Apple, IRS Highlight The Need For Tax Reform

What do Apple CEO Tim Cook and countless Tea Party followers have in common? All have been the subject of congressional hearings this week about the frailties of our current tax system.

The same week that the Internal Revenue Service admitted that it knew in May 2012 that it was delaying approval of applications for tax-exempt status from various conservative organizations, Tim Cook was attacked in Senate committee hearings because Apple ( AAPL +0.48%) only paid the tax it was owed. Apple, of course, is one of the most valuable and profitable companies in America, but those characteristics alone do not translate into large tax liabilities.

Our tax system does not work well. Some say it is broken. Many Americans pay no income taxes; others pay far more than they think reasonable. Ordinary Americans are angry, particularly when there is reason to believe that the tax administration and enforcement varies by taxpayer.

But what can be done to get out of this mess?

Our tax system has three fundamental weaknesses: (1) marginal tax rates are too high; (2) the structure of both personal and corporate taxes are much too complicated; and (3) the incentives for political mischief at the IRS are high while the likelihood of detection is low. It turns out, all three of these weaknesses are related, and they have one simple solution: tax simplification.

To see the need for tax simplification, consider the events of the past week.

Conservative groups are rightly angry because their anticipated tax break, namely tax-exempt status, was delayed or disallowed.

Some senators, such as Michigan Democrat Carl Levin and Arizona Republican John McCain, are angry because Apple took advantage of legal tax breaks. "So the moral of the story of this is that at least in my view, Apple has violated the spirit of the law, if nor the letter of the law," McCain said.

There’s nothing wrong with legally avoiding taxes. Villanova Professor J. Richard Harvey, a witness at Tuesday’s Senate Permanent Subcommittee on Investigations hearing, admitted to Republican Senator Rand Paul of Kentucky that he chose to minimize his tax burden through taking deductions. Harvey said he "absolutely" did not think that he was a bad person for doing that. Neither does this writer, who also takes permitted deductions.

A simpler tax system would solve many problems. It would likely reduce and simplify the benefits of tax-exempt status for all groups. A simpler tax would also reduce incentives of companies such as Apple to avoid the American tax jurisdiction. But most importantly, tax simplification would stimulate economic growth.

If you want to find complicated taxes, don’t look to China. The economy grows at nearly double-digit rates, individuals save almost half of their income, according to Chinese University of Hong Kong professor Lawrence J. Lau, and taxes are less complicated than in America. A complex tax code is not a prerequisite to economic growth.

America’s tax system has become so complex that a 2012 Taxpayer Advocate Service Report found that 6.1 billion hours per year are spent by individuals and business preparing taxes, not including time spent on audits or responding to IRS notices. (You can read the report by clicking here.)

President Obama, Senate Democrats, and House Republicans have all proposed lowering corporate tax rates. Reducing and simplifying corporate taxes would bring in more investment from abroad — together with additional revenue.

America’s corporate rate, 35%, is now the highest in the industrialized world, far above the average of 24% for countries in the Organisation for Economic Co-operation and Development, which is made up of our major competitors. Plus, America taxes income on a worldwide rather than territorial basis.

Two examples — Canada and Germany have 15% corporate tax rates. Both tax corporate income generated only within their borders, rather than corporations’ worldwide income, as does America.

Republicans and Democrats both know that our corporate tax rates are too high, and that bringing U.S. corporate tax rates in line with worldwide rates tax reform will probably bring in revenue and discourage other investments from leaving.

The Senate Permanent Subcommittee on Investigations has estimated that American companies, including Apple, hold around $1.7 trillion of earnings offshore from foreign operations. Some of this would be repatriated with a lower U.S. tax rate.

Although senators on both sides of the aisle in Tuesday’s hearing agreed on the need for corporate tax reform, it will not be easy.

First, Democrats want tax reform to raise revenue, and Republicans regard tax reform as revenue neutral.

Second, with lower corporate rates, the differential in rates between small businesses — who file under the individual tax schedule with top rates of 39.6% — would widen. Ideally, rates should be identical, so that all entities face the same rates. Some businesses would incorporate to get lower rates.

Third, capital-intensive corporations such as automobile manufacturers would likely lose some deductions with lower tax rates. Tax reform would help service and financial industries but could result in an increase in taxes on manufacturers.

Some have suggested replacing both corporate and individual income tax codes with a value-added tax or a national sales tax. (You can read one such proposal at www.fairtax.org.) Such a tax might be efficient, but is unlikely to pass in the current political climate. Moreover, Congress is unlikely to eliminate the income tax entirely, and a value-added tax that adds on to the income tax would leave America with the worst of both worlds — an inefficient income tax, and a VAT that can be raised at the whim of politicians.

Another approach would be to allow immediate, first-year write-offs of plant and equipment for corporations and small businesses. This would bring our current tax system closer to a consumption tax — under which income that is saved or invested is not taxed — and generate much-needed new investment in plants and equipment.

The past week has made all too clear to both Congress and the American public that our tax system is not working well. High rates, complexity, and the appearance of political mischief discourage even the most earnest taxpayers.

The solution is to simplify the tax code. Congress can and should do it, unless it wants to see its future filled with hearings about dwindling tax revenues, corporations that pay no taxes, IRS political shenanigans, and taxpayers who have lost trust in government.

This piece originally appeared in WSJ's MarketWatch

This piece originally appeared in WSJ's MarketWatch