places several pieces of equipment and 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 fifty percent appreciation maybe it's one hundred percent if they purchase too much equipment section one seventy nine isn't available if they don't earn enough money section one seventy nine 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 not know of the new incentives 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're revived after much debate but only for another temporary period it's 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 evaluate the impact of those changes on their businesses it's even hard to plan when the new tax law takes effect in the same year that it's 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 corporate entity the small business jobs act passed last september expanded an existing provision to allow one hundred percent gain exclusion on the sale of small business  certain conditions were met there are several requirements to qualify for this exclusion it must be a corporation of a qualifying business the stock cannot exceed a certain value and must be held for more than five years the key here is that this provision only benefits the corporation so it excludes many small businesses that are conducted a sole proprietor or pass through entity this is an excellent example of a provision that was helped  designed i'm sorry 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 thank you thank you miss thompson came in and are on the time as well financial officer and a minority owner of lake erie electric a position i've held since one thousand eighty seven and a former board member of the ohio society of certified public accountants i'm speaking today on behalf of both the lake erie electric and the c lake erie electric based in cleveland ohio is a electrical contracting company that was first formed as a c corporation in the one nine hundred fifty s depart merrily serve industrial customers in the automotive and steel sectors of the midwest my company is seen many changes since its inception both in terms of its corporate structure and business strategies in one thousand nine hundred seventy we modified the corporate structure of the company to a pass through subchapter s corporation t 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 transitioned our customer base to be more heavily weighted to commercial businesses in the health care sector the main message i want to deliver to you today gentleman 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 than necessary lines with which to make decisions regarding growth investment or reinvestment of capital and expanding new employee job opportunities further a simpler tax code being small business owners can spend less time on costly and burdensome compliance activities and invest more of their time innovation in 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 businesses about one thing in america jobs for all business sectors subchapter s corporations are structured so that at net income or losses business are distributed to the shareholders of the company and reflected on the individual's federal state and even local income tax returns the tax assessed that their individual income tax rates legislation should be discussions of assessing that higher tax rates on individuals at the two hundred thousand dollar level and families at the two hundred fifty thousand dollars level will have a direct impact on the ability of many small business owners to reinvest in their businesses and or grow their workforce in addition to subchapter s corporations other forms of past that will be similarly impacted are limited liability companies partnerships limited liability partnerships and sole proprietorships roughly seventy five percent of small businesses are passed through entities as we know the primary reason there are so many past rights because double taxation 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 drive tax law doesn't matter to small business past because they modify business practices to adjust for the last 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 is retroactive an impact causing business owners to be confused and uncertain how to proceed frequency of tax law changes affect small businesses particularly because of the unpredictability often slows for discourages the hiring or rehiring of employees or investing in new capital or other products and services well certainly businesses  are impacted by the frequency of tax law changes they have a far greater impact on small businesses so many of them operate on tight profit margins predictability helps to keep costs down as fewer changes equate to fewer compliance costs associated to changing practices and procedures that in many cases are longstanding and successful from a cost benefit stamp a lower cost equals greater ability to reinvest in component company and future growth the current structure of past such a subset dress corporations provide flexibility and control the small business owners and should be maintained in a tax reform proposal going forward tax reform should help small business by reforming issues such as simple flying compliances rules regarding filing you verify shifting the burden away from being the watchdog for various government entities its employees reforming the timing requirements for corp formations increasing the amount of small business small business it makes pass on the federal tax returns reasonable independent contractor rules gentleman the alternative minimum tax should be eliminated if it can't be eliminated and a more reasonable and consistent threshold for the alternative minimum tax in a related matter i do applaud your efforts to address the expanded to ninety nine requirements currently on schedule to become effective january in two thousand and twelve from a small business perspective this is the classic example of a compliance costs on both businesses and the internal revenue service outweighing the benefits derived you can wrap up right now thank you meaningful tax reform that focuses great thank you chairman teaberry ranking member neil members of the committee subcommittee us 