The Tax Reduction and Reform Act of 2007: An Overview
The Tax Reduction and Reform Act of 2007:
Updated June 20, 2008
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
The Tax Reduction and Reform Act of 2007:
On October 25, 2007, Chairman Charles B. Rangel of the House Ways and
Means Committee announced his tax revision proposal, H.R. 3970, the Tax
Reduction and Tax Reform Act of 2007. One of the objectives of the plan was to
address the problem with the individual alternative minimum tax (AMT), a provision
that was originally aimed at high-income taxpayers’ preferences but, because it was
not indexed, is increasingly reaching upper middle class taxpayers. The most
significant provisions, measured by revenue effect, were a revision in 2007 and
subsequent repeal of the AMT (costing $845 billion over 10 years) and an additional
tax on high-income individuals (raising $832 billion).
The plan also contained other tax revisions for individuals, to produce a roughly
revenue neutral overall individual tax revision. Taxes were reduced for lower-
income individuals by $86 billion, including an increase in the standard deduction,
an increase in the earned income tax credit for families without children, and an
increase in the refundability of the child credit. Taxes were increased for higher-
income individuals through a restoration of the phaseout of personal exemptions and
itemized deductions and a restriction on miscellaneous itemized deductions, for a
total gain of $38 billion. These general provisions resulted in tax reductions for over
95% of taxpayers, with increases in tax liability at very high income levels. The
individual section also contained base broadening provisions, raising $61 billion.
The most important of these were increased taxes on managers of hedge fund and
other investments, who tend to have high incomes.
The proposal also extended a number of expiring tax provisions for an
additional year at a cost of $21 billion.
The plan also included a corporate/business package that cut the corporate tax
rate from 35% to 30.5% (costing $364 billion over 10 years) and made an increased
expensing allowance for small business equipment permanent (a $21 billion cost).
Offsetting these losses were revenue raisers that resulted in a small net gain of $14
billion for this portion of the plan. The major revenue raising provisions were a
repeal of the domestic production activity deduction, increased taxes for
multinational corporations, and changes in inventory accounting.
Overall, the bill would lose $53.8 billion over five years and $7.5 billion over
10 years; thus, over the ten-year period it is close to revenue neutral as the loss is
only 3/100 of 1% of income tax revenues.
Individual Tax Revision.............................................3
Revisions in the AMT..........................................3
Tax Benefits for Lower-Income Individuals.........................4
Tax Increases on High-Income Individuals..........................5
Individual Base Broadening......................................7
Corporate Tax Provisions..........................................11
Appendix: A Discussion of Extenders.................................17
List of Tables
Table 1. Major Provisions of H.R. 3970, The Tax Reduction and Reform Act
Table 2. Provisions of H.R. 3970 Affecting Lower-Income Taxpayers........4
Table 3. Provisions of H.R. 3970 Affecting Higher-Income Taxpayers........6
Table 4. Individual Base-Broadening Provisions of H.R. 3970 ..............7
Table 5. Distributional Effects of Major Individual Income Tax Provisions of
Table 6. Corporate Base Broadening Provisions of H.R. 3970..............12
Table 7. Extenders that Primarily Affect Individuals: Revenue Cost of
H.R. 3970’s One-Year Extension................................18
Table 8. Extenders that Primarily Affect Businesses: Revenue Cost of
H.R. 3970’s One-Year Extension ...............................19
Table 9. Other Extenders: Revenue Cost of H.R. 3970’s One-Year
The Tax Reduction and Reform Act of 2007:
On October 25, 2007, Chairman Charles B. Rangel of the House Ways and
Means Committee announced his tax revision proposal, H.R. 3970, the Tax
Reduction and Tax Reform Act of 2007. The most significant provisions, measured
by revenue effect, were a revision in 2007 and subsequent repeal of the individual
alternative minimum tax (AMT) and an additional tax on high-income individuals.
