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GUIDE TO TAX REFORM PANEL REPORTBy Ernst & Young

Table of Contents

I. Summary . . . . . . . . . . . . . . . . . . . . . . . . 1256A. Background . . . . . . . . . . . . . . . . . . . . 1256B. Short-Term Outlook . . . . . . . . . . . . . . 1256C. Longer-Term Outlook . . . . . . . . . . . . . 1256D. Panel Recommendations . . . . . . . . . . . 1257E. Changes Affecting Individuals in Both

Plans . . . . . . . . . . . . . . . . . . . . . . . . 1257F. Simplified Income Tax Plan . . . . . . . . . 1261G. Growth and Investment Tax Plan . . . . . 1263

II. Economic Effects . . . . . . . . . . . . . . . . . . 1265A. Summary . . . . . . . . . . . . . . . . . . . . . . 1265B. Large Tax Cut Assumed . . . . . . . . . . . . 1265C. Effect on Savings . . . . . . . . . . . . . . . . 1265D. Effect on Business Investment . . . . . . . 1266E. Consumption . . . . . . . . . . . . . . . . . . . 1266F. Housing Sector . . . . . . . . . . . . . . . . . . 1266G. State and Local Government Sector . . . 1266H. U.S. Production and International

Trade . . . . . . . . . . . . . . . . . . . . . . . . 1267I. Compliance Costs . . . . . . . . . . . . . . . . 1267J. Government Assistance Programs . . . . . 1267K. Conclusion . . . . . . . . . . . . . . . . . . . . . 1268

III. Individuals . . . . . . . . . . . . . . . . . . . . . . 1268

A. Simplified Income Tax Plan . . . . . . . . . 1268B. Growth and Investment Tax Plan . . . . . 1274C. Unanswered Questions . . . . . . . . . . . . 1274

IV. Savings and Benefits . . . . . . . . . . . . . . . 1275A. Simplified Income Tax Plan . . . . . . . . . 1275B. Growth and Investment Tax Plan . . . . . 1276C. Unanswered Questions . . . . . . . . . . . . 1276

V. Large Businesses . . . . . . . . . . . . . . . . . . 1277A. Simplified Income Tax Plan . . . . . . . . . 1277B. Growth and Investment Tax Plan . . . . . 1280C. Unanswered Questions . . . . . . . . . . . . 1282

VI. International . . . . . . . . . . . . . . . . . . . . . 1283A. Simplified Income Tax Plan . . . . . . . . . 1285B. Growth and Investment Tax Plan . . . . . 1288C. Unanswered Questions . . . . . . . . . . . . 1289

VII. State and Local . . . . . . . . . . . . . . . . . . . . 1289A. Simplified Income Tax Plan —

Corporate . . . . . . . . . . . . . . . . . . . . . 1289B. Simplified Income Tax Plan —

Individual . . . . . . . . . . . . . . . . . . . . . 1290C. Growth and Investment Tax Plan . . . . . 1291D. Unanswered Questions . . . . . . . . . . . . 1291

VIII. Passthrough Entities . . . . . . . . . . . . . . . . 1292

On November 1, President Bush’s Advisory Panelon Federal Tax Reform unveiled two options foroverhauling the nation’s tax system — a SimplifiedIncome Tax Plan and a Growth and Investment TaxPlan. The authors believe that in the current politicalenvironment tax reform is a ‘‘heavy lift,’’ but that thelong-term odds for legislative change look signifi-cantly better. In particular, they think, as 2008 ap-proaches, the ‘‘triple witching’’ effect of expiring taxcuts, the first wave of Baby Boom retirements, andthe burgeoning reach of the alternative minimum taxmay drive tax reform to fruition. In this report, Ernst& Young’s tax professionals examine the panel’srecommendations and their implications for corpo-rations, individuals, and industries.

The information contained herein is general innature and is not intended, and should not beconstrued, as legal, accounting, or tax advice oropinion provided by Ernst & Young LLP to the

reader. The reader also is cautioned that this materialmay not be applicable to, or suitable for, the reader’sspecific circumstances or needs, and may requireconsideration of nontax and other tax factors if anyaction is to be contemplated. The reader shouldcontact his tax professional prior to taking any actionbased on this information. Ernst & Young LLP as-sumes no obligation to inform the reader of anychanges in tax laws or other factors that could affectthe information contained herein.

Copyright 2005 Ernst & Young LLP. All rightsreserved. No part of this document may be repro-duced, retransmitted, or otherwise redistributed inany form or by any means, electronic or mechanical,including by photocopying, facsimile transmission,recording, rekeying, or using any information stor-age and retrieval system, without written permissionfrom Ernst & Young LLP.

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A. Simplified Income Tax Plan . . . . . . . . . 1292B. Growth and Investment Tax Plan . . . . . 1293C. Unanswered Questions . . . . . . . . . . . . 1293

IX. Financial Accounting . . . . . . . . . . . . . . . 1294A. Simplified Income Tax Plan . . . . . . . . . 1294B. Growth and Investment Tax Plan . . . . . 1295C. Unanswered Questions . . . . . . . . . . . . 1295

X. Real Estate . . . . . . . . . . . . . . . . . . . . . . . 1296A. Simplified Income Tax Plan . . . . . . . . . 1296B. Growth and Investment Tax Plan . . . . . 1298C. Unanswered Questions . . . . . . . . . . . . 1298

XI. Financial Services . . . . . . . . . . . . . . . . . . 1298A. Simplified Income Tax Plan . . . . . . . . . 1298B. Growth and Investment Tax Plan . . . . . 1299C. Unanswered Questions . . . . . . . . . . . . 1300

XII. Retail and Consumer Products . . . . . . . . 1300A. Simplified Income Tax Plan . . . . . . . . . 1300B. Growth and Investment Tax Plan . . . . . 1300C. Unanswered Questions . . . . . . . . . . . . 1301

XIII. Industrial Products . . . . . . . . . . . . . . . . . 1301A. Simplified Income Tax Plan . . . . . . . . . 1302B. Growth and Investment Tax Plan . . . . . 1302C. Unanswered Question . . . . . . . . . . . . . 1302

XIV. Energy and Utilities . . . . . . . . . . . . . . . . 1303A. Simplified Income Tax Plan . . . . . . . . . 1303B. Growth and Investment Tax Plan . . . . . 1304C. VAT Proposal . . . . . . . . . . . . . . . . . . . 1305D. Unanswered Questions . . . . . . . . . . . . 1305

XV. Technology, Communications &Entertainment . . . . . . . . . . . . . . . . . . . . 1306A. Simplified Income Tax Plan . . . . . . . . . 1306B. Growth and Investment Tax Plan . . . . . 1307C. Unanswered Questions . . . . . . . . . . . . 1308

XVI. Health Sciences . . . . . . . . . . . . . . . . . . . 1308A. Simplified Income Tax Plan . . . . . . . . . 1308B. Growth and Investment Tax Plan . . . . . 1309

I. Summary

A. Background

In January 2005 President Bush formed a bipartisan,nine-member Advisory Panel on Federal Tax Reform torecommend options that would make the tax code ‘‘sim-pler, fairer, and more conducive to economic growth.’’ OnNovember 1, 2005, the panel released a report offeringtwo options for reform — the Simplified Income Tax Planand the Growth and Investment Tax Plan.

Based on the panel’s work, the Treasury Department iscontemplating legislative recommendations that Presi-dent Bush is expected to take to the next level in 2006 —congressional debate. Among congressional observers,there is little expectation that the path to reform will bequick or smooth. If history is any guide, tax reform is infor a long and possibly bumpy ride in Congress.

That is true even though many tax policymakers inCongress and elsewhere believe the tax system in theUnited States would benefit from change. The last major

reform of the federal income tax was the Tax Reform Actof 1986 (the 1986 Act). The 1986 Act lowered the topindividual marginal tax rate from 50 percent to 28 percentand the top corporate tax rate from 46 percent to 34percent. Since then, the top individual marginal tax ratehas been changed several times, ranging as high as 39.6percent before being reduced to 35 percent in 2001. Onthe business side, the top corporate marginal income taxrate has increased from 34 percent to 35 percent since1986.

In addition, the alternative minimum tax, which laymostly dormant for many years, affects an escalatingnumber of taxpayers each year because of the lack ofinflation indexing. The AMT will affect an estimated 21million taxpayers in 2006 and 52 million taxpayers in2015.

At the same time, U.S. companies face increased globalcompetition, and there has been an increase in themobility of tangible and intangible assets, as well aslabor, around the world. Emerging economies now play alarger role in the global economy, aided by reducedcommunication costs and lower political barriers. Manycountries have lowered their top business tax rates belowthe U.S. 35 percent rate.

B. Short-Term OutlookOver the next few months, the Bush administration

faces a number of decision points that will be watchedclosely by those looking to project the odds and timetablefor tax reform. By early 2006 the Treasury Departmentwill have sifted through the panel’s recommendations,formulated a single tax reform package, and forwarded itto the White House. The White House will accept ormodify the proposal, prioritize it against other items onthe president’s agenda, and set a game plan for movingforward.

For the first time since 1986, anational dialogue is getting under wayon what the nation’s tax systemshould look like and how best to getthere.

In early February, when the fiscal 2007 budget pro-posal is submitted to Congress, the administration’sgame plan for tax reform will be known in greater detail.Lawmakers will begin to take sides, along with thebusiness community and the public at large. As legisla-tion is drafted, the economic choices and politicaltradeoffs needed to achieve fundamental reform willbecome clearer.

For now, the panel has taken a bold first step inattempting to spur a national policy debate on the taxsystem. For the first time since 1986, a national dialogueis getting under way on whether to fundamentally alterthe nation’s tax system, and how best to do so.

C. Longer-Term OutlookIn the spring, it is likely that formal legislation will be

introduced in Congress. The legislation will need totraverse the usual congressional milestones, beginningwith committee hearings, additional deliberations by

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House and Senate taxwriters, and ultimately companionbills that will be combined to a single measure in aHouse-Senate conference.

Although the timetable for legislative change is uncer-tain, due in part to the upcoming 2006 elections, anumber of pending fiscal issues are slated to grow inintensity over the next three years, and in the processcreate budget pressure that could drive tax reform toenactment. For one, the first wave of Baby Boomers willbegin to retire, which will draw down Social Securitysurpluses that have had the effect of obscuring the truesize of the federal deficit. Second, the tax cuts enacted in2001 and 2003 are scheduled to expire beginning in 2008.Third, the AMT, which affected 3 million taxpayers in2004, will snare an estimated seven times that many filersin 2006 — an estimated 21 million. By 2008 the AMT willhit close to 30 million taxpayers and bring in morerevenue than the regular federal income tax.

Together those factors will bring pressure not just onthe federal budget, but on the tax code as part of abudgetary solution.

D. Panel RecommendationsThe panel recommended two options for overhaul of

the tax code: (1) the Simplified Income Tax Plan and (2)the Growth and Investment Tax Plan. The two plansdiffer in terms of how they would tax business andcapital income, but are similar in terms of the changesthey propose for individual taxpayers. For a side-by-sidecomparison of the two plans with current law, see Table1-1 on p. 1258.1. The Simplified Income Tax Plan. The SimplifiedIncome Tax Plan uses the current Internal Revenue Codeas its starting point and aims to simplify the process offiling tax returns and make it easier to project taxconsequences when planning for the future. Under thisoption, a number of major features of the current law —exemptions, deductions, and credits — that are subject todifferent definitions, limits, and eligibility rules would beconsolidated and streamlined.

The Simplified Income Tax Plan would simplify taxesgenerally for small businesses (those with receipts lessthan $1 million) by allowing them to use a cash methodof accounting — business receipts minus business cashexpenses equals business taxable income. Medium-sizebusinesses (those with more than $1 million but less than$10 million in gross receipts) would report on the samecash basis as small businesses, but would be required todepreciate rather than expense the purchase of newassets and, in some cases, maintain inventories. Largebusinesses (those with gross receipts in excess of $10million) would be taxed at a maximum rate of 31.5percent whether conducted in corporate or partnershipform. Both domestic and international tax rules would bemade simpler as many special business tax preferenceswould be eliminated and the international tax systemwould be replaced with a territorial system.2. The Growth and Investment Tax Plan. The Growthand Investment Tax Plan is a blended tax structure thatwould move the current tax system toward a consump-tion tax while preserving some elements of incometaxation. That plan would combine a progressive tax onlabor income with a flat-rate tax on interest, dividends,

and capital gains, and with a single-rate tax on businesscash flow. In general, under the Growth and InvestmentTax Plan, businesses would pay tax at a single rate of 30percent on their cash flow, which is defined as their totaldomestic sales, minus purchases of goods and servicesfrom other U.S. businesses, minus wages and othercompensation paid to their workers. Expensing would beallowed for the total cost of new investments.3. Other options considered. The panel also developedand analyzed — but did not recommend — a pureprogressive consumption tax plan (which would elimi-nate the tax on capital) and a proposal for a value addedtax that would replace a portion of both the individualand corporate income tax. The panel rejected a proposalfor a complete replacement of the federal income tax witha national retail sales tax. Key to that decision, the reportsaid, was that such a new system would not be appro-priately progressive without a mechanism to relieve theburden on lower- and middle-income taxpayers and thatthe institution of a cash grant program to address pro-gressivity would require an inappropriately large newgovernment entitlement program.

E. Changes Affecting Individuals in Both PlansThe basic premise of the panel’s recommendations for

individuals involves the broadening of the tax base,removing some of the complexity in the rules, eliminat-ing the AMT, and eliminating most tax deductions andpreferences, coupled with a reduction in the number ofindividual tax brackets. Under the Simplified Income TaxPlan, the number of brackets would be reduced from thecurrent six to four (15 percent, 25 percent, 30 percent, and33 percent). Under the Growth and Investment Tax Plan,the number of tax brackets would be reduced from six tothree (15 percent, 25 percent, and 30 percent).

Under both recommendations, the standard deduc-tion, personal exemptions, child tax credit, and head ofhousehold filing status would be consolidated into a‘‘family credit.’’ The base credit amount would equal$1,650 for single filers; $3,300 for married filers; $2,800 forsingle filers with dependent children; and $1,150 fordependent taxpayers. To that base amount, each familywould add $1,500 for each dependent child and $500 foreach other dependent. Those amounts would be adjustedannually for inflation. The tax preferences for highereducation costs also would be simplified by replacing thecurrent credits and deductions with a full family creditallowance of $1,500 for all families with full-time stu-dents age 20 and under. Under both plans, the popularitemized deduction for state and local taxes would beeliminated.

In addition, both plans would consolidate the currentearned income tax credit and refundable child tax creditinto a single ‘‘work credit.’’ As under the current system,the work credit amount would increase as the amount ofearnings from work (wages and self-employment in-come) increases, and the rate and maximum creditamount would be higher for workers who live withqualifying children. For the first year, the work creditmaximum amount would be $412 for workers with nochildren; $3,570 for workers with one child; and $5,800

(Text continued on p. 1259.)



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Table 1-1. How the Tax Code Would Change

Provisions Current LawSimplifed Income

Tax PlanGrowth and

Investment Tax PlanHouseholds and FamiliesTax rates Six tax brackets: 10%, 15%, 25%, 28%, 33%,

35%Four tax brackets: 15%,25%, 30%, 33%

Three tax brackets:15%, 25%, 30%

Alternative minimumtax

Affects:— 21 million taxpayers in 2006— 52 million taxpayers in 2015

Repealed

Personal exemption $3,200 deduction for each member of ahousehold; phases out with income

Replaced with family credit available to alltaxpayers: $3,300 credit for married couple; $2,800credit for unmarried with child; $1,650 credit forsingles; $1,150 credit for dependent taxpayer;additional $1,500 credit for each child; and $500credit for each other dependent

Standard deduction $10,000 deduction for married couples filingjointly; $5,000 deduction for singles; $7,300deduction for heads of households; limited totaxpayers who do not itemize

Child tax credit $1,000 credit per child; phases out for marriedcouples between $110,000 and $130,000

Earned income taxcredit

Provides lower-income taxpayers refundablecredit designed to encourage work. Maximumcredit for working family with one child is$2,747; with two or more children is $4,536

Replaced with work credit (and coordinated withthe family credit); maximum credit for workingfamily with one child, $3,570; with two or morechildren, $5,800

Marriage penalty Raises the tax liability of two-earner marriedcouples compared to two unmarriedindividuals earning the same amounts

Tax brackets and most other tax provisions forcouples are double those of individuals

Other Major Credits and DeductionsHome mortgageinterest

Deduction available only to itemizers forinterest up to $1.1 million of mortgage debt

Home credit equal to 15% of mortgage interestpaid; available to all taxpayers; mortgage limitedto average regional price of housing (limitsranging from about $227,000 to $412,000)

Charitable giving Deduction available only to itemizers Deduction available to all taxpayers (who givemore than 1% of income); rules to addressvaluation abuses

Health insurance Grants tax-free status to an unlimited amountof premiums paid by employers or theself-employed

All taxpayers may purchase health insurance withpretax dollars, up to the amount of the averagepremium (estimated to be $5,000 for an individualand $11,500 for a family); Employers may providetax-free health insurance up to those amounts

State and local taxes Deduction available only to itemizers; notdeductible under the AMT

Not deductible

Education HOPE credit, lifetime learning credit, tuitiondeduction, student loan interest deduction; allphase out with income

Taxpayers can claim family credit for somefull-time students; simplified savings plans

Individual Savings and Retirement ArrangementsDefined contributionplans

Available through 401(k), 403(b), 457, andother employer plans

Consolidated into save at work plans that havesimple rules and use current-law 401(k)contribution limits; AutoSave features pointworkers in a pro-saving direction (Growth andInvestment Tax Plan would make save at workaccounts ″prepaid″ or Roth-style)

Defined benefit plans Pension contributions by employers areuntaxed

No change

Retirement savingsplans

IRAs, Roth IRAs, spousal IRAs — subject tocontribution and income limits

Replaced with save for retirement accounts($10,000 annual limit) — available to all taxpayers

Education savingsplans

Section 529 and Coverdell accounts Replaced with save for family accounts ($10,000annual limit); would cover education, medical,new home costs, and retirement saving needs;available to all taxpayers; refundable SaversCredit available to low-income taxpayers

Health savings plans MSAs, HSAs, and flexible spendingarrangements

Dividends received Taxed at 15% or less (ordinary rates after2008)

Exclude 100% ofdividends of U.S.companies paid out ofdomestic earnings

Taxed at 15% rate



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for workers with two or more children. The work creditwould be adjusted annually for inflation.

1. Charitable giving incentives. Both plans would allowall taxpayers to claim a deduction for charitable contri-butions that exceed 1 percent of income. Further, theplans would allow taxpayers over age 65 to contributedistributions from individual retirement accounts toqualified charitable organizations without incurring taxliability. The plans would also allow taxpayers to sellappreciated property without recognizing a gain andreceive a full charitable contribution deduction if all theproceeds are donated to a charity within 60 days of thesale.

To improve documentation of charitable contribu-tions, the plans would require charities to report largegifts ($600 or higher in annual contributions) directly tothe IRS and to the donor. All cash and noncash contribu-

tions of $250 or more would count toward the $600threshold. The panel recommended exempting from theinformation reporting requirements small charities thatdo not receive (1) more than 250 contributions of $600 ormore or (2) total contributions of more than $150,000.

For noncash contributions, the plans would recom-mend new rules requiring appraisals, establishing stan-dards for qualified appraisers, and requiring appraisersto report the value of contributed property to the IRS aswell as to the donor and the charity. The plans also wouldrecommend increasing penalties on appraisers who mis-state, by more than 50 percent, the value of property.

To curb abuses associated with current self-reportingof the value of clothing and household items, the panelrecommended allowing the deduction for those contri-butions only when the taxpayer receives a price list anditemized receipt from the charity.

Table 1-1. How the Tax Code Would Change (continued)

Provisions Current LawSimplifed Income

Tax PlanGrowth and

Investment Tax PlanCapital gains received Taxed at 15% or less (higher rates after 2008) Exclude 75% of

corporate capital gainsfrom U.S. companies(tax rate would varyfrom 3.75% to 8.25%)

Taxed at 15% rate

Interest received (otherthan tax-exemptmunicipal bonds)

Taxed at ordinary income tax rates Taxed at regularincome tax rates

Taxed at 15% rate

Social Security benefits Taxed at three different levels, depending onoutside income; marriage penalty applies

Replaces three-tiered structure with simplededuction; married taxpayers with less than$44,000 in income ($22,000 if single) pay no tax onSocial Security benefits; fixes marriage penalty;indexed for inflation

Small BusinessTax rates Typically taxed at individual rates Taxed at individual

rates (top rate loweredto 33%)

Sole proprietorshipstaxed at individualrates (top rate loweredto 30%); other smallbusinesses taxed at30%

Recordkeeping Numerous specialized tax accounting rules foritems of income and deductions

Simplified cash-basisaccounting

Business cash flow tax

Investment Accelerated depreciation; special small-business expensing rules allow write-off of$102,000 in 2005 (but cut by ¾ in 2008)

Expensing (exception for land and buildingsunder the Simplified Income Tax Plan)

Large BusinessTax rates Eight brackets: 15%, 25%, 34%, 39%, 34%, 35%,

38%, 35%31.5% 30%

Investment Accelerated depreciation under complicatedrules

Simplified accelerateddepreciation

Expensing for all newinvestment

Interest paid Deductible No change Not deductible (exceptfor financialinstitutions)

Interest received Taxable (except for tax-exempt bonds) Taxable Not taxable (except forfinancial institutions)

International taxsystem

Worldwide system with deferral of businessprofits and foreign tax credits

Territorial tax system Destination-basis(border taxadjustments)

Corporate AMT Applies second tax system to business income RepealedSource: Panel’s Report, pp. xvi-xvii (as of November 15, 2005).



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The panel made no specific recommendations on therules governing exempt organizations, but recommendedgenerally greater oversight and better governance ofthem.2. Replace mortgage interest deduction with homecredit. One of the more controversial proposals made inthe two options would convert the current home mort-gage interest deduction into a ‘‘home credit’’ equal to 15percent of the interest paid on the mortgage on a primaryresidence. The panel recommended limiting that credit tointerest on a standard principal amount. That standardamount would vary by region of the country and wouldbe adjusted annually to reflect variations in home prices.Thus, if home prices rise, so too would the taxpayer’slimit under the home credit.

The cap on the eligible mortgage indebtedness wouldbe tied to the ceilings that the Federal Housing Admin-istration (FHA) sets for the amount of a home mortgageloan that it will insure. The ceilings are determined usingmedian home prices and are provided on a county-by-county basis. Under the plans, those amounts would beadjusted to reverse a discount the FHA applies and toaccount for the difference between median and averageprices. To determine mortgage loan limits, the amountthe FHA reports would be grossed up to 100 percent ofmedian values and then increased by 125 percent. Ac-cording to the panel’s report, if the credit was in placetoday, the limits would be between approximately$227,147 and $411,704.

The panel recommended phasing in those changesover a five-year period. During the transitional period,taxpayers would be allowed to claim either the homecredit or the mortgage interest deduction on existingmortgages. The current-law $1 million mortgage interestlimit would be reduced annually during the five-yeartransition period. Interest on a second home or a homeequity loan would not be eligible for transition relief, andthe deduction would be repealed after the effective date.Interest on new or refinanced mortgages would notqualify for the transitional mortgage interest deduction,but would be eligible for the new home credit.

Both plans would retain a modified version of theexclusion for gains on the sale of a primary residence bysetting the exclusion at $600,000 for joint filers ($300,000for single filers) and indexing that level for inflation.Gains greater than that amount would be taxed atordinary income rates under the Simplified Income TaxPlan and at 15 percent under the Growth and InvestmentTax Plan. The panel also recommended applying theexclusion only if a taxpayer occupies the residence forthree of the last five years (rather than two of the last fiveyears).3. Limitations on tax-favored health coverage and otherfringe benefits. The panel recommended allowing em-ployers to continue deducting the cost of employeecompensation, whether in the form of cash compensationor health insurance premiums.

Further, the panel recommended allowing workers topurchase insurance either through their employer or ontheir own with pretax dollars up to the average cost forhealth insurance. Taxpayers who do not have access toemployer-provided plans would be allowed a new de-duction for health premiums equal to the exclusion

available to workers whose employers provide healthinsurance. The panel recommended limiting the exclu-sion to the average amount projected to be spent onhealth insurance premiums. For 2006 that amount wouldbe $11,500 for families and $5,000 for individuals. Thelimit would be adjusted for annual increases in overallinflation, not health inflation.

In addition to the changes related to health benefits,both plans would make significant changes to the defi-nition of taxable compensation for employees. Specifi-cally, employer-provided fringe benefits, like educationalassistance, child-care benefits, group-term life insurance,and long-term care insurance, which now are excludable,would be taxable to the employee. The value of ‘‘in-kind’’benefits provided to all employees (for example, meals ata company cafeteria) would continue to be excludable.The employer’s deduction for compensation would notchange. The additional taxable compensation would besubject to both income and payroll taxation.4. Four-pronged ‘savings package.’ Both reform plansinclude a four-pronged savings package that the panelrecommended should move forward as a unified wholeto have the desired effects on the personal savings rate.The plans include three savings vehicles — a save atwork account, a save for retirement account, and a savefor family account. The plans also include a refundablesavers credit. The plans would not change the currentdefined benefit plan rules.

i. Save at work accounts. The save at work accounts,which track the Bush administration’s employer retire-ment savings account proposal, would replace manycurrent employer defined contribution plans and wouldsimplify the current nondiscrimination rules, which aredesigned to ensure that the plans are not biased in favorof highly compensated employees. In general, save atwork accounts would follow the existing contributionlimits and rules for 401(k) plans, but the qualificationrules would be simplified. Under the Simplified IncomeTax Plan, contributions to save at work accounts wouldbe made on a pretax basis and withdrawals would betaxed as ordinary income. Under the Growth and Invest-ment Tax Plan, contributions would be made on anafter-tax basis and withdrawals would not be taxed.

Both reform plans would introduce AutoSave ‘‘defaultrules’’ that would provide for automatic enrollment,growth over time in contributions, diversified invest-ments, and automatic rollover should the employeechange jobs. The employee would be given the opportu-nity to opt out. The panel recommended that the Auto-Save proposal also include the following provisions:

• clarifying current law to confirm that federal lawspermitting automatic payroll deductions for retire-ment plans supersede any state laws that mightprohibit that practice;

• extending fiduciary liability protection against in-vestment losses to sponsors of save at work plansthat incorporate AutoSave features to the sameextent provided by current law to all plans in whichthe employee exercises control over the investmentof plan assets; and

• entitling AutoSave plans to discrimination testingthat is less stringent than current law.



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The panel also recommended that, to demonstrateleadership in that area, the federal government adoptAutoSave for its Thrift Savings Plan.

It is not clear from the panel’s report whether tradi-tional profit-sharing, money purchase, or Keogh planswould also be replaced by save at work plans.

ii. Save for retirement accounts. The save for retire-ment accounts would replace all current IRAs as well asdeferred executive compensation plans. Contributions ofup to $10,000 per year would be permitted into thoseaccounts with no income phaseouts for contributions.Those accounts would be fully back-loaded, in thatcontributions would be ‘‘after tax’’ with no tax on ac-count earnings. Tax-free distributions would be permit-ted after age 58, or on death or disability. Tax andpenalties would apply to distributions for any otherreason.

Roth IRAs would be automatically converted to savefor retirement accounts. Existing traditional IRAs (includ-ing those to which nondeductible contributions weremade) could be converted into a save for retirementaccount by subjecting the value of those accounts to taxesonce, similar to a current-law conversion of a traditionalIRA account to a Roth IRA account. No income limitswould restrict conversions. Similarly, on separation, saveat work accounts could be rolled directly from an em-ployer plan into a save for retirement account by payingincome tax on the rollover amount. Existing traditionalIRAs not converted into a save for retirement accountwould continue to exist, but new contributions wouldhave to be made to the save for retirement accounts.

iii. Save for family accounts. The save for familyaccounts would replace all other tax-favored savingsvehicles in the tax code (health savings accounts, flexiblesavings accounts, education accounts, and so on). Indi-viduals would be permitted to make contributions of upto $10,000 each year in those accounts. There would be noincome phaseouts and earnings would be tax-free. With-drawals would be limited to $1,000 each year for anypurpose. Unlimited withdrawals would be permitted tocover health costs, education expenses, home purchase,or retirement.

iv. Savers credit. The panel recommended a refund-able ‘‘savers credit,’’ which would equal 25 percent forcontributions up to $2,000 that are made into thoseaccounts. The rules would be coordinated with the workcredit to target that benefit to lower-income savers, andthe credit would phase out ratably as income rises.5. Treatment of savings outside tax-favored vehicles.The panel also recommended as part of the SimplifiedIncome Tax Plan a more consistent treatment of savingsheld outside of those tax-preferred accounts. Currently,there are no annual limits on the tax benefits for somedeferred compensation arrangements and increases inthe cash value of annuities and life insurance. The panelrecommended putting new rules in place to treat thosearrangements like other investments.

Regarding the inside buildup in some life insuranceand annuity policies, the panel recommended treatingthe increase in value in those policies as current incomethat would be subject to tax annually, at the taxpayer’sordinary income tax rate. However, the Simplified In-come Tax Plan would allow whole-life insurance policies

and deferred annuities to be purchased like other finan-cial investments through tax-deferred save for retirementand save for family accounts, subject to the dollar limits.

Also, the panel report provided that annuities, lifeinsurance arrangements, and deferred compensationplans currently in existence would continue to be taxedunder current-law rules.

In general, the Simplified Income Tax Plan would taxinterest income (other than that from tax-exempt munici-pal bonds) earned outside the tax-favored vehicles atordinary income rates. The Growth and Investment TaxPlan would tax interest income (other than that fromtax-exempt municipal bonds) at a rate of 15 percent. Bothreform plans would maintain current-law treatment ofstate and local tax-exempt bonds for individual investors.Under the Simplified Income Tax Plan, however, thepanel recommended eliminating the exclusion from busi-ness income for state and local tax-exempt bond interest.