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 of temporary tax cuts it's 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 relationship 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 one seventy nine 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 passed through entities as corporations limited liability companies partnerships and sole proprietorships all over the double taxation that applies to income earned by c corporations third the benefits of organizing as a pass through are not limited to small businesses some large businesses adopt these forms as well although these large firms account for a tiny share of pass through entities they represent a substantial substantial fraction of pass through economic activity for example only point three percent of s corporations had revenues above fifty million dollars in two thousand and five but they accounted for more than a quarter of s corp income the situation is even more extreme with partnerships only point two percent of partnerships had revenues about fifty million dollars but they accounted for fifty seven percent of partnership income lawmakers should therefore take care not to assume that all pass through are small businesses fourth small businesses face disproportionately high costs and complying with the tax code they're also more likely to understate their income and underpay their taxes high compliance costs thus the disadvantage responsible small businesses while the greater opportunity to evade taxes can advantage less responsible ones fifth and ideal tax system would collect enough revenue to pay for government services while minimizing distortions economic activity to the extent possible economic fundamentals not tax considerations should drive business decisions about organizational structure by treating passthrough and see corporations differently our current tax system deviates from that ideal six and finally in discussing reform proposals it is important to distinguish between businesses a broad category that includes pastors and corporations which generally means the 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 pastors and c corporations pastors would see their tax bur written testimony and briefly in your verbal testimony you mentioned a couple things i'd like you do expand on if you could you mentioned simplifying compliance rules regarding a filing in 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 even our filing 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 evaluate five show you can have an employee and electrician for example that comes on the payroll for three let's say three weeks four weeks three months and then yesterday 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 th process and we have to do that within three days of him being on the payroll but when we do that and since we have roughly four or five hundred electricians and they  rotate we could have this that same employee being even are fired three or four times a year it's time consuming it takes away from other opportunities and the other issue and even a filing we haven't had much to do with eve eve filing but i know for small businesses it can be very difficult simply because many of the small businesses are not that i'm going to call  technologically have that technological abilities and your point about being a watchdog small business is beyond that that isn't just at the federal level that's an all levels of government garnishments withholdings support it it goes throughout it's a tremendous burden thank you dr carole 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 non corporate businesses i would note and i know you're aware for example of the house republican pledge to america proposes a twenty percent deduction for small business income which would i believe be a similar rate cut from thirty five percent to twenty eight percent for small businesses can you give us some thoughts on that yeah sure i think the a couple of ways that that could could be accommodated in our current tax system what one approach would be to put in place a separate rate schedule somewhat to dividends and capital gains another approach would be to put in a deduction for certain fraction of up the return to labor and return to capital associated with that income for s corporations it's fairly straightforward i would say corporations are required to pay the owners are a reasonable level of compensation but for other organizational forms such as one would have to address that issue some of the nordic countries have tried to split up labor to return to labor and return to capital but it's they've come up with very very complicated  approaches for that last question and 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 miss thompson starting with you what would be a ballpark figure that you think you could lower rates for pass through entities and get rid of some of the things that might benefit some pass who it is but not  all actually doesn't take a position the best alternative to come up with but what they have is the report talks about reform alternatives for the twenty first century and what they think about when evaluating the tax refor they want to look for simplicity within the measure whether it's there whether it has economic growth in efficiency neutrality whether it's transparent to everybody whether or whether or not it's minimizing the noncompliance because we all know that that is a significant issue in the easier you make something the more people will be whether it has the ability to have cost effective collection and the impact on the government revenue whether their certainty in it and whether their payment convenien so at this point doesn't have a position to answer your question on it but after proposals come up we could take a look at them and and see what we can probably move your bill right now actually i think everyone agrees with what you've said since simplicity and predictability for small business is essential so that they know what to do moving forward as we all know in small businesses  it's usually the owner that leads it and he's not necessarily the key in financial decision making that's why many times the c f o is known