The tax code is filled with provisions that are temporary under the law but permanent in practice in that they are continually extended. Why would Congress do this?
Imagine you were a financial officer at 3M, trying to budget how much to spend on research in 2012. You knew there had been a federal tax credit for increased research spending since 1981 — but it expired at the end of 2011. Of course, it had expired 13 times previously over the past 30 years, always to be reinstated, retroactively when needed.
So, would you have planned on the credit applying retroactively to 2012 or not, particularly given today’s political climate?
Clearly these kinds of “temporary” tax provisions that keep getting extended are terrible policy. They exist to provide incentives, but are ineffective if taxpayers are unable to plan on them.
So in the 3M example, assume the company prudently decided it could not count on the provision being in effect for 2012 when it set its research budget for the year. Extending the credit retroactively would then serve no purpose. Either research was not done that otherwise would have been or the government just gave away tax dollars for something that happened anyway.
You would be wrong to think this is an rare situation. The tax code is filled with provisions that are temporary under the law but permanent in practice in that they are continually extended. Why would Congress do this? The answer isn’t about tax policy but about the federal budget.
Congress only budgets out 10 years and in doing so assumes that current law will stand. Consequently, an expiring provision like the research credit does not add to future deficit projections, even though it has been part of the tax law for 30 years.
Indeed, Congress plays games with the budget in so many ways that it is hardly a stretch to say that if it was held to the same accounting standards as public corporations the entire Congress would be in jail for fraud.
My favorite example is the Roth individual retirement account established in 1997. In a traditional IRA, taxes on earnings are deferred until the funds are withdrawn or upon death. So assume someone puts in $5,000 per year from age 25 until retirement at 65. At that time, assuming an 8 percent annual rate of return over the years, that someone would have over $1.5 million, nearly all of which would be taxed on withdrawal. The advantage of a Roth IRA — to which taxpayers contribute after-tax dollars — is that earnings will not be taxed on withdrawal. So the more than $1.3 million in lifetime earnings will never be taxed.
A Roth IRA is a tremendous deal for most taxpayers. It will eventually cost the government trillions of dollars in lost revenue. Yet when the budget office scored up the Roth IRA in 1997 it was a revenue-raiser! That sleight of hand was made possible by a provision allowing taxpayers to convert a traditional IRA to a Roth IRA. The conversion meant that taxpayers had to pay current tax on the earnings to date but saved on all future earnings. Only those taxpayers who stood to greatly benefit converted, thereby generating current revenue for the government at a much greater cost in the future. However, since future costs would be more than 10 years out they are treated as never happening from a budget viewpoint.
You would be naïve if you thought this was an isolated instance. Congress has gone back to this same well several times, including the 2013 fiscal-cliff agreement. One of the few revenue-raisers in that agreement was a provision allowing taxpayers to convert their Section 401(k) plans into a Roth 401(k) if their employers offered such a plan. A Roth 401(k) is a relatively recent creation where taxpayers contribute with after-tax dollars but all future earnings are shielded from taxation on withdrawal. So again taxpayers can pay current tax now to shield much more income from taxation later. This long-term revenue loser was scored as raising 12.1 billion over the next 10 years.
It is no surprise that Congress thinks in terms of the short-term. What is perhaps surprising to many is the manipulation of accounting rules to grossly understate future effects of today’s legislation. Indeed it is hardly an exaggeration to say that Congress is cooking the books to minimize our long-term budget difficulties.
The bottom line is that no matter how bad you think the budget deficit is, it is actually far worse.
By the way, the fiscal-cliff legislation retroactively reinstated the research credit back to Jan. 1, 2012. It now expires on Dec. 31, 2013.
Paul G. Gutterman is director of the Masters of Business Taxation program at the University of Minnesota’s Carlson School of Management.
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