Individual investors would be able to deduct theamount of interest incurred to generate taxable invest-ment income. The deduction for investment interestwould be limited to the amount of taxable investmentincome reported by a taxpayer.

F. Simplified Income Tax Plan1. Corporate tax changes

i. In general — corporate integration with individualincome tax. The Simplified Income Tax Plan also wouldinclude substantial reforms to the corporate tax rules. Ingeneral, it envisions full corporate integration for U.S.corporations so that the double tax on corporate incomewould be reduced. Foreign-based firms would not beeligible for that treatment. Under the plan, individualsand corporations would be able to exclude 100 percent ofdividends attributable to domestic earnings. Corpora-tions would notify shareholders of the portion of divi-dends subject to tax based on the proportion of thecorporation’s income not subject to U.S. taxation in theprior year.

Individuals could exclude 75 percent of capital gainsattributable to sales of corporate stock held for longerthan one year, with the remaining 25 percent of capitalgain includable in an individual’s taxable income andtaxed at ordinary rates. The panel noted that the specialtreatment for corporate capital gains is warranted to levelthe playing field between businesses that pay out earn-ings in the form of dividends and those that retainearnings when shareholders realize those gains on dis-position of the corporate stock. All other capital gainsreceived by individuals would be taxed as ordinaryincome.

In addition, the Simplified Income Tax Plan wouldsubstantially reverse the current code’s bias for debtfinancing over equity financing by reducing the doubletaxation on corporate profits, possibly resulting in addi-tional investment in corporate equity.

ii. ‘Clean’ tax base. The plan called for using a cleantax base for the corporate tax and eliminating all creditsand special preferences, except for accelerated deprecia-tion. The panel report specifically highlighted the elimi-nation of the section 41 research credit, the recentlyenacted section 199 production deduction, and the cor-porate deduction for state and local income taxes.



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The corporate tax rate would be reduced to 31.5percent and would be paid by all business entitiesregardless of form (that is, passthrough entities likepartnerships, S corporations, and limited liability compa-nies would pay the corporate tax rate at the entity level).Large businesses would be defined as having annualreceipts of $10 million or more. Passive investmentvehicles like regulated investment companies and realestate investment trusts would be treated as under cur-rent law. In addition, the plan would abolish the corpo-rate AMT.

The panel noted that it evaluated a proposal to taxlarge business entities based on financial statement netincome, as opposed to requiring a separate calculation oftaxable income as under current law. It recommendedfurther study of that concept.

iii. Simplified cost recovery for large businesses. Thepanel recommended a greatly simplified cost-recoverysystem for large taxpayers — replacing the nine differentasset class lives, three different recovery methods, andthree different applicable conventions with a systemusing only four asset categories. The panel envisionedthe new system providing roughly the same cost-recovery deductions as does current law but with sim-plification gains. Under the new plan, taxpayers wouldincrease the balance in one of four property accounts bythe amount of new purchases and be allowed a uniformallowance each year. Depreciation would be computedby multiplying the account’s average balance by thedepreciation rate applicable to the specific asset class. Thecategories and recovery percentages would be as follows:

iv. Changes for small and medium-size businesses.The plan would simplify the rules governing small andmedium-size businesses and improve compliance in thatarea. Under the plan, small and medium-size businesses(firms with less than $10 million in annual receipts)would be taxed on a cash basis at the top individual rateof 33 percent.

Small businesses (with receipts less than $1 million)would report income based on cash receipts less cashbusiness expenses. That method would apply to all items

of income and expense except for building and landpurchases. Small businesses also would be permitted toimmediately expense all business expenditures (exceptfor building and land purchases, which would generallybe treated as under current law). Thus, there would be noneed for businesses to keep track of depreciation sched-ules for specific assets. Medium-size firms (with annualreceipts between $1 million and $10 million) would besubjected to a simplified depreciation system for pur-chased business assets and, in some cases, a simplifiedinventory method for physical inventories. The grossreceipts figure (for determining small and medium-sizebusiness eligibility) would be based on the firm’s priorthree-year average.

Businesses with gross receipts less than $10 millioncould elect to be treated as a large business to availthemselves of the exclusion rules for dividends andcorporate capital gains.

To aid with compliance, small and medium-size busi-nesses would be required to set up a business bankaccount; those accounts could not be used for personaltransactions. Banks would be required to provide to theIRS and to the taxpayer annual information reports onthe transactions in and out of the accounts. Similarly, forthose businesses, credit and debit card companies wouldbe required to provide annual information reports sum-marizing business credit transactions.

2. International tax changes. The Simplified Income TaxPlan would impose new disclosure requirements onforeign earnings and would adopt two international taxproposals that also had been developed by the staff of theJoint Committee on Taxation and included in a 2005report entitled ‘‘Options to Improve Tax Compliance andReform Tax Expenditures’’ (the JCT Report).1 In additionto the new disclosure requirements for foreign earnings,the plan would replace the worldwide, deferral-basedsystem of current law with a territorial tax regime andwould define a publicly traded foreign-incorporated en-tity’s residence by reference to the location of its primaryplace of management and control.

i. Disclosure of foreign earnings. The plan wouldcontemplate new reporting requirements for U.S. multi-national corporations, including the filing of a newschedule with their income tax return that shows consoli-dated worldwide revenues and income before taxes, asreported in their annual financial statements. The newschedule would disclose the proportion of domestic andforeign revenues and income. Also, businesses would berequired to reconcile the income reported on their bookswith the taxable income reported on their returns. (Notethat most of that information is already required for U.S.multinational corporations required to file Schedule M-3,so a new schedule as described would result in someduplicate reporting.)

1‘‘Options to Improve Tax Compliance and Reform TaxExpenditures,’’ prepared by the staff of the JCT in response to aFebruary 2004 request by Senate Finance Committee ChairChuck Grassley, R-Iowa, and ranking minority member MaxBaucus, D-Mont. (JCS-02-05).

Table 1-2. Asset Categories Under the SimplifiedDepreciation System

Category Types of Assets PercentageI Assets used in agricultural,

mining, manufacturing,transportation, trade, andservice sectors

30.0

II Assets used for energyproduction, a few otherrelatively long-lived utilityproperties, and most landimprovements

7.5

III Residential buildings 4.0IV Non-residential buildings

and other long-lived realproperty

3.0

Source: Panel’s Report, p. 132 (as of November 15, 2005).



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ii. Territorial tax system. The Simplified Income TaxPlan would retain some features of current law likesubpart F. Branches and controlled foreign corporations(foreign affiliates) would be placed on an equal footing,with income of foreign branches treated like income of aforeign affiliate. Under a general rule, payments that aredeductible abroad would be taxed in the United States. Aforeign tax credit would be available to offset tax onpassive and highly mobile income, subject to a single,overall FTC limitation. Thus, while nondividend pay-ments (for example, interest, royalties, and paymentsfrom intercompany transfers) from a foreign affiliate to aU.S. corporation would be fully subject to U.S. tax, therewould be little opportunity for cross-crediting. Note alsothat no change would be made to the export source ruleunder section 863(b), but the benefits of that rule wouldbe significantly diminished in view of the limited func-tion of the FTC under the new system.

Following are some other important elements of thepanel’s Simplified Income Tax Plan:

• Special rule for hybrid securities. The panel’s rec-ommendation contemplated that a ‘‘hybrid securityrule would be required to prevent a payment that istreated as deductible interest abroad from beingtreated as an exempt dividend in the United States.’’

• Need for an active financing provision undersubpart F. The panel report recognized that ‘‘specialrules would need to provide that qualifying finan-cial services business income is treated as foreignbusiness income.’’

• Retention of other foreign-base company rules.The panel rejected the JCT Report’s suggestion toconsider repealing the foreign-base company salesand services income rules and instead specificallydescribed that income as ‘‘mobile income’’ thatwould remain subject to U.S. taxation.

• Allocation of interest and general and administra-tive (G&A) expenses. The expense allocation rulesrecommended by the panel were based on thepremise that expenses attributable to exempt foreignearnings should not be allowed as a deduction onthe U.S. return. Thus, interest expense would beallocated between American and foreign affiliatesunder rules similar to the worldwide allocationrules enacted as part of the American Jobs CreationAct of 2004 (the Jobs Act, P.L. 108-357). Similarly,G&A expenses that are not charged out to foreignaffiliates or otherwise recovered by intercompanyfees would be allocated between exempt and non-exempt foreign income.

• Allocation of research and experimentation ex-penses. The Simplified Income Tax Plan wouldallocate R&E expenses between domestic andforeign-source mobile income only, based on therationale that no R&E expenses should be allocatedagainst exempt foreign-source income because allroyalty income associated with the R&E expenseswould be taxable in the United States.

• Transition. The panel decided that all distributedearnings of foreign affiliates should be subject to thenew territorial regime, regardless of whether thedistributions are paid out of pre-effective-date orpost-effective-date earnings.

iii. New rule for determining corporate residency.The panel’s recommendation would modify the defini-tion of businesses that are subject to U.S. tax by providinga ‘‘comprehensive rule’’ that treats a business as a resi-dent of the United States if the United States is either theplace of legal residency or the business’s place of ‘‘pri-mary management and control.’’ In effect, that provisionwould circumvent the effective date of the anti-inversionrules included in the Jobs Act, which permanently grand-fathered most inverted structures already in place (inaddition to newly incorporated entities that establishcorporate charters in foreign jurisdictions).

G. Growth and Investment Tax Plan1. Corporate tax changes

i. In general — cash flow taxation. Under the Growthand Investment Tax Plan, all businesses (except soleproprietorships) would be taxed at a 30 percent rate ontheir cash flow (defined as total sales less purchase ofgoods and services from other businesses and less wagesand other compensation paid to employees). Sole propri-etorships would be taxed at ordinary individual incomerates. Flow-through entities, like partnerships and LLCs,would also be taxed at the 30 percent rate on theirbusiness cash flow, although owners of those entitiescould report and compute the tax on their individualreturns.

Companies would be able to immediately expense allbusiness investments, including all employee wages andother compensation. That plan also would remedy thecurrent code’s preference for debt financing over equityfinancing. Nonfinancial businesses would not be taxedon income from financial transactions like dividend andinterest payments, but they would not receive any de-ductions for interest paid or other financial outflows.

Firms that generate losses could carry those lossesforward indefinitely, and those carryforwards wouldaccrue interest.

ii. Treatment of financial institutions. Under theplan, financial institutions would be treated very differ-ently from nonfinancial institutions, necessitating newdefinitions and a significant change in the tax base.Financial institutions would treat all principal and inter-est inflows as taxable income and deduct all principaland interest outflows.

Customers of financial institutions would disregardfinancial transactions for tax purposes. Complicatedrules would prevent the ‘‘over-taxation of business pur-chases of financial services’’ attributable to deductiblefinancial intermediation services (which would be de-ductible as an expense for the customer).

Table 2-1. Estimated Increases in National Income

Category10

Years20

YearsLongRun

Simplified Income Tax Plan 0.5% 1.0% 1.2%Growth and InvestmentTax Plan 1.8% 3.6% 4.7%Progressive ConsumptionTax Plan 2.3% 4.5% 6.0%Source: Treasury Department, Office of Tax Analysis.



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Rules would be necessary to determine which busi-nesses qualify as financial institutions, particularly in thecase of businesses with both financial and nonfinancialbusiness activities. The report recognized that there maybe an incentive for nonfinancial services firms to charac-terize transactions as financial to escape taxation (forexample, the Appendix to the panel’s report contains anexample of a car dealership posting a low sales price ona car but selling the car on credit with a high financingcharge). A similar incentive may exist to recharacterizenonfinancial transactions as financial in the case of de-rivatives (for example, the panel’s report indicated that aderivative entered into to hedge a nonfinancial businessasset or liability should be taxed in a manner similar tothe treatment of the underlying asset — subject to thecash flow tax).

Also, an interest rate that would be used as a proxy forthe financial cost component of financial cash flowswould have to be established to determine the value ofthe separate taxable service component.

iii. Transition relief. In moving from the currentincome tax system to the hybrid consumption tax modelof the Growth and Investment Tax Plan, the panelrecommended several specific types of transition relief:

• first, transition relief on depreciation allowances ofexisting assets (phased out evenly over a five-yearperiod: 80 percent, 60 percent, 40 percent, 20 per-cent, and 0 percent);

• second, for businesses with outstanding debt, thesame five-year phaseout structure for interest de-ductions (80 percent, 60 percent, 40 percent, 20percent, and 0 percent); and

• specialized transition relief for financial institutions(because financial firms never received a deductionagainst cash flow when raising capital for outstand-ing loans, it is not fair to tax returns on that capital;interest on those loans would be taxed, however).

In the report, the panel recognized that other potentialareas for transition relief exist but cautioned that expand-ing the level of transition relief would mean a corre-sponding increase in the broadly applicable tax rates.

iv. Miscellaneous issues.• Tax-free formations and mergers/acquisitions. The

adoption of tax-free business combination rules maycreate opportunities to inappropriately transfer busi-ness losses, and the panel suggested that it may benecessary to import some judicial doctrines like thestep transaction doctrine and business purpose testto guard against those results.

• Employee stock options (for example, incentivestock options and nonqualified options). Thoseoptions may pose particular challenges under theGrowth and Investment Tax Plan in that they are aform of compensation that is difficult to value.

2. International tax changes. The Growth and Invest-ment Tax Plan would tax international transactions undera ‘‘destination basis’’ principle, with border tax adjust-ments (that is, imports would not be deducted from cashflow and the cash flow tax would be rebated on exports).The panel, however, did not provide definitive recom-mendations regarding important implementation issues.As such, if the Bush administration chooses to pursuethat option, there is far more work yet to be done onthose fundamental issues.

Figure 1. Deficit Projections With and Without Extension

Of the 2001 and 2003 Rate Reductions

Source: The Budget and Economic Outlook: An UpdateCongressional Budget Office, , August 2005.

Effect on deficit of extending the expiring 2001 and 2003 Act tax rate provisions(not including extra debt service of approximately $200 billion between 2006-2015)

Current projected deficit

Fiscal Year

Defi

cit

(in

Bil

lion

s)

0

50

100

150

200

250

300

350

400

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015



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II. Economic Effects

A. Summary

Both the Simplified Income Tax Plan and the Growthand Investment Tax Plan would continue a trend of lowmarginal tax rates and low government revenues as apercentage of gross domestic product. Both plans wouldalso increase incentives to save, lower the cost of capitalfor most business investment, reduce subsidies for anumber of industries, and reduce compliance costs.

The Simplified Income Tax Plan and the Growth andInvestment Tax Plan were designed to raise the sameamount of revenue as President Bush’s baseline budgetover the next 10 years, and to provide essentially thesame distribution of the federal income tax burden.Treasury estimated that the Simplified Income Tax Planwould reduce taxes for 54 percent to 56 percent of alltaxpayers while increasing taxes for 25 percent to 26percent of all taxpayers. Similarly, the Growth and In-vestment Tax Plan is estimated to reduce taxes for 52percent to 57 percent of all taxpayers while increasingtaxes for 25 percent to 26 percent of all taxpayers. Theeffect on a particular taxpayer would depend on thetaxpayer’s sources and uses of income.

The Simplified Income Tax Plan would reduce com-pliance burdens and reduce the number of tax incentivesaffecting business decisions. Although the plan wouldincrease incentives to save and reduce the double taxa-tion of corporate income, it is estimated to have relativelymodest growth effects, with national income projected torise by 0.5 percent over 10 years, and 1 percent over 20years. The incremental approach of the Simplified In-come Tax Plan places more weight on simplicity andcertainty, with less emphasis on economic growth.

The Growth and Investment Tax Plan is designed tostimulate even greater savings and investment, whichwould help increase productivity and achieve higherGDP in the future. Treasury estimated the plan wouldincrease national income by 1.8 percent over 10 years and3.6 percent over 20 years, largely by reducing taxes oncapital income. Treasury estimated that further increasesin national income would be possible if the plan’s re-maining tax on investment income were eliminated un-der a progressive consumption tax, which the panelconsidered but did not endorse in its final report. (SeeTable 2-1 on p. 1263.) The increase in national incomewould be less, however, to the extent transition reliefwere provided.

To put those projected savings increases in perspec-tive, a 1 percent increase in national income wouldrepresent approximately $400 annually to the averagehousehold.

B. Large Tax Cut AssumedAlthough the panel was directed to produce revenue-

neutral options for reforming the income tax system, italso was directed to use as its baseline the assumptions ofPresident Bush’s fiscal 2006 budget proposal. That bud-get assumed that the 2001 and 2003 tax cuts, which areslated to expire between 2008 and 2011, would be madepermanent. The cost of making those tax cuts permanentis estimated to be $1.3 trillion over the fiscal 2006 to fiscal2015 period, with most of the loss taking place in the 2011to 2015 period. (See Figure 1 on preceeding page andTable 2-2 above.)

For example, the panel used the 35 percent rate ineffect now, rather than 39.6 percent rate scheduled to bein effect after 2010, to determine the cost of lowering thetop individual rate to 33 percent under the SimplifiedIncome Tax Plan. Similarly, the 15 percent tax rate ondividends and capital gains under the Growth andInvestment Tax Plan was scored as revenue-neutral bythe panel, even though the current 15 percent rate isscheduled to expire after 2008.

Because the Panel used the president’s budget as itsbaseline, the plans are considered revenue neutral overthe 10-year budget horizon. If the Panel had based itsdeterminations on current law, or followed congressionalbudget scoring rules, the plans would be consideredsignificant revenue reductions over the same period.After 2015, however, both plans are considered revenuereductions under the Panel’s approach, as well as currentlaw and congressional budget scoring rules, as a result oftheir proposed savings accounts.

C. Effect on SavingsThe panel’s recommendations would simplify and

consolidate the numerous savings incentives in the cur-rent federal income tax system. For most households, theplans would generally increase annual savings by ex-empting investment income from federal income tax.Contribution limits for the tax-preferred savings accountswould be more than $30,000 annually, which is more thanthe vast majority of taxpayers save in a year. Somehigh-income individuals may not find the new rules asgenerous as current law, however, when factoring in thepanel’s recommendations about taxing deferred compen-sation. An administrative plus, however, is that middle-income families would have fewer savings options to

Table 2-2. Deficit Projections as a Percentage of GDP With and Without ExtensionOf the 2001 and 2003 Rate Reductions

Fiscal Years 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Total2006-2015

Current deficit -2.4% -2.4% -2.3% -2.1% -2.0% -1.3% -0.5% -0.4% -0.3% -0.3% -1.3%

Deficit with permanent

tax rate reductions -2.4% -2.4% -2.4% -2.3% -2.1% -2.2% -2.0% -1.9% -1.9% -1.8% -2.1%

Source: Congressional Budget Office, The Budget and Economic Outlook: An Update, August 2005.



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wade through for education, retirement, and healthcarepurposes as a result of the consolidation of those incen-tives under the plans. (For a discussion of the savingsproposals, see Part III.)

D. Effect on Business Investment

Both the Simplified Income Tax Plan and the Growthand Investment Tax Plan would provide a significantstimulus to business investment in the United States. TheSimplified Income Tax Plan would reduce the doubletaxation of corporate income by excluding from tax (1)corporate dividends paid from U.S.-taxed income of U.S.corporations and (2) 75 percent of capital gains from U.S.corporations. It would also lower the top statutory cor-porate tax rate from 35 percent to 31.5 percent. That ratereduction would be offset, however, by the repeal ofnumerous credits and incentives, among them the re-search credit, the deduction for state and local incometaxes paid, tax-exempt bonds for businesses, and thedomestic production deduction. Thus, taxpayers couldexperience higher corporate tax liability even with therate reduction to 31.5 percent (for further discussion ofthe plans’ effects on corporate tax liability, see the Ap-pendix). Note also that for corporations currently benefit-ing from the domestic production deduction, the topeffective corporate rate is slated to decline to a littleunder 32 percent by 2009.

Under the Growth and Investment Tax Plan, businessinvestment in the United States would benefit from 100percent expensing during the first year. That wouldsignificantly lower the cost of capital on business invest-ment in the United States. The plan also would disallowthe business deduction for interest expense (to avoidnegative tax rates when combined with 100 percentexpensing for investments), so companies that are highlyleveraged may not see a decrease in their corporate taxliability. In theory, there would be no tax reason for abusiness to favor debt over equity when choosing financ-ing, though businesses might still have nontax reasonsfor preferring one over the other.

E. Consumption

Because the plans are designed to increase householdsavings and reduce spending, they could have a short-term depressive effect on the U.S. economy. Over the longterm, though, the improved savings rate would boost theeconomy and GDP, resulting in increased householdconsumption.

The Growth and Investment Tax Plan would beborder-adjustable, with export revenues exempt fromU.S. tax and import purchases not deductible to busi-nesses. That is similar to the border adjustment of othercountries’ VATs. Although many economists argue thatexchange rate changes would result in no overall changein the terms of trade with a border-adjustable tax, reach-ing that state would not necessarily be instantaneous orcomplete, especially with major imports denominated indollars and many countries’ exchange rates pegged to thedollar. Rather, border adjustability could, in the shortterm, increase the prices of some products more heavilythan others because of the extra tax importers would pay.

F. Housing SectorBoth plans would significantly change the current

incentive for residential mortgage borrowing. The cur-rent mortgage interest and property tax deductions ben-efit less than 30 percent of taxpayers and provide a largertax benefit to higher-marginal-tax-rate taxpayers. Theplans would scale back the benefit of larger mortgagesand provide a uniform 15 percent credit to mortgageborrowers for owner-occupied housing. Overall, Trea-sury estimated the plans would increase the benefit toowner-occupied housing, reducing the marginal effectivetax rate from 0.1 percent to -1.5 percent as a result ofexpanding the mortgage interest credit to all taxpayers,not just itemizers.

The proposed 15 percent mortgage interest credit forprimary residences, contained in both plans, would re-duce the benefit for a number of homebuyers in highertax brackets and others who borrow more than the FHAlimit mortgage. That could reduce the demand forhigher-priced homes and vacation homes, which wouldbe reflected in lower housing prices. Even with transitionrules for existing homeowners, it likely would affectupper-end housing prices immediately due to the ex-pected decrease in future demand. That could lead toserious consequences for some financial institutions withmortgage portfolios focused on high-end homes withhigh loan-to-value ratios.

On the other hand, the 15 percent credit could alsostimulate the demand for starter homes, as it would beavailable to all taxpayers and not just those who cur-rently itemize.

The plans could create a lock-in effect for existinghomeowners and mortgage borrowers, depending on thetransition rules. Families could face higher housing costsif they had to relocate, and they might be less likely torefinance mortgages if they lose the current tax benefit.

Some economists have estimated that the housingmarket has added roughly one percentage point to GDPover the past two years. That is due to high levels ofresidential home construction and rehabilitation, andincreased consumption from the refinancing and cashingout of higher home prices. Some of that housing sectorcontribution to GDP may be reduced by rising interestrates, and could be further reduced by those plans. Atemporary stimulus of home buying and mortgage refi-nancing could take place, depending on the grandfather-ing and effective date rules.

G. State and Local Government SectorThe plans would affect the state and local government

sector in several ways. States would continue to benefitfrom the federal tax exemption of state and local govern-ment bond interest, although the gap between taxableand tax-exempt interest rates would narrow with theexpansion of savings incentives, lower tax rates, and thelimitation to individual investors. The gap would narroweven further under the Growth and Investment Tax Plan,with its 15 percent capital income tax rate.

Both plans would repeal the deductibility of state andlocal taxes. For itemizers, that would increase the after-tax cost of state income taxes and local property taxes.Because itemizers are only one-third of taxpayers, but aregenerally middle- and upper-income families, there



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could be more pressure to reduce high, progressive stateincome taxes and high property tax assessments. Perhapsmore important, state governments that piggyback on thefederal individual and corporate income taxes wouldhave their tax bases affected by the tax base changes.States may be less likely to tax capital income that isexempt from federal income tax, especially if it wouldrequire a separate information reporting and audit sys-tem. If the Growth and Investment Tax Plan were en-acted, it would be difficult for an individual state tomaintain a system of income tax depreciation if thefederal rule provided for 100 percent first-year expens-ing.

One issue the panel did not directly address was theintergovernmental relationship between the federal andstate/local governments on fiscal matters. By not propos-ing a national retail sales tax or VAT, the panel kept thestates’ and local governments’ relative exclusivity to theconsumption tax base. The panel, however, did notaddress a number of important state issues that haverisen to debate at the federal level, including the stream-lined sales tax/remote seller nexus, the business activitytax nexus rules, preemption of state taxing authority (forexample, Internet Tax Freedom Act limiting state taxationof Internet access services), and the decision on state andlocal economic tax incentives in Cuno v. DaimlerChrysler,Inc., 386 F.3d 738, Doc 2004-17647, 2004 TNT 174-13 (6thCir. 2004). (For a more complete discussion of the panelrecommendations’ effect in the state and local tax area,see Part VII.)

H. U.S. Production and International TradeBoth plans were designed to stimulate the U.S. busi-

ness sector and make it more competitive in the globalmarket. The Simplified Income Tax Plan would move thetaxation of U.S. multinational corporations closer to aterritorial tax regime, which would not subject foreign-source active income to tax at the U.S. business level,similar to many other countries’ tax regimes.

The Simplified Income Tax Plan’s reduction in thebusiness marginal tax rate to 31.5 percent (combined withthe repeal of the state income tax deduction) would keepthe United States with a relatively high combined federaland state marginal tax rate (39 percent), compared tomost U.S. trading partners, particularly many developingcountries. A continued high marginal tax rate on U.S.-source income would keep pressure on the transferpricing rules applicable to transactions between foreignrelated parties and the United States.

The Growth and Investment Tax Plan would have asignificant effect on international trade as currently struc-tured. The plan would be border-adjustable, so Americanexport revenue would be exempt from taxation while nodeduction would be allowed for purchases of importedgoods and services. That would subject imports to a 30percent tax rate. Because of the deductibility of employeecompensation, which would be taxed at progressive ratesunder the Growth and Investment Tax Plan, the aggre-gate average tax rate of the plan on total value addedfrom production in the United States would be much lessthan 30 percent, thus favoring U.S. production overimports.

The tax on imported goods and services, less anyexchange rate adjustment, would act like a tariff onimports. That would raise the price of many importedgoods, thereby reducing the demand for imports andencouraging greater U.S. production. Because oil is cur-rently denominated in dollars, there would be no ex-change rate offset for oil imports, meaning the plan couldincrease the price of gasoline by 50 cents per gallon. Thepanel recognized that the Growth and Investment TaxPlan’s border adjustability may be subject to challengeunder the World Trade Organization rules and thus didnot count the revenue from the import tax in its revenue-neutral calculation.

I. Compliance CostsThe Simplified Income Tax Plan was designed to

lower taxpayers’ costs of complying with the currentsystem. The plan would reduce the complexity andcompliance costs in a number of areas, particularly forhouseholds. Transitioning from the current system to theplan could be complicated enough, however, to keepcompliance costs roughly the same in the initial years.Smaller businesses would benefit from simpler rules, butwould have some added requirements like maintainingseparate business checking accounts. Unintended conse-quences, like individuals leasing their cars to or fromfriends and families to benefit from expensing plusallowable interest deductions, could increase some typesof tax planning and the associated complexity under theSimplified Income Tax Plan.

Companies that do not pay tax at the business entitylevel (partnerships and S corporations) would have tocalculate and pay tax if their revenues exceed $10 million.They would also have to include tax calculations in theirfinancial reports.

The compliance costs on large businesses are not likelyto be substantially reduced under the Simplified IncomeTax Plan. While many business incentives would berepealed, much of the complexity would be in themeasurement of income. For example, capitalization andamortization rules would remain in place despite thereduction from nine to four depreciation classes. Theforeign tax rules would be simplified in some respects,but there would be increased pressure and complexity inother areas. The report noted that a territorial systemwould require greater scrutiny of transfer pricing.

The Growth and Investment Tax Plan would removetwo of the most burdensome aspects of business taxation:expensing would greatly simplify depreciation and bor-der adjustability would eliminate the need for transferpricing. Differential treatment of financial services, par-ticularly corporations with both financial and nonfinan-cial operations, would be a major new administrative andcompliance issue for the government and taxpayers.

J. Government Assistance ProgramsAlthough many argue that the tax system should be

used only to raise revenue, the current tax system in-cludes numerous provisions designed to provide incen-tives or assistance to different groups and activities.Those provisions have been enacted as tax expendituresrather than direct expenditure or credit programs. Gov-ernment assistance for orphan drug production or low-income housing, for example, could be provided outside



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the tax code, but there would be no budget or totalsimplification effect from shifting it from the tax code toa direct expenditure program.

The panel’s recommendations proposed eliminatingmany tax expenditures to ‘‘clean up’’ the tax base. Thepanel’s recommendations were made in the context of taxreform rather than as part of a systematic review of thecost and benefits of all government assistance programs.In many cases, those provisions were included in the taxcode because Congress thought it would be more effi-cient (or possibly more politically effective) to have themin the tax code rather than as a direct expenditureprogram. Some observers may wonder whether the panelmissed an opportunity to address the institutional pro-cess of tax policy, to prevent what happened after the1986 Act (increasing rates and erosion of the tax base)from happening again in the future.

In its report, the panel noted: ‘‘Even as the panel wasconducting its deliberations, lawmakers continued toenact additional tax breaks for certain industries. Yetagain, greater value was placed on creating targeted taxbreaks than on establishing broad-based provisions thatwould apply to all businesses.’’ The panel’s recommen-dations did not address that aspect of the current taxpolicy process.