The proposal also contained tax cuts for lower-income taxpayers, some tax increases
on high-income individuals, several base broadening provisions, one-year extensions
of a number of expiring tax provisions, and a corporate and business revision
package that included rate reduction and base broadening.1 The 2007 AMT
provision, the extenders, and some other provisions are also included in a tax bill
subsequently passed by the House (H.R. 3996). The 2007 AMT provision was
eventually enacted in P.L. 110-166. Current bills also include some provisions,
including some revenue raisers: H.R. 6275 to extend the AMT revision for another
year, and H.R. 6049, which includes the extension of expiring provisions.
Table 1 shows the major provisions and categories of minor provisions of H.R.
3970. The AMT provision includes a one year “patch” that would extend temporary
increases in the exemption and credits that prevent the AMT, a provision originally
targeted at very high-income individuals, from affecting many upper middle class
taxpayers. The AMT revisions would lose revenues projected at $845.2 billion over
the 10-year period FY2008-FY2017. Roughly offsetting this loss is an increase in
taxes on higher-income individuals, in the form of an increased tax rate of 4% and
4.6%, which would gain $831.7 billion in revenues. These amounts are slightly
under 5% of total individual income tax revenue projected to be collected over the
In addition to these major provisions, there are $86 billion in tax cuts for lower-
income individuals, including an increase in the standard deduction, the earned
income credit, and the refundability of the child credit. There are also additional
taxes on higher-income individuals in the form of restrictions on itemized deductions
and personal exemptions. There are also a series of base broadening provisions, with
the most significant ones increases in taxes on investment managers.
1 Base broadening provisions expand the amount of income subject to tax or taxes collected;
they raise revenue and largely involve restricting deductions and exemptions, although one
of the major ones imposes a higher rate (treating certain income as ordinary income rather
than capital gains).
Table 1. Major Provisions of H.R. 3970, The Tax Reduction and
Reform Act of 2007
Provision ($billions) (% )
Lower-Income Tax Cuts-86.2-0.40
Additional Tax on High Incomes831.73.85
Other Provisions Affecting High Incomes37.80.17
Primarily Affecting Individuals -6.0-0.03
Primarily Affecting Business-15.2-0.07
Production Activities Deduction114.90.53
Small Business Expensing -20.5-0.10
Small Other Provisions10.10.05
Source: Joint Committee on Taxation.
The proposal also includes one-year extensions of 37 tax benefits that are
scheduled to expire, mostly at the end of 2007. The most significant of these are the
research and experimentation credit, the deduction for state and local sales taxes, and
the 15-year recovery period for certain lease-hold improvements and restaurant
Finally the proposal reduces the top corporate tax rate from 35% to 30.5%, with
the change offset by a series of base broadening provisions, with the most important
ones repealing the domestic production activities deduction, a set of international tax
provisions, and two inventory revisions.
As indicated by the table, the individual section is essentially revenue neutral
(raising as much revenue as it loses), the extenders have a very small loss, and the
corporate revisions a very small gain. Overall the bill has a negligible effect on
revenues over a 10-year period. Note, however, that these measures reflect the
standard baseline for legislative proposals that assumes the 2001 tax cuts are allowed
to expire. Were the tax cuts to be extended, the revenue loss associated with the
repeal of the AMT would be larger, or, to put it another way, if H.R. 3970 were
enacted, the cost of extending the tax cuts would be larger. This interaction occurs
because the lower tax rates enacted in 2001 were not fully realized (were “taken
back”) for many taxpayers, especially as time passed, because these taxpayers were
subject to (or became subject to) the AMT.2
The provisions in the bill that provide the AMT patch through 2007 and the
extenders are included in H.R. 3996, a bill passed by the House on November 9,
2007 that deals with more immediate issues.3 The revenue cost of the AMT patch
in that bill is $50.6 billion, as compared to $49.6 billion in H.R. 3970. The
difference apparently reflects a larger increase in the AMT exemption to allow for
real income growth.
Individual Tax Revision
The individual tax revisions constitute the major portion of