You work hard to grow your business and then every April your silent partners, the federal and state governments, step in to take up to 45 percent of every additional dollar you made. We need tax reform and, with the new Republican controlled House, Senate, and White House, that just might be possible. Though it’s uncertain what changes if any will emerge this year, the ideas being discussed could have a major impact on your bottom line.
If you think tax reform means lower taxes, look at some hard realities our politicians keep trying to avoid. First, our federal debt is already growing at an unsustainable rate because of inadequate tax revenue to fund expenditures. The Congressional Budget Office predicts that even with current tax rates and expenditures, the debt (at press time, about $19.8 trillion) will grow to at least 150 percent of our total annual Gross Domestic Product in 30 years.
Economists forecast that level of debt will cause per capita average GDP to decline by up to 6 percent. This means more and more tax revenue will be used just to pay the interest on the debt.
Second, although no actual legislation has been introduced, an analysis of the broaden-the-base, reduce-the-rate tax proposals being promoted by Republican leadership and the Trump Administration shows all will add to the long-term debt. This flatter tax system would also eliminate many tax benefits and incentives specifically intended to help small businesses. Most of the benefit from the proposed tax rate reductions would go to those earning more than $1 million annually, with potential tax increases for those earning between $75,000 to $500,000. This is because all the changes need to score as revenue neutral to be done under the budget reconciliation process, which requires only 51 votes to pass the Senate.
And lastly, when you hear your politicians saying, “reducing tax rates on the wealthy and large corporations will stimulate the economy enough to offset the revenue losses,” look at the actual results of the 2001-2003 Bush tax cuts which promised the same thing. I think it’s safe to say our industry still remembers the economic impact (recession) that resulted from those tax cuts.
How will tax reform affect your business? The following are changes currently being discussed.
BORDER ADJUSTED CASH FLOW TAX
One dangerous new tax proposal by House Republican leaders that clearly threatens most furniture retailers, and any business that sells imported products or components, is the Border Adjusted Cash Flow Tax (BAT). It’s intended to raise revenue to allow lower corporate tax rates. It would prevent the original business importer of any foreign-made product or component from deducting the cost of the item in the calculation of their taxable income. This would effectively add a 20-30 percent tax cost to every imported item, and new administrative burdens in tracking which items can be deducted and which can’t. Economists believe some of this added cost will eventually be offset by foreign countries lowering exchange rates, but that would also have negative international economic and trade consequences for exporters.
In addition to generally raising prices on most consumer goods, the BAT would create a permanent 20-30 percent cost advantage for foreign businesses who sell directly to U.S. consumers or non-taxable organizations. To avoid the appearance of being a tariff, the current proposal imposes no tax consequence to end consumers who directly purchase foreign products, or foreign manufacturers or retailers who sell directly to U.S. customers. It would be like the current sales tax advantage internet sellers have over in-state retailers, only with far higher percentage rates. Foreign direct sellers could even use the same container splitting and nationwide in-home delivery services that domestic retailers have helped develop over the last few years.
The Republicans’ stated purpose for the BAT, in addition to its revenue, is to make American manufacturers more competitive, and reduce multinational business profit shifting to low tax countries. This can be far better accomplished by a system that simply allocates the tax on world-wide multinational business profits by their percentage of product sales in each country (like the process states use to tax national and international businesses). It would correct the current international tax avoidance problems and also provide a simple tax cost reduction for U.S. exporters without all the negative impacts on domestic businesses or product costs.
The HFA’s Government Relations Action Team (GRAT) is working with other industry and retail trade groups to make sure Congress kills this proposal.
Cash Flow Taxation
Another House Republican proposal is to change the current cost amortization system of taxable income calculation. Currently, major investments are depreciated over a period of years to somewhat match the period over which they help produce income. The proposed change would be a cash-flow based tax system where most capital expenditures, even new building construction, are fully expensed in the year they’re paid. This would be a radical change from standard business accounting practices.