The tax system has become a pervasive part of theeconomy, providing incentives and disincentives to indi-viduals and businesses. The panel’s plans would alter therelative prices facing individuals and businesses. As theworld has become more global, more mobile, with moresophisticated financial markets and more intangibles,changes in prices have real effects. Many of the effects canbe predicted while many others will be called unintendedyears from now.

K. ConclusionThe panel’s recommendations were designed to make

the system simpler, fairer, and more pro-growth. Thequestion is how much improvement there would be, andwhether there is the political constituency to enact eitherplan when most taxpayers would lose current tax ben-efits, and roughly a quarter of the taxpayers would payhigher taxes overall.

III. IndividualsHighlights and Potential Implications

Both Plans• Reduce the number of tax brackets.• Eliminate almost all adjustments and itemized de-

ductions allowed under the current tax systemwhen calculating adjusted gross income and taxableincome, respectively.

Simplified Income Tax Plan• Allow individuals to receive tax-free dividends if

paid from U.S. corporations domestic earnings.• Allow individual taxpayers to exclude 75 percent of

the long-term capital gains on the sale of stock inU.S. corporations.

Growth and Investment Tax Plan• Tax dividend and interest income at a 15 percent

rate, and leave taxpayers with more income forreinvestment or spending.

A. Simplified Income Tax Plan1. Reduction in the number of tax brackets. The planwould cut the number of tax brackets from six in thecurrent system to four. Because the maximum tax ratewould be 33 percent, higher-income taxpayers could seetheir tax bills shrink, assuming they do not otherwise losea corresponding amount of deductions and credits. Thatcould leave those taxpayers with more money to investor spend.2. Calculating total income. The computation of totalincome under the Simplified Income Tax Plan would besimilar to the current income tax system, except that theplan would include in wage and salary income the valueof all employer-provided fringe benefits (other thanin-kind benefits and health insurance premiums under$11,500 for families and $5,000 for individuals). Thatmeans that qualified fringe benefits like health insurancecoverage in excess of those limits, child-care benefits,educational assistance, group-term life insurance, trans-portation (transit passes, parking, and transport in acommuter highway vehicle), retirement planning ser-vices, employee discounts on products and services soldby the employer, employer-operated gym and athleticfacilities, and a host of other fringe benefits that arecurrently tax-free to employees would be taxable. Pre-sumably, however, working condition fringe benefits(expenses directly related to employment like businesstravel) or company cafeterias and meal plans that areopen to all employees equally would continue to beexcludable from employee income.

Many employees could see a significant increase in theamount of taxable compensation reported on their W-2forms. That would increase taxes they have to pay, andmay even move some into a higher marginal tax bracketthan they otherwise would be under the current system.Because of that change, employees might lobby forconversion of taxable fringe benefits into additional cashwages. Some employers also might choose to dismantlethose benefits programs and save the costs of adminis-tration.

The $11,500 and $5,000 caps (for families and singles,respectively) that would be imposed on the amount ofhealth insurance premiums eligible for the tax benefitwould be based on average costs of health insurance.Employees who are enrolled in health plans with premi-ums above the average could realize a significant in-crease in their taxable wages. The higher cost of thoseplans could drive affected employees to enroll in cheaperplans and pay more of the cost of healthcare servicesactually received through higher plan deductibles andlarger co-pay percentages. The greater cost of healthcarecould even alter how employees choose to use healthservices. (The plan does, however, provide for save forfamily accounts, which could be used to pay for healthexpenses on a tax-favored basis.)

It appears that practically all adjustments allowedunder the current income tax system in calculating AGIwould be disallowed under the Simplified Income TaxPlan. Thus, for example, an employee who can deductunreimbursed moving expenses as an adjustment todetermine AGI would be unable to do so under the plan.As a result, some individuals may be more resistant torelocating. Some of the adjustments would move to other



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areas of the tax return — for example, the self-employment tax deduction and contributions to self-employed retirement plans would appear directly onSchedule C.

To minimize the effort required today to fill out anindividual income tax form, the proposed Form 1040SIMPLE would cut the number of line items used tocalculate an individual’s total income. At first blush, thatmay look like simplification, but the reality is that itactually would combine many sources of income —income that flows from the current Schedules C, E, and F— onto one line as well as unemployment compensationand other income all onto another line labeled ‘‘otherincome.’’ Some taxpayers may find that consolidation ofincome items onto one line even more confusing than thecurrent Form 1040 that breaks out those items line-by-line.3. Tax on dividends. The Simplified Income Tax Planwould allow individual taxpayers to receive dividendsfrom U.S. corporations tax-free (to the extent the divi-dends are attributable to a company’s U.S.-taxed in-come). In combination with the 75 percent exclusion forgains on the sale of stock of those corporations discussedin this part, that tax incentive could drive individuals tosteer their investment dollars toward stock in U.S. cor-porations. (For further discussion of the effect of thatprovision, see Part VI.A.1.)

It is also possible that companies might lower thedividend rate on their stock because their investors’after-tax return would be substantially higher.4. Tax on capital gains. The Simplified Income Tax Planwould dramatically change how capital gains are taxed.How does the provision for taxing capital gains compareto the current system? How might those changes affectindividual taxpayers’ behavior in choosing investments?

The plan would generally tax capital gains at ordinaryincome rates. There would be no special preferential ratesfor long-term capital gains as there are under the currentsystem. The plan would, however, allow taxpayers whosell stock in U.S. corporations to exclude 75 percent of thelong-term capital gains realized. As a result, the effectivetax rate on sales of domestic company stock that producelong-term gains would be 3.75 percent to 8.25 percent,depending on the taxpayer’s ordinary income taxbracket. That exclusion could also result in substantialstate tax savings in states where the tax is calculatedbased on federal income. (That is especially critical ifstate and local taxes are not deductible, as further pro-posed by the panel.)

Under the current system, the tax rate on long-termcapital gains from the sale of any capital asset (other thansome gain from real estate and gain from the sale ofcollectibles) is pegged at 5 percent for taxpayers whosetaxable income is in the 10 percent or 15 percent taxbrackets, and 15 percent for those in the 25 percentbracket or above. The proposed capital gains tax ruleswould tax gains from sales of assets other than stock in aU.S. corporation at ordinary income rates. If enacted,investors who realize gains from selling those assetscould see their tax liability skyrocket. Taxpayers in the 15percent bracket today would find the rate charged oncapital gains tripled (even more for sales occurring in2008 because current law is scheduled to cut the capital

gains rate to 0 percent for taxpayers who are in the 10percent and 15 percent brackets). Taxpayers in higherbrackets would see their capital gains rate hiked evenmore substantially. Those higher rates would apply togains from such traditional financial instruments asbonds. (It is unclear what the rate would be on gains fromother instruments, like mutual funds or exchange tradedfunds, which are based on the underlying value ofcorporate stock.)

The effect of that large disparity between the effectivetax rates applied to long-term capital gains from the saleof U.S. corporate stock versus all other assets couldencourage taxpayers to concentrate their investment dol-lars in shares of U.S. corporations. It might also causetaxpayers to change how they own other capital assets.Rather than owning them outright or in passthroughentities like partnerships, they may set up U.S. corpora-tions to hold those assets. (It is unclear whether thatfavorable tax treatment would apply to shares of adomestic S corporation.)5. Tax on capital gains from the sale of a primaryresidence. The Simplified Income Tax Plan would retainthe current-law exclusion of a substantial portion of thecapital gain realized when individuals sell their primaryresidence. The plan would increase the exclusion from$500,000 ($250,000 for single taxpayers) under currentlaw to $600,000 ($300,000 for singles). However, whilecurrent law would tax the excess gain at a maximum 15percent tax rate, the plan would tax the excess gain atordinary income tax rates. Taxpayers who would be inthe 25 percent tax bracket or above if the plan wasenacted could pay 67 percent to 120 percent more in taxeson the taxable gain than they would under current taxlaw. Those taxpayers would retain much less of theirprofit from the sale. Finally, the plan would make it moredifficult for taxpayers to qualify to use the exclusion. Theplan also would extend the amount of time that thetaxpayer must use the home as the primary residencefrom at least two of the five years before sale to at leastthree of the preceding five years.6. Curtailing tax deferral benefits of life insurancepolicies, annuities, and nonqualified deferred compen-sation plans. Under the Simplified Income Tax Plan, theincrease in the value in life insurance policies would betreated as current income and therefore would be subjectto tax on an annual basis, just like a savings account. Aswith other investments (stocks or bonds) whole-life in-surance policies and deferred annuities could be pur-chased through tax-deferred save for retirement and savefor family accounts, subject to the same dollar limits. Lifeinsurance that cannot be cashed out and annuities thatprovide regular, periodic payouts of substantially equalamounts until the death of the holder (known as lifeannuities) would not be taxed on an inside buildup, butat the same treatment as under current law. (For adiscussion of the potential effect on the insurance indus-try, see Part XI.A.6.)

The intent of the plan would be to substitute save forretirement accounts for that type of life insurance. Be-cause those accounts would have substantially lower




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Table 3-1. Proposed Changes for Individuals

Provisions Current LawSimplified Income

Tax PlanGrowth and

Investment Tax PlanHouseholds and FamiliesTax rates Six tax brackets: 10%, 15%, 25%, 28%, 33%,

35%Four tax brackets: 15%,25%, 30%, 33%

Three tax brackets:15%, 25%, 30%

Alternative minimumtax

Affects:— 21 million taxpayers in 2006— 52 million taxpayers in 2015

Repealed

Personal exemption $3,200 deduction for each member of ahousehold; phases out with income

Replaced with family credit available to alltaxpayers: $3,300 credit for married couple; $2,800credit for unmarried with child; $1,650 credit forsingles; $1,150 credit for dependent taxpayer;additional $1,500 credit for each child; and $500credit for each other dependent

Standard deduction $10,000 deduction for married couples filingjointly; $5,000 deduction for singles; $7,300deduction for heads of households; limited totaxpayers who do not itemize

Child tax credit $1,000 credit per child; phases out for marriedcouples between $110,000 and $130,000

Earned income taxcredit

Provides lower-income taxpayers refundablecredit designed to encourage work. Maximumcredit for working family with one child is$2,747; with two or more children is $4,536

Replaced with work credit (and coordinated withthe family credit); maximum credit for workingfamily with one child: $3,570; with two or morechildren, $5,800

Marriage penalty Raises the tax liability of two-earner marriedcouples compared to two unmarriedindividuals earning the same amounts

Tax brackets and most other tax provisions forcouples are double those of individuals

Other Major Credits and DeductionsHome mortgageinterest

Deduction available only to itemizers forinterest up to $1.1 million of mortgage debt

Home credit equal to 15% of mortgage interestpaid; available to all taxpayers; mortgage limitedto average regional price of housing (limitsranging from about $227,000 to $412,000)

Charitable giving Deduction available only to itemizers Deduction available to all taxpayers (who givemore than 1% of income); rules to addressvaluation abuses

Health insurance Grants tax-free status to an unlimited amountof premiums paid by employers or theself-employed

All taxpayers may purchase health insurance withpretax dollars, up to the amount of the averagepremium (estimated to be $5,000 for an individualand $11,500 for a family); Employers may providetax-free health insurance up to those amounts

State and local taxes Deduction available only to itemizers; notdeductible under the AMT

Not deductible

Education HOPE credit, lifetime learning credit, tuitiondeduction, student loan interest deduction; allphase out with income

Taxpayers can claim family credit for somefull-time students; simplified savings plans

Individual Savings and Retirement ArrangementsDefined contributionplans

Available through 401(k), 403(b), 457, andother employer plans

Consolidated into save at work plans that havesimple rules and use current-law 401(k)contribution limits; AutoSave features pointworkers in a pro- saving direction (Growth andInvestment Tax Plan would make save at workaccounts ‘‘prepaid’’ or Roth-style)

Defined benefit plans Pension contributions by employers areuntaxed

No change

Retirement savingsplans

IRAs, Roth IRAs, spousal IRAs — subject tocontribution and income limits

Replaced with save for retirement accounts($10,000 annual limit) — available to all taxpayers

Education savingsplans

Section 529 and Coverdell accounts Replaced with save for family accounts ($10,000annual limit); would cover education, medical,new home costs, and retirement saving needs;available to all taxpayers; refundable savers creditavailable to low-income taxpayers

Health savings plans MSAs, HSAs, and flexible spendingarrangements

Dividends received Taxed at 15% or less (ordinary rates after2008)

Exclude 100% ofdividends of U.S.companies paid out ofdomestic earnings

Taxed at 15% rate



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contribution limits than current life insurance, however,many taxpayers would see their tax-favored savingsreduced.

The Simplified Income Tax Plan also would eliminatethe ability of some taxpayers to save on a tax-deferredbasis through the use of executive deferred compensationplans. Those plans allow executives to elect to defer aportion of their compensation to receive an amount laterthat has grown tax-deferred. Recently enacted legislation(section 409A) tightened the rules applicable to deferredexecutive compensation, but retained a number of excep-tions that allow tax-deferred growth on deferred wages.(Treasury and the IRS recently issued lengthy proposedregulations interpreting that legislation.)

The Simplified Income Tax Plan would require allamounts deferred under a nonqualified deferred com-pensation plan to be included in income to the extentthose amounts are not subject to a substantial risk offorfeiture and were not previously included in income.That would effectively eliminate any elective deferredcompensation — if an executive were taxed at vesting,there would be no point in deferring receipt. Deferredcompensation likely would be used solely as an incentivevehicle — compensation would be subject to perfor-mance or employment conditions but would be paid outimmediately on meeting those conditions.

Annuities, life insurance arrangements, and deferredcompensation plans that currently are in existence wouldcontinue to be taxed under current-law rules.

7. Elimination of adjustments to total income. As men-tioned, although the proposed Simplified Income TaxPlan appears to calculate total income in the samemanner as the current income tax system (except for theinclusion of employer-provided fringe benefits in wagesand compensation), the plan would eliminate the currentincome tax concept of AGI. The adjustments that reducetotal income under current income tax law would bemostly eliminated under the plan. The tax benefits fromsome of those adjustments would disappear altogetherwhile others would be replaced with new deductions andcredits. Some of the most significant adjustments and the

potential implications to taxpayers who claim them un-der the current tax system are identified in the followinglist:

• No reduction to total income for alimony paid. Theelimination of the alimony deduction could raise theout-of-pocket cost to the paying spouse anywherefrom 15 percent to 33 percent (30 percent under theGrowth and Investment Tax Plan). Typically, whendivorcing parties negotiate alimony, the after-taxcost of the alimony to the paying spouse is a keyconsideration in determining the amount to be paid.For spouses who have been paying alimony underexisting agreements, the elimination of the alimonydeduction could create a significant, unanticipatedhardship. It is currently unknown whether therewould be any sort of ‘‘grandfather’’ clause thatwould preserve the alimony deduction for existingalimony agreements.Elimination of the alimony deduction could alsohave a significant influence on the structure offuture alimony and property settlement agreements.

• No deduction for qualified moving expenses. Theloss of that tax subsidy for employees and self-employed individuals would effectively make amove more expensive. Some taxpayers may be morereluctant to move because of the added cost ofrelocating.

• No more deduction for contributions to traditionalIRAs for eligible taxpayers. The plan would replacetraditional IRAs with a save for retirement plan,which would be similar to the current Roth IRA.

• No deduction for student loan interest or tuitionand fees. The plan would replace that deductionwith the family credit of $1,500 per student for allfamilies with full-time students age 20 or younger.Some families may find a greater tax benefit fromthe replacement of the current system of educationdeductions and credits. Others may find that thecost of education for their children has increased.

• No deduction for legal fees and expenses fromcivil rights lawsuits. The deduction provided by thetax law for those fees and expenses would bedisallowed. That would have a chilling effect on

Table 3-1. Proposed Changes for Individuals (continued)


Tax PlanGrowth and

Investment Tax PlanCapital gains received Taxed at 15% or less (higher rates after 2008) Exclude 75% of

corporate capital gainsfrom U.S. companies(tax rate would varyfrom 3.75% to 8.25%)

Taxed at 15% rate

Interest received(other than tax-exemptmunicipal bonds)

Taxed at ordinary income tax rates Taxed at regularincome tax rates

Taxed at 15% rate

Social Security benefits Taxed at three different levels, depending onoutside income; marriage penalty applies

Replaces three-tiered structure with simplededuction; married taxpayers with less than$44,000 in income ($22,000 if single) pay no tax onSocial Security benefits; fixes marriage penalty;indexed for inflation

Source: Panel’s Report, pp. xvi-xvii (as of November 15, 2005).



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contingent fee arrangements and the willingness oftaxpayers to bring those suits.

• Deductions partially retained. The plan wouldcontinue the current-law deductions for one-half ofself-employment tax and all contributions to SEP,SIMPLE, and other defined contribution plans madeby small-business owners — that is, sole proprietor-ships with gross receipts of less than $1 million.Those deductions appear on the proposed newSchedule C, ‘‘Profit or Loss From Small Business.’’ Itis unclear whether either or both of those deduc-tions would be available to self-employed businessowners with medium-size businesses or whosebusinesses are structured as partnerships.

8. Broadening the deduction for health insurance fromself-employed individuals to all taxpayers. Althoughthe Simplified Income Tax Plan would eliminate thecurrent-law deduction for health insurance paid by self-employed individuals, the plan would provide a deduc-tion for all taxpayers — not just self-employed individu-als — for health insurance premiums paid up to $11,500for families and $5,000 for single taxpayers. That newdeduction could effectively reduce the cost of healthinsurance to those taxpayers who need to purchase itthemselves. The panel’s report cited a Treasury estimatethat providing the healthcare deduction could ‘‘reducethe number of uninsured Americans by 1 to 2 millionpeople.’’ For taxpayers who already are paying for healthinsurance directly, the proposed deduction may leavemore money in their pockets to save, invest, or spend.9. Replacement of the home mortgage interest deduc-tion with a 15 percent home credit. The replacement ofthe home mortgage interest deduction with a 15 percenthome credit for mortgage interest paid could signifi-cantly raise the after-tax cost of financing the purchase,construction, or substantial improvement of a home.Taxpayers who are in the 25 percent ordinary income taxbracket or higher and who itemize deductions wouldlose a portion of the tax benefit of the home mortgage

interest they currently realize. Instead of a 25-percent-or-greater tax benefit from the deduction, those taxpayerswould realize only a 15 percent credit.

The narrowing of the amount of mortgage interesteligible for the home credit could reduce the tax benefitseven more for taxpayers who have relatively large mort-gage balances on their primary home, a home equityloan, or a mortgage taken out to buy, build, or substan-tially improve a second home.

The 15 percent credit would be available only forinterest paid on the eligible mortgage indebtedness thatwas obtained to buy, build, or substantially improve thetaxpayer’s primary residence. While current law capseligible mortgage indebtedness at $1 million ($1.1 millionwith a home equity loan), the plan would cap eligiblemortgage debt based on the amount of the averageregional home purchase price where the residence islocated. The limit would range from $227,147 to $411,704.

Under the plan, a deduction or credit would not beavailable for mortgage interest paid on a second home,nor would a deduction or credit be allowed for interestpaid on a home equity loan.

The winnowing of the tax subsidy for home mortgageinterest could affect taxpayers in a multitude of ways.Homes that are currently valued significantly above theaverage home purchase price for their location could fallin value as the market of buyers who could afford to buythose homes shrinks and supply of those homes outstripsdemand. Some homeowners could even see the value oftheir homes shrink below the outstanding balance ontheir mortgage loans.

Others who have relied on being able to deduct thefull amount of the mortgage interest they have paidcould find themselves no longer able to afford theircurrent residence. They could find that they need to selltheir home. If home values also have fallen, those tax-payers could find themselves in even more difficultfinancial straits.

Table 3-2. Tax Treatment of Selling a Home (Joint Returns)

Current LawSimplified Income

Tax PlanGrowth and Investment

Tax PlanRate 15%a 33%b 15%a

Exclusion $500,000 $600,000 $600,000Gain on Sale:

$600,000 $15,000 $0 $0700,000 30,000 33,000 15,000800,000 45,000 66,000 30,000900,000 60,000 99,000 45,000

1,000,000 75,000 132,000 60,0001,100,000 90,000 165,000 75,0001,200,000 105,000 198,000 90,0001,300,000 120,000 231,000 105,0001,400,000 135,000 264,000 120,0001,500,000 150,000 297,000 135,000

aAssumes top capital gains rate applies.bAssumes top tax rate applies.Source: Ernst & Young.



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Owners of second homes who would lose the currentmortgage interest deduction could decide that it is moreadvantageous to convert those homes into a rental prop-erty. That way, they may be able to deduct the portion ofthe mortgage interest that is attributable to the rental useof the home.

On the other hand, the transformation of the itemizeddeduction for home mortgage interest into a credit underthe plan could benefit taxpayers who currently paymortgage interest but do not itemize deductions. Thosetaxpayers would realize a 15 percent tax credit on mort-gage interest paid, compared to the zero benefit theyreceive under the current tax system. Also, individualswho are currently renting and are now interested inbuying, or individuals who are looking to move up to abigger home, may be able to buy the home of theirdreams for much less than they could in the currentenvironment. In effect, enactment of the home mortgageprovisions could trigger a shift in wealth from currenthomeowners to those who are now looking to buy.

Although the proposed home credit would providefor a five-year transition period for interest paid on aprimary home, the effect on housing prices might bemore quickly and acutely felt by current homeownersand future buyers alike long before the transition periodends. The narrowing of the tax benefit on primary homemortgages and the elimination of the tax subsidy formortgages on second homes would immediately affectthe ability of purchasers to finance those purchases.Individuals who have been financing purchases throughtax-subsidized home equity loans may curtail theirspending because the cost of borrowing would suddenlybecome more expensive if the home credit provision wasenacted.10. Elimination of other itemized deductions. The Sim-plified Income Tax Plan would virtually eliminate theitemized deductions provided by the current income taxsystem (other than those for charitable contributions andinvestment interest expense). If enacted, taxpayers whocurrently itemize might see an increase in their taxliability. Some of the most common deductions and thepotential implications to taxpayers who claim them un-der the current tax system are identified in the followinglist:

• No deduction for state and local income, realestate, or personal property taxes. Taxpayers in‘‘high-tax’’ states could find that the cost of continu-ing to live in their current homes has risen signifi-cantly because of the loss of the tax subsidy pro-vided under current law.

Some of those affected taxpayers may choose to liveelsewhere because of the increased costs. Taxpayerswho are subject to the AMT, however, might not seeany difference in their cost of living, as they cur-rently receive no tax benefit from those deductions.

• No deduction for ‘‘excess’’ medical expenses. Tax-payers who must pay for significant amounts ofmedical expenses that are not reimbursed by insur-ance would no longer be able to deduct thoseexpenses. (Currently, taxpayers can deduct the por-tion of medical expenses that exceeds 7.5 percent oftheir AGI.) For those taxpayers, their out-of-pocket

costs of medical care would increase by 15 percentto 33 percent (30 percent under the Growth andInvestment Tax Plan) depending on their taxbracket. The loss of the medical expense deductioncould increase the financial pressure on individualswho are hit with large, unreimbursed medical billsbecause of a catastrophic illness or even a chronichealth problem that is costly to manage. However,the panel’s proposed save for family account couldbe used to pay for those expenses on a tax-favoredbasis.

• No deduction for theft or casualty losses. Taxpay-ers confronted with catastrophic losses from a casu-alty or theft would no longer receive a tax benefit tohelp offset the out-of-pocket costs of those losses.Under the current system, individuals can deduct aproperty loss to the extent it has not been compen-sated for by insurance, the unreimbursed loss ex-ceeds $100 per casualty or theft, and the aggregateof those losses exceeds 10 percent of the taxpayer’sAGI. (Note, however, that recently enacted relief forvictims of Hurricane Katrina waives the $100 perloss and 10 percent of AGI thresholds.) The elimi-nation of the tax relief from that deduction couldincrease the financial strain the victims of thoselosses face in trying to restore what was destroyedor stolen.

• No miscellaneous itemized deductions. Miscella-neous itemized deductions for employee businessexpenses, tax planning and preparation fees, invest-ment expenses, and so on, that are currently subjectto the 2-percent-of-AGI disallowance would beeliminated. It is unclear whether other deductions,like gambling losses and the deduction for estate taxon income of a decedent (IRD), would be disal-lowed. If so, disallowance could have a profoundeffect on how and to what extent employees andinvestors incur related expenses. The disallowanceof the IRD deduction could result in an extremelyhigh combined rate of tax on that income.

11. Investment interest expense offset to investmentincome. Although the Simplified Income Tax Plan wouldvirtually eliminate itemized deductions, the plan wouldstill allow taxpayers who borrow to finance the purchaseof their investments to deduct the interest paid to theextent of taxable investment income recognized duringthe year. That continuing deduction would require tax-payers to allocate interest expense to various activities.12. Restructuring the charitable deduction. The newcharitable contribution deduction provision would en-able all taxpayers — whether or not they itemize deduc-tions under the current income tax system — to receive atax benefit from making donations to charity. A thresholdwould have to be crossed, however, before the taxpayerwould realize any tax benefit. Charitable contributionscould be used to reduce taxable income only to the extenttotal contributions exceed 1 percent of the taxpayer’stotal income.

For many taxpayers who itemize under the currentincome tax system, the tax benefit of charitable donationswould be diminished under the plan. The reduction intax benefit may even apply to taxpayers whose itemized



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deductions were cut by the 3 percent phase-out limitationif the amount of other itemized deductions they claimedexceeded the amount of forfeited deductions.

For taxpayers who currently itemize and whose chari-table contributions are typically less than 1 percent oftheir total income, the tax benefit from charitable dona-tions could be lost. Itemizers who have an incentive tomake charitable contributions under the current systemcould have less incentive to give. Others may bundle twoor more years’ worth of donations into one tax year toobtain at least some tax benefit.

The plan would eliminate valuation uncertainty forthe contribution of property in many cases. The panelrecommended allowing taxpayers to sell property with-out recognizing gain and receive a full charitable deduc-tion if the entire sales proceeds are donated to a charitywithin 60 days of the sale. That rule would apply to thesame extent that the property would be eligible for acharitable contribution deduction equal to fair marketvalue under current law (other than items of personalproperty that are eligible because they are related to thecharity’s purpose or function). The donor of the proceedswould not be required to pay capital gains taxes on theappreciation of the property. The charitable contributiondeduction would be available to the extent that thedonor’s total contributions exceed the 1 percent of in-come threshold. To be eligible, the sale of property wouldneed to be an arm’s-length sale to an unrelated party.

The plan would remove an impediment under currentlaw to selling appreciated property and donating cashproceeds, which is frequently more useful to charities.The sale would provide an objective measure of themarket value of the property and reduce the charity’scost and the burden of selling the property.13. Elimination of the AMT. A principal component of —and objective for developing — the Simplified IncomeTax Plan would be the elimination of the AMT. Ever-larger pools of taxpayers have been and are expected, infuture years, to be subject to the AMT. Taxpayers caughtby the AMT effectively lose the benefit of itemizeddeductions for state and local taxes, interest paid on ahome equity loan or on a refinanced mortgage not usedfor home purchase or improvements, and miscellaneousitemized deductions that had been allowed for determin-ing regular taxable income (that is, in excess of 2 percentof AGI). Also, itemized deductions taken for medicalexpenses and investment interest expense may be at leastpartially lost.

The Simplified Income Tax Plan would resemble thestructure of the AMT in that no itemized deductionwould exist for state and local taxes, interest paid on ahome equity loan, and miscellaneous itemized deduc-tions. Indeed, the plan would go even further in limitingdeductions that are currently available to reduce alterna-tive minimum taxable income.

B. Growth and Investment Tax PlanThe components of the Growth and Investment Tax

Plan that were specifically designed for individuals arebased on the Simplified Income Tax Plan. The manner inwhich taxable income of an individual would be deter-mined is the same as under the Simplified Income TaxPlan.

However, the Growth and Investment Tax Plan wouldhave only three tax brackets: 15 percent, 25 percent, anda top marginal tax rate of 30 percent. Also, capital income— interest, dividend, and capital gains income — wouldbe taxed at a flat 15 percent rate.1. Tax on interest and dividend income. Compared tothe current income tax system, the plan’s 15 percent taxrate on interest and dividend income would be substan-tially lower than the tax rate applied to taxpayers whosemarginal tax bracket in the current income tax system isabove 15 percent. That proposed cut in the tax rate oninterest and dividend income could leave taxpayers withmore income in their pockets that is available for rein-vestment or spending.2. Tax on capital gains. For taxpayers in the 28 percentordinary tax bracket or above in the current income taxsystem, the proposed 15 percent flat tax rate on capitalgains would be the same rate as what they currently pay.What would be different, however, is that the plan wouldcharge a 15 percent tax rate on all capital gains, no matterhow long the asset was held. The plan would notdifferentiate between long-term and short-term capitalgains as under the current system. Because the tax effectrelated to how long an investor owns a capital assetbefore selling it would disappear, investors might bemore inclined to sell capital assets more quickly than theyotherwise would in the current tax environment.

The only taxpayers to lose out on the capital gainsprovision would be those who are currently in the 10percent and 15 percent tax brackets. The proposed 15percent flat tax rate on capital gains would be three timesgreater than the 5 percent tax rate those taxpayers wouldpay under today’s tax rules. The tax cost imposed oncapital gains under the plan would climb even higherafter 2007 because taxpayers in the 10 percent and 15percent brackets in the current system would have no taxon capital gains (0 percent tax rate). The effect of thehigher tax rate on capital gains for those taxpayers wouldbe a reduction in the amount of after-tax income availablefor consumption or new investment.

C. Unanswered Questions1. Both plans

• How would capital loss carryforwards of both long-and short-term capital losses from pre-enactmentyears be treated?

• Would the 75 percent exclusion of capital gainsapply to sales of other financial instruments, likemutual funds or exchange traded funds, which arebased on the underlying value of corporate stock?

• Would the 75 percent exclusion of capital gainsapply to the sale of shares of a domestic S corpora-tion?

• Would there be a provision grandfathering the de-duction for alimony paid under existing alimonyagreements?

