You are the director of a Washington, D.C., think tank focusing on tax and econo

Question

You are the director of a Washington, D.C., think tank focusing on tax and economic policy issues. You were recently (and informally) contacted by staff of the Congressional Joint Committee on Taxation to weigh in on a number of issues currently under consideration by the committee. In particular, the committee asked you to reflect upon the following proposed changes and issues.

(I) The committee has proposed phasing out the PAD for domestic corporations.
(II) The committee has considered separating the gift and estate tax systems from one unified system to two completely independent systems.
(III) The committee is intrigued by the idea of eliminating the double taxation of corporate earnings. The members are, however, unsure which level of taxation should be eliminated.

The committee would like for you to summarize your conclusions regarding the potential effects—both good and bad—of these potential changes. In formulating your answer, please discuss all of the possible tax and economic implications that you see arising from these transactions on all taxpayers.

Explanation / Answer

1. The deduction for domestic production activities was created in part to replace the tax code’s extraterritorial income exclusion, which allowed businesses to exclude income from certain types of transactions that generate receipts from trade with foreign countries. According to the World Trade Organization, that exclusion violated its agreements by subsidizing exports. The deduction was intended to reduce the taxes on income from domestic production without violating the organization’s rules.

This option would repeal the deduction for domestic production activities. Doing so would increase revenues by $192 billion from 2014 through 2023, the staff of the Joint Committee on Taxation estimates.

If the phasing discontinues, it would increase the economic distortions. Although the deduction is targeted toward investments in domestic production activities, it does not apply to all domestic production. Whether a business activity qualifies for the deduction is unrelated to the economic merits of the activity. Thus, the deduction gives businesses an incentive to invest in a particular set of domestic production activities for more economically beneficial, investments in domestic production activities that will not qualify if the PAD is phased out.

An argument against implementing this option is that simply repealing the deduction for domestic production activities would increase the cost of domestic business investment and could reduce the amount of such investment. Alternatively, the deduction could be replaced with a revenue-neutral reduction in the top corporate tax rate (a cut that would reduce revenues by the same amount that eliminating the deduction would increase them). That alternative would end the current distortions between activities that qualify for the deduction and those that do not. It also would reduce the extent to which the corporate tax favors noncorporate investments over investments in the corporate sector and foreign activities over domestic business activities.

2.

The individual will be entitled to make annual exclusion according to the tax slab laid down by the government. The individual will have two different taxes to pay, it will be difficult for the committee to decide if the gift presented by the donor if it will fall in the gift tax or as estate tax. There will be other set of rules to be made if the property is transferred as gifts. The transfer tax regarding the estate tax will be confusing to be calculated and make it difficult for both the committee as well as individual to be calculated.

3

By eliminating the double tax, the proposal will reduce tax induced distortions that, in the current tax system, encourage firms to use debt rather than equity finance and to adopt non corporate structure. As the shareholders get exempted from tax on corporate income, the proposal reduce incentives for only a certain type of corporate tax planning. It will enhance corporate governance by eliminating the current bias against the payment of the dividends. It increases the accountability of corporate management towards its investor and it will promote the economy as a whole.

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