as and always followed 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's that simple as that i was a quite impressed with where the president's fiscal commission came out i served on a parallel domenici rivlin commission both of those did full scale tax reform right individual and corporate at the same time and in both of those i came out in roughly the same place as saying that we should aspire to a system where both the top corporate rate in the top individual rate are the same and begin with the two and it's kind of twenty seven twenty eight somewhere in there thank you and finally dr kerry i would just following on dr ahrens comments we thousand and seven treasury competitiveness report we were able to get the right at that time down to about the same if you eliminated all business tax expenditures you could get the right down to about twenty twenty seven twenty eight percent and that that includes getting rid of provisions like accelerated depreciation and so some provisions that are longstanding and certainly a widely used and one of the things i think you need to also consider is is when you add in the state rates even if you got the business right down to twenty eight percent for corporations on for flow through when you add in state rights you would still have it right on the order of about thirty three percent  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 and which ones are used equally by both corporations and pass through its base broadening though seems to be the best way to accomplish reform how do you think that congress should address this real  concern start with broad principles and kind of the broad from the security of being a think tank economist kind of right the number one principle i start with a sort of a leveling the playing field that to 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 are to get close close attention a second one in this one i want to just because it doesn't come up as much we often talk about a strategy of rolling back tax preferences lowering rates a strategy for doing corporate reform and business reform there is another strategy which is to keep favorable depreciation policies possibly even move more towards expensing but then pay for that by walking back the deductibility of interest and 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 our current system that favor leverage in favor debt and in principle could be a way that would have favorable investment incentives but in a paid for way carol i think the the challenge is there's been some discussion of corporate reform focus on trying to lower bring the corporate rate down primarily due to the pressures from abroad with  the corporate rights 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 of business tax reform needs to be somewhat more broadly considered i think it's 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 flows through as well as the corporations  think one needs to pursue not just reform of the corporate income tax but more broadly reform of the business tax system a look at that in a more holistic fashion and the tax system is very intertwined there are a lot of there are a lot of  interrelationships between as i've discussed in my written testimony between the corporations in the flow through sector but also in the taxation of investor level income in the form of capital gains and dividends which is part of the double talks on corporate profits at the outset that the use of the you know well last year was very important for suggesting that at certain times some tax cuts are better than others and i think there's some evidence over the years that  acceleration of depreciation allowance has worked in terms of changing behavior in an economic downturn prepared to suggest that that ought to be eliminated as a possibility of i'm not i'm not really  here to suggest what should be eliminated or kept with respect to accelerated depreciation and expensing think it's a pretty common view among economists that expensing and accelerated depreciation are  help stimulate business investment during periods of academic weakness but it's also i think very helpful in terms of longer term tax policy accelerated depreciation and expensing help move the with all the complex depreciation options but i'm 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 the argument that the four of you seem to be unified around based upon predictability that's a given but since you mentioned how tax accountant here differs from financial accounting is conformity a recommendation that you would make we're not really saying that the tax rules need to be the same as the financial accounting rules but what we're thinking is that it's just one area that can be analyzed to see if it can be made and it can be more predictable because as we had said during two thousand there were quite a few because i think the vat a is a microcosm of what's going out economically going on economically in the country as a whole in two thousand and four two thousand we created nearly sixty eight thousand new jobs in two thousand and five to two thousand budget taxes on small business does it through the top two individual income tax rates from thirty three percent to thirty six percent and then from thirty five percent to thirty nine point six percent reinstate the personal exemption ability of a small business to be able to plan a long term five year plan a ten year plan with these increase potential increase taxes of seven hundred billion dollars and the extension for only two years tax liability is going to be in the future because if he knows that his taxes are going to increase it's going to have an impact on a cash flow has an impact on cash flow that's going to be potentially cuts in other areas and unfortunately that might be workers it's hard to say but they will tax rates that we have i would agree it's 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 and i would say in the past ten to fifteen years last change annually sometimes retro it's very very difficult for small businesses to do that they have to bring in their experts their tax advisors and that's costly if they if small business owners understood