• How would distributions from current IRAs anddefined contribution plans, including 401(k) plans,be taxed?

• Where would investment interest be deducted? Theproposed Form 1040 has no provision for such adeduction.



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• What would happen to the current ‘‘kiddie tax’’structure, which taxes children under age 14 at theirparents’ rates on unearned income?

IV. Savings and BenefitsHighlights and Potential Implications

Both Plans• Limit employers to a single type of defined contri-

bution savings plan with few design alternatives.• Eliminate all nonqualified deferred compensation.• Reduce opportunities for tax-favored savings for

highly paid employees.

A. Simplified Income Tax Plan1. Save at work accounts. Under current law, employerscan choose among a wide variety of qualified retirementplans and plan designs. While qualified defined benefitpension plans (including cash balance plans) would beunaffected by the plan, the save at work accounts wouldlargely eliminate flexibility as to the type and design ofqualified defined contribution plans that an employer

can provide for employees. Those accounts would limitemployers to a single type of defined contribution sav-ings plan with very few design alternatives. Currentdefined contribution savings plans, like section 401(k)plans, SIMPLE 401(k) plans, SIMPLE IRAs, section 403(b)annuities, SARSEPs, and others, would all be replacedwith the new save at work accounts. That would put allemployees on a more level playing field regarding theirwork-related savings opportunities, although, as undercurrent law, it appears that no employer would berequired to offer a save at work option to their employees.

The plan indicates that the existing contribution limitsfor section 401(k) plans — $14,000 for 2005 (as indexedfor cost of living) — would apply to save at work plans.

2. Save for retirement accounts. The current variety ofIRAs — deductible IRAs, nondeductible IRAs, RothIRAs, and so on — would be replaced by one type of savefor retirement account that would basically work like thecurrent-law Roth IRAs, but without a phaseout based onincome level.

Table 4-1. Consolidation of Retirement AccountsRetirement Accounts

Description Contribution Limit Save for Retirement Accounts($10,000 annual contribution

limit)IRAsa, b $4,000 ($5,000 in 2008)a

Roth IRAsa $4,000 ($5,000 in 2008)a

aContribution limit may phase out based on income.bContributions made to those accounts are excluded from income.Source: Panel’s Report, p. 121 (as of November 15, 2005).

Table 4-2. Consolidation of Health, Education, and Other Tax-Preferred SavingsHealth Incentives

Description Contribution Limit

Save for Family Accounts($10,000 annual contribution

limit)

Health Savings Accounts(HSAs)b

$2,600 single/$5,150 family

Archer MSAsb (smallbusinesses andself-employed)

75 percent of deductible forhigh-deductible health plan

Flexible SpendingArrangementsb

Unlimited (but portion maybe forfeited if not usedwithin prescribed timeperiods)

Education Savings IncentivesDescription Contribution Limit

Coverdell Savings Accounts $2,000 (per student)Qualified Tuition Programs(529s)

Effectively unlimited

Savings Bonds Interest excludable up toqualified higher educationexpensesa

Other Tax-Preferred SavingsDescription Contribution Limit

Life Insurance UnlimitedExecutive DeferredCompensation

Unlimited

aContribution limit may phase out based on income.bContributions made to those accounts are excluded from income.Source: Panel’s Report, p. 121 (as of November 15, 2005).



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Perhaps most significantly, those new accounts wouldalso replace all nonqualified deferred compensation. Anemployer’s ability to provide nonqualified deferred com-pensation to executives and to supplement its executives’qualified retirement plan benefits, already greatly con-strained by the Jobs Act, would be eliminated. Anexecutive’s ability to avail himself of tax-favored savingsopportunities would be reduced significantly underthose accounts, as the executive would be limited to$10,000 in combination with any other retirement sav-ings.

Employers would need to restructure their compensa-tion packages to eliminate nonqualified deferred com-pensation and presumably replace it with current cash orequity compensation. For example, employers would nolonger be able to make up executive benefits restricted bythe qualified retirement plan limits with supplemental(or ‘‘excess’’) arrangements that mirror a qualified de-fined benefit plan or section 401(k) plan. While that shiftto higher current compensation might mean higher cur-rent deductions for many employers, for public compa-nies that are subject to the $1 million deduction limitationunder section 162(m) for their top five executives, theelimination of deferred compensation would eliminate avaluable tool for preserving compensation deductions.3. Save for family accounts. Under current law, there aremany different types of medical, educational, and otherindividual savings arrangements available. For example,for medical benefits alone, there are health savings ac-counts, Archer medical savings accounts, and flexiblespending accounts. All of those plans have different rulesand eligibility. Similarly, there also is a wide array ofeducation savings accounts currently available, includingeducation IRAs, Coverdell education savings accounts,qualified state tuition programs, the HOPE scholarshipcredit, and the lifetime learning credit — all with differ-ent rules and eligibility. The plan would replace thatconfusing array of arrangements with the single save forfamily account that would allow every taxpayer to save$10,000 each year.

As would be the case for the save at work accountsand the save for retirement accounts, contributionswould not be deductible and would instead follow theRoth IRA model. Those new accounts would have asingle set of rules and eligibility requirements. Under thecurrent system, because many of the current-law ac-counts are set up by individuals rather than employers,the wide array of accounts, eligibility requirements, andrules have been particularly troublesome and a signifi-cant obstacle to their success as savings vehicles. At thevery least, the plan should go a long way to eliminatingcomplexity and confusion as a stumbling block to estab-lishing those savings accounts.

Under the current system, many of those accounts,like flexible spending accounts, are maintained and ad-ministered by employers. The change to individuallymaintained accounts, along with the proposed elimina-tion of the exclusion for employer-provided educationalassistance, could reduce employer administrative costsrelating to those benefits. However, it is likely thatemployees would expect increased cash compensation inlieu of the eliminated benefits.

B. Growth and Investment Tax Plan1. Save at work accounts. The proposed Growth andInvestment Tax Plan contains the same savings proposalsoutlined above as part of the Simplified Income Tax Plan,with one significant difference. While the save at workaccounts proposed under the Simplified Income Tax Planwould provide an up-front tax benefit similar to currentsection 401(k) plans and deductible IRAs, the save atwork accounts proposed under the Growth and Invest-ment Tax Plan would be ‘‘back-loaded’’ in the samemanner as current-law Roth IRAs.

Employee contributions to the save at work accountswould not be excludable from income as they are undercurrent law. Instead, like current Roth 401(k) plans, theearnings would accumulate tax-free and distributionswould generally be tax-free. Under that system, employ-ees would not have an immediate incentive for contrib-uting. However, it is possible that the proposal’s Auto-Save provisions would mitigate that potential problem.Under the AutoSave provisions, an employer could,among other things, automatically make employees par-ticipants in the employer’s save at work plan, withemployees having the ability to opt out of participation.Also, the employee contribution percentage would auto-matically increase over time. Neither those nor the otherAutoSave provisions would be mandatory for employersor employees.


• How would stock options be treated? The panel’sreport is silent on the topic of stock options; how-ever, the Appendix to the report indicates that oneapproach to take under the Growth and InvestmentTax Plan would be to treat all options under rulessimilar to those currently applicable to incentivestock options — that is, the employer would not beallowed a deduction at any point and the employeewould not recognize any compensation income.Another proposed alternative would be to calculatethe value of an option at the date of grant. Underthat alternative, the employer would get a deduc-tion at grant and the employee would have taxablewages at grant, each equal to the value of the option.

• Would defined contribution plans that do not allowemployee contributions (that is, provide only foremployer contributions) be replaced by the save atwork accounts? Those plans would include tradi-tional profit sharing, money purchase, and stockbonus plans, including employee stock ownershipplans.

• Would the limits for save at work accounts applyonly to employee contributions or to employercontributions as well? If the limits apply only toemployee contributions, would current-law limitscontinue to apply to employer contributions?

• Would employer deductions be affected in any way?• What is the scope of the provision that would

eliminate nonqualified deferred compensation? Forexample, how would that provision affect severancepay arrangements that pay out over multiple years?How would it apply to traditional year-end bonusprograms?



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• What transition relief would apply to existing plansand arrangements? Presumably, extensive transitionrelief would have to be made available.

V. Large BusinessesHighlights and Potential Implications

Simplified Income Tax Plan• Requires a revaluation of net deferred tax assets and

liabilities.• Eliminates many current-law incentives and credits

to achieve an overall rate reduction.Growth and Investment Tax Plan

• Provides ability to expense business investments.• Eliminates bias for debt financing compared to

equity financing.

A. Simplified Income Tax Plan1. Rate of tax. The plan would lower the maximum taxrate on business profits from 35 percent to 31.5 percentfor large businesses (those with receipts exceeding $10million). To achieve that rate, it would also eliminatemany incentives and credits large companies use to lowertheir tax liability. For many of those companies, theproposed 31.5 percent rate would not be low enough tooffset the tax increases that would result from the loss ofincentives and credits. For large companies benefitingfrom the domestic production deduction, the rate changewould not be much lower than the top effective corporaterate they would enjoy by 2009 (just under 32 percent).

From a global perspective, a 31.5 percent rate is notconsidered by many to be competitive with the rest of theworld. China taxes foreign-funded enterprises at anaverage rate of 11 percent and permits them to deduct allwages. Ireland has cut its top corporate tax rate to 12.5percent; many eastern European countries, eager to at-tract foreign investment, are also lowering their corpo-rate tax rates. Even France (with a 34 percent tax rate) andGermany (38 percent) are more competitive than theUnited States if state income taxes are taken into account.Compared to tax rates in other countries, the plan’sproposed 31.5 percent rate may not be low enough tokeep large multinational companies from transferringprofits to lower-tax countries.2. Elimination of incentives and credits. As noted, theplan would eliminate many of the incentives and creditslarge companies use to lower their tax liability. What isnot clear, however, is which incentives and credits wouldbe eliminated. The panel’s report noted that the planwould eliminate ‘‘40 business tax breaks,’’ but identifiedonly the research credit, the rehabilitation investmentcredit, the domestic production deduction, and the de-duction for state and local taxes as candidates for elimi-nation. (For a list of incentives and special provisions thatcould be considered part of the 40 business tax breaks,see Table 5-2 on p. 1279) For large companies that relyheavily on existing incentives and credits, the proposedelimination would result in an increase in their overalltax burden, even with a lower corporate tax rate.

For large U.S. companies that engage in research anddevelopment, the proposed elimination of the researchcredit would also make the United States a less attractiveplace to perform research. Recognizing the importanteconomic benefits research spending provides, many U.S.

trading partners provide tax incentives for performingresearch in their countries. For example:

• Australia provides a 125 percent deduction forresearch.

• Canada provides a permanent flat credit on 20percent of research spending.

• China offers a 150 percent deduction for companieswhose research spending increases at least 10 per-cent from the previous year.

• France allows a 50 percent credit for amounts spenton research.

• India allows a 100 percent tax deduction for profitsfrom scientific research.

Given that U.S. companies are reportedly performingmore of their research overseas already, the proposedelimination of the research credit, combined with thoseother incentives, could prompt large companies to shiftmore U.S.-based research overseas.3. Elimination of the AMT. The plan would eliminate thecorporate AMT, a form of prepayment on the regularincome tax that applies generally when a corporation hastoo many deductions associated with so-called tax pref-erence items. Enacted originally to ensure that corpora-tions paid a minimum amount of tax on business profits,the AMT is a separate tax computation. To determinewhether AMT is due, a corporation adds its tax prefer-ence items to the amount of its income, and by applyingthe minimum tax rate, determines the minimum amountof tax that it must pay. The excess of that minimumamount over its regular tax (generally before credits) thenbecomes the amount of minimum tax due. The reasonthat tax is referred to as a prepaid income tax is that anyminimum tax paid becomes a credit that may be used tooffset regular tax liability (to the extent it exceeds mini-mum tax liability) in future years.

Elimination of the corporate AMT would relieve largecompanies of the administrative burdens of performingseparate alternative tax computations and tracking theuse of minimum tax credits. For companies with unusedAMT credits, however, the proposed elimination wouldresult in a tax increase, as they would presumably losethe ability to apply their AMT credits to their regular taxliability.4. Moving to a territorial tax system. The plan wouldmove the U.S. corporate income tax to a territorialtaxation system that (1) would not tax active businessprofits U.S. corporations earn outside the United States;(2) would tax payments deductible abroad, like interestand royalties paid to U.S. corporations; and (3) would taxinvestment or passive income. Consistent with thosechanges, the panel’s report indicated that corporationswould not be permitted to deduct the expenses ofearning foreign income against their U.S. tax liability.Because a territorial tax system could encourage corpo-rations to shift active income offshore to avoid U.S. tax,the panel also envisioned enhanced transfer pricingenforcement.

The proposed change to a territorial tax system wouldmore closely harmonize the U.S. corporate tax systemwith those employed by U.S. trading partners world-wide. As a result, income earned abroad would less likelybe subject to double taxation, which would free large



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companies from the complicated rules that now addressthe double taxation of foreign-earned income.5. Depreciation. The Simplified Income Tax Plan wouldmake a major change in the tax depreciation rules,moving from the Modified Accelerated Cost RecoverySystem (MACRS) with accelerated depreciation and nineclass lives to a simplified depreciation system based onfour categories of assets. Each asset category would havea depreciation rate that applied its average balance forthe year. The average balance for the year would bedetermined by increasing the balance in each propertyaccount for new purchases during the year (after reduc-ing the prior years’ balance for depreciation allowed inthe prior year).

While moving from nine class lives to four wouldreduce complexity, large capital-intensive businesseswould still have to track four different asset categories.The smaller number of categories could also result inlonger recovery periods for some assets, effectively mak-ing them more expensive to purchase. For example,incorporating into a single category what are today 3-, 5-,7-, and 10-year assets would effectively make 3- and5-year assets more expensive to purchase and 7- and10-year assets less expensive.

Table 5-3 on p. 1280 illustrates the difference in thediscounted present value of total depreciation deductionsfor a $1,000 asset under the Simplified Income Taxcompared to current law. The discounted present value of

depreciation for a 30 percent recovery asset under thepanel’s recommendation would total $883 (assuming a 6percent rate) while a comparable 3-year asset undercurrent law would generate a discounted present value of$947. In general, the Simplified Income Tax Plan’s depre-ciation change would reduce the present value of depre-ciation for 3- and 5-year MACRS assets and structures.While the depreciation provisions would be revenueneutral over the 10-year budget period, they wouldgenerally reduce the present value of the depreciationdeductions.

Table 5-4 on p. 1281 compares the depreciation deduc-tions for a $1,000 asset in different classes over the first 10years of life. In the first year for a 30 percent recoveryasset under the plan, a business could deduct $300.Under current law, a comparable asset with a 3-year lifewould generate a $333 deduction in year one.

6. Taxation of dividends received by individuals. Underthe plan, dividends paid out of a U.S. corporation’sdomestic earnings would not be subject to tax. To enableshareholders to determine the excludable portion of theirdividends, the plan would require corporations to trackand report to shareholders the proportion of their prioryear’s income that was subject to U.S. tax. Because it isnot always obvious whether taxes are ‘‘paid’’ on compo-nent parts of prior-year income, complying with theplan’s proposed tracking and reporting requirements

Table 5-1. Proposed Changes for Businesses


Tax PlanGrowth and Investment

Tax PlanSmall BusinessTax rates Typically taxed at individual

ratesTaxed at individual rates (toprate lowered to 33%)

Sole proprietorships taxed atindividual rates (top ratelowered to 30%); other smallbusinesses taxed at 30%

Recordkeeping Numerous specialized taxaccounting rules for items ofincome and deductions

Simplified cash-basisaccounting

Business cash flow tax

Investment Accelerated depreciation;special small businessexpensing rules allowwrite-off of $102,000 in 2005(but cut by ¾ in 2008)

Expensing (exception for land and buildings under theSimplified Income Tax Plan)

Large BusinessTax rates Eight brackets: 15%, 25%,

34%, 39%, 34%, 35%, 38%,35%

31.5% 30%

Investment Accelerated depreciationunder complicated rules

Simplified accelerateddepreciation

Expensing for all newinvestment

Interest paid Deductible No change Not deductible (except forfinancial institutions)

Interest received Taxable (except fortax-exempt bonds)

Taxable Not taxable (except forfinancial institutions)

International tax system Worldwide system withdeferral of business profitsand foreign tax credits

Territorial tax system Destination-basis (border taxadjustments)

Corporate AMT Applies second tax system tobusiness income

Repealed

Source: Panel’s Report, pp. xvi-xvii (as of November 15, 2005).



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could be difficult for many large companies. For ex-ample, it is unclear whether the savings that would resultfrom applying a tax incentive like the low-income hous-ing credit (assuming it remained) to a company’s U.S. taxliability would be considered income not subject to U.S.tax. If so, a company’s attempt to reduce its tax liabilitywould increase the amount of shareholder dividends

subject to U.S. tax, potentially pitting the company’sinterests against those of its shareholders. Taxes paidfollowing IRS audits of prior years’ income, as well as thebenefits associated with loss and credit carrybacks (to theextent those remain permissible under the plan), couldfurther complicate the process of balancing company andshareholder interests for the same reason.

Table 5-2. Business Tax Breaks at Risk?Deductions, Deferrals, Exclusions, Exemptions, and Credits

Likely to Be Eliminated if Either Plan Moves Forward

Tax ExpenditureCost in MillionsFY 2006-2010

Business Deductions, Deferrals, Exclusions, and ExemptionsDeduction for U.S. production activities $42,900Exclusion of interest on state and local bonds 42,700Expensing of research and experimentation expenditures 31,330Graduated corporate income tax rate 19,630Deferral of tax on shipping companies 15,150Exclusion of interest on life insurance savings 14,120Special ESOP rules 12,980State and local corporate income tax deductions* 12,000Deductibility of charitable contributions 11,180Inventory property sales source rules exception 10,980Exemption of credit union income 7,550Excess of percentage depletion over cost depletion 7,310Extraterritorial income exclusion 6,370Deferral of income from installment sales 6,010Expensing of exploration and development costs 2,510Expensing of multiperiod timber growing costs 1,990Special Blue Cross/Blue Shield deduction 1,890Empowerment zones, enterprise communities, and renewal communities 1,630Tax exemption of certain insurance companies owned by tax-exempt organizations 1,170Expensing of certain capital outlays and multiperiod production costs 1,050Small life insurance company deduction 400Exemption of certain mutuals’ and cooperatives’ income 340Special rules for certain film and TV production 140Business Tax CreditsCredit for low-income housing investments 17,640Credit for increasing research activities 3,670New technology credit 3,630Alternative fuel production credit 2,500Tax credit for preservation of historic structures and rehabilitation 2,010Enhanced oil recovery credit 1,810Tax credit for orphan drug research 1,470New markets tax credit 950Work opportunity and welfare-to-work credits 740Small business retirement plan credit 700Credit for holders of zone academy bonds 680Tax credit for corporations receiving income from doing business in U.S. possessions 550Tax credit for certain expenditures for maintaining railroad tracks 480Alcohol fuels credit 180Credit for disabled access expenditures 70Employer-provided child care credit 50Total Business Tax Expenditures 288,460Total business tax expenditures as a percent of FY 2006-2010 corporate taxes 24%*Not a tax expenditure, but singled out to be repealed.Source: Office of Management and Budget, FY 2006 Budget Special Analyses.



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7. Taxation of capital gains. The plan would furtherreduce the double taxation of corporate income by ex-cluding 75 percent of the gain from the sale of stock ofU.S. corporations held by individuals for more than oneyear. That proposed exclusion would help level theplaying field between large businesses that pay out theirearnings as dividends and those that retain their earn-ings. It would also make U.S. companies more attractiveto investors, which could lower the cost of capital for U.S.corporations.8. Tax accounting methods. Because the plan would notfundamentally alter the basic tax accounting rules gov-erning the timing of income and expense recognition,larger businesses would continue to account for revenueswhen paid or accrued, use inventories for items offeredfor sale in the ordinary course of business, and distin-guish between capital and ordinary business expenses.9. Tax accounting. The proposed 31.5 percent maximumtax rate on business profits, as well as the possibleshortening of asset lives by moving to a simplifieddepreciation system, would require a revaluation of netdeferred tax assets and liabilities. As discussed in greaterdetail in Part X, the effect of those revaluations wouldflow through earnings in the year any tax reform isenacted.

B. Growth and Investment Tax Plan1. Transition. The Growth and Investment Plan wouldessentially replace the current-law corporate income taxsystem with a subtraction method value added taxsystem that would (1) tax positive business cash flows at

a flat 30 percent rate and (2) permit the deduction ofwages and other compensation. Enactment of that planwould mean moving to a type of tax with which Ameri-can businesses are largely unfamiliar. Accordingly, tran-sitioning from the current income tax system to the newsystem would pose numerous challenges, not all ofwhich can be identified beforehand.

To ease the transition, the panel recommended rapidtransition rules for (1) the depreciation of existing invest-ments in capital assets; (2) outstanding debt; (3) theplan’s proposed border tax adjustment mechanism (seesection V.B.4. for further discussion); and (4) financialinstitutions. For many large companies, however, thosetransition rules may not adequately address the problemsinherent in moving to such a different tax system. Forexample, phasing out depreciation allowances over afive-year period would mean that the amounts investedrecently in longer-lived assets would never fully berecovered.

The panel did not address many other potential tran-sition issues, like how the transition would affect U.S.companies’ financial statements or what the treatment ofexisting inventory holdings and carryover tax attributes(for example, FTCs, business credit carryforwards, andloss carryovers), would be under the plan. As a result, theeffects on large businesses of transitioning to the newsystem remain largely unclear.2. Expensing of business investments. The plan wouldreplace the current depreciation system with immediateexpensing of business investments. Assets with longerlives, like structures with a 39-year MACRS life, would

Table 5-3. Present Discounted Value of Depreciation Deductions for a $1,000 InvestmentProposed Law ( The Simplified Income Tax Plan)

Discount Rate

Category I(30% Annual

RecoveryPercentage)

Category I(7.5% Annual

RecoveryPercentage)


RecoveryPercentage)

Category IV(3% Annual

RecoveryPercentage)

6% 883 589 424 3538% 853 523 360 29510% 825 471 314 25412% 800 431 280 22415% 767 383 242 192Current LawDiscount Rate 3-Year 5-Year 7-Year 10-Year 27.5-Year 39-Year6% 947 904 864 811 497 3948% 931 876 827 762 414 31610% 915 851 794 720 353 26212% 901 827 763 681 306 22315% 881 794 721 632 254 182Comparison: Present Value Proposed Law Less Present Value Current Law

Discount Rate3-Year vs.

30%5-Year vs.

30%7-Year vs.

30%10-Year vs.

30%27.5-Year vs.

4%39-Year vs.

3%6% -63 -20 19 73 -73 -418% -78 -24 25 90 -54 -2110% -90 -26 31 105 -38 -812% -101 -27 37 119 -26 115% -114 -27 46 135 -11 10Source: Ernst & Young.



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yield the largest tax savings. Because large businessescould diminish their tax liabilities by purchasing inven-tory immediately before year end, the plan could reduceor perhaps eliminate year-end plant shutdowns, whichremain common among many manufacturers.3. Financing transactions. The plan would eliminate thecurrent bias in favor of debt financing by largely elimi-nating the deduction for interest paid. Some exceptions,however, would apply. For example, businesses thatprovide financial services could deduct interest paid, butwould have to include in income all principal andinterest inflows. Similarly, customers of those businessescould deduct the amounts of financial cash flows paid forservices, like financial intermediary services, as amountspaid for services.

4. Destination-based taxation of cross-border transac-tions. The plan would tax consumption in the UnitedStates regardless of where goods consumed were manu-factured. For exports, manufacturers would exclude thesales proceeds of exported goods from their tax base, andreduce their cash flows by (1) the purchase price ofU.S.-supplied materials used to make the exported goodsand (2) the labor costs of producing the goods. Thereduction for the purchase price of U.S.-supplied materi-als would effectively create a rebate of the amount of taxpaid on the purchase price of materials used to makemanufactured goods. That rebate of the Growth andInvestment Tax paid is known as a border tax adjustment.

Exporters that have border tax rebate adjustments thatexceed their taxes on domestic cash flows would receive

Table 5-4. Nominal Depreciation Deductions for a $1,000 Investment, First 10 YearsProposed Law ( The Simplified Income Tax Plan)

Year


RecoveryPercentage)

Category I(7.5% Annual

RecoveryPercentage)


RecoveryPercentage)

Category IV(3% Annual

RecoveryPercentage)

1 300 75 40 302 210 69 38 293 147 64 37 284 103 59 35 275 72 55 34 276 50 51 33 267 35 47 31 258 25 43 30 249 17 40 29 2410 12 37 28 23Current Law

Year 3-Year 5-Year 7-Year 10-Year 27.5-Year 39-Year1 333 200 143 100 17 122 445 320 245 180 36 263 148 192 175 144 36 264 74 115 125 115 36 265 0 115 89 92 36 266 0 58 89 74 36 267 0 0 89 66 36 268 0 0 45 66 36 269 0 0 0 66 36 2610 0 0 0 66 36 26Comparison: Proposed Law Less Current Law Deductions

Year 3-Year 5-Year 7-Year 10-Year 27.5-Year 39-Year1 -33 100 157 200 23 182 -235 -110 -35 30 2 33 -1 -45 -28 3 1 34 29 -12 -22 -12 -1 25 72 -43 -17 -20 -2 16 50 -7 -39 -23 -4 07 35 35 -54 -30 -5 -18 25 25 -20 -41 -6 -19 17 17 17 -48 -8 -210 12 12 12 -53 -9 -3Source: Ernst & Young.



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refunds. Conversely, because that adjustment would notapply to imported goods, large businesses that import asignificant amount of their goods may operate at a lossafter taxes. The panel report commented that relativecurrency valuations may move to ameliorate some of thenegative effect the system would have on businesses thatimport a significant amount of goods. (For further dis-cussion on this point, see Part II.H.)


• How would states respond to the plan? Could thegoal of simplification be achieved if states do notsignificantly alter their tax structures?

• What would the plan’s effective date be? Obviously,the effective date of any reform that is enactedwould establish a deadline around which most, ifnot all, businesses in the United States would needto evaluate the manner in which they are structured.Any reforms on the scale proposed by the panelmay therefore engender massive amounts of mergerand acquisition activity.

2. Simplified Income Tax Plan• Which business tax breaks would be eliminated

under the plan?3. Growth and Investment Tax Plan

• How would the transition from the current systemto the Growth and Incentive Tax Plan be achieved?

• What would be the financial statement implica-tions?

• What would happen to carryover tax attributes?• How would companies finance their operations

given the nondeductibility of interest?

Plans’ Effect on the Tax Liability of Four HypotheticalCompanies

SummaryTables 5-5 on the next page and 5-6 on p. 1284 present

four hypothetical subchapter C corporations with differ-ent economic and tax profiles, and show how their taxliability might change under the two plans. The resultsvary dramatically depending on the assumptions ofprofitability, sources of income and underlying economicactivity, and their tax treatment. Although the calcula-tions are hypothetical, and highly sensitive to the under-lying assumptions, they help to identify some of the keytax policy issues affecting the taxation of U.S. corporateincome under the two plans.

The tables illustrate how the plans would affect (1) amultinational corporation with foreign subsidiaries; (2) aU.S. manufacturer with depreciation and interest ex-penses; (3) a domestic service corporation that is laborintensive; and (4) a U.S. technology company with sig-nificant exports.Simplified Income Tax Plan

In the examples, the corporate income tax wouldincrease 8 percent to 12 percent for the multinational, U.S.manufacturer, and technology company due to the repealof the domestic production deduction, the state and localincome tax deduction, and nonforeign tax credits. Theservice corporation has a 3 percent decline in corporatetax because it doesn’t benefit from the production deduc-tion. Because the production deduction will already

reduce the marginal tax rate on manufacturing income to31.85 percent by 2009, the 31.5 percent marginal tax rateproposed under the Simplified Income Tax Plan wouldnot significantly reduce taxes on many companies’ in-come. The plan’s proposal to reduce the corporate taxrate by 10 percent would not be sufficient to offset itsproposed elimination of other deductions and credits formany companies.

In contrast, the Simplified Income Tax Plan wouldsignificantly reduce shareholder taxes on dividends andcapital gains from U.S. domestic-source income of U.S.corporations, effectively reducing the cost of capital forcorporate investment. When both the corporate andindividual tax changes are considered, three of the fourhypothetical companies have reductions in the totalcombined tax (company and shareholder-level) on cor-porate income. For three of the four companies, theindividual shareholder tax reductions more than offsetthe increase in corporate income tax. For the fourthcompany (the technology company), the individual taxreduction just offsets the corporate tax increase. Thetechnology company’s individual tax change is smallerdue to its greater reliance on retained earnings andcapital gains, which already benefit from deferral andlower rates.

The hypothetical company examples are consistentwith the panel’s report, which shows that the effective taxrate on corporate business income falls from 23.7 percentto 22 percent under the Simplified Income Tax Plan. Thereport did not show the different effects of the corporateand shareholder tax changes.Growth and Investment Tax Plan

The Growth and Investment Tax Plan would signifi-cantly reduce the corporate-level tax for all four hypo-thetical companies due to expensing of capital invest-ment and exclusion of export and foreign-sourcerevenue, even with the disallowance of interest expenseand import purchases. That is consistent with the panel’sreport, which shows the tax rate on corporate incomefalling to 7.2 percent. The Growth and Investment TaxPlan would reduce individual tax liability on corporateincome, but not as much as the Simplified Income TaxPlan, due to the 15 percent capital income tax. TheGrowth and Investment Tax Plan calculations are quitesensitive to the shares of export sales and importedbusiness purchases, and would be affected by changes inexchange rates and interest rates.The Data and Assumptions

The examples are based on aggregate statistics fromthe Internal Revenue Service’s Statistics of Income Corpo-rate Source Book, U.S. Commerce Department industrystatistics, and some aggregated information from annualreports of large companies.

