Editor: Please tell us about your professional background.
Kelly: I started my career at KPMG, where I spent 17 years. I then spent 10 years serving as a tax director of a commercial bank, which, during my tenure, grew from a small community bank into a regional bank with a national mortgage company as part of its footprint. That company was sold, and I came to Marcum, where I head the corporate tax practice for the firm. I have local office responsibilities as well as national responsibilities in the corporate arena.
Editor: How has sentiment about increasing the tax on revenues changed as a result of the November elections?
Kelly: I think the tides are changing. There was a spirited debate between those who wanted to raise revenues and rates and those who wanted to control spending and limit tax deductions, and each side was unwilling to compromise. Since the election, the reality is setting in that there needs to be some coming together: eventually, everyone has to give something. Government has been put in place to do certain things, and we need revenues to run the government. That said, there is widespread consensus that this is a spending issue and not just a revenue issue. Everyone was waiting on the outcome of the election, and now that it is here, we have to deal with it.
Editor: There has been a great deal of discussion about tax initiatives put forth by Bowles-Simpson and Rivlin-Domenici. What are the strengths of these proposals?
Kelly: They both do a very good job of laying out the real problem. The two approaches acknowledge that while this is less of a revenue problem and more of a spending problem, both revenue and spending – especially on entitlements – must be addressed. I don’t think one plan is better than the other; each lays out a reasonable framework. Both plans simplify the tax code, both go after deductions, and both appear to be modeled on President Reagan’s 1986 Act, in which Reagan got rid of some deductions and lowered overall rates.
The problem lies with the lobbyists and politicians. Today’s Internal Revenue Code is a complicated law that has resulted from government attempts both to raise revenues and to manipulate behavior for some positive social outcome. For example, the government decided that home ownership was a good thing, so today we have a deduction on home mortgage interest. Likewise, charitable giving deductions serve as incentives for people to donate to nonprofits because the government knows it cannot do it all. Today these incentives are called loopholes. You therefore end up with an interesting debate about which loopholes should be closed – and which special interests will be upset as a consequence. Some say that if the mortgage interest deduction is taken away, the housing market will collapse. The 1986 Tax Reform Act ended passive losses for rental properties, and in the late 1980s, the whole real estate market took a dive. There is always an unintended consequence following changes to the tax code.
Editor: While changes to the tax structure regarding individuals have grabbed the headlines, there are other changes contemplated for business such as the percentage of the FICA tax and changes in depreciation schedules. Please comment on how these changes might affect economic growth in the U.S.
Kelly: I believe some corporate tax changes – such as changes to capital depreciation and bonus depreciation deductions – will cause a slowdown. Businesses may have elected to accelerate purchases on capital improvements or new equipment in the last days of 2012 in order to take advantage of the better tax benefit, and so we may witness a slowdown in such purchases in the first and second quarters of 2013.
The FICA tax is really borne by the individual, as it is more or less a salary withholding mechanism. Various R&D credits are expiring as well, which I believe may be detrimental to business.
But overall, a wait-and-see attitude prevails: the sooner there is some clarity, the better off everyone will be. Predictability is key in the marketplace, and businesses need to know what their taxes will be in order to write their budgets. I have always told my clients that taxes are the single most important business line item on its financial statements, after gross sales and cost of goods sold. Taxes can represent 40 percent of the business’s budget. To think that people aren’t planning on how to minimize that 40 percent for a corporation – or that 35 percent rate for an individual – is just being naïve.
Editor: Do you see the merits in flattening the tax and closing certain tax loopholes?
Kelly: I am not a proponent of closing specific loopholes. The better answer, I believe, is to bring rates down and cap itemized deductions. This way, people can pick and choose. They can keep the charitable deductions if they like, or take the state and local tax deduction. What people often fail to realize is that there is a whole segment that is subject to the alternative minimum tax (AMT) – the current patch expired January 1. There is a possibility that a rate differential alone will not get more revenue out of some taxpayers (especially in high-tax states like New York or California) who are subject to the AMT tax. Taxpayers who are subject to the AMT currently are not getting the benefit of their state and local tax deductions. The AMT is a parallel tax calculation in which the taxpayer pays the greater amount when compared to the regular tax that has been calculated. A change in the regular tax rate could have the effect of changing the break-out of their tax returns but not the overall tax. If the AMT is fixed and the overall rate is dropped, then I would favor capping total deductions and not specifically targeting one group. This way the pain is spread among everybody.
Editor: For years U.S. industry has faulted the tax on overseas earnings when repatriated from abroad. What would you recommend?
