PAYGO--Excuse For Higher Taxes?

Dr. Martin Regalia

When the Democratic Congress took control last November, it adopted the principle of PAYGO or pay-as-you-go as its overarching guideline for fiscal policy. Simply put, PAYGO means that every spending proposal or change to the tax code that results in a loss of revenue must be "paid" for with an equivalent spending cut or tax increase. Now, on the face of it, this approach may not seem so bad and may even appeal to those who focus exclusively on the size of the budget surplus or deficit as a measure of sound fiscal policy. But this approach is, at best, an overly simplistic operational guideline and, when rigidly applied, is fraught with a number of problems.

Responsibility or Roadblock?
Among a host of other faults, PAYGO fails to prioritize spending proposals and, instead, suggests that any spending is OK as long as the budget implication is neutral. It completely ignores the overall size of the government, and the tax bite needed to finance it, as a policy goal. It ignores the dynamic response of the economy to changes in the tax code, and it is applied within an arbitrary and artificial time horizon of either 5 or 10 years. Rigid adherence to PAYGO virtually ensures that every discussion of tax policy becomes mired in the rhetoric of class warfare.

In the current environment, a shortsighted allegiance to PAYGO is actually standing in the way of the broader discussion of fundamental tax reform, entitlement reform, health care reform, increasingly urgent infrastructure needs, and energy policy. The nation hasn't been able to deal with the alternative minimum tax because no one can agree on whether or how to pay for it. We fail to address the fact that our corporate tax structure is a major obstacle to our world competitiveness because we cannot come up with acceptable revenue raisers or "pay-fors" to offset any change. Finally, rigid adherence to PAYGO may ultimately lead the economy into recession when the Bush tax cuts expire if whoever is running the country at the time is unable to deal with these challenges without corresponding tax increases.

In the near term, PAYGO has placed the business community squarely in Congress' sights as the preferred source of tax revenue for virtually every spending proposal that has come, or is coming, down the legislative track. Tax increases on business may make for great populist campaign rhetoric, but impeding international competitiveness, slowing investment, retarding job growth, discouraging corporations from hiring U.S. citizens, and instituting retroactive tax hikes are just not good public policy.

In the Crosshairs
One popular choice targets U.S. citizens working abroad for U.S. companies. Right now, the income of those U.S. citizens is exempt from U.S. income tax up to certain levels. Further, those citizens take a credit for taxes they pay to foreign governments against any tax liability remaining after the exemption. The current proposal would end this exemption, requiring them to include all their income earned abroad in their adjusted gross income. At first glance, that doesn't seem so wrong. Those U.S. citizens earn income, so shouldn't they pay U.S. taxes? But a closer inspection reveals that this proposal would have troubling results. It would discourage U.S. companies from employing U.S. citizens abroad. Particularly, in low tax jurisdictions or in jurisdictions with high housing costs, U.S. companies would be forced to hire foreign workers. So why would Congress want to deter U.S. companies from hiring U.S. citizens? The answer is quite simple: It would raise $57 billion over the next 10 years. And $57 billion sure can fuel a big spending spree.

Who else would Congress hit with its pay-fors? Government contractors. Federal, local, and state governments will be required to withhold 3% from payments they make to government contractors for goods and services provided after 2010. Congress says we have to do this because we need to close the tax gap. The tax gap is the difference between the amount of tax that should have been paid, on a timely basis, and the amount actually received by the government for a specific tax year. But why punish the innocent compliant taxpayer to make up for the noncompliant?

Why not address the real issue-the complexity of the tax code? Considering its complexity, the amount of tax that actually gets collected is quite impressive. The Internal Revenue Service estimates that 86% of people voluntarily comply with the tax law and pay their taxes. Does Congress recognize that a voluntary tax code has its limits? Does Congress try to decrease the complexity of the tax code? No. Instead, Congress mandates unnecessary withholding in order to raise $7 billion in the name of PAYGO.

But Congress doesn't stop there. To raise more revenue, it would require private equity and hedge fund managers to pay taxes on their carried interest (profits) at ordinary income tax rates rather than at more favorable capital gains rates. In addition, if these funds become publicly traded partnerships, Congress would tax them as corporations, imposing another layer of tax. Under either proposal, Congress insists on singling out one group of taxpayers. Perhaps, instead of trying to quash private equity and hedge funds, Congress should strive to find a workable solution that promotes the growth and risk taking that drives the economy forward. Why would Congress try to quash this one group of taxpayers who try to stimulate growth and investment? Because Congress estimates that these changes would raise between $20 billion and $30 billion over the next 10 years.

But wait, Congress is on a roll. Under another proposal, it would retroactively change the formerly enacted effective date of loss deferral rules for sale-in, lease-out (SILO) leases entered into on or before March 12, 2004, if the lessee is a foreign person or entity. Why would Congress make retroactive changes to the tax code and disrupt the certainty that businesses rely on to make sound decisions by changing rules applicable to past decisions? This proposal would generate another $3.24 billion over 10 years.

There are still more pockets to pick, so don't worry. Other congressional proposals eye compensation provisions perceived as tax breaks for corporate fat cats. These proposals would limit the annual amounts that can be deferred under nonqualified deferred compensation agreements, expand the definition of "covered employees" whose compensation in excess of $1 million is not deductible, and significantly decrease the deduction for stock option expenses.

Unfortunately, the so-called corporate fat cats aren't the only ones who suffer under these proposals; midsize and startup businesses and midlevel managers at larger companies do too. Why would Congress want to punish these medium size and burgeoning businesses? The compensation-related proposals alone would raise almost $1 billion over the next 10 years. And the stock option proposal would raise $10 billion per year.

But wait, there is more. Another proposal would codify the common law doctrine of economic substance, which denies tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in federal taxes. At first glance, that doesn't seem so far-fetched. 

Nevertheless, there is already existing case law that prevents businesses from engaging in transactions that lack economic substance, so why does the doctrine need to be codified? Because if Congress does, it can restructure the doctrine in such a way that previously legitimate business transactions can now be shut down. Why would Congress take years of well-established case law and twist and turn it into another confusing code section? Because it would generate $10 billion over the next 10 years.

The Bottom Line
Who will get dinged and how badly? At this point, no one knows. However, the people who propose these tax increases clearly believe that pitting business against business in a cannibalistic food fight will take the onus off them. Our primary goal here at the U.S. Chamber is to ensure that this divide-and-conquer strategy is not successful.