The examples (1) assume fully phased-in law for boththe transition rules and for the production deduction; (2)use 2005 tax rates and tax credits for current law; and (3)make more than 20 assumptions for current tax liabilityand the two plans. The calculations also ignore a numberof potentially important considerations, including (1)transition rules, (2) the AMT, (3) existing NOLs and creditcarryovers, (4) potential changes in exchange rates and



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interest rates, (5) potential behavioral changes in businessor tax planning, and (6) the plans’ potential growtheffects on the economy.

VI. InternationalHighlights and Potential Implications

Simplified Income Tax Plan• Changes fundamentally U.S. taxation of foreign-

source active income.

• Eliminates ‘‘cross-crediting’’ of high-taxed foreigndividends with low-taxed foreign income.

• Encourages planning and restructuring as incomesource and transfer pricing become even more im-portant.


Table 5-5. Change in Tax Liability for Hypothetical Companies Under the Simplified Income Tax Plan

MultinationalDomestic

Manufacturer Service CorporationTechnology Corp.

With Exports

CurrentLaw

SimplifiedIncome

Tax PlanCurrent

Law

SimplifiedIncome

Tax PlanCurrent

Law

SimplifiedIncome

Tax PlanCurrent

Law

SimplifiedIncome

Tax PlanCurrent law U.S.corporate taxableincome

2,680 2,680 670 670 150 150 500 500

1. Base broadenersProductiondeductionrepealed

— 149 — 54 — 0 — 34

S&L income taxdeductionrepealed

— 105 — 33 — 8 — 25

Depreciationchanges

— 57 — 15 — 1 — 7

Other basebroadeners

— 27 — 7 — 2 — 5

2. Base narrowersDividends fromforeignsubsidiaries

— 515 — 0 — 0 — 0

Proposed lawtaxable income

— 2503 — 779 — 160 — 571

Statutory marginaltax rate

35% 31.5% 35% 31.5% 35% 31.5% 35% 31.5%

Tax liability beforecredits

938 789 235 245 52.5 50 175 180

Foreign tax credits (216) 0 0 0 0 0 0 0Other tax credits (19) 0 (14) 0 (1) 0 (9) 0Corporate taxliability aftercredits

703 789 221 245 52 50 166 180

Percent change intax liability atcorporate level

— 12% — 11% — -3% — 8%

Tax liability oncorporate incomeat shareholderlevel

185 80 42 2 9 0.5 16 3

Total U.S. tax oncorporate income

888 869 263 247 61 51 183 183

Percent change intotal U.S. taxliability oncorporate income

— -2% — -6% — -17% — 0%

See description of assumptions. Results are dependent on the assumptions. Can vary from large tax decreases to large taxincreases.Source: Ernst & Young.



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Table 5-6. Change in Tax Liability for Hypothetical Companies Under the Growth and Investment Tax Plan

MultinationalDomestic

Manufacturer Service CorporationTechnology Corp.

With Exports

CurrentLaw

Growthand

InvestmentTax Plan

CurrentLaw

Growthand

InvestmentTax Plan

CurrentLaw

Growthand

InvestmentTax Plan

CurrentLaw

Growthand

InvestmentTax Plan

Current lawU.S. corporatetaxable income

2680 2680 670 670 150 150 500 500

1. Base broadenersProductiondeductionrepealed

— 193 — 54 — 0 — 34

S&L income taxdeductionrepealed

— 105 — 33 — 8 — 25

Interest expensedeductionrepealed

— 536 — 402 — 8 — 25

Importpurchasesdeductionrepealed

— 2000 — 800 — 20 — 300

Other basebroadeners

— 27 — 7 — 2 — 5

2. Base narrowersExpensingrather thandepreciation

— 810 — 246 — 15 — 101

Financial incomeexcluded

— 2000 — 300 — 20 — 250

Export revenueexcluded

— 2000 — 1000 — 0 — 2000

Proposed lawtaxable income

— 731 — 420 — 152 — -1463

Statutorymarginal tax rate

35% 30% 35% 30% 35% 30% 35% 30%

Tax liabilitybefore credits

938 219 235 126 52.5 46 175 -439

Foreign taxcredits

(216) 0 0 0 0 0 0 0

Other tax credits (19) 0 (14) 0 (1) 0 (9) 0Corporate taxliability aftercredits

703 219 220 126 52 46 166 -439

Percent changein tax liability atcorporate level

— -69% — -43% — -12% — -364%

Tax liability oncorporateincome atshareholder level

185 115 42 25 9 5 16 23

Total U.S. tax oncorporateincome

888 868 263 152 61 51 183 -416

Percent changein total U.S. taxliability oncorporateincome

— -62% — -42% — -17% — -328%

See description of assumptions. Results are dependent on the assumptions. Can vary from large tax decreases to large taxincreases.Source: Ernst & Young.



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Growth and Investment Tax Plan• Essentially repeals current U.S. international tax

rules.• Eliminates deductibility of interest and thus funda-

mentally alters cross-border capital structure con-siderations.

• Creates uncertainty about compliance with U.S.obligations under income tax and trade agreements.

A. Simplified Income Tax Plan1. Integration. The panel’s integration approach wouldseek to reduce double taxation of corporate income byallowing U.S. individuals to receive dividends from U.S.corporations tax-free to the extent paid from U.S.-taxedearnings, and by excluding 75 percent of capital gainsfrom the sale by U.S. individuals of U.S. corporate stock.The dividend and gains exemption would not extend toforeign corporate stock, and it is unclear how the pro-posal would apply to foreign shareholders of U.S. corpo-rate stock.

The plan would have a number of significant implica-tions for multinational corporations and their individualU.S. shareholders. Because the exemption would belimited to dividends paid by U.S. corporations fromU.S.-taxed income, U.S. individual investors would be-come sensitive to the earnings profile (U.S.-taxable vs.foreign-exempt) of the U.S. corporations in which theyinvest. The result could be that investment by U.S.individuals in U.S. corporations with a greater propor-tion of U.S.-taxable earnings might increase.

Also, because both the partial dividend exemptionand partial capital gains exclusion would be limited tostock in U.S. corporations, U.S. individual investmentmight be biased toward investment in U.S. companies. Inthe Jobs and Growth Tax Relief Reconciliation Act of 2003(JGTRRA), the decision was made to extend the lowerrate to some foreign dividends to avoid creating disin-centives to investing in foreign stock (also, the lower rateon capital gains already applied and continued to applyat the new lowered rate under JGTRRA to capital gainsfrom the sale of foreign stock). Presumably, the currentlaw’s favorable treatment of foreign dividends and for-eign stock capital gains would either be repealed or beallowed to expire.

Because U.S. individual shareholders of U.S. corpora-tions could exclude only dividends paid out of U.S.-taxedearnings, U.S. individual shareholders would need toknow how much of each dividend received was paid outof foreign-exempt earnings and therefore subject to U.S.tax. Under the plan, each year, U.S. corporations wouldreport to U.S. individual shareholders the excludableportion of any dividends, based on the proportion in theprior year of U.S. taxable income to worldwide income.The panel did not specify a method, but suggested thatsimplicity should prevail over precision, and posed anexample that simply divides U.S.-taxable income byworldwide pretax income as reported on the corpora-tion’s financial statements. Even a simplified method,however, would place compliance burdens on U.S. multi-nationals and increase required disclosures. Moreover,the panel additionally recommended requiring U.S. cor-porations to file with their tax returns a schedule show-ing their consolidated worldwide revenues and income

before taxes, as reported on their financial statements,and reconcile the consolidated revenues and incomereported on their financial statements with the taxablerevenues and income reported on their tax returns. Thepanel anticipated that this disclosure, combined with theexclusion of dividends paid out of U.S.-taxed earnings,‘‘would provide disincentives for corporations to under-state the amount of income subject to U.S. tax.’’

If the plan were enacted, U.S. multinational corpora-tions would have to balance the incentive to maximizeexempt foreign-source active income with the effectincreased exempt foreign-source income would have onthe taxability of dividends distributed to shareholders.U.S. multinationals would also need to consider thebenefit for U.S. foreign tax credit purposes of increasingforeign-source income (especially low-taxed or untaxedforeign-source income, such as income from section863(b) sales), although as discussed later in this part,proposed changes to the FTC system to account for theforeign-source active income exemption would reduce(but not eliminate) the current incentive to increaseforeign-source income. In any case, the proposal wouldextend the current complex rules regarding the determi-nation of foreign- vs. U.S.-source income to entirely newareas and new U.S. taxpayers, and would significantlyalter current incentives for creating foreign-source in-come.2. Foreign subsidiary dividend and foreign active busi-ness income corporate tax exemption. The proposedmove to a more territorial tax system under whichdividends from foreign subsidiaries would be exemptfrom tax would more closely align the U.S. corporate taxsystem with those of our major trading partners. (SeeTable 6-1 on the next page.)

Adoption of the proposed exemption from U.S. corpo-rate tax of dividends from foreign subsidiaries wouldresult in many changes for multinational taxpayers,especially when combined with the exemption from U.S.corporate tax of much foreign active business income, aswell as the shareholder-level exemption of dividendspaid from U.S. earnings. For a typical U.S. multinationaltaxpayer receiving dividend, royalty, and other incomefrom controlled foreign corporations or other foreignsources, and directly from foreign operations and activi-ties, the proposed system would have both favorable andunfavorable consequences.

The most favorable consequence of the proposedforeign dividend exemption would be the increasedability of U.S. corporate taxpayers to repatriate earningsfrom CFCs with no U.S. income tax (the panel’s reportcontemplated that a special ‘‘hybrid security rule wouldbe required to prevent a payment that is treated asdeductible abroad from being treated as an exemptdividend in the United States’’). This exemption wouldallow taxpayers greater flexibility in determiningwhether to invest foreign earnings in the United States orto reinvest them abroad. Under the current system, manytaxpayers decide to reinvest foreign active earningsabroad, thereby deferring or perhaps avoiding U.S. fed-eral income tax on those earnings, but at the cost ofpotentially better pretax returns from U.S. investments.As we have seen over the last year with the enactment ofthe temporary lower U.S. tax rate on CFC repatriations



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under section 965, many U.S. corporations would bringback greater amounts of cash to the United States if theU.S. tax cost were lower. However, the combination of thedividend exemption with the active income exemptionwould mean that active foreign earnings would not besubject to U.S. corporate tax either when earned or whenrepatriated (foreign mobile income would continue to besubject to tax at the U.S. corporate level when earned).That could encourage increased investment abroad. It isimportant to keep in mind, however, as discussed in thissection, that foreign exempt earnings of U.S. corporationswould be subject to tax in the hands of the corporation’sinvestors when distributed as dividends. By contrast,U.S.-taxed earnings would be received tax-free by U.S.investors when distributed as dividends.

The foreign dividend and foreign active income cor-porate tax exemption would also greatly simplify FTCplanning and calculations, as the FTC rules would applyto U.S. multinationals only with respect to nondividend,mobile income, and, in addition, would apply a singleoverall FTC limitation, as opposed to the current multiplelimitation or ‘‘basket’’ system. On the other hand, be-cause foreign taxes paid with respect to dividends andactive foreign income would no longer generate a credit,U.S. multinational taxpayers may wish to consider tax

planning and structuring that allow for the minimizationof foreign taxes generally with respect to that income,especially foreign dividend withholding taxes. Regardingthe latter point, the recent trend in U.S. tax treaties toeliminate dividend withholding taxes would gain evengreater significance, as currently the primary effect ofeliminating foreign country withholding on dividends isto make FTC planning easier, as opposed to lowering theoverall tax level. When combined with the plan, treatyelimination of foreign country withholding on dividendswould result in dividends being fully exempt from bothU.S. corporate and foreign withholding tax (although theearnings presumably may have been subject to foreigntax when earned, and dividends from the U.S. corpora-tions paid out of earnings attributable to the foreigndividends would be subject to U.S. tax in the hands ofU.S. individual investors).

The proposed foreign dividend exemption would not,however, result in lower U.S. taxes for all U.S. multina-tionals. For instance, the provision would effectivelyeliminate the benefits many taxpayers receive from‘‘cross-crediting’’ high-taxed income and low-taxed in-come. Under the current system, ‘‘cross-crediting’’ gen-erally occurs as follows: A taxpayer receives a high-tax(greater than 35 percent) dividend from a CFC and alsoreceives a low-tax royalty payment. If both the dividendand royalty are in the same FTC basket (likely the generallimitation basket), the excess credits associated with thedividend may effectively reduce the residual U.S. tax thatwould otherwise be owed with respect to the royalty.However, under the proposed foreign dividend exemp-tion, that type of cross-crediting would not be allowed.High-tax dividend income (and some foreign activebusiness income) would be exempt from U.S. taxationand that income, and the associated foreign taxes paidwould no longer be included in the overall (or any) FTCbasket. As a result, low-taxed nonexempt foreign-sourceincome, such as most royalties, would be subject to U.S.taxation with little or no FTCs available to offset the U.S.tax. That would mean that for some U.S. multinationals,the provision on foreign dividend exemption wouldresult in an increase in their U.S. taxes. U.S. multinationalsin the high-tech and pharmaceutical sectors may beparticularly negatively affected.

The foreign dividend and foreign active income ex-emption elements of the plan also would result in the lossof deductions for some overhead and interest expenseitems allocable to exempt (that is, active business) foreignearnings. The loss of the ability to claim interest andother expense deductions may result in a higher U.S. taxburden. Also, the requirement to allocate expenses sepa-rately to exempt and nonexempt income, and the stakesinvolved, would likely put increased IRS scrutiny on theallocation of expenses. Interestingly, the panel recom-mended that no research and development deductions beallocated to exempt foreign earnings. That is, the panelrecommended that research and development expensesbe allocated entirely to U.S.-source income and to foreignmobile income, and, thus, that no part of those deduc-tions be lost. The JCT Report’s territoriality proposalincluded no such favorable provision and would appearto result in the loss of at least some research anddevelopment deductions.

Table 6-1. Home Country Tax Treatment of Foreign-Source Dividend Income of Resident

CorporationsExemption Foreign Tax Credit

Australiaa Czech RepublicAustria IcelandBelgium JapanCanadaa KoreaDenmark MexicoFinland New ZealandFranceb PolandGermany United KingdomGreecea United StatesHungaryIcelandItalyb

LuxembourgNetherlandsNorwayPortugala

Slovak RepublicSpainSwedenSwitzerlandTurkeyNote: In general, tax treatment depends on qualifying cri-teria (e.g., minimum ownership level, minimum holdingperiod, the source country, the host country tax rate). Thetable reports the most generous treatment of foreign directdividends in each case.aExemption by treaty arrangement.bExemption of 95 percent.Source: Panel’s Report, p. 243 (as of November 15, 2005).



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Finally, it should be noted that the panel’s report didnot define exempt ‘‘foreign business income’’ but didprovide that not all foreign active business income would beexempt. The report stated that ‘‘foreign active businessincome that is not likely to be taxed in any foreignjurisdiction (for example, some income from personalservices and income from international waters andspace), and income from the sale of property purchasedfrom or sold to a related person by a foreign corporationlocated in a country that is neither the origin nor thedestination of that property’’ will be taxed when earned,as ‘‘mobile income.’’ In general, mobile income would bedefined to include income such as interest, dividends,rents, and royalties arising from passive assets, with theadditions just described. Thus it appears that the panelwas recommending that the current rules of subpart Fregarding ‘‘foreign base company sales and servicesincome’’ be retained in large part, in addition to retainingthe subpart F rules regarding foreign personal holdingcompany income (the panel report does recognize, how-ever, that ‘‘special rules would need to provide thatqualifying financial services business income is treated asforeign business income,’’ but, contrary to the JCT report,does not recommend that the temporary so-called ‘‘activefinancing’’ exceptions of current subpart F be madepermanent). Recall that the JCT Report considered amove to a more territorial system and suggested, inaddition, that consideration be given to the repeal of theforeign base company sales and services rules. Recall aswell that an early version of the Jobs Act had providedfor the repeal of the foreign base company sales andservices rules. Many had hoped that the panel wouldrecommend their repeal as well, but it does not appearthe panel did.

The panel’s report also does not address whether thecurrent source rules would need to be revised or refined.Because active business income from foreign sourceswould be exempt from U.S. corporate tax, source ofincome determinations would become even more impor-tant than under current law (under current law, for U.S.multinationals, source of income is important primarilyfor foreign tax credit purposes, and, as such, in thatrespect would become less important under the proposal,with the lessening of the importance of the U.S. FTCregime). For example, the report does not address thetreatment of income from sales of inventory manufac-tured in the United States and sold abroad, which, underthe current rules of section 863(b), would generally be atleast 50 percent foreign source, and thus potentially 50percent exempt from U.S. corporate tax.

The panel’s report did provide, however, that the‘‘exempt earnings of foreign affiliates could be rede-ployed to other foreign affiliates in different foreignjurisdictions without losing the benefit of exemption,’’which echoed another provision dropped from the JobsAct, regarding the exclusion from subpart F income ofsome CFC-to-CFC payments, although the panel’s pro-posal may not be as broad as that which was consideredduring the debate on the Jobs Act.3. Taxation of foreign branch operations. The planwould also change the taxation of certain foreign branchoperations. It would treat foreign trades or businessesconducted directly by a U.S. taxpayer effectively as CFCs

for federal income tax purposes. That is, the mobileincome of those branches would be taxable to the U.S.corporation when earned, but active foreign incomewould be exempt when earned and when repatriated, butwith associated FTCs eliminated. Also, any branch losseswould no longer flow immediately and directly to theU.S. taxpayer. Thus, the proposed change could increasethe U.S. taxes paid by a U.S. company that had lossoperations overseas conducted through a branch, inaddition to any increase due to the plan’s general restric-tions on cross-crediting.4. Reporting. The plan would require additional report-ing for the system to function properly. U.S. multination-als would be required to file with their tax return aschedule showing their consolidated worldwide rev-enues and income before taxes as reported on theirfinancial statements, and reconcile those amounts tothose reported on their tax returns. As the report noted,that disclosure, combined with the exclusion of divi-dends paid out of U.S. earnings, would provide a disin-centive for U.S. corporations to understate their U.S.taxable income. Also, publicly traded corporations wouldbe required to report in their financial statements theproportion of U.S. and foreign income and revenues,which, the report states, would increase transparencyand ‘‘provide a better top-down view of a corporation’sglobal operations to shareholders, potential investors,and regulators.’’5. Transition. The transition from the current ‘‘world-wide’’ tax system to the proposed ‘‘territorial’’ systemcould be complex and onerous. At a minimum, the newdividend and active income exemption provisions wouldrequire all U.S. multinational taxpayers to examine theircurrent structures and FTC positions to determinewhether opportunities exist to enhance their tax positionand whether changes should be made to reduce poten-tially deleterious tax consequences. For example, compa-nies may wish to consider how their capital structuremay be made more tax-efficient, such that foreign taxesthat are no longer generally creditable are reduced whilethe proportion of exempt foreign-source net active in-come to U.S.-source income is increased. The panel didrecommend, however, that the territorial system shouldapply fully when effective, even with respect to pre-effective-date earnings, which would avoid many com-plicated transition issues that would arise were thesystem to apply only to post-effective-date earnings, asthe JCT Report had recommended.6. Effect on existing U.S. income tax treaties and tradeagreements. The effect of this new exemption system onexisting U.S. income tax treaties may be substantial, asmost treaties require the United States to provide an FTCfor taxes paid to the treaty partner, as opposed to anexemption. Thus, existing treaties would have to beoverridden in part for the provision to have its intendedeffect, and then presumably renegotiated. Existing trea-ties would remain in force and continue to have effecteven if overridden in part, but a treaty partner couldobject and fail to honor its own obligations under thetreaty because of the U.S. override, or perhaps even moveto terminate the treaty. The treatment under the proposalof income from export sales is not clear, but to the extentit is exempt from U.S. corporate tax, that could raise



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issues under U.S. trade agreements as to whether theproposal provides a prohibited export subsidy.7. Effect on transfer pricing. As a collateral matter, theplan would result in greater attention being focused onrelated-party transfer pricing. Taxpayers might have anincentive to shift active income offshore if doing sowould result in that income being exempt from U.S. taxwhile also being subject to low or no foreign tax. Thatshifting, however, likely would lead the IRS to scrutinizethose related-party transactions even more closely than iscurrently the case. In fact, the panel’s report notes in oneplace that under the proposed territorial system ‘‘itwould be necessary to continue to devote resources totransfer pricing enforcement’’ and in another that‘‘[b]ecause insuring that related entities charge each other‘arm’s length’ prices for goods and services is even moreimportant in a territorial system than under current law,additional resources would need to be devoted to exam-ining these transfer prices.’’8. Determining corporate residency. Under the panel’splan, a corporation organized or incorporated underforeign law would nevertheless be taxed as a U.S.-resident corporation if its ‘‘primary management andcontrol’’ is in the United States. The panel’s reportprovided no detail, however, regarding the determina-tion of place of primary management and control.

The proposal was similar to one included in the JCTReport, under which a foreign corporation would betaxed as a U.S.-resident corporation if the company’s‘‘primary place of management and control’’ is in theUnited States. For purposes of the JCT Report, thedetermination would be based on the ‘‘substantial pres-ence test’’ included in the 2004 protocol to the UnitedStates-Netherlands income tax treaty, which test incorpo-rates a ‘‘primary place of management and control’’concept based on the place where ‘‘executive officers andsenior management exercise day-to-day responsibilityfor . . . strategic, financial and operational policy decisionmaking.’’ The JCT Report proposal would be limited topublicly traded foreign corporations.

The panel’s plan to change the standard for determin-ing corporate tax residency would extend the policiesunderlying the ‘‘anti-inversion, anti-corporate expatria-tion’’ provisions of current sections 7874 and 367(a) toforeign corporations not subject to those provisions of thecode, as well as to foreign corporations with no previousdirect or indirect U.S. nexus. In fact, section 7874 wouldlimit the application of the provision, as that sectionalready operates to ‘‘re-domesticate’’ many U.S. corpora-tions that reincorporate overseas. However, the plancould have significant consequences to those foreigncorporations that inverted before the effective date ofsection 7874, that never were incorporated in the UnitedStates, or are otherwise not subject to the redomesticationprovisions of section 7874.

Also, unlike the parallel JCT Report proposal, it ap-pears that the scope of the panel’s proposed changewould not be limited to publicly traded foreign corpora-tions, and thus, redomestication under the plan couldextend to foreign subsidiaries and other nonpubliclytraded corporations, if the ‘‘primary management andcontrol’’ of those subsidiaries was in the United States.The absence of the limitation is significant, as U.S.

multinationals that operate through local foreign corpo-rations controlled and managed from the United Stateswould have their foreign subsidiaries deemed U.S. cor-porations for U.S. tax purposes.

The overall effect of the plan, however, might besomewhat mitigated by other elements of the proposal,such as limiting the application of the subpart F regimesolely to ‘‘mobile’’ or ‘‘passive’’ income, and exemptingforeign dividend and active income, as those provisionswould narrow the difference in U.S. taxation betweenU.S.-resident and non-U.S.-resident corporations. Thedifference in U.S. taxation of U.S. investors in U.S.-resident vs. non-U.S.-resident multinational corporationswould increase under the proposal, however, as de-scribed above, in a way that would amplify the effects ofthe panel’s corporate residency proposal.

B. Growth and Investment Tax PlanUnder the Growth and Investment Tax Plan, U.S.

businesses would be taxed on total sales less certaininputs, and interest and dividend payments would beexempt from tax when received by U.S. businesses andnot deductible when paid by them. Thus, the plan maycreate a strong incentive for U.S. multinationals to‘‘push’’ debt down and finance their foreign subsidiarieswith parent company debt, as the interest paid would befree from U.S. tax when received but potentially deduct-ible by the foreign subsidiary for local country taxpurposes. It also appears under the plan that the FTCwould no longer be available to U.S. taxpayers and thatthe antideferral rules of the code, such as subpart F,would be repealed. U.S. individuals would be taxed at aflat 15 percent rate on all returns from corporate invest-ment (that is, dividends and gains), apparently regardlessof whether the investment is in U.S. or foreign corpora-tions.

A possible result of the proposed Growth and Invest-ment Tax Plan may be uncertainty regarding the charac-terization of the tax under current U.S. income taxtreaties. Specifically, where the United States has incometax treaties with foreign countries that use an FTC system(for example, the United Kingdom), the foreign jurisdic-tion may not view the consumption tax as a creditable taxunder the existing treaty (because, for example, the tax isnot based on net income), and may not allow theirresidents a credit for the U.S. tax. That double taxationcould result in decreased foreign activities in the UnitedStates, or, more likely, a renegotiation of U.S. tax treaties.Moreover, most treaties require that the United Statescredit foreign taxes and that some expenses, like interest,be deductible for purposes of imposing income taxes onnonresident businesses. The plan might create issueswith respect to those treaty provisions. In addition,because imports would not be deducted from total salesand the tax with respect to exports would be rebated,there may also be an issue as to whether under U.S. tradeagreements, this tax may be deemed a prohibited exportsubsidy (and the tax would not be exempt from thatscrutiny because unlike a VAT, for example, it is a direct,not an indirect, tax). For related reasons, the constitution-ality of the tax might even be questioned, because if thetax is a direct tax, it must, under the Constitution, beapportioned according to population (which it clearly is



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not), unless it is income tax (which it appears that the taxmay not be, given the restrictions on deductions).

C. Unanswered Questions1. Simplified Income Tax Plan

• How would exempt ‘‘foreign business income’’ bedefined?

• How would the current source-of-income rules berevised, if at all, especially regarding exports?

• What would be the calculation method for thepercentage of dividend income excludable by U.S.individual shareholders?

• How would noncontrolled foreign affiliates (so-called 10/50 companies) be treated?

• How would payments such as royalties be imputedfrom foreign branches?

• What would be the reach of the ‘‘domestication’’provisions regarding U.S. management and control?

2. Growth and Investment Tax Plan• How would it be determined when and if goods and

services have been exported?• How would taxable presence be determined, espe-

cially for businesses that have a minimal presence inthe United States, such as some Internet vendors?

• How would cross-border payments for intangibles,such as royalty payments, be treated?

• How would current antideferral regimes, such assubpart F, and the current FTC rules, be affected?

3. Both plans• How would foreign direct and indirect investment

into the United States be treated?• What would be the effect on U.S. obligations under

its income tax treaties and trade agreements?

VII. State and LocalHighlights and Potential Implications

Simplified Income Tax Plan• Eliminates state and local income tax deduction,

thereby increasing the net cost to taxpayers andplacing greater importance on state and local taxplanning.

• May require states conforming to the new territorialtax regime to review their treatment of domestic-source dividends to ensure compliance with dor-mant Commerce Clause principles (absent congres-sional authorization).

• Eliminates federal tax credits; states wishing toretain similar credits would need to generate theirown rules, increasing compliance costs for taxpay-ers.

Growth and Investment Tax Plan• Requires states to significantly alter their tax base if

they wish to continue piggybacking on the federalsystem.

• Shifts toward taxing consumption rather than in-come, which would put pressure on how revised taxbase of multijurisdictional taxpayers should besourced among the states, potentially resulting ingreater disparity.

A. Simplified Income Tax Plan — Corporate1. State conformity to Internal Revenue Code. In gen-eral, states are free to choose whether to conform to thecode. Some states opt for ‘‘fixed’’ conformity and followthe code as of a certain date, while others choose ‘‘selec-tive’’ conformity and adopt only certain code provisions.

Figure 2. State Conformity With the Internal Revenue Code

Source: Ernst & Young.

Rolling

Fixed Date

Selective

No Income Tax

WA

OR

CANV

ID

AZ

TX

NM AR

MS

FL

GA

SC

NC

VAWV

KY

IN

MI

WI

IA

MN

ND

SD

WY

ME

NHVT

NJ

UTCO

MT

NE

KS

OK

MO

IL

TN

AL

LA

OH

PA

NY MA

CT RI

DEDC

MD



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Others practice ‘‘rolling’’ conformity, automatically up-dating their reference to the code on a continual basis,thus conforming to the most recent version of the code.

While following federal tax provisions is administra-tively less burdensome, some federal tax provisions coststates significant amounts of revenue. Accordingly, statesmay choose not to follow selective provisions of the‘‘new’’ tax system.2. Changes to taxation of passthrough entities. Moststates limit their definition of ‘‘taxpayer’’ to corporations.Partnerships in those states are not subject to state tax atthe entity level. The proposed imposition of an entity-level federal tax on passthrough entities would notautomatically subject partnerships to state tax at theentity level. To conform to the plan’s proposed taxationof partnerships at the entity level, states would need toamend their definition of ‘‘taxpayer’’ or ‘‘corporation.’’

How partnership distributions would be taxed underthe plan is unclear. Currently, a corporate partner in-cludes in its AGI its distributive share of partnershipgross income under section 61(a)(13). The assumption isthat this provision would be eliminated (or modified) topreserve the integrity of the ‘‘single tax’’ concept appli-cable to partnerships and to create equality with thecorporate entity form. If the federal tax reform proposalcorrects the inequity through an amendment to section61, the effect at the state level would be dependent oneach state’s conformity rules (that is, rolling, static, orselective). That could create some interesting scenarios ina ‘‘static’’ state that chooses to broaden its definition of‘‘taxpayer’’ but otherwise keeps its conformity date fixed.

For LLCs, the analysis is a bit different. Under theplan, single-member LLCs would presumably be taxed inall situations as corporations.