what it's going to be for a five year  take into account all the interactions that there are a lot of tax preferences out there that really look a lot like spending programs they've just been dressed up to a purist tax cuts and that as a result if someone if someone's 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 as a result some of the you know there are ways basically to increase revenues that you know are not that not for five minutes thank you mr chairman well the good news is we all agree on something and we all agree that the status quo has got to change there's no voice here on this panel and there's no voice among witnesses that says let's let's stick with the status quo and that is actually good news that mean there's a shared premise that we can move forward from what i'm interested you know we're all products of our environment and we're all reflecting our districts today mr heller talked about nevada i'm from suburban chicago and my district has an extraordinary number of manufacturers small manufacturers tool and die you know types that are that are selling into foreign markets and are selling around the world selling to the  caterpillars the world and so forth illinois has a unique dynamic that i'm concerned about it's nothing that that we're going to do about anything about today it was a bad decision i think that was made but it's having an impact on this larger conversation about passthrough let me just give you a couple of quick facts on illinois illinois just raises taxes so the individual rate went from three to five percent sixty seven percent increase the corporate income tax rate went from seven point three to nine point five thirty percent tax increase illinois now has the fourth highest combined national local corporate income tax rate and according to tax foundation we've dropped from twenty three to thirty six in the country among states now that's not your problem that's my problem because i'm an illinois resident but it's also the problem of a lot of companies and businesses that i represent so if we're making changes at a macro level in terms of us 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 there jammed right they've got to they've got 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 carol i'm 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 passthrough is as as a little bit of a sideshow you mentioned three key points i want to yield you some time could you go through those key factors that the distortions within the marketplace the debt equity  forth because i think it's an important part of the calibration that this subcommittee needs to take into consideration as we move forward as i mentioned in my oral statement and the written test and i explained in some detail in the written testimony one of the major differences between being the taxation and the as a c corporation as a flow through is the double talks on corporate profits the notion that if you dollar invested in the corporate sector as for the return to that investment for subject to the corporate income tax and then taxed again at the individual level either when it's paid out as a dividend or if the return is retained that 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 that distorts economic decision making decision making in a couple of ways dr marion had mentioned that economic fundamentals should drive decision making not tax considerations one of the things that the corporate tax does because it's a tax on equity finance investment interest expenses are deductible but dividends are not and so it's a tax on equity finance investment which creates a bias or adds to the bias for debt financed investment increases the leverage within overall leverage within the economy to the extent that firms are more highly leveraged because of this tax bias they're going to be more susceptible to financial distress during times of economic weakness so that's one of the distortions the tax bias for for debt finance the tax bias for greater leverage that's that's an issue another issue is you have a treatment different treatment of investment in the corporate sector versus elsewhere in the economy in the non corporate sector and 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 by four tax considerations considerations not economic fundamentals when you have the misallocation of capital the capital stock will not be allocated to its best and highest  use and that's going to reduce economic growth and then third it raises the cost of capital the double tax on corporate profits is a second it's another layer of tax on capital formation  that higher cost of capital discourages capital formation and investment and again would reduce the overall growth rate of the economy recognize thank you mr chairman thanks for holding this hearing and thanks to all the witnesses for being here and 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 ninety nine matter to the forefront that is the thirty billion or twenty five billion dollars worth of tax evasion that's going on how do you capture how do you address that i think that would probably be on  purchase i think that the existing rules that are in place cover services and i don't think that everybody is in even in compliance with that one so we might start working on that i think the way the legislation is written right now it's covering goods and it's covering corporations and that's not realistic you're going to solve the problem the example that everybody's talking about is if a small business owner goes into staples and purchases their office applies and they happen to spend more than six hundred dollars a year they're going to be required to send a ten ninety nine to wal mart and staples and it just doesn't seem like it's the right target that you're looking for on the issue a couple of you've raised the whole issue of complexity and for those of us who are in the meeting that we had the full committee when we got the briefing on all the tax structure it's pretty hard to argue that the system isn't just overwhelmingly complex  and 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 and we understand things need to  be revenue neutral you need