Kelly: I would recommend a lowering of corporate rates and maybe even granting a tax holiday to have companies repatriate their earnings overseas back into the U.S. There is a tremendous amount of cash sitting overseas that if brought back to the U.S. would have a 35 percent tax rate, so companies will let it sit there. Logically, companies that have capital oversees will continue to invest overseas.
I read somewhere that the tax collections for corporations in the 1960s were about four percent of the budget, and now they are down to about 1.5 percent. At the end of the day, the real tax revenue is with individuals. It always has been and always will be.
Editor: Please describe President Obama’s proposal to take advantage of deferral of repatriation. What is his proposal for bringing back to the U.S. facilities that have been established abroad?
Kelly: Currently, if a corporation has an overseas subsidiary that is allowed to make money, as long as that cash is not taken back in the form of a dividend and is instead permanently reinvested, the potential U.S. income tax on that income can be permanently deferred and never be taxed in the U.S.
President Obama’s proposal is that to the extent that you have overseas investments, the government will levy a tax, whether or not you bring the money back. That would possibly stop people from investing overseas, but generally people invest overseas for reasons other than taxes. The economic reality is that costs of doing business are often lower. We have become very much a global economy, with people who are transportable and technology that allows communication everywhere. The tax code has not kept up with the mobility of companies today.
Furthermore, while Obama’s proposal might raise some revenue, it would put the United States at a further competitive disadvantage: multinationals would react by changing the way they do business. There is a certain pain level people will put up with, and then they begin to plan around it. If a multinational has the capability of moving its facilities to a lower-cost location with the same talent and personnel and get a lower tax rate, why would it deploy that capital here in the U.S., with its higher labor costs, unpredictable raw material costs and higher tax rate? A tax rate is simply a toll charge on people deploying capital. If I am a UK company and I have a chance to put a plant in Ireland – where I get a lower rate than in the U.S. – or in the U.S., why wouldn’t I choose to be profitable in Ireland? Capital flows internationally, and business can be set up anywhere.
Editor: Is the current corporate tax code affecting manufacturers and service companies differently?
Kelly: Service companies are typically outlaying more in cash than are manufacturers because there are fewer deductions or depreciations to offset their income. It would appear to me that from a cash flow perspective, service industries probably pay more in taxes than manufacturers. Due to various tax provisions, manufacturers have the advantage of depreciating their investments in fixed assets, allowing them to defer their tax payments. They have also been targeted for tax legislation that allows production credits, which, if they qualify, result in a permanent tax reduction. It should be noted that temporary differences like depreciation do not change the calculation of the effective rate that is used on financial statements as a benchmark. The company’s overall effective rate enters into the calculations of a public company or an investor group as a cost of doing business and must be quantified. Usually there is an attempt to mitigate or reduce this overall cost to a company.
Editor: How do we persuade legislators to adopt a sensible, non-partisan approach to legislation to reform our current tax code patchwork?
Kelly: Legislators need to stop the campaigning and do a reality check. As I said earlier, there needs to be some recognition that raising revenues is required, but that this is not the entire picture, as this is also a spending issue. People need to put aside partisanship because the reality is that we are dealing in a global economy and there is only a finite sum of money. We need to address these problems and not push them to the next generation – or it never is going to be solved.
Editor: How can the U.S. best effect a strategy that will foster economic growth for U.S. companies both domestically and abroad?
Kelly: First, reduce the corporate tax rate. Second, we need to have realistic regulations, not reactionary ones; no doubt we can develop smarter regulations by bringing in some of America’s brilliant minds at the outset. Ultimately, we want to attract capital, and we need to figure out how to do so. We certainly have the best technology, and we are a powerhouse in terms of natural resources – we just need to attract capital by reducing the overall cost of doing business, which includes both the cost of complying with regulations and taxes.
As I mentioned, a tax holiday allowing companies to repatriate their overseas earnings would help encourage the free flow of capital and result in growth. Companies are going to move to where to it is most cost-effective to operate. Of course this also applies in the U.S. at the state level, where certain states’ tax structures are much more competitive and attract businesses. Businesses and individuals react to what it costs to maintain a presence in a particular state – they do not operate in a vacuum.
Editor: Might any changes to deductions be made?
Kelly: I believe we need to have depreciation deductions, but perhaps we could scale them back. We might simplify the code, and instead of these various depreciation rule and allowances, which are dependent on service date, we could adopt permanent and more uniform allowances for wear-and-tear obsolescence. If we want to spur companies on, we should certainly keep such deductions as the one for R&D. But if the rate itself is lowered, these deduction issues become less important when it comes to overall financial planning.