State tax treatment would depend on each state’sconformity rules, but states with rolling conformity datesor updates to their conformity dates would be alignedwith the proposed federal tax treatment of LLCs. Unlikewith partnerships, states should not need to amend theirdefinitions of ‘‘taxpayer.’’3. ‘Territorial’ tax system vs. current ‘worldwide’ taxsystem. From a state tax perspective, conformity with theplan’s territorial tax regime would effectively tax multi-nationals on U.S.-source income and foreign mobileincome. It is uncertain how that would be accomplishedfor federal tax purposes, although presumably rules suchas those under current subpart F would be used. Whenthe exclusion involves a branch (as opposed to a foreignaffiliate), states that conform to this provision may needto take action regarding the apportionment factors toexclude factors of income attributable to income deemedearned outside the United States.

Absent congressional authorization to the contrary,states that conform to the proposed territorial tax regimemay have to review their treatment of domestic-sourcedividends to ensure compliance with the CommerceClause of the U.S. Constitution. While Kraft General FoodsInc. v. Iowa Dept. of Rev. & Finance, 505 U.S. 71 (1992),prohibited states from discriminating against foreigncommerce in favor of interstate commerce, it is unclearwhether the converse holds true (that is, whether statesmay discriminate in favor of foreign commerce to thedetriment of interstate commerce).

4. Elimination of tax credits. Under the Simplified In-come Tax Plan, the tax base is to be ‘‘cleaned,’’ whichwould result in the elimination of many tax credits andspecial preferences. Accordingly, states would have toadjust some of their own tax credits that piggyback orfollow similar federal credits, particularly in the invest-ment area. For instance, the proposed elimination of thefederal research credit could affect the tax bases of stateswith research credits modeled on the federal version,depending on how taxpayers previously elected to ac-count for their R&E expenses. Furthermore, the absenceof the federal rules would require states to generate theirown rules if they continued those incentives, whichwould likely increase compliance costs for taxpayers onthe state level and work against the overall goal of taxsimplicity.5. Elimination of state and local income tax deduction.The plan’s proposed elimination of the deduction forstate and local income taxes would prompt taxpayers topay greater attention to their state tax burden. As such,state tax planning would take on heightened importance.6. Elimination of the AMT. For the few states that havea corporate AMT, the effect of eliminating the federalcorporate AMT would depend on the extent to which theoverall plan would affect their tax bases. Those stateswould have to decide whether to change or eliminatetheir AMT. The proposed Simplified Income Tax Planalso could negatively affect a state’s revenue to such adegree that the state would have to adopt an AMT or anew or higher minimum tax, such as New Jersey’salternative minimum assessment, to replace lost revenue.7. Changes for small and medium-size businesses. Thesimplification benefits of the plan’s changes to the cur-rent depreciation system could be derailed if stateschoose to decouple from this provision. Small businesseslocated in states that chose to decouple would still needto keep track of depreciation schedules for specific assetsfor state tax purposes.8. Compliance/transition issues. The panel’s report didnot indicate how the Simplified Income Tax Plan wouldbe implemented. Whether the plan would take effect ona specified date or be phased in over a period of years, itsimplementation would create significant transition bur-dens and compliance costs for both states and taxpayers.

B. Simplified Income Tax Plan — Individual1. Conformity. There is a lack of uniformity among thestates in how they tax individuals (for example, Pennsyl-vania taxes gross income, California allows itemizeddeductions, and so on). Accordingly, adoption of a newfederal tax system would affect states differently. Forexample, states that allow taxpayers to itemize deduc-tions or that receive a significant amount of revenue fromtaxing capital gains would be affected more than statesthat do not.2. Elimination of deduction for state and local taxespaid. The elimination of the federal deduction for stateand local tax paid would have the greatest effect in statesthat have a high percentage of taxpayers who itemizetheir federal deductions due, in part, to the state’s highstate and local income tax rates (that is, California andNew York). It would have negligible effect on states that



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(1) have a low percentage of taxpayers who itemize or (2)do not impose a state income tax.

C. Growth and Investment Tax Plan1. General overview. The proposed business tax is con-ceptually similar to a VAT that is based on the differencebetween a taxpayer’s sales and all purchases from otherbusinesses. However, the wage and compensation com-ponent of value added is not included in the base becauseit is taxed at progressive rates under the individualincome tax. The proposed business tax contains many ofthe features found in the modified VATs used in Michi-gan (the single business tax) and New Hampshire (thebusiness enterprise tax). However, the Michigan andNew Hampshire taxes do include a substantial portion ofwages and compensation in the business tax base.2. State conformity and compliance issues. If a con-sumption tax were ultimately adopted by the federalgovernment, state and local governments would be sig-nificantly affected and would face a number of compli-ance and financial issues. The biggest implication wouldbe a state’s ability (or, in this case, inability) to piggybackits income tax laws on the federal tax system. Thatinability would ultimately result in states having to (1)adopt a similar tax regime, (2) define their income taxbases independent of the federal government, or (3)adopt a different tax scheme altogether. That result couldfurther diminish uniformity among state tax systems. Itcould also increase compliance costs for taxpayers as theywould be forced to deal with significantly different taxbases and systems in each jurisdiction. Furthermore, thetransition rules that would be required for dealing withthe phasing in of the new tax base would cause consid-erable administrative burdens for the states and compli-ance issues for taxpayers.3. Effect on multijurisdictional taxpayers. A changefrom an income-based system to a consumption-basedsystem would be of significant concern for multijurisdic-tional taxpayers. For instance, how would the statesensure ‘‘fair apportionment’’ in allocating ‘‘cash flow’’ toeach respective state? The situation could exacerbate thecurrent lack of uniformity and certainty in the ultimatedetermination of a corporation’s tax liability and result inan increased number of controversies between the statesand multijurisdictional taxpayers. While some states mayretain their current sourcing rules, others may opt todevelop a new apportionment formula more consistentwith the new federal business tax base.

From a nexus perspective, what would constitute‘‘substantial nexus’’ in the case of a corporation thatbenefits from services or use of intangible property in thestate but is not physically present in that state? WouldQuill v. North Dakota, 504 U.S. 298 (1992), be applicable,and thus would a physical presence standard be man-dated? Would movement toward a consumption-basedtax allow the states to hurdle the problems inherent inexpanding the sales and use tax base to include services?Would this scenario render the need to clarify the scopeof the physical presence standard found in Quill v. NorthDakota substantially moot?

Another issue would be the proper treatment of ‘‘cashflow’’ generated from intercompany transactions —would there be an elimination of those transactions to

prevent multiple taxation among members of the affili-ated group? Would combined reporting or consolidatedfiling be allowed?4. Taxation of financial institutions. Under the Growthand Investment Tax Plan, financial institutions wouldtreat all principal and interest inflows as taxable incomeand deduct all principal and interest outflows. Custom-ers of financial institutions would be allowed to disre-gard financial transactions for tax purposes. Currently,states vary widely in their definitions of financial insti-tutions for tax purposes. Rules for determining whichbusinesses qualify as financial institutions have becomeparticularly complex, especially when the entity has bothfinancial and nonfinancial business activities. From astate and local tax perspective, this provision may requirethe states to either adapt their current system of taxingfinancial institutions to the new federal taxing regime ordecouple. Under current law, although many states cur-rently subject financial institutions to an income-basedtax, alternative methods to apportion the income areused. Also, some states that impose net worth and othertypes of separate taxes on financial institutions would notbe affected by the new federal regime or have to changetheir structure unless they chose to follow the federalsystem. All of the compliance and regulatory issuesidentified under the federal regime would be multipliedby the various state taxing jurisdictions, resulting inadditional compliance costs for the states and taxpayers.5. Tax-free formations and mergers/acquisitions. Underthe Growth and Investment Tax Plan, adoption of tax-freebusiness combination rules may create opportunities toinappropriately transfer business losses. Thus, the panelstated that it may be necessary to import certain judicialdoctrines, such as step transaction and business purpose,to guard against those results. Movement in that direc-tion would no doubt exacerbate the degree of nonunifor-mity and complexity that already exists between thefederal/state, state/state, and state/local tax systems.

D. Unanswered Questions1. Simplified Income Tax Plan — Corporate

• How would a state react to a simplified federalincome tax system? Would it conform to or decouplefrom a simplified income tax system? The revenueeffect of a simplified federal income tax system on astate may cause varying degrees of decoupling fromthe federal changes.

• If a state loses revenue under either a simplifiedincome tax or income-based consumption tax,would it increase other taxes (that is, sales and use,property) or perhaps impose a new tax system (forexample, Ohio’s commercial activity tax, Michigan’ssingle business tax, Washington’s business and oc-cupation tax, and so on) to recover the lost revenue?Conversely, if a state realizes a windfall, would itreduce other taxes?

• Given the interwoven and complex national andsubnational tax, spending, and entitlement pro-grams that exist within the U.S. federal system, is itappropriate to evaluate and adopt federal reformoptions based on the federal effect alone, or shouldthe state revenue effect have been analyzed by thepanel as well?



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• Should federal reform incorporate various preemp-tion provisions (for example, require uniform con-sumption tax sourcing rules) to simplify complianceand reduce multistate nonuniformity?

• How would a federal VAT regime affect state andlocal taxes? Although the panel did not recommenda VAT, it offered the VAT as a future possibility.Thus, if a federal VAT regime were adopted in lieuof (as opposed to an add-on to) the federal incometax, states would have to decide which business taxsystem to adopt: a gross receipts tax, an income tax,a modified VAT, or the business component of thefederal income-based consumption tax.

• Can a state offer a tax incentive limited to in-stateactivities and not extend those benefits to similarnon-U.S. activities that are incorporated into goodsor services imported into the United States? Statetax systems are subject to various restrictions notrelevant to the federal government. For instance, theImport-Export Clause of the U.S. Constitution pro-hibits the states from imposing any imposts orduties on imports or exports, except what may beabsolutely necessary for executing its inspectionlaws. If federal tax reform moves towardconsumption-based taxation and/or a territorial taxregime, architectural limitations may exist at thestate level that would need to be carefully consid-ered.

• What is the likelihood of a proposal to tax largebusiness entities based on financial statement netincome, as opposed to requiring a separate calcula-tion of taxable income as under current law, beingenacted? The panel recommended that such a pro-posal be studied further. If enacted, how wouldstates react?

• The panel considered, but ultimately rejected, adop-tion of a national retail sales tax, although it could beconsidered in the future as a possible replacementfor the income tax. A national retail sales tax wouldsignificantly affect state and local tax systems. Howwould a national retail sales tax interact with thedefinitions of taxable sales in the various state andlocal tax jurisdictions, especially in regard to ser-vices? Also, would the imposition of a national retailsales tax, with the necessary high tax rate, cause adecline in state and local sales tax revenue?

2. Simplified Income Tax Plan — Individual• How would a state react to the new federal indi-

vidual income tax system? Would it conform to ordecouple from the new federal system? Would thestate eliminate its individual income tax altogetherand increase other taxes, such as sales tax or prop-erty tax?

• How would states conform to the new ‘‘savingspackages’’?

• If an entity-level tax were imposed on partnershipsand other passthrough entities, how would thischange affect a partner’s/member’s state filing ob-ligations?

3. Growth and Investment Tax Plan• How would a state react to an income-based con-

sumption tax? How many states would decide toretain their current income-based system? Compli-ance and enforcement would become extremelydifficult given the fact that states would now need toaudit the ‘‘starting point’’ — that is, determine theaccuracy of a corporation’s federal taxable incomeand not just their respective modifications.

• How much would it cost a state to switch from itscurrent income tax system to an income-based con-sumption tax? Would a state’s tax collection costsincrease?

• If a state adopted the new consumption-based taxsystem, would the state in the first few years ofimplementation be able to reasonably determinehow much revenue the tax would generate? Wouldthere be safeguards such as a state rate adjustmentmechanism?

• If an income-based consumption tax were ulti-mately adopted by the federal government, howwould it tax certain industries, such as the insur-ance, telecommunications, utility, and transporta-tion industries? For example, most states impose taxon insurance companies based on the gross value ofpremiums, while a few subject them to the generalincome-based tax. Would all states move to a pre-mium tax, or would they apply the cash flow tax toinsurance companies?

VIII. Passthrough EntitiesHighlights and Potential Implications

Simplified Income Tax Plan• Provides that all large business entities, regardless

of form (for example, C corporation, partnership, Scorporation), would be taxed at the entity level.

• Provides a 100 percent dividend exclusion for divi-dends from U.S. corporations paid out of domesticearnings and a 75 percent exclusion for capital gainson sale of stock in a U.S. corporation.

Growth and Investment Tax Plan• Applies a flat 30 percent tax on all businesses other

than sole proprietorships.• Allows owners of passthrough entities to continue

to report and compute tax on business cash flow ontheir returns.

A. Simplified Income Tax Plan1. Elimination of passthrough items. Under the Simpli-fied Income Tax Plan, all large business entities would betaxed the same — at the entity level. Thus, the individualtax characteristics of the owners would be irrelevant indetermining the tax paid on the entity’s income. Businessentities with less than $10 million in receipts would beable to choose between being taxed as a corporation (thatis, at the entity level) or at the owner level.

To provide for parity in the taxation of businessentities, the Simplified Income Tax Plan provides for a100 percent exclusion for dividends from a U.S. corpora-tion that are paid out of domestic earnings and a 75percent exclusion of capital gains on the sale of stock of aU.S. corporation.



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2. Elimination of capital gain rates on asset sales. TheSimplified Income Tax Plan would allow a 75 percentexclusion of the capital gain resulting from the sale ofstock of a U.S. corporation. All other capital gains wouldbe fully taxable. In the case of a large business, thisprovision would result in an entity-level capital gains taxon asset sales at the corporate rate of 31.5 percent.Currently, capital gains realized by an S corporation or apartnership are taxed at the lower individual capitalgains rates. Thus, this provision would generally result ina tax increase for S corporation and partnership entitieswith capital gains other than from U.S. stock sales.3. Imposition of a double tax on certain dividends andcapital gains. The Simplified Income Tax Plan would taxa portion of dividends based on the proportion of incomenot subject to U.S. tax during the prior year. As such,shareholders would pay tax at ordinary rates only on thereported proportion of dividends not based on incometaxed in the United States during the prior year. Whilenot entirely clear, it appears that distributions from an Scorporation or a partnership subject to the entity-level taxwould be treated as dividends and therefore subject totax unless paid out of domestic earnings. The SimplifiedIncome Tax Plan would also impose a capital gain tax atthe owner level on the sale of an interest in a businessentity. Thus, instead of a single level of tax on the incomefrom partnership and S corporation entities, ownerswould be subject to an additional level of tax on distri-butions taxed as dividends from non-U.S. earnings andcapital gain on sales of business entity interests.

This change would have the greatest effect when theowners of a partnership or S corporation decide to havethe S corporation or partnership sell all of its assets andthen liquidate. Currently, that transaction is subject to asingle level of tax for both the entity and owner levelbecause of the owners’ basis adjustments from paying theentity’s tax. Under the Simplified Income Tax Plan, in thecase of a large business, it appears that there would beimposition of an entity-level tax with no passthroughtreatment, resulting in the owners paying an additionaltax on the capital gain incurred when the entity distrib-utes capital gain proceeds in excess of the owner’s basisin the entity. This change would result in the owners’ saleof the S corporation or partnership business interestsbeing the tax-favored method of disposing of the part-nership or S corporation business from the sellers’ per-spective, and would provide an incentive for deferraltechniques.

B. Growth and Investment Tax Plan1. Single rate of tax on all business income. The Growthand Investment Tax Plan would apply a flat 30 percenttax on all businesses other than sole proprietorships,regardless of their legal structure. However, in contrast tothe Simplified Income Tax Plan, which, in the case of alarge business, imposes a tax at the entity level (regard-less of form), under the Growth and Investment Tax Plan,the owners of a passthrough entity could continue toreport and compute the tax on business cash flow ontheir individual returns, albeit at the same business entityrate.2. Elimination of capital gain rates on asset sales. TheGrowth and Investment Tax Plan would impose a busi-

ness entity-level tax of 30 percent on all cash flow. Thus,all capital gains (unless from a ‘‘financial transaction’’)would be taxable at the entity rate without any exclusion.This provision would result in a capital gains tax onentity asset sales at the corporate rate of 30 percent.Currently, capital gains realized by an S corporation or apartnership and allocated to an individual owner aretaxed at the lower individual capital gains rates. Thus,this provision would result in a tax increase for allindividual owners of passthrough entities on nonfinan-cial capital gains recognized by the entity.3. Imposition of a double tax on dividends and capitalgains. Unlike the Simplified Income Tax Plan, whichwould provide a 100 percent exclusion for dividendsfrom a U.S. company paid out of domestic earnings, theGrowth and Investment Tax Plan would impose a 15percent tax on all dividends and capital gains received byindividuals. While not entirely clear, it appears thatdistributions from an S corporation or a partnershipwould be treated as dividends and therefore subject totax at a 15 percent rate. Thus, in accordance with thestated goal of eliminating tax-driven choice of entity,instead of a single level of tax on the income frompartnership and S corporation entities, owners would besubject to an additional level of tax on distributions taxedas dividends from non-U.S. earnings and capital gain onsales of business entity interests.

This change would have the greatest effect when theowners of a partnership or S corporation decide to havethe S corporation or partnership sell all of its assets andthen liquidate. Currently, that transaction is subject to asingle level of tax at both the entity and member levelbecause of the members’ basis adjustments from payingthe entity’s tax. Under the provision, it appears that therewould be imposition of an entity-level tax with nopassthrough treatment, resulting in the members payingan additional tax on the capital gain incurred when theentity distributes capital gain proceeds in excess of amember’s basis in the entity. This change would result inthe owners’ sale of the S corporation or partnershipbusiness interests being the tax-favored method of dis-posing of the partnership or S corporation business andprovides an incentive for deferral techniques.


• Does the plan envision that an interest in apassthrough entity be treated as ‘‘corporate stock’’for all purposes of the plan?

• Would all partnerships and S corporations (includ-ing small businesses) be taxed like corporations?The panel’s report indicates that partnership and Scorporation items would be reported on Form 1120,currently used for corporations. However, in a sepa-rate section, the panel ‘‘recommends that rules ap-plicable to passthrough entities be ‘simplified andstreamlined’’’ in connection with small businesses.‘‘For example, greater uniformity among the rulesfor contributions, allocations of income, distribu-tions, and liquidations would eliminate confusionand simplify choice of entity considerations.’’ Thatlanguage appears inconsistent with treating partner-ships and S corporations that are ‘‘small businesses’’



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as corporations and inconsistent with the specialprovision reversing current law and allowing amarried couple in an unincorporated business toelect to be taxed as a sole proprietorship.

2. Both plans• Would liquidating distributions made by S corpora-

tions and partnerships be taxed as stock sales? Asdescribed in this chapter, the imposition of anentity-level tax would create a tax-favored methodfor disposing of a partnership or S corporation.

• Would the plans reverse the current law that part-ners in a partnership are taxed as self-employedpersons and subject to the self-employment tax ontheir distributive shares of partnership income?

IX. Financial AccountingHighlights and Potential Implications

Simplified Income Tax Plan• Requires revaluation of recorded deferred tax assets

and deferred tax liabilities.• Requires that passthrough entities subject to tax

would have to establish tax accounts.• Requires reversal of any deferred taxes provided for

overseas active income.Growth and Investment Tax Plan

• Generates larger deferred tax liabilities due to accel-erated expense of capital expenditures.

• Raises the question as to the applicability of FAS109.

A. Simplified Income Tax Plan1. Corporate tax rate reduced from 35 percent to 31.5percent. The Simplified Income Tax Plan would reducethe corporate tax rate from 35 percent to 31.5 percent forlarge corporations (businesses with receipts greater than$10 million). While a reduction in the corporate tax ratewould be significant, the proposed elimination of specialpreferences and credits could, in some circumstances,cause a company’s effective tax rate to actually increase.

A reduction in the corporate enacted tax rate wouldrequire the remeasurement of existing applicable de-ferred tax assets and liabilities and a resulting charge orincrease to earnings of the company in the period thelegislation is enacted. Those companies in a position of anet deferred tax asset would record additional tax ex-pense from continuing operations while companies in anet deferred tax liability position would reflect a taxbenefit.

An analysis of the 2004 annual financial statements ofthe largest 50 companies in the Fortune 500 list (ignoringthe fact that some of the deferred taxes apply to state andforeign jurisdictions that would not be affected) revealsthat this group has a total net deferred tax liability ofapproximately $97 billion. However, the range of thislimited group of companies runs from a net deferred taxasset of $19.2 billion to a net deferred tax liability of $21.3billion. Of the companies that comprise the largest 50companies within the Fortune 500 list, 32 have a netdeferred tax liability and 18 have a net deferred tax asset.A change from the current 35 percent rate to a 31.5percent rate may have a significant effect.2. State and local income taxes. The deduction for stateand local income taxes would be eliminated for large

businesses under the plan. Currently, deferred taxes areprovided for temporary differences recognized for fed-eral, state, and foreign income tax purposes. The stateand local deferred taxes are computed using the enactedstate and local rates net of the appropriate federal taxbenefit taken on the federal return. To the extent that stateand local taxes would no longer be deductible, thedeferred tax assets and liabilities previously establishedwould have to be adjusted to eliminate the federal taxbenefit.3. Passthrough entities. Because there is currently noentity-level taxation for passthrough entities (for ex-ample, partnerships, LLCs, and S corporations), thoseentities are not required to maintain income tax accounts,including deferred income tax assets and liabilities. Un-der the plan, large passthrough entities that would betaxable (and other business entities with less than $10million in receipts that ‘‘elect’’ to be taxed as a corpora-tion) would be required to create and maintain a full setof income tax accounts for the financial reporting pur-poses. (For a discussion of this provision, see Part I.E.1.)For passthrough entities with less than $10 million inreceipts that do not elect to be treated as a corporation,the plan would provide for owner-level taxation at theowner’s applicable tax rate and allow such an entity tocontinue to not provide for income taxes for financialreporting purposes.4. Simplified cost recovery. The plan may provide forgreater accelerated cost recovery than the current taxsystem. For example, under the plan, small businesseshave the ability to expense capital purchases. To theextent that asset lives would be shortened (or expensed)in comparison to financial reporting lives, companieswould recognize additional deferred tax liabilities withrespect to those differences.5. International implications — territorial tax system.Because most companies have not provided deferredtaxes on foreign earnings and because many companieshave repatriated a significant amount of foreign earningsunder the temporary dividends received deduction pro-vision of section 965, a change to a territorial tax systemfor most companies with active foreign business incomewould have a lessened financial reporting effect. If theproposed territorial tax system is enacted, those compa-nies that have previously provided taxes on the deferredamounts relating to overseas active income may recog-nize current income at the time of enactment as a result ofthe reversal of the income tax provision on the deferredamounts.2

2The territorial tax system proposes that overseas activeincome would not be subject to U.S. taxation, permitting thetax-free repatriation of such income. This change would elimi-nate the need for the FTC regime for active overseas income.The Simplified Income Tax Plan would maintain U.S. taxingjurisdiction on overseas passive income, thus necessitating theFTC rules for that income. With respect to financial accounting,APB 23 provides, in part, that all unremitted earnings of aforeign subsidiary should be included in income and accountedfor as a temporary difference unless the law provides a methodby which the unremitted earnings can be recovered tax-free.Deferred taxes under FAS 109 are not recognized for an excess


(Footnote continued on next page.)


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B. Growth and Investment Tax PlanUnder the Growth and Investment Tax Plan, all com-

panies (other than sole proprietorships) would be taxedat a 30 percent rate on their cash flow, which is defined astotal sales less (1) purchase of goods and services fromother businesses and (2) wages and other compensationpaid to employees. Passthrough entities like partner-ships, LLCs, and S corporations would also be taxed atthe 30 percent rate on their business cash flow, althoughowners of those entities could report and compute the taxon their individual returns.

The Growth and Investment Tax Plan has been de-scribed in the panel’s report as a ‘‘blended tax structurethat would move the current tax system towards aconsumption tax, while preserving some elements ofincome taxation.’’ Depending on the specific provisionsand transition rules of any enacted legislation, the Finan-cial Accounting Standards Board may need to considerwhether FAS 109 would continue to apply or whetheradditional guidance would be required. Currently, FAS109 applies only to taxes based on (or substantially basedon) income. As such, FAS 109 (and the correspondingprovisions of APB 28 and FIN 18 related to interimreporting of income taxes) may not apply to the Growthand Investment Tax Plan, if enacted.1. Corporate tax on cash flow. Regarding the capitalexpenditures component in the plan’s definition of ‘‘cashflow,’’ several observations are noteworthy. First, assum-ing that any enacted change is treated as an income tax,many companies would generate larger deferred taxliabilities from the accelerated expense of capital expen-ditures for tax reporting purposes while financial report-ing would continue to depreciate the expenditures. Forexample, for the largest 50 companies in the Fortune 500list for 2004, the group had a reported deferred taxliability for property, plant, and equipment in excess of$104 billion resulting from the current tax system.2. Corporate tax rate reduced from 35 percent to 30percent. As with the proposed Simplified Income TaxPlan, reducing the corporate income tax rate wouldrequire revaluation of the amount of deferred tax assetsand liabilities in a company’s balance sheet coupled withthe resulting effect on the income statement. (For adetailed analysis of the effect of this proposed change, seethe discussion in Part IX.A.1.)3. Passthrough entities. Under the plan, all businessesother than sole proprietorships would be taxed at a flat 30percent regardless of entity form. In contrast to theSimplified Income Tax Plan, passthrough entities underthe Growth and Investment Tax Plan may report andcompute the tax on business cash flow on their indi-vidual returns, thus avoiding a provision for income tax.Otherwise, as noted in the discussion on the SimplifiedIncome Tax Plan, full sets of income tax accounts for

financial reporting purposes would be required forpassthrough entities, regardless of size. (For a detailedanalysis of the effect on passthrough entities and incometax accounts, see the discussion in Part IX.A.3.)


• What transition issues would companies face ifeither plan were enacted? As recognized by thepanel, from a financial reporting point of view, thetransition issues would be significant. Those issueswould need to be identified and addressed to un-derstand the financial effects of the proposedchanges and to garner support from the businesscommunity for any legislation that would result. Tothe extent significant changes are enacted, Congresswould need to address whether they would bephased in over a period of time or applied using acutoff date. The methods of transition may affect taxrevenue, complexity, and delay of implementationto the new system.

• What effect would the enactment of a reduced taxrate have on financial reporting? One of the mostsignificant issues would be the financial reportingeffect of the change in enacted tax rate on therecorded deferred tax assets and liabilities. Thatwould be a one-time adjustment that would need tobe understood by the financial community.

• What effect would eliminating tax credits have onfinancial accounting? If tax credits were eliminated,Congress would have to deal with the issue ofexisting carryovers of tax credits and net operatingloss carryforwards. In enacting a replacement com-mercial activity tax for the income tax in Ohioduring 2005, that legislature adopted a phased-inapproach for using many of the credit carryoverswith an ability to convert the former credits to newcredits under the proposed system. The Ohio legis-lature also took an interesting approach to compa-nies with NOLs by measuring the amount of NOLqualifying for relief using financial accounting con-cepts. Companies with Ohio NOLs of more than $50million net of any valuation allowance could elect toconvert the NOL to a credit against the new tax.From a financial accounting perspective, to theextent that those credit and NOL carryforwards arereflected in the deferred tax assets of companies,adjustments to the carrying amounts may be neces-sary.

• What issues would repeal of the AMT create? Underboth plans, the panel has recommended repealingthe AMT for both businesses and individuals. To theextent a company has an AMT credit carryforward,Congress may need to consider those carryforwardsin transitional rules.

• What additional transition issues would arise if theGrowth and Incentive Tax Plan were adopted? Inconsidering that plan, one would have to addresstransition issues, including:• Unrecovered tax basis of existing depreciable

assets (the panel recommended a five-yearphaseout period for depreciation allowances)and existing inventory. The remaining tax basis

of the amount of financial reporting over the tax basis of aninvestment in a foreign subsidiary (or foreign joint venture) thatis permanently reinvested overseas. Thus, APB 23 assumes anentity provides for income taxes on the unremitted earningsunless the entity can show that those earnings are permanentlyreinvested.



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of capital expenditures purchased in prior yearswould need to be addressed in transition rules. Itseems unlikely the government could allow for acurrent-year deduction of the remaining, un-depreciated tax basis in a single year after anytransitional period.

• Adjustments resulting from the change to a cashflow basis from an accrual basis, especially itemsof income and expense that have been recognizedunder the accrual basis but would be reflected infuture cash flows.

X. Real EstateHighlights and Potential Implications

Simplified Income Tax Plan• Steers investors away from real estate investments

by eliminating current tax law advantages of part-nerships over C corporations and eliminating thefavorable individual capital gain rates on the sale ofreal estate.

• Eliminates incentives to invest in affordable rentalproperties.

Growth and Investment Tax Plan• Increases economic returns on investments in real

estate in the short term through immediate expens-ing of business assets.

• Repeals deduction for business and investment in-terest expense, which could offset the economicbenefit of immediate expensing.

A. Simplified Income Tax PlanCurrently, much of the investment in real estate is

made through passthrough entities (for example, part-nerships, LLCs, and S corporations) in part because (i)only one level of tax is imposed on the earnings of thoseentities at the owner level; (ii) the character of gains,income, deductions, and credits passes through to theowners, and, thus, for example, individual owners aretaxed at the lower capital gain rates on the passthroughof capital gains; and (iii) losses pass through to theowners and may be used to offset an owner’s otherincome. Under the plan, the tax on ‘‘large’’ passthroughentities at the same 31.5 percent tax rate as large Ccorporations, the elimination of the shareholder-level taxon corporate dividends, and the taxation of gains on thesale of real estate at ordinary rates would eliminate thecurrent-law tax advantage of partnerships over C corpo-rations.

For example, under current law, capital gain on thesale of real estate by a partnership is passed through tothe partners. Noncorporate partners are subject to amaximum capital gain rate of 25 percent on ‘‘unrecap-tured section 1250 gain’’ and 15 percent on any remainingcapital gain. Under the plan, that capital gain would betaxed at the entity level at a 31.5 percent rate. To avoid the31.5 percent business entity tax, tax-exempt investorsmight invest directly in real estate, rather than throughpartnerships with other tax-exempt or taxable investors.