money to do all the things that the government does but the lower our tax rate is the more people will hire the higher wages will pay the better video will be good at the employees and we're paying them well you know they should they should pay taxes do you do you think that's a pretty accurate approach do we have too many to any of you to have too many tax options for business like mr neil said it  earlier that it's complex of everything that's there that makes it complex was there to address a certain issue or in most cases to help business do we do businesses have too many tax options on the table  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 five years people can plan that i can my company can plan that we understand that we can move forward that's the difficulty 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 when that retroactive application is if we knew that we can plan that's what we need so if there were fewer options we didn't have the l l c didn't have the corp stuff you didn't have is just a business tax well i'm not saying that type of entity i'm saying within that type system is we do afford companies with businesses with different choices on how to organize themselves and i've 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's probably one of the the many distinguishing features of the us economy in comparison to our maging major trading partners that flex flexibility probably adds to the dynamism of the u benefit of not complying to the taxpayer is greater with the higher rates so one of the benefits of lowering rights generally would be that you would help mitigate and reduce avoidance behavior recognizing five minutes thank you mr chairman and it's nice to be having a hearing that's focused on small business entities and appreciate your testimony here today and knowing that we're in a very globally competitive economy absolutely and 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 is a lot of members that are in the staff people in the administration or even members of congress who don't understand the allocation of capital and that's really what this is about is how you allocate capital in the global environment one of my concerns with the administration's proposal on tax reform recently is that it's centered more on the corporate tax side least on the president's state of the union proposal and he talks more about having a revenue base revenue neutral basis for corporate tax reform and i want to make sure that that's not going to be an expensive trap for small business entities and cancer entities such as the sole proprietorships partnership successor and if that's the track that is ultimately pursued and a lot of our nation's employers are going to see tax increases because we eliminated certain but tax business expenditures i like deductions for depreciating depreciation except what you talked about what would be some of the model actually ensuring they also would be hit with this inefficient double tax so let me just ask mr carroll first maybe you know if the purpose of reform is to actually make the u s government more competitive or our economy more competitive i should say encourage job creation does it make making in some fairly fundamental ways it's kind of widely recognized say among economists or in the policy community that the double tax on corporate profits is a significant problem it contributes to the leverage in among businesses  misallocated capital and it raises the overall call cost of capital for the economy most other nations developed nations have provided some relief from the double tax on corporate profits and some why they've shifted a little bit in the last ten years and how they do that whether they do it at the shareholder level whether they do it at the corporate level the mechanism in which which they deliver it but the us is tends to have a  fairly even after the lower rates on dividends and capital gains were enacted in two thousand and three we still have a fairly high double tax on corporate profits such that a dollar of investment in the corporate sector that's paid out as dividends tax pretty highly relative to two most other things i think that's that's a problem it kind of complicates and i think it really complicates if you try to redraw the line between the path the flow through sector and the  to your clients if they got pushed into this model i think it's really too early to say what would happen if they moved into the corporate form because we haven't it hasn't been worked out on what all the details of that are are there going to be changes to is there going to be a double tax so it's really too early to answer that question mr chairman to follow up on a different angle to it mr carroll i know you look at the economic issues that are associated with s corporations and with a subset of s corporations namely employee as corporations in particular and these are companies essentially the employer and they fared much better in tough economic times in terms of that could actually growing their companies into in during these trying times also putting people back to work providing retirement security actually for their employees if the administration's proposal to move and eliminate some of these pass through became a reality for instance what would this mean for privately on employee owned companies potentially who would be those companies based on some work that i've done suggests that those companies perform better during the economic downturn that kind of the rest of the economy in a sense although it's not a huge segment of the economy through the eighty six tax reform and everything else it's you know small business tends to make decisions first of all on the economics but they're really influenced by the taxation and it seems to me when it i enjoyed the the  financial officer i mean that's what a lot of these small businesses aren't and when there's laws that are pastoral convoluted or complicated you know the trying to look at that and figure that out in the point of having a third party analyzes for the business i mean those are things that again specifically help little moments in time but i think overall really cause