In the short-term this would be an advantage to businesses that make major capital investments, and are able to in effect borrow from the government by using their tax deductions in advance. It would probably stimulate B2B purchases, but not consumer purchasing. However, it would also result in higher taxable income for businesses in later years when tax rates may also be higher, and could increase business failures.
Most furniture retailers can already take advantage of Section 179 Small Business Expensing of up to $500,000 per year in capital purchases, excluding new building construction, and the new $5000 per item asset replacement expensing provision. Much of the added benefit of full expensing would go to large businesses.
A shift to cash flow accounting has other potential consequences. As a revenue offset the change would also prevent the deduction of business loan interest, which could have a major impact on new businesses with high levels of debt. Businesses that make major capital investments would also appear unprofitable on their tax returns the next time they seek business financing. From a national economic perspective, the immediate deduction of capital investments will reduce tax revenues and increase the short-term federal deficit. Full expensing also uses up the major economic tool of additional bonus expensing that Congress needs to stimulate the economy during recession periods.
Value Added Taxes
Unlike the proposed BAT, which is not used by any other country, Value Added Taxes (VAT) are a true consumption tax and are used by almost every other country in conjunction with their income taxes. VATs are a percentage tax, usually 5-10 percent added on the increase in value added at each step of the distribution chain from manufacturer to end consumer. They are fully border adjustable under World Trade Organization standards, and can also tax imported products from foreign manufacturers who have no U.S. income tax nexus. Under the most common invoice method, each step of distribution— manufacturer/importer, wholesaler, retailer— would pay the VAT rate on their sales, listing the amount of VAT on each sale invoice. They then deduct the amount of VAT they can prove they paid on the products or services they resold. The tax is based on gross sales, regardless of whether the business is profitable.
Like a state sales tax which consumers know will be added to their invoice, it potentially becomes a psychological barrier to new retail purchases particularly when combined with existing 3-8 percent state sales taxes, which don’t exist in most VAT countries. Even with some adjustments, the tax is generally income regressive and would most heavily impact lower and middle-income consumers. A VAT would also require a major new tax administration infrastructure and new or modified accounting systems for all businesses.
Pass-Through Business Income Differentiation
One positive proposal is the differentiation of small business pass-through income received from an S-corporation, partnership, LLC, or proprietorship. This would enable Congress to give it a reduced rate in the personal income tax code or a hybrid unified business tax system. Currently, income from a pass-through business, which most small businesses are, is reported on your personal tax return at the same tax rate as your salary and investment interest. Small businesses have long argued that if tax rates for large C-corporations are reduced, they should also be reduced for small businesses, but the lack of differentiation of the income has made that difficult. The biggest issues that may prevent this from being included in tax reform are how to separate active business owners from other investors, and how to prevent business owners and professionals from reducing their earnings to shift the income to the lower pass-through entity rate.
Inflation Indexing of Very Long-Term Capital Gains
Another positive issue just starting to receive recognition by Congress is the need to adjust the taxation on really long-term capital gains for the monetary inflation that has occurred since the asset’s purchase. Most furniture retailers tend to own their businesses, and often also some business property, for 10, 20, 30, or more years. The current tax treatment of capital gains gives the maximum tax benefit of a lower tax rate to items held for just one year.
Unfortunately, after you own your business for many years, you’ll pay the capital gains tax on the simple dollar difference between your basis and the selling price, not on the actual current dollar value of the payment you receive. If you pay the current federal 23.8 percent capital gains tax on a $1 million taxable gain from selling a business you started or bought 30 years ago, that gain is only worth $419,900 in 1977 dollars. You would pay an effective constant dollar tax rate of 56 percent. If you had bought it 40 years ago, the constant dollar tax rate on the gain would be 131 percent. There’s a clear need to adjust longer term capital gains for inflation, but it will require more education to convince Congress to include this provision.
It’s still too early to tell which of these concepts may gain support in final tax reform legislation, but HFA members can stay informed on this and other issues and learn how to influence the outcome with the member-only legislative updates.
HFA members who want to be part of the conversation can join the GRAT by contacting HFA’s government relations liaison, Lisa Casinger, at firstname.lastname@example.org.