The elimination of the tax benefits associated withsome types of passthrough entities may reduce the taxbenefits and increase the tax costs associated with realestate, which could cause investors to shift some of theirinvestment dollars away from real estate. Individuals

might also choose to reduce their investments in realestate because gains on the sale of real estate would betaxed at ordinary rates, as opposed to gains on the sale ofstock in U.S. corporations, which would benefit from a 75percent deduction.

REITs would continue to be treated the same as undercurrent law. Thus, it appears that a REIT would not besubject to income tax to the extent it distributes itsearnings, and instead, as under current law, shareholderswould be taxed on the dividends received, althoughthere would be no favorable capital gain rate for capitalgain dividends received by individuals.

The repeal of the low-income housing credit mayaffect investments in affordable rental properties. Also,the mortgage interest deduction for investment propertymay be limited, thereby affecting investors’ decisions toinvest in rental properties and thus affecting the rentaland housing markets.

The immediate deduction for small businesses underthe simplified corporate tax for all business capital ex-penditures (except for building and land purchases) anda simplified depreciation system for medium-size busi-nesses could decrease the administrative burdens im-posed on those businesses in connection with theirinvestments in assets that, under current law, haveshorter-term useful lives. Land would continue to benondepreciable and buildings would continue to bedepreciable, but at a uniform 4 percent rate of theirundepreciated balance for residential buildings and a 3percent rate for nonresidential buildings for small,medium-size, and large businesses. For medium-sizebusinesses, the inclusion of the full gross proceeds fromthe sale of depreciable assets, coupled with the apparentinability to currently deduct the remaining basis ofdepreciable assets (unless all of the assets in a particularcategory are disposed), could act as a disincentive todispose of recently acquired depreciable assets (whichwould have a relatively high tax basis under current law)in a taxable transaction. Medium-size businesses mightchoose not to use the simpler accounts-based system forthat reason.

For primary residences, the reduction in the rate andbenefit of the mortgage deduction under the home credit,coupled with the elimination of the deduction for realproperty taxes, could substantially reduce the values ofsome residential real estate, which in turn would affecthomebuilders, land developers, and investors in multi-family properties. Individual investors who sell realestate owned directly, rather than through an entity,would pay federal income tax on long-term capital gainat ordinary rates. This elimination of capital gain treat-ment for real estate would apply not only to business andinvestment real estate, but also to personal residences, sothat capital gain on the sale of a personal residence inexcess of the exclusion ($500,000 under current law,$600,000 indexed for inflation, under the plan) would betaxable at ordinary rates. The elimination of the deduc-tion for state and local income and real estate taxes wouldalso affect the form and debt leverage of real estate




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What Are Deferred Tax Assets and Liabilities?

Generally, most items of revenue and expense included in pretax income for financial reporting purposes are alsoincluded in taxable income in the same year. However, some items are recognized for financial reporting purposesbefore or after the items are recognized for tax purposes. Over time, those ‘‘temporary’’ differences arise in one period,reverse in another, and eventually offset each other. Some other items do not have tax consequences (for example,some revenues are exempt from taxation and some expenses are not deductible) and may give rise to temporarydifferences.

Income tax expense for financial reporting purposes equals the current income tax expense (that is, the amount dueper the income tax return) plus the deferred tax expense (that is, the amount related to the change in temporarydifferences). Increases in deferred tax liabilities and reductions in deferred tax assets increase a company’s income taxexpense, while reductions in deferred tax liabilities and increases in deferred tax assets reduce a company’s incometax expense. Deferred tax assets and deferred tax liabilities represent basis differences between the tax basis andfinancial reporting basis of items and are measured using the enacted tax rates expected to apply to taxable income in theperiods in which the deductible or taxable temporary differences are expected to be realized or settled. If newlegislation is enacted that changes this rate, the effect of the change on deferred tax assets and liabilities is recognized as acomponent of income tax expense from continuing operations in the period the change is enacted (FAS 109.27).

Deferred Tax Assets

Deferred tax assets generally result from:Revenues or gains that are taxable before they are recognized for financial reporting purposes. For example, an advance

payment may be taxable in an earlier period than reported for financial statement purposes. Assume Company Arecognizes $100 of income for tax purposes in Year 1 that is not reportable for financial statement purposes until Year2. If the enacted tax rate is 35 percent, Company A would record for financial statement purposes in Year 1 a deferredtax asset of $35, which would remain on the financial statements until the temporary difference reverses (in this case,Year 2).

Expenses or losses that are deductible after they are recognized as an expense for financial reporting purposes. An examplewould be a liability (for example, a bad debt) that may be recognized as an expense for financial reporting purposesbut will not be deductible for tax purposes until a future period when the liability is settled (for example, thereceivable is written off). Other examples include (1) accrued environmental liabilities, (2) pension and OPEBliabilities, and (3) accrued warranties.

Carryforwards. These are deductions or credits that cannot be used on the current-year tax return and that may becarried forward to reduce taxable income or taxes payable in a future year. A tax net operating loss carryforward is anexcess of tax deductions over taxable gross income in a year; a tax credit carryforward is the amount by which tax creditsavailable for use exceed statutory limitations. Different tax jurisdictions may have different rules governing whetherexcess deductions or credits may be carried forward and the length of the carryforward period.

Valuation Allowance

The carrying amount of a deferred tax asset may need to be reduced by a valuation allowance. A valuationallowance is recognized if, based on the weight of available evidence, it is more likely than not (likelihood of morethan 50 percent) that some portion, or all, of the deferred tax asset will not be realized. For example, a start-upcompany with a NOL carryforward and no expectations of future profitability may require that the carrying value ofa deferred tax asset resulting from the NOL carryforward be reduced to zero by applying a 100 percent valuationallowance.

Deferred Tax Liabilities

Deferred tax liabilities generally result from:Revenues or gains that are taxable after they are recognized for financial reporting purposes. An asset (for example, a

receivable from an installment sale) may be recognized in revenues for financial reporting in an earlier year, but willresult in future taxable income in a subsequent period when the asset is recognized for tax purposes. A deferred taxliability would be established to account for the future tax liability.

Expenses or losses that are deductible before they are recognized as an expense for financial reporting purposes. The cost ofan asset (for example, accelerated depreciation on certain depreciable personal property) may have been deducted fortax purposes faster than it was recovered for financial reporting purposes. Other examples include separatelyidentifiable intangible assets with an indefinite life for financial reporting purposes, but a 15-year amortization for taxpurposes.



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investments by individuals. (For additional discussion ofthe proposed change in treatment of home mortgageinterest, see Part III.)

B. Growth and Investment Tax PlanThe immediate expensing of all business assets, in-

cluding real estate (that is, land and building), coupledwith the indefinite carryforward period for losses (in-cluding the increase in the NOL for interest), couldsignificantly increase the economic returns relating toinvestments in real estate in the short term. For example,most purchases of rental real estate properties (for ex-ample, offices, apartment buildings, and so on) wouldlikely result in a significant loss in the year of purchase(that is, the expensing of the cost of the purchase wouldgreatly exceed the operating income derived on the rentalof the property), and that loss could be carried forwardand offset operating income for several years. The imme-diate deduction of the entire purchase price of businessand investment real estate could significantly increase itsvalue in the short term, perhaps generating overbuildingsimilar to the result of the 15-year write-off for real estate,enacted in 1981, which later contributed to the real estatebust beginning in the late 1980s.

Conversely, the repeal of the deduction for businessand investment interest expense could offset the eco-nomic benefit of the immediate expensing. The entity-level tax on the net positive cash flow of passthroughentities at the same rate as C corporations would elimi-nate the tax advantage of partnerships over C corpora-tions under current law.

As discussed in this part, the reduction in the rate andbenefit of the mortgage deduction under the home credit,coupled with the elimination of the deduction for realproperty taxes, could substantially reduce the values ofresidential real estate, which, in turn, would affect home-builders, land developers, and investors in multifamilyproperties.


• Would income, gains, and deductions from realestate held for investment by an individual, partner-ship, or LLC be treated as business income anddeductions?

• Would entities that are disregarded for federal in-come tax purposes under current law be treated asentities subject to entity-level tax under the plan?

• Would the subchapter K regime remain in place forsmall partnerships?

XI. Financial ServicesHighlights and Potential Implications

Simplified Income Tax Plan• Taxes inside buildup in life insurance policies and

annuity products.• Expands compliance responsibilities of financial in-

stitutions.• Taxes many hedge funds at the entity level, materi-

ally affecting economics of these funds.• Increases possibility of defaults and foreclosures on

existing mortgages.Growth and Investment Tax Plan

• Requires financial institutions to treat all principaland interest inflows as taxable income and to deductall principal and interest outflows.

A. Simplified Income Tax Plan1. Entity-level taxation. At the entity level, a reduction incorporate income tax rates would be beneficial to finan-cial service corporations, subject to the effect of any basebroadening through the elimination of special prefer-ences (such as for banks and insurance companies).However, with limited exception (significant exceptionsbeing RICs (mutual funds) and REITs), the plan wouldrequire corporate tax to be paid by all business entitieswith receipts of more than $10 million regardless of entityform. That means that many financial service entitiesoperating, for example, as partnerships, LLCs, and Scorporations would now be required to pay an entity-level tax at corporate rates. That would represent afundamental change in how those entities operate andinteract with their partners/shareholders and wouldrequire a thorough reexamination of the structuresthrough which they do business.2. Effect of increased savings. To the extent that savingsis encouraged under the proposed Simplified Income TaxPlan, and, in fact, increases, financial institutions shouldbe beneficiaries of the additional capital saved. Theexclusion from tax of dividends attributable to U.S.-taxedincome of U.S. corporations, along with the 75 percentexclusion for capital gains on the sale of stock in U.S.corporations, should be a further boon to investing andtrading in U.S. corporate stock. Investing in foreignstocks would presumably be disadvantaged without thespecial exclusions targeted to U.S. stock.3. Compliance responsibilities. Under the SimplifiedIncome Tax Plan, the compliance responsibility of finan-cial institutions for their customers would expand sig-nificantly. Currently, banks and other lending institutionsthat service home mortgage loans are required to reportdeductible interest and points to the IRS and borrowersannually on Form 1098. Under the plan, those institutionswould be required to determine how much of eachborrower’s interest payments qualify for the home creditusing the information available from the FHA and wouldbe required to provide that information to borrowers andthe IRS.

Also, banks would be required to provide small andmedium-size businesses with an annual statement ofaccount inflows and outflows from the designated bankaccounts required under the Simplified Income Tax Plan,and that summary would be reported directly to the IRS.Similarly, issuers of debit and credit cards would berequired to report to businesses and the IRS payments forcredit and debit card purchases of their cardholders.4. Mortgage lending. The limitation on the deductibilityof home mortgage interest and the elimination of thededuction of state and local taxes may adversely affectmortgage lending and related activities. As the effectivecost of capital to the homeowner becomes more expen-sive for higher-priced and second homes, prices maydrop and the demand for funds may decline. As thefive-year transition rule for the mortgage interest deduc-tion would not apply to interest on second homes, home



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equity loans, refinanced mortgages, or new mortgages,the possibility of defaults and foreclosures may increase.5. Tax-exempt bonds. As compared to other asset classes,tax-exempt bonds may lose some of their appeal underthe proposed Simplified Income Tax Plan. That would becaused by the reduction in the tax benefit from holdingtax-exempts compared to other investment alternatives.Also, the plan would eliminate the exclusion of state andlocal tax-exempt bond interest from business income,thereby reducing demand from many corporate custom-ers.6. Insurance industry. The insurance industry would besignificantly affected by the dramatic changes resultingfrom the implementation of the plan. Insurance productsare the subject of numerous provisions in the plan.Notably, the plan would, for the first time, provide for thetaxation of the inside buildup in life insurance policiesand annuity products, except for those purchasedthrough tax-deferred save for retirement and save forfamily accounts (which are subject to dollar limits).Changes in the tax treatment of employer-providedfringe benefits, such as life insurance premiums, and theproposal to cap the deduction for the cost of healthinsurance premiums (and the related income exclusionfor employees), would generally increase the after-taxcost of certain insurance products. On the other hand, insome instances, the plan would decrease the after-tax costof certain insurance products. For example, taxpayerswho do not have access to employer-provided healthplans would now be allowed a deduction for healthpremiums equal to the exclusion enjoyed by workerswhose employers provide health insurance.

On balance, however, the plan would have far-reaching repercussions, in particular, for life and annuitycompanies and their agents and brokers, whose salescould be reduced materially.7. Hedge funds. Hedge funds and hedge fund structureswould be significantly affected by the plan. Except foroffshore corporations in which U.S. tax-exempt and non-U.S. persons generally invest, hedge funds are generallytreated as partnerships for U.S. income tax purposes.Thus, to the extent that a hedge fund is treated as a largebusiness entity, it would be taxed at the entity level as acorporation, materially affecting its economics (for ex-ample, domestic earnings would be subject to tax at thebusiness level; owners would obtain the benefits of the100 percent exclusion for U.S. company domestic divi-dends and the 75 percent exclusion of capital gains on thesale of their interest in a U.S. fund). Investing throughmanaged accounts, which could presumably take advan-tage of the special treatment of dividends and capitalgains, may avoid that corporate-level taxation.

Also, deferred compensation for managers of offshorehedge funds, a key attribute of many hedge fund struc-tures, would be adversely affected by the general provi-sion on deferred compensation under the SimplifiedIncome Tax Plan. Thus, amounts deferred under a non-qualified deferred compensation plan would be includedin income to the extent those amounts are not subject toa substantial risk of forfeiture and were not previouslyincluded in income.8. Territorial tax regime. As a general rule, under theterritorial tax regime contained in the Simplified Income

Tax Plan, income earned abroad by controlled foreigncorporations and foreign branches of U.S. corporationswould be treated in one of two ways: (1) as ‘‘foreignbusiness income,’’ active business income which wouldgenerally be exempt from U.S. taxation at the businesslevel when repatriated as a dividend; and (2) as ‘‘mobileincome,’’ passive and highly mobile income, includinginterest, dividends, rents, and royalties from passiveassets, which generally would be taxed by the UnitedStates when earned. However, the panel recognized thatfinancial services businesses, such as banks, securitiesdealers, and insurance companies, earn interest and othertypes of mobile income in the conduct of their activebusiness. Accordingly, under the plan, special ruleswould be provided under which qualifying financialservices income would be treated as foreign businessincome to the extent that the income is earned throughactive business operations abroad. Further, antiabuserules would be provided to prevent passive investmentincome earned by financial services businesses frombeing treated as foreign business income.

Perhaps the most significant effect of the proposedterritorial tax regime on financial service corporationswould be the treatment of foreign branches of U.S.financial service corporations, which, under current law,are taxed subject to applicable FTCs. Under the plan,income of foreign branches would be treated the same asthat of foreign affiliates under rules that would treatforeign trades or businesses conducted directly by a U.S.corporation as foreign affiliates. In the case of financialservices businesses, the result would generally be foreignbusiness income exempt from U.S. taxation.

B. Growth and Investment Tax Plan1. Taxation of financial institutions. Under the Growthand Investment Tax Plan, financial institutions wouldtreat all principal and interest inflows as taxable incomeand deduct all principal and interest outflows. Absentspecial rules, businesses that primarily provide financialservices would have perpetual losses under this plan.Those losses would occur because the cash flow tax basefor those financial entities would not include the rev-enues that they generate from lending and investing atrates above their cost of funds, but would, however,allow a deduction for the cost of compensation of work-ers as well as other purchases.

2. Compliance responsibilities. To prevent the overtaxa-tion of business purchases of financial services under theGrowth and Investment Tax Plan, financial institutionswould be required to inform business customers of theamount of financial cash flows that are attributable todeductible financial intermediation services.

3. Hedge funds. Just as in the case of the SimplifiedIncome Tax Plan, hedge funds would be affected underthe Growth and Investment Tax Plan, as a result of thetaxation of passthrough entities at the business tax rate.Mechanically, owners of those entities under the Growthand Investment Tax Plan could report and compute thetax on the net business cash flow on a separate scheduleof their individual returns. However, net business cashflow is a very different tax base than dividend, interest,and capital gain income, and that would need to be taken



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into account in evaluating what, if any, changes wouldneed to be made to hedge fund planning and structure toeffect the best tax result.


• Would special tax provisions for financial institu-tions, such as banks and insurance companies, beeliminated as part of the Simplified Income TaxPlan?

• What would be the effect of a territorial tax regimeon the business of global financial institutions?

• What is a financial service business and what isqualifying financial service business income forpurposes of the territorial tax regime?

2. Growth and Investment Tax Plan• What is a financial institution for purposes of the

Growth and Investment Tax Plan?• What rules would be implemented to address busi-

nesses that have both financial and nonfinancialbusiness activities?

• How would the tax liability of financial institutionsunder the plan’s cash flow tax base compare to thetax liability under the existing system of taxation?

• What specialized transition rules would apply tofinancial institutions and products?

• What legal, implementation, and execution burdenswould be placed on financial institutions in fulfill-ing their obligation to provide financial cash flowinformation to business customers regarding finan-cial intermediation services?

• How would the destination-basis cross-border taxa-tion rules operate and be implemented for financialservice businesses?

• How would hedge fund and master/feeder struc-tures be taxed?

XII. Retail and Consumer ProductsHighlights and Potential Implications

Simplified Income Tax Plan• Reduces corporate tax rate, benefiting retailers who

currently have few available tax credits or incen-tives.

• Eliminates some existing tax deductions (for ex-ample, state income tax, mortgage interest), depress-ing consumer spending.

Growth and Investment Tax Plan• Makes imports nondeductible, raising retail prices

significantly, which could hurt retailers but couldhelp domestic manufacturers.

• Raises the tax cost of imported fuel, increasing thecost of making and distributing goods.

• Benefits retailers that own their own buildings byallowing immediate deductibility of capital invest-ments.

A. Simplified Income Tax Plan1. Corporate income tax

i. Rate reduction. A reduction in the corporate tax rateto a maximum 31.5 percent would be welcomed by bothretailers and consumer products manufacturers. Underthe current tax system, retailers and consumer productscompanies have typically had one of the highest effective

tax rates because they enjoy few tax breaks, credits, andincentives (for example, work opportunity tax credit(WOTC), welfare-to-work, research credit, and so on).Because of their traditionally high effective tax rates,retailers especially stand to gain from a rate reduction.

ii. International tax changes — territorial system.Because the majority of U.S. retailers do not have signifi-cant foreign-source income, the proposed territorial sys-tem would be of limited benefit to most in the retailindustry. For retailers that have an international presence,the territorial system would likely be a welcome change,facilitating the tax-free repatriation of foreign earnings.Large consumer products companies with internationaloperations would similarly benefit from the territorialsystem, simplifying FTC and repatriation planning.2. Individual income tax

i. Home credit. Replacing the home mortgage interestdeduction with a 15 percent home credit would on itsface increase the tax burden of individual taxpayers inhigh-priced demographic regions such as New York andCalifornia, among others. That would result in a corre-sponding reduction in disposable income in those demo-graphic groups, with some slight effect on retailers thatsell to middle- to upper-middle-class markets.

The reduction of the home mortgage interest taxbenefit could continue or speed the current cooling of thehousing market, which has already slowed as a result ofrising interest rates. As real estate activity slows, consum-ers may not have the same disposable income that theyhave had in the past few years with the recent refinancingboom. Also, industry studies show that consumers spendsignificant amounts when moving into new homes.Therefore, a secondary effect of reduced real estate activ-ity could be a reduction in consumers’ demand for manysignificant retail items, such as furniture and appliances.That too could chill the U.S. consumer spending that hasbeen the backbone of the economy over the past fewyears, negatively affecting retail sales.

ii. Four-pronged ‘savings package.’ In general, incen-tives to save may have some negative effect on consumerspending, which could negatively affect both retailersand consumer products companies. Nevertheless, theU.S. consumer may continue to spend robustly, evenwhen offered additional incentives to save.

B. Growth and Investment Tax Plan1. Corporate tax rate of 30 percent. As under the Simpli-fied Income Tax Plan, a reduction in the corporate tax ratewould be welcomed by retailers and consumer productsmanufacturers. Because retailers and consumer productscompanies currently enjoy few tax credits and incentives,they would generally expect to be in a better positionunder a credit-free rate of 30 percent.2. Immediate deduction for capital expense; eliminationof interest expense. To the extent retailers and manufac-turers own their own buildings (note that roughly 50percent of retailers own their stores), they could signifi-cantly benefit from immediate deductibility of capitalinvestments, despite the elimination of interest deduct-ibility. For shorter-lived items, like equipment, the elimi-nation of the deductibility of interest would be more orless offset by the immediate deductibility of capitalexpenditures, depending on a number of factors. For



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example, a typical retailer or manufacturer purchasing anew piece of distribution center equipment for $10 mil-lion would instead be able to immediately deduct the full$10 million, rather than taking an interest deduction of$700,000 per year (at 7 percent interest, fully financed)and a depreciation deduction of $2 million per year(five-year property). On a simplified level, a retailer withan 11 percent rate of return would, in theory, be indiffer-ent to those two options. For a building, however,immediate deductibility would be significantly morevaluable than depreciation over 39 years with an interestdeduction benefit.3. Border adjustability; nondeductibility of imports.The nondeductibility of imports could have a negativeeffect on retailers, depending on economic adjustmentsand transition rules, and a potentially positive effect ondomestic manufacturers. In almost every subsector of theindustry, retailers source many of their goods fromoffshore locations such as China. By markedly increasingtheir import volumes over the past few years, U.S.retailers have become reliant on foreign-made goods tosupport low retail prices in today’s competitive retailenvironment. Under the plan, if the cost of imports werenot deductible, retailers could be forced to absorb at leastsome of an additional 30 percent tax on the portion oftheir merchandise that was imported. To preserve theirmargins and profitability, retailers would attempt to raiseretail selling prices. That could result in a retail sellingprice increase of roughly 15 percent for items or inven-tories in which 50 percent of their cost is made up ofimports. Depending on the subsector, the customer base’ssensitivity to price increases, the original price point ofmerchandise, and the degree to which a retailer sellsimported goods, the retail selling price increase thatcould result from this proposal may have an adverseeffect on some retailers’ businesses. Certainly, competi-tive dynamics would change between competitors withdifferent mixes of domestic/imported products.

To the same degree, consumer products companies inthe United States could receive a benefit from thisprovision. As the cost of competitors’ imported productswould become ineligible for tax deductibility, effectivelyincreasing the cost of the goods by 15 percent, domesticmanufacturers would be able to sell more of their prod-ucts at higher prices. Domestically produced productscould increase in price, improving U.S. manufacturers’profitability. Nevertheless, to the extent U.S. consumerproducts companies used imported materials in theirmanufacturing processes, their cost structures and taxburdens could also increase. All considered, this could bea substantial benefit to domestic manufacturing.

For both retailers and manufacturers, perhaps themost significant costs affected by the nondeductibility ofimports would be transportation costs driven up by theincreased ‘‘cost’’ of nondeductible imported gasoline andoil. (See the discussion in Part XIV.B.1.) Not only wouldthe nondeductibility of imported fuel costs drive uptransportation and other costs of retail and manufactur-ing, but it could also affect how much money is inconsumers’ pockets.


• What is the bottom-line effect on consumers? Be-cause the effect of the tax reform plan on consumerspending would ultimately depend on the degree towhich different classes of consumers ‘‘win’’ or‘‘lose,’’ and because the bottom-line change in dol-lars in consumers’ pockets is difficult to quantify atthis time, the effect of the Simplified Income TaxPlan on consumer spending remains a wild card.Under the plan, wealthier individual taxpayerswould certainly be adversely affected by the changein treatment of home mortgage interest. Combinedwith the nondeductibility of state and local incometaxes, that could negatively affect the spending ofmiddle- to upper-middle-class consumers (espe-cially in states with high income tax rates, likeCalifornia and New York).A reduction in capital gains rate could increasehigher-income-class spending or may have a morelimited effect, as capital gain income may be morelikely to be saved or reinvested than wage income.

2. Growth and Investment Tax Plan• Would nondeductibility of imports slow consumer

spending? The potential effect of the plan is difficultto anticipate. The nondeductibility of importswould essentially act as a customs duty of 30percent on imported consumer products, potentiallyslowing consumer spending due to a ‘‘stickershock’’ effect, especially on big-ticket items such ascars and plasma televisions, if there are not largeoffsetting exchange rate adjustments.

• Would retailers be subject to international sanc-tions? The plan could, depending on many factors,violate some international trade agreements. Be-cause of the potential for the WTO to imposesanctions on any affected industry, the combinedburden of sanctions imposed may be aimedsquarely at a particular industry. There is some riskthat U.S. manufacturing or retailers may be affectedby potential international trade organization sanc-tions.

• How would financial institutions be taxed? Becausethe plan remains unclear on the details of howfinancial institutions would be taxed, many unan-swered questions exist around how financial opera-tions of retailers would be taxed.

XIII. Industrial ProductsHighlights and Potential Implications

Simplified Income Tax Plan• Encourages the migration of research activities and

intellectual property development offshore by elimi-nating the research credit.

• Strengthens U.S. competitiveness in the global mar-ket under a territorial tax system.

Growth and Investment Tax Plan• Permits immediate expensing, but eliminates inter-

est deductions associated with capital expenditures.• Subjects manufacturers that import parts and com-

ponents, but are not large exporters, to greater nettaxation.



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A. Simplified Income Tax Plan1. Tax on dividends. The plan would reduce the currentdouble federal taxation of corporate income by allowingU.S. taxpayers to receive tax-free dividends paid out of aU.S. corporation’s domestic earnings, as well as 75 per-cent of capital gains from the sale of corporate stock.These changes should further encourage greater invest-ment in industrial products (IP) manufacturers.2. Corporate rate reduction. The panel proposed a newcorporate tax rate of 31.5 percent but also recommendedeliminating many deductions and credits. For many IPmanufacturers, the proposed 31.5 percent rate may not below enough to offset the tax increase that would resultfrom the loss of deductions and credits. For IP manufac-turers benefiting from the domestic production deduc-tion, the rate change would not be much lower than thetop effective corporate rate they will enjoy by 2009 (justunder 32 percent).3. Elimination of the research credit. The proposedelimination of the research credit, as well as the possibleelimination of the deduction for R&D expenses (see Table5-2 on p. 1279), would increase research costs for IPmanufacturers that perform research in the United States.Given the tax incentives many foreign governments offerto companies that perform research in their countries,this change could prompt IP manufacturers to movemuch of their U.S.-based research activities and intellec-tual property offshore.4. Territorial tax system. The panel’s recommendationthat the United States adopt a territorial tax systemwould likely affect IP manufacturers, many of which aremultinational companies, more than the other proposedreforms. U.S.-based IP manufacturers would likely favorthe proposed tax-free repatriation of overseas activeincome because it would foster long-term domestic eco-nomic growth and job creation, and would clearlystrengthen U.S. competitiveness in the global market.

A territorial system would also affect multinational IPmanufacturers in terms of capital inflow and outflow.Multinationals with excess FTCs and/or overall foreignlosses would no longer be deterred from repatriatingprofits earned outside the United States and would notneed to engage in extensive tax planning and othercost-reduction efforts to repatriate cash to the UnitedStates. Outbound investments for new plants and facili-ties would be based more on other business issues and beless tax-sensitive.

However, some aspects of a territorial system maydisadvantage IP manufacturers. The elimination of for-eign tax credits would end cross-crediting between high-taxed dividends and low-taxed mobile income, such asroyalties. Increased scrutiny of transfer pricing, an issuemany multinational companies identified in Ernst &Young’s Global Transfer Pricing Survey as their numberone tax issue, also would likely result, as territorialitymight give multinationals an incentive to shift incomeoffshore if doing so would make that income exemptfrom U.S. tax and subject it to low or no foreign tax.5. Passthrough entities. Many IP manufacturers usepassthrough entities in joint ventures with other suppli-ers or companies that are designed to reduce productioncosts and/or share technology. Multinational IP manu-

facturers use passthrough entities to optimize theirworldwide tax position by offsetting gains from profit-able entities with losses from unprofitable entities. Theplan’s proposed elimination of the distinctions betweencorporations and passthrough entities for federal taxa-tion purposes would require IP manufacturers to re-evaluate their existing structures and possibly alter theirfuture tax planning strategies. To the extent those manu-facturers would have to reorganize or restructure theiroperations, their state and local tax planning would beaffected.6. Employer-provided healthcare. The plan’s limitedincome exclusion for employer-provided health coveragewould affect IP manufacturers with organized laborworkforces, particularly automotive manufacturers. Byoffering an exclusion with relatively high limits ($11,000for families, $5,000 for single individuals), the planwould enable employees to continue shifting the grow-ing cost of healthcare to employers and the government,effectively increasing product costs. To lower those costs,IP manufacturers would likely prefer a lower exclusionamount, which would encourage cost-sharing of em-ployee health expenses between employers and employ-ees, thereby lowering product costs and allowing them tobetter compete globally.

B. Growth and Investment Tax PlanAspects of the panel’s Growth and Investment Tax

Plan could prove controversial for IP manufacturers,given the global nature of their operations and how theyfinance their capital assets. The frequency with which IPmanufacturers must update or replace their capital assetswould make the plan’s 100 percent expensing for capitalexpenditures appealing; the proposed elimination of thededuction for interest, in contrast, would likely hurt IPmanufacturers, as they largely use debt to finance theircapital assets. Ultimately, the loss of the interest deduc-tion would likely offset the benefits of 100 percentexpensing enough to make the Growth and InvestmentTax Plan little more than a break-even proposition formost IP manufacturers. To the extent immediate expens-ing generated losses that could be carried back to profit-able tax years, the plan could be a positive stimulus fordistressed IP manufacturers in the automobile, airline,steel, and other capital-intensive industries.