a lack of focus in what may be a small business should be focused on and so one of the things that i've heard you  saying that potentially when you eliminate some of the accelerate depreciation other things that you could ring the rate down to twenty seven twenty percent i wonder if you've ever looked at just the silo of passthrough entities if you said just looking at this like to yeah i think if you're if you're looking at just the flow through sector by itself i haven't done the calculation terms of how low the right could be brought down as i mentioned that flow through entities  use about twenty two percent of the business tax expenditures and a report about forty percent of the net income and pay about forty three percent of the business taxes so in that sense the c corporation c corporations kind of made greater use somewhat greater use of business tax expenditures so that might give you some sense of kind of the relative reduction the rights and i would point out that it if one tried to just do corporate reform and and try 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 pastors i think that would be a very very complex complicated system trying to make those distinctions and something like accelerated depreciation that's probably available to all business forms and trying mention the one hundred percent gain exemption and that was a little bit new to explain that briefly and how that could benefit if they were implemented for past the provision that if you have a gain on the sale of a small business you can exclude one hundred percent as long as you purchased the stock between september two thousand and ten and december september two thousand and ten and december two thousand and eleven and starting in ten year two thousand and twelve it's going to drop down to fifty percent gain exclusion but what happens with that provision right now is it's only available to see corporations and as we have talked about most of the small businesses are running as pass through entities and so if that's the corporation provision it automatically excludes everybody who's been running their small business as a pass through entity the value has to be less than fifty million dollars and it has to be in certain types of business and it can't be any type of personal service business it can't be restaurant hotels motels those types of things so it's really very narrow and it's even more narrow because it's only the clubs which most of the small businesses thank you the other issues come up time and time again is the uncertainty and unpredictability and i think whatever our tax rates were whatever our deductions were they were set in stone for fifteen years would be a good thing for small business and probably all business as long as it's competitive and so i guess looking at that i'm asking myself what are the taxes out there that are on like short term trigger that need to be renewed that create this uncertainty out there in our current current tax code as it relates to to the past two entities what are those  either deductions or one of those things that you're aware of that create an uncertainty that could be addressed in this congress and i'm not directing the first one could absolutely be the tax rate because we do probably 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 tax cuts at the end of two thousand and twelve which raises a considerable uncertainty and you also have the for holding this hearing is a very important hearing some time ago i was back home doing a town hall meeting and i was talking about american competitiveness in the need to lower the corporate tax rate so we can compete in the global economy and after got me to thinking well you know you're 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  think our our corporate tax system is very much out of step and in a global economy most other nations have lowered developed nations within the have lowered their corporate tax rates significantly over the last  certainly since the mid one nine hundred eighty s and we now have the second highest corporate tax rate exceeded only by japan japan is is as likely to reduce their corporate tax rate in april in which case we'll have the highest so that of provides a backdrop for for why there's an interest in corporate tax reform we want the u s to be able to compete in a global economy in the world's really changed different now than it was but what's economic consequence here in the u segment of the economy employs fifty four percent of the private private labor force workforce and to have a very different treatment pastor is relative to see corporations as a as a problem like d forty and you have another twenty five you've created a gigantic incentive for creative people to think about how do i exploit this to best advantage and that's thinking that would be better deployed doing something else in the economy and so if you can do fundamental reform of the entire system but you know that means  the issue of accelerated depreciation and we saw this after the hurricanes is probably the single most important thing congress did to spur the louisiana economy after hurricanes katrina and rita and i appreciate your rules and everything else which i read with great interest and we look at the report that you all have as well but how how could tax reform simplify some of these rules related to capital investment that would allow for small businesses to  actually capital formation 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 time thinking about it for example if you wanted it to be effective january one two thousand and eleven put it in place if you could in two thousand and ten and don't have it just for a one year period had it for a much longer period of time because and 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's just that it comes in too frequently at various times during the year it's just challenging which is that i'm sympathetic to approaches that would move more towards expensing if at the same time you think about walking back to deductibility of ensurance otherwise you accidentally end up in a system where if interest is deductible you can have a situation which we effect we