An Enemy of Income Tax Reform: The “Business Transfer Tax” (a/k/a “Business Activity Tax” and “Business Flat Tax”)

The “Business Transfer Tax” in all its forms is a proposal for a dual-tax system, to have a value-added tax built upon a rejiggered income tax. This second tax comes disguised as income tax reform, with the VAT label avoided. Sad to say this ill-conceived proposal amounts to a cover-up and remedy for the failure of U.S. trade negotiators to insist that VAT nations abide by the principles of free trade. But, two wrongs don’t make a right. As an enemy of real income tax reform, it would make the income tax even more disjointed and difficult to unscramble into a simple, tax-neutral, low-rate income tax.

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By James K. Jeanblanc | May 24, 2016

an enemy

The proposal to enact a “business transfer tax” to replace the corporate income tax and payroll taxes, is an enemy of reform.  It’s an anti-reform measure, cloaked in sheep’s clothing to appear as an income-tax reform proposal.  It’s the wolf – a proposal for a value-added tax (VAT), not to achieve fundamental income-tax reform.

The income tax changes in the proposal would be to gut the tax base and cut everyone’s income taxes and make the VAT politically-attractive.  The resulting reduction in tax collections would make the VAT an essential second tax for the Treasury.  The proposal would leave the income tax as an archaic, person-taxing system, not to be made into a true income tax.

The VAT label is avoided. Two of the GOP presidential candidates, now out of the race, made the proposal part of their tax plans. Senator Rand Paul called his version of the VAT, the “business activity tax.”  Senator Ted Cruz called his version, the “business flat tax.”

The Proposal

This proposal is for a dual-tax system: (1) a retained income tax on personal income, with business income fully excluded from the income-tax base; and (2) the VAT, itself, to replace the corporate income tax and also the payroll taxes. Under the proposal, business income no longer would be income-taxed.  And, despite elimination of personal tax breaks, the exclusion of the lower level of taxpayer income from taxation would be overly-generous.

Suffice to say, on the subject of income tax reform, any proposal for the blanket exclusion of income from the tax base is not on the road to real income tax reform. Real reform means expanding the tax base, not contracting it.

Another dubious aspect of this proposal is its cavalier elimination of the payroll taxes, this justified on the faulty premise that the payroll taxes are income taxes. Seemingly ignored is that payroll-tax elimination would also terminate an important funding mechanism of the Medicare and Social Security Programs. Among many other issues, the proposal fails to address how worker beneficiary account balances and benefits are to be accrued and treated once workers and their employers no longer are to pay into the Social Security Program.

Leaving income tax reform aside, the Medicare and Social Security Programs, themselves, are in need of reform.  The cavalier elimination of this program-funding mechanism means loss of a-something which could be important in crafting a suitable reform of those programs, unless the goal is to leave them completely unfunded and destined to become straight-out, means-tested welfare programs.

How Would this VAT Work?

The VAT is intended to apply to all elements of domestic business activity. It would be a tax imposed at the business level on an adjusted definition of business income (Senator Paul would have a 14-1/2% rate; and Senator Cruz, a 16% rate). Starting with business income, added back would be interest expense and salaries and wages paid. No longer would the cost of business assets be depreciated; instead, the full cost of all new capital investments to the business (buildings, land, and equipment) would be deducted.

To mirror the “border adjustments” employed by nations having a VAT, there would be further computations: Added (to be taxed) would be the cost of all imports, and subtracted would be the revenue from exports (not to be VAT taxed).

This VAT tax system would affect more than businesses. Exempt organizations would owe the tax on their salaries and wages paid. So would individuals on salaries and wages paid for domestic help. And, individual consumers would owe the tax on their purchases from abroad.

Many people will regard this VAT as resulting in a double-taxation of wages and salaries – first at the employer level when paid and, again, as personal income when received. And, to the extent the VAT is seen, as intended, as a consumption tax borne by the consumer (and not as an income tax borne by the business), many workers will complain that they are being taxed a third time in the form of higher prices for goods and services purchased.  It’s no wonder why this VAT is not given a consumer label and is labeled the “business activity tax,” the “business transfer tax,” or the “business flat tax.”

Then, there’s the question of the VAT proposal’s possible adverse impact upon job and wage growth. Employers, previously allowed an income-tax deduction on salaries and wages paid, will become directly taxed on these payments. This tax cost would be partially mitigated from the employer-paid half-portion they no longer will pay because of the payroll-tax elimination. Regardless, salaries and wages, previously income-tax deductible, would henceforth be VAT taxed.  Employers will have a lower VAT tax bill by not granting workers pay-raises and/or requiring them to do more without new hiring.

 The Trade Factor

The major driving force behind this VAT proposal is an unresolved and unfair trade practice employed by VAT nations, long ignored by U.S. trade representatives.  VAT nations (such as China, Japan, and the EU countries) have structured their VATs to have “border adjustments” to impose their VATs on imported goods and to rebate it on their exports. In terms of their trade with the U.S., these “border adjustments” function as tariffs on imports from the U.S. and as export subsidies on goods shipped to the U.S.

This “border-adjustment” system is inconsistent with traditional principles of free trade. However, it’s self-compensating in the case of trade between the VAT nations themselves, but is unfair in the case of their trade to and from non-VAT countries, such as the United States.

U.S. trade negotiators should have insisted that VAT nations make no such “border adjustments” in the case of their trade with the U.S.  Achieving this would remove the justification behind this proposal for the U.S. to have a VAT and, as collateral damage, muck-up the income tax system even more. (Side point: Tough fair trade negotiations lie ahead, but failing that, fair trade principles would justify the U.S. enacting its own “border adjustment” system to counter the unfair VAT adjustments on the other side, without defaulting the U.S. into having a VAT such as here proposed.)

The Verdict

The “Business Transfer Tax” in all its forms is a proposal for a dual-tax system, to have a value-added tax built upon a rejiggered income tax. This second tax comes disguised as income tax reform, with the VAT label avoided. Sad to say this ill-conceived proposal amounts to a cover-up and remedy for the failure of U.S. trade negotiators to insist that VAT nations abide by the principles of free trade. But, two wrongs don’t make a right. As an enemy of real income tax reform, it would make the income tax even more disjointed and difficult to unscramble into a simple, tax-neutral, low-rate income tax.


James K. Jeanblanc is a CPA and Tax Counsel to the law firm Grove, Jaskiewicz & Cobert in Washington, DC. He is also Senior Fellow for Tax Policy at the Selous Foundation for Public Policy Research, author of The FreedomTax and a contributor to SFPPR News & Analysis.

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