The plan would also prohibit manufacturers fromexpensing imported goods, but would not tax exports.For domestic IP manufacturers whose products containimported parts and components, such as automobilemanufacturers, the disallowance for imported goodswould significantly increase production costs on domes-tically manufactured goods. The plan would likely resultin greater net taxation for U.S. automobile manufacturersbecause they are not large exporters of finished products.Whether IP manufacturers would benefit under the planwould depend on where they source their raw materialsand where they sell their finished products.

C. Unanswered Question1. Growth and Investment Tax Plan

• Who in the supply chain would be viewed as theimporter and how would this be reflected on theitem losing or retaining its character as an import?Consider the question of whether to use a supply



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company that is in a chronic business loss position(an NOL company) as the initial importer. Assume aforeign company would be the exporter of the part(raw material) to a U.S. auto manufacturer as thefinal tier in the supply chain:‘‘Foreign Co.’’ sells/exports a part to be used in themanufacture of an automobile; this part is pur-chased by U.S.-based ‘‘NOL Supplier’’ for $45. NOLreceives the part and processes it for shipment toU.S.-based ‘‘ABC Motor Company.’’ ABC pays NOL$49. Will ABC get to take a $49 deduction for thepart? Did the part lose its character as an import onthe domestic-to-domestic sale? Would the IRS disal-low use of the NOL entity as a sham transaction?Would the answer change as NOL Supplier goesfrom being a mere middleman to a value addedprocessor?This proposal raises the ‘‘border adjustability’’ issue.More specifically, would this treatment of an importfrom Mexico or Canada violate the North AmericanFree Trade Agreement? Further, if the import werefrom another non-U.S. country, would there bepossible WTO consequences?

XIV. Energy and UtilitiesHighlights and Potential Implications

Simplified Income Tax Plan• Repeals credits and special preferences, which

would be especially problematic for the oil and gasindustry.

• Repeals the AMT but also repeals the percentagedepletion allowance, which would cause most min-ing companies to pay more in cash taxes.

• Eliminates direct expensing for exploration anddevelopment costs for new and expanded mines.

• Eliminates tax on dividends, which will enhance thevalue of utility industry stocks.

Growth and Investment Tax Plan• Eliminates deduction for imported goods and inter-

est.• Allows direct expensing of capital additions, which

would reduce the tax burden of the highly capital-intensive gas and electric utilities industries.

A. Simplified Income Tax Plan1. Oil

i. Rate reduction. While lowering the tax rate to 31.5percent would be helpful to an industry with as muchtaxable income as the oil industry, the qualification of theindustry’s domestic activities for the section 199 domesticproduction deduction has already moved the industrytoward a 32 percent tax rate.

ii. AMT repeal. Although the oil industry has tradi-tionally favored repeal of the corporate AMT, the tax’srepeal now would not benefit the industry because noneof its members is an AMT taxpayer as a result of currentcommodity price levels.

iii. Credits and preferences. The proposed repeal ofcredits and special preferences would be one of the plan’smore problematic aspects for the oil and gas industry.The oil industry has been very successful over the yearsin lobbying for tax benefits, as well as tax provisions that

address the peculiar nature of this industry. Enactment ofthe plan would certainly mean repealing tax credits likethe enhanced oil recovery (EOR) and the section 29credit. Less certain would be the current treatment ofintangible drilling and development costs (IDCs) andgeological and geophysical costs (G&G). If those lattertax provisions were repealed, it is unclear how thoseexpenses would be recovered under the plan.

iv. Territorial tax system. Moving to a territorial taxsystem would basically be a wash for the oil industry. Oilcompanies generally have significant excess FTCs be-cause of the high rate of tax in host countries. A territorialsystem would certainly reduce administrative costs, butwould likely not result in large U.S. tax savings. Thecompanies generally pay little or no U.S. tax on foreign-source income.

v. Depreciation. The Simplified Income Tax Plan’sdepreciation system contains two categories of nonbuild-ing assets: upstream (exploration and production) indus-try assets are currently recovered over 7 years; refineryassets are recovered over 10 years. Under the plan’ssimplified cost-recovery system, Category I assets in-clude mining and manufacturing assets and Category IIassets include energy production assets (like long-livedutility assets). It is unclear whether oil and gas assets areCategory I or Category II assets. Presumably, refiningassets are manufacturing assets and are depreciated atthe 30 percent recovery rate. Because upstream assetscurrently have a shorter life than refinery assets, it is notreasonable to assume they will be called ‘‘energy produc-tion’’ assets and recovered at the slower 7.5 percent rate.

vi. Research and development. Most of the researchand development (R&D) done in the oil industry is donein the United States. Not having to allocate R&D ex-penses to foreign-source income other than mobile in-come would be a benefit.

vii. Corporate integration. The effect of corporateintegration on the oil industry is unknown. The taxbenefit would be on the individual side, and the effect onstock prices would be the real issue for corporations.Because only ‘‘domestic’’ dividends and ‘‘domestic’’ capi-tal gains receive reduced rates, it may well be that thestock market would view corporations with largeamounts of foreign-source income as less attractive thancorporations that have only U.S.-source income.2. Mining

i. Rate reduction. While lowering the regular corpo-rate tax rate would generally be good for the industry,most mining companies already reduce their income taxbase substantially through the statutory depletion allow-ance that can permanently eliminate regular income taxon up to 50 percent of mining income.

ii. AMT repeal. The repeal of the corporate AMTwould at first appear to be a good proposal for mining inthe United States because (1) current law treats percent-age depletion benefits as preference items to be addedback when determining the AMT and (2) most miningcompanies are subject to the AMT as a result of thisadd-back. The tax benefit associated with percentagedepletion would presumably be eliminated, resulting inmost mining companies paying a higher level of cash



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taxes under the plan than under current law (20 percentAMT vs. 31.5 percent under the Simplified Income TaxPlan).

iii. Exploration and development. Under current law,mining companies enjoy direct expensing of explorationand development costs for new and expanded mines.Although it is not clear from the plan, those would likelybe treated as ‘‘special preferences’’ and eliminated.

iv. Territorial tax system. Moving to a territorial taxsystem would likely not affect mining companies sub-stantially. The mining industry is a global business thatoperates in less-developed countries that generally taxmining heavily. As a result, mining companies havesubstantial excess FTCs because of the high rate of tax inthe host countries. A territorial system would certainlyreduce administrative costs, but would likely not resultin U.S. tax savings. The companies generally pay little orno U.S. tax on foreign-source income.

Most of the R&D done in the mining industry is donein the United States. Not having to allocate R&D ex-penses to foreign-source income other than mobile in-come would be a benefit.

v. Depreciation. Currently, mining industry assets(depreciable equipment) are generally recovered over 7years. Downstream processing facilities may have longerclass lives, but typically no longer than 10 years. Underthe recommended simplified cost-recovery system, Cat-egory I assets include mining and manufacturing assets,so mining assets would enjoy a 30 percent cost-recoveryallowance. That would generally be more rapid thanunder current law.

vi. Corporate integration. The effect of corporateintegration on the mining industry is unknown for thesame reasons outlined in this part’s earlier discussion onthe implications of corporate integration for the oil andgas industry. As the mining industry is generally moreglobal in scope, those companies with large foreignoperations may become less attractive when compared totheir predominantly domestic counterparts.3. Electric and gas utilities

i. Eliminating tax on dividends. The integration ofcorporate-level tax eliminating individual income tax ondividends paid from U.S.-taxed earnings would likelyenhance the value of investing in utility stocks. Thosestocks tend to pay greater dividends than other indus-tries, so one would expect utilities to see substantialincreases in market values. Recent reductions in tax ondividends (to 15 percent) resulted in a similar change forutilities’ stocks.

ii. Rate reduction. Lowering the corporate tax rate to31.5 percent would result in lower cost of service forutilities, which would prompt public utility commissionsto evaluate the rates charged to electric and gas utilityservice customers for rate-regulated operations. Consum-ers would benefit from the lower tax burden on gas andelectric utility income. That benefit would be passed onin the form of lower electric and gas utility rates. How-ever, see the following comments regarding the unan-swered questions for the rate-regulated aspects of theplans. The timing of that benefit to the ratepayers wouldbe critical in determining how much the current ratemak-ing system and its stringent rules would need to changeto facilitate implementation of this provision.

iv. Depreciation. Currently, utilities typically have thepredominant portion of their depreciable assets catego-rized as 15- or 20-year property. Presumably, utilityindustry assets would be included in Category II assets(energy production) and would be recovered followingthe 7.5 percent rate. Although that would be muchsimpler, the benefit would generally be slightly less thanunder current law (which applies a 150 percent decliningbalance method). Other assets used by utilities currentlyenjoy much more rapid rates of depreciation, such aspollution control equipment, which may be included inCategory II. The simplicity offered in the plan could besomewhat hindered by the transition rules, which woulddetermine how these changes would be implementedand, more importantly in the utility context, when theywould be implemented for purposes of applying theeffect to their regulated rates for service.

v. AMT repeal. Many utilities become subject to thecorporate AMT due principally to adjustments related todepreciation and periodic erosion of the tax base due toextraordinary events (for example, storm damage) orspecific investments (for example, synfuel plant invest-ments). Repeal of the AMT would greatly simplify elec-tric and gas utilities’ income tax planning, as well asunderlying reporting of the AMT for regulatory pur-poses.

B. Growth and Investment Tax Plan1. Oil

i. Deductions. The Growth and Investment Tax Planwould have a dramatic negative effect on the oil industry.The dominant issue will be that no deduction is availablefor imported goods. Eliminating a deduction for im-ported goods would be the economic equivalent of a 30percent oil import fee. The price of domestically pro-duced oil would immediately rise to the same level. Atcurrent prices, that means that the price of a barrel of oilcould rise from $60 to $80, and the price of a gallon of gaswould increase by about 50 cents.

Other than the lack of a deduction for imports, theproposed cash flow tax would generally benefit the oiland gas industry because of the highly capital-intensivenature of the industry.

Although the loss of the interest deduction under theplan would hurt the industry, record recent profits haveallowed the industry to buy down debt, thereby reducingits interest expense.

ii. Rate reduction. Lowering the tax rate to 30 percentwould be helpful to the oil and gas industry, given theextent of the taxable income it currently has.

iii. Territorial tax system. Moving to a territorial taxsystem would basically be a wash for the oil industry, asoutlined in this part’s earlier discussion on the territorialtax system in the section on the Simplified Income TaxPlan. In contrast, exempting foreign-source income bymoving to a destination-based consumption tax wouldhave effectively raised the price of oil and refined petro-leum products by 30 percent, as detailed in the discussionon deductions in this section.

iv. Expensing domestic capital. The ability to expensedomestic capital would help the industry, but would beless beneficial to upstream activity than to refining assets



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(which are longer-lived under current law) because muchof the industry’s upstream costs are recovered as IDCs.

v. Exempting exports. Exempting exports from taxwould not help the oil industry much. No oil, and verylittle product, is exported from the United States.2. Mining

i. Rate reduction. The lower tax rate (30 percent)would generally be a good thing for the industry; how-ever, as noted earlier in this part, the trade-off of deduc-tions and special preferences for a lower rate couldactually result in a tax increase, depending on whichdeductions, credits, or special preferences are eliminated.

ii. Interest deduction. The loss of the interest deduc-tion under the Growth and Investment Tax Plan wouldhurt the industry because it is highly capital-intensiveand uses debt financing to a large degree.

iii. Direct expensing. Even with the benefits of directexpensing, mining companies would likely pay more taxunder this regime over time. The benefits of being able todirectly expense items, such as capital additions orexploration and development expenditures, would notoffset the presumed loss of the percentage depletionallowance under current law.

iv. Territorial tax system. The implications of a terri-torial tax system for the mining industry under theGrowth and Investment Tax Plan are substantially similarto those for mining under the Simplified Income TaxPlan, discussed earlier in this chapter.

v. Exempting imports. Exempting exports from taxcould help the mining industry, but the effect woulddepend on the nature of the commodity being mined. Forexample, most gold mined in the United States is gener-ally exported for further processing/refining. Aggregateproducers, however, almost never export their produc-tion. Note that the price of coal often trails the prices foroil and gas so the phenomena noted above for the oil andgas industry (that is, an increase in the price of oil) wouldresult in similar pricing adjustments for coal.3. Electric and gas utilities

i. Interest expense deduction. The proposed elimina-tion of the deduction for interest expenses would likelyaffect the debt and equity markets, which could indi-rectly affect the utility industry. Gas and electric utilitiesare highly capital-intensive and rely on debt and equitymarkets for financing. Elimination of the interest expensededuction would dramatically change the after-tax costof capital for gas and electric utilities, which is the basisfor determining the regulated rates for services.

ii. Direct expensing. Direct expensing of capital addi-tions would dramatically reduce the tax burden of thehighly capital-intensive gas and electric utilities. Over thenext 10 years, gas and electric utilities have substantialcapital investment plans for rebuilding and enhancingthe electric and gas transmission infrastructure in theUnited States. Under the Growth and Investment TaxPlan, those investments would be expensed.

Another possible effect of direct expensing would bean increase in market entrants. Under the current rateregulation system, many would-be market participantsfound distasteful the inability to see immediate financialresults from an investment and the need to prove theprudency of an investment to a public utility commis-sioner to ensure even the opportunity to recover any

portion of an expense. A direct expensing regime wouldadd more certainty to an investment’s financial effect, atleast for tax purposes, and eliminate the often time-consuming and potentially disappointing negotiationswith state commissioners.

iii. Rate reduction. A lower tax rate applied to utilities(30 percent) would lower their cost of service, whichcould result in lower cost of service for consumers. Asunder the Simplified Income Tax Plan, public utilitycommissions would be prompted to evaluate gas andelectric utility rates.

C. VAT ProposalUnlike the panel, which did not recommend a VAT,

the oil industry has advocated the replacement of theincome tax with a credit invoice VAT for more than 30years. The industry is used to dealing with a VAT inmany of the countries in which it operates. It alsobelieves a credit invoice VAT is simpler to administer, isborder-adjustable, captures the underground economy,does not discriminate between industries, does not dis-criminate between companies in an industry, and can bezero rated to deal with progressivity issues.

D. Unanswered Questions1. Simplified Income Tax Plan

i. Oil.• How would oil and gas assets be categorized for

depreciation purposes?• How would intangible drilling and development

and other unique industry expenditures (for ex-ample, G&G expenditures) be treated under theplan?

ii. Mining• Would the tax benefit associated with statutory

depletion be repealed under the Simplified IncomeTax Plan?

• How would mine exploration and development betreated? Would those expenditures be deducted asunder current law or would they be included inCategory I and recovered at a 30 percent rate?

• How would the existing AMT tax credit carry-forward amount be treated in the transition period?Most mining companies have substantial AMT taxcredits. Would they be available to offset the newcorporate income tax? To what limit?

iii. Electric and gas utilities.• How would normalization be affected? For the

utility taxpayer, the enjoyment of the benefitsboasted by the Simplified Income Tax Plan wouldnot come without a significant administrative cost.The plan creates a number of issues for rate-regulated enterprises. Rate-regulated businessesmust, under current law, normalize the effect (taxbenefit) of accelerated depreciation and investmenttax credits. Normalization is the process by whichthe tax benefit for those items is deferred so that theratepayers (consumers) do not receive the benefitimmediately by reduced rates for cost of service;ratepayers realize these benefits over the life of theassets that gave rise to them. As a result of normal-ization, utilities have substantial deferred tax liabili-ties that are determined based on the current incometax rates and accelerated depreciation methods.



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The plan includes four categories of assets forpurposes of depreciation. Those categories wouldlikely result in more accelerated depreciation ex-pense than that recorded for financial reportingpurposes. Would utilities be required to normalizethe tax benefit of that acceleration as under currentlaw? How would utilities treat the tax benefits thathave been normalized under current law in thetransition period?

• What would be the real effect of rate reduction?How would utilities account for those deferred taxesif the corporate tax rate were reduced to 31.5 per-cent? Historically, rate reductions of that naturewere accompanied by provisions that required theutilities to maintain the deferred income taxes andamortize the lower rates into the cost of servicegenerally over the remaining useful life of therelated assets. Most likely, that tax rate reductionwould increase the number of instances in whichpublic utility commissions determine the rates thatutilities may charge. As a general matter, statepublic utility commissions and ratepayer advocatesare opposed to provisions that prevent the immedi-ate disgorgement by utilities of overcollected taxes.

2. Growth and Investment Tax Plan

i. Oil• How would transition rules work? Transition rules

from the current tax system would be important tothe oil industry. The details on transition rules arelimited and questions remain.

ii. Mining• How would the acquisition of mineral rights be

treated under the plan? Is the expenditure deductedin arriving at the taxable base, or is it deferred?Would there be a percentage depletion allowance?

• How would mine exploration and development betreated under the Growth and Investment Tax Plan?Are these deducted against the tax base like othercapital expenditures?

• How would the existing AMT tax credit carryfor-ward amount be treated in the transition period?Most mining companies have substantial AMT taxcredits. Would they be available to offset the newcorporate consumption tax? To what limit?

iii. Electric and gas utilities• How would normalization be affected? As noted

under the Simplified Income Tax Plan, current lawrequires utilities to normalize accelerated deprecia-tion and investment tax credit benefits. How wouldthose existing deferred taxes be treated for ratemak-ing purposes? Would those tax benefits continue tobe deferred, or would utilities be required to reducetheir costs of service immediately and reduce ratescharged to consumers? Any proposal whose imple-mentation by state public utility commissionswould require reflecting the tax rate change imme-diately in utility rates charged to ratepayers, wouldcause, at least in the short term, the exact type ofprice volatility that the current regulated rate struc-ture avoids. The direct expensing of capital invest-ment in plant and equipment would substantiallyreduce utility taxable income. Would utilities be

required to normalize this tax benefit as undercurrent law, or would they pass the tax benefitthrough to consumers by immediately reducing costof service? What about previously stranded coststhat were determined to be imprudently incurredand thus not recoverable? Would the propriety ofthose costs change under a system in which directexpensing is the rule? If not, what about consis-tency?

• How would imported capital investments (that is,plant and equipment) be treated under the expens-ing regime? Presumably, capital investments thatare imported (that is, foreign manufactured) wouldnot be expensed under the consumption tax regime.

XV. Technology, Communications & EntertainmentHighlights and Potential Implications

Simplified Income Tax Plan• Eliminates the federal research tax credit.• Creates possibility of losses being trapped in

passthrough entities, preventing them from beingused to offset gains from profitable joint ventures.

• Provides tax-free repatriation of active foreign earn-ings, which allows TCE companies to be morecompetitive with foreign rivals.

Growth and Investment Tax Plan• Provides tax savings with nonrecognition of interest

income.• Eliminates the deduction for interest expense.

A. Simplified Income Tax Plan1. Elimination of the research tax credit. As currentlydesigned, the plan would eliminate most tax credits,most notably the research credit. The proposed elimina-tion of the research tax credit would hurt the technology,communications, and entertainment (TCE) industry,which decided to invest in research, software develop-ment, and self-constructed assets based, in part, on thecredit’s availability. The effect would be magnified ifstates opted to follow the federal model and eliminatetheir own research credits. By making R&D more expen-sive in the United States, the plan could prompt morecompanies to move their R&D activities offshore.2. Taxing passthrough entities. In recommending theimposition of an entity-level tax on passthrough entities,the panel did not clarify whether the recommendationwould result in losses being trapped at the entity level. Ifso, the proposed entity-level tax on passthrough entitieswould hurt both the entertainment and technology in-dustries.

In many instances, a large film or television companywill enter into numerous joint ventures using an LLC foreach production activity (television show or individualfilm). Separate LLCs are set up to limit liability and shareprofits or losses between the various parties to the jointventure. Because LLCs are treated as flow-through enti-ties, a major film or television company can offset thelosses and gains from its various joint ventures againsteach other. If, however, the tax is paid at the LLC level,the major companies in the film and television industrycould end up paying tax on their profits without beingable to use the losses as an offset.



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The inability to offset losses with gains could alsoaffect new alliances and joint ventures formed withsmaller technology companies offering complimentaryand bundled services.3. International tax changes. The proposed U.S. corpo-rate tax exemption for repatriated foreign earnings maypotentially provide the largest effect, both positive andnegative. This provision would presumably continue toencourage intangible development in, and migration to,low-tax jurisdictions, such as Ireland. Irish foreign earn-ings, for example, may be taxed in Ireland at 12.5 percentand then escape further U.S. tax if the earnings arebrought back. That would allow technology companies,as well as communications companies that provide inter-national services, to be more competitive with theirforeign rivals. Also, the ability to more freely circulatecash among foreign operations through the tax-free repa-triation provisions may be attractive to companies con-sidering international mergers. On the other hand, theexemption would effectively eliminate taxpayers’ abilityto use foreign tax credits associated with high-taxedforeign repatriated earnings to offset U.S. tax on low-taxed foreign income, such as most royalties paid byforeign persons. That could significantly increase sometaxpayers’ U.S. tax liability with respect to some foreignincome.

Shareholders might be affected as dividends receivedfrom foreign earnings of multinationals would not havethe same zero tax rate as dividends out of domesticearnings. The details as to how revenue, expenses, andultimately income is sourced would be critical, as thecommunications industry, in particular, has a long-standing commitment to paying quarterly dividends,and the exclusion of dividend income attributable to U.S.income would be an important benefit for shareholders.Also, inversion transactions would effectively be out-lawed as management and control, not place of legalincorporation, would define residency for income taxpurposes.

The plan would also change the taxation of someforeign branch operations. The proposed system wouldtreat foreign trades or businesses conducted directly by aU.S. taxpayer as CFCs for all federal income tax pur-poses. That would mean that branch losses would nolonger flow directly into the income of the U.S. taxpayer.That could have a rate effect for a number of the nation’scommunications companies that provide their interna-tional telecommunications services through foreignbranches.

In summary, the industry relies on new technologydevelopment and business expansion to provide addi-tional service offerings and to expand its current cus-tomer base. Any reduction or increase in overhead bur-den as it relates to deploying those strategies would be amajor factor in determining whether the simplificationmethod is viewed favorably by the industry.4. Changes to depreciation and capitalization rules. Anydepreciation and capitalization changes would affectcash taxes and the industry’s ability to invest in newtechnologies and joint ventures and expand their currentbusiness. The simplified depreciation system formedium-size and large businesses would provide admin-

istrative ease for assets with shorter lives. The immediatededuction to small businesses for all business capitalexpenditures (except for building and land purchases)would provide a tax cash flow savings.5. Elimination of the AMT. The proposed elimination ofthe corporate AMT would relieve publishing companiesof the need to track section 173 circulation expenses on anAMT and regular tax basis, thereby easing their admin-istrative burden.6. Elimination of deductions for mortgage interest andstate and local taxes. From an individual perspective, theproposed replacement of the deduction for mortgageinterest with a limited home ownership credit, coupledwith the elimination of the deduction for state and localtaxes, may adversely affect employees of technology-richstates. States such as California, New York, and Massa-chusetts have high housing prices and high state andlocal tax rates. Those proposed changes in the individualincome tax area could also adversely affect TCE compa-nies by making the labor pool in those states either moreexpensive or harder to find.7. Shareholder issues. Both the proposed elimination ofthe tax on dividends paid from U.S.-taxed earnings andthe reduction of tax on capital gains from the sale of U.S.corporate stock by U.S. individuals would most likely beviewed favorably by shareholders. The telecommunica-tions industry in particular has a long-standing commit-ment to paying quarterly dividends. As such, the plancould substantially reduce a shareholder’s tax bill ondividends, potentially making telecommunications com-panies (and others that regularly pay dividends) moreattractive to own.

B. Growth and Investment Tax Plan1. General overview. The effect on individuals in the TCEindustry under the Growth and Investment Tax Planwould largely be the same as it is under the SimplifiedIncome Tax Plan. Corporations, however, would face thebigger changes. Corporate income would be much closerto a cash flow model with only some expenses allowed.The major categories of allowable expenses would in-clude compensation, capital purchases, and purchasesfrom other businesses. The immediate write-off of equip-ment may lead to greater investment in capital assetswith a resulting modernizing effect on production.2. Elimination of interest expense deduction and in-come received. Most communications companies havesignificant interest expense, as they have financed mostof their capital budgets with debt. Other companies in theTCE industry that have leveraged themselves to acquireother businesses may also have significant interest ex-pense. Therefore, this change would be detrimental toTCE companies because they would lose a sizable deduc-tion against taxable income. Additionally, this provisioncould substantially change the way TCE companies makeacquisitions in the future.

While the disallowance of interest expenses wouldhurt TCE companies, the nonrecognition of interest in-come may provide a tax savings, as many companiesmake cross-border loans to subsidiaries that are expand-ing in a new area.



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• Given the propensity for the television and filmindustry to enter into numerous joint ventures usingan LLC for each production activity, would theplan’s notion to tax passthrough enitites at the entitylevel result in trapped NOLs in an LLC?

• Would states follow the plan and reduce theircredits and incentives provided to TCE companiesas well?

2. Growth and Investment Tax Plan• How would stock options be treated?• Would a 30 percent tax on cash flow alleviate the

need for income forecasting if taxed only on cashflow?

• Would a tax on cash flow allow all companies totake deductions up front (as the income forecastmethod is a burdensome calculation based on anestimate)?

• Would companies be allowed a deduction from cashflow for Form 1099 payments? A deduction fromcash flow would be allowed for ‘‘employee compen-sation.’’ In the media and entertainment industry,however, the majority of ‘‘compensation’’ is paid asForm 1099 compensation (actor, author rights, andso on).

XVI. Health SciencesHighlights and Potential Implications

Simplified Income Tax Plan• Eliminates the research and orphan drug credits,

increasing overall corporate tax liability.• Affects the form and structure of drug development

collaborations.• Encourages intangible property development in,

and migration of manufacturing activities to, low-taxed jurisdictions.

• Removes tax incentives that healthcare providershave for employing some individuals.

Growth and Investment Tax Plan• Allows immediate deduction for the cost of expen-

sive medical equipment purchases and capital im-provements.

A. Simplified Income Tax Plan1. Corporate rate reduction. The proposed corporate ratereduction to 31.5 percent would provide an overall taxbenefit to for-profit healthcare providers, although thebenefit would be somewhat reduced by the loss of federalwage credits. Because many hospitals and long-term carefacilities are located within concentrated urban areas,healthcare providers are generally significant employersof low-income wage earners that qualify for the WOTCand enterprise zone credits. The loss of those creditswould remove one of the incentives that healthcareproviders may have for employing certain individuals.While it’s difficult to predict whether the loss of thosecredits would change a hospital’s hiring practices, theloss of the credits would result in an increase in federaltaxes.2. Research credit and orphan drug credit. For lifescience companies, the potential elimination of the re-search and orphan drug credits would result in an

increase in corporate tax that would likely outweigh theproposed rate reduction. The loss of the credit on domes-tic research may result in additional consideration toshifting research jobs to less expensive foreign jurisdic-tions. (If the business tax breaks that would be eliminatedto broaden the corporate tax base include the ability toexpense research expenditures in the year incurred, theplan would increase taxes on life science companiessubstantially.) The elimination of the orphan drug creditcould result in pharmaceutical companies reevaluatingthe economic benefits of investing in the development ofdrugs that benefit only a small portion of our population.Those diseases, however, are often among the moredebilitating of all illnesses.3. Passthrough entities. The provision to tax partner-ships and flow-through entities would affect the formand structure of drug development collaborations. To fillproduct pipeline and minimize the risk of development,most pharmaceutical companies collaborate with otherbiotech and pharmaceuticals in the identification anddevelopment of target compounds. Those collaborationsare often structured as passthrough entities to allow thecorporate partners to offset development-stage expensesand resulting credits against commercial profits at thecorporate level. Although decreasing with advances intechnology, the period for drug development ranges from6 to 10 years. By providing a tax at the passthrough level,the tax benefit of development-stage losses would berestricted to future profits at the joint venture level or onliquidation of a failed joint venture.4. International. The proposed changes relating to inter-national taxation would likely provide a significant ben-efit to many life science companies. Many pharmaceuti-cal, biotech, and medical device companies hold theforeign rights to intellectual property in tax-favoredjurisdictions. In addition, they may also operate manu-facturing facilities in Ireland and Puerto Rico, where theyhave derived low-taxed profits. Those provisions wouldcontinue to encourage intangible property developmentin, and migration of, manufacturing activities to low-taxjurisdictions. Companies would be able to repatriate thefunds at no additional tax cost and could readily reflectthe benefits of the comparatively lower tax rates forfinancial statement purposes without consideration ofthe permanent reinvestment restrictions of APB 23. How-ever, those life science companies receiving low-taxedroyalties from offshore as well as high-taxed dividendsfrom foreign affiliates may see their taxes increase underthe proposal, as noted in Part VI.A.2. Also, shareholderswould be affected as the portion of dividends receivedfrom the foreign earnings of multinationals would not beexempt from individual taxation as compared to thedomestic earnings portion of dividends.5. Charitable donations to tax-exempt healthcare pro-viders. Many academic medical centers and communityhospitals supplement their operating income with con-tributions received from the public and/or investmentincome from endowments. Although charitable deduc-tions would be allowed directly from income, they wouldbe limited to amounts exceeding 1 percent of income.Taxpayers who are encouraged to donate to tax-exemptproviders partly due to the tax benefit that they derivemay be inclined to scale back the level of contributions. In



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addition, as individual tax rates decrease, the tax benefitderived from donations also diminishes; although withthe proposed elimination of other deductions, charitabledonations may be perceived as one of the last tax breaksavailable.

B. Growth and Investment Tax Plan1. Deduction of capital expenditures and loss of interestdeductions. Due to the escalating costs of rapid develop-

ments in medical technology, for-profit healthcare pro-viders would significantly benefit from the ability toimmediately deduct the cost of equipment purchases andcapital improvements. That benefit would be partiallyoffset by the lack of deductibility of investment expensesrelating to the financing of those acquisitions.



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