have negative tax 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's very complex it adds unnecessary costs to business operations and distorts business investment decisions that the code is unnecessarily complex as 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  particularly in las vegas which is the community that i represent half of the businesses although i know everybody thinks of las vegas is the glitz and the glitter in the big hotels and in fact that is part of our persona and has served us well until the latest economic crash but a half of the people that are employed in the state of nevada are employed by small businesses so what we're talking about today is very important i know that this is the beginning of a very long process and the state of nevada passed through entities outnumber c corporations by almost three to one so what we're 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 you sings i know that we're all talking about budget neutrality and if we could bring down the corporate rate to twenty seven twenty eight percent across the board get rid of all of the  tax extenders the tax breaks the tax credits it would add to predictability and simplicity which you have the body believes would be better for small businesses if you know what's happening but you can plan for ten years from now five years from now obviously it is impact on your business decisions and gives you an opportunity to make better ones but having been through the tax extenders debates and having everybody that i knew that the business of some kind coming into my office and asking for an extension of their tax break to mow matter what business there and if it's propane gas or speedways throughout the united states i'm wondering how willing businesses are going to 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 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 eight percent after they take advantage of all their tax breaks and i have another that's over thirty and they're both pretty big companies now i wonder how the the company that is now paying about eight percent of their taxes is going to feel when we pass legislation that kind of stabilizes everybody at around twenty seven twenty eight percent while eliminating the tax breaks can you comment on that yeah there are a lot lot of a lot of points that you've raised there that all what economists call a marginal effective tax rate relative relative to two other nations there's a recent study that was released by an academic in canada jackman's that that makes that point  we also have a very high effective tax rate and a measured on a financial statement basis based on some work by an academic doug shackleford down in north carolina i think 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 what question you're asking but by a number of different metrics the u s is looks like it's pretty out of step relative relative to two other countries so that's i think what one point two to keep in mind let me add mr marron you pointed out in your testimony the connection between the complexity of the code and the tendency of small businesses to under paid their taxes can you share irresponsible i just distinguish rights of small business is 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 who are able to to avoid you know unfortunate i don't have any good recommendations for you i mean again some of these things have to do with cash transactions which are hard to monitor as just sort of you know a fundamental nature of some of these transactions if they're going to be more difficult to reach to there was the effort with the ten ninety nine which has gotten a lot of answer a question no suggestions on how we can in fact have what we can do with the tax code where simplification would have the highest effect on compliance no out by asking all four of you well two of you a question and then i'll follow up with the other two earlier this week in a publication called tax notes an article gentlemen the mardi nobody actually invited as a witness a couple 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 full on all flow through basis i'd like to get opinions from dr carroll and dr marion on dr sullivan's point that double taxation business income is bad for jobs and the economy and good policy means moving toward taxing business income wants do you agree or disagree and why i do agree with that as i've already alluded to stated in my comments the double talk from corporate profits distorts economic decision making in a number of very important ways that it leads to a higher degree of leverage in the economy which is problematic it leads to mis allocation of capital throughout the economy which is problematic and it raises the cost of capital which discourages capital for may that's also problematic using one of something donald said earlier you know economic fundamentals not tax considerations should drive decision making and the double tax i think violates the principle that you document i agree as well i mean there are lots of plans over time 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 mr tare if you were forced to go and become a c corp how would that impact your ability as a  create jobs from your current tax system i think it would diminish 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 that this is what how they think one time tax on that earnings flow through entities allow for that miss 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  rate 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 they're going to be now corporations and you're only the double tax in place they would be hurt tremendously i've had clients have been c corporations in the past who when they went to sell their business they end up paying more than fifty percent in taxes and that was overwhelming to them so it would really hurt them significantly if they had to go to a sequel  security let me follow up and the point mr thompson was making to you about anti abuse rules if the corporate tax was significantly lowered and you pointed out as you did that the lower rate usually don't but i think what he was trying to get  that the abuse that might arise at the corporate rate was fifteen percent to the highest individual rate was at thirty five percent you see some movement of earnings to the corporate form oh you there is movement between  high level there's there's movement between kind of flow through sector and the c corp sector depending on the relationship of the the individual tax rate and the corporate tax rate we saw that after the eighty six act with the repeal of general utilities doctrine and as well as the change in the relationship with the rights we saw a movement that some research that i did a while back scribed to the change in the right austin 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 thank you mr paulson is recognized thank you mr chairman and maybe i'll just follow up with mr carney i didn't get to ask you question before but you listed several items as a part of your testimony that were important for tax reform to be in consideration necessary get the corporate component of the pastor entities which we're talking about today but can you just discuss in greater detail a couple of the items or maybe the top handful of most important issues that should be focused on that would be the best i mean the absolute best actually help spur economic growth and capital formation and investment you know if there's just sort of a top wish list that should absolutely be focused on i think the timing is a requirement of an ass corporation because it is complex because of the levels of if you have certain stock structures you can't be an escort gratian certain number of shareholders you couldn't these things i think that could be simplified i don't 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 it needs to revised and simplified and those are the two and you have any idea how many small this is and these end up falling into sort of the alternative minimum tax because of their past through income or and maybe mr carroll you and you may know but you cannot under head and neck i actually don't know the answer to that to that question but it's a very interesting question when somehow it makes tax to have to look into that too a because you know the alternative minimum corporate rate is relationship to other countries across the world the question is tell me about the past entities in these other countries and again  start a lot of other countries push businesses into the corporate form in pursuit of limited liability as one of the distinguishing features i think between the u s and other countries is is it's much easier to get limited liability in this country because the flow through form into various organizational forms within in that sector and so it's that's one of the reasons we have a much larger flow through sector than the most most of the other nations  that's that's the in terms of the one could also do a comparison of the kind of the tax rates that those are those are the flow through income or c by individuals in the u s is subject to us compared to other nations i'm less familiar with those statistics you miss your my question kind of you know here in america we're trying to keep those two rates pretty close are you that we should look at the net rate not the growth rate but my question these other countries is there pass through rate similar to the corporate rate or is there a disparity in these other countries that we're aware of it i think there does without having looked at the data in detail my 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 system particularly the nordic countries where they treat the partnership income very very differently question when that nets out to the individual stockholder where which we're competing with another country that has a low corporate income tax are they paying a very high personal income tax so that net that person's pain  so when you when you look at looking at a different way if you look at the kind of the net after tax amount received for a dollar invests in the corporate sector kind of what is the sum total of the double tax on invested in the corporate sector and paid out as dividends in our major trading partners and if the rate where to go top individual the dividends and capital gains rights were to go up and that difference would become actually fairly substantial ecretary 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 paulson 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 this size that secretary g that's not the level of my clients my clients are very small business they have probably four to six members and their revenues are probably employees many owners of the  geithner was referring to it's a it's a very small percentage of the population but a significant fraction of the economic activity so you say that again if you do it by counting the number of firms of the number of businesses in the number that are in that size range appears to be very small but because they're large they account for a fairly large fraction of the economic activity whether it's assets or revenues or income that are accounted for by pastors as a whole businesses but many of these large partnerships actually joint venture partners happen to be corporations themselves there's a significant fraction of partnership income definition an individual and but for partnerships based on the statistics i've seen roughly fifty percent of partnership income is results from partnerships that are that have corporate owners you know two companies that engage in a in a partnership a joint venture to do something build a project and then they distribute the income to the two corporate owners it's about half of the about half of the partnership business activity is  seems to be owned by corporations so if we were to tax those entities those large partnerships or joint ventures like c corpse the effect we're subjecting them to triple income that flows from one part of the complex business unit to another so in effect the joint venture is being taxed the corporate port partners are being taxed and then the shareholders of the corporate partners would be taxed in they 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's hopefully helpful in living the conversation forward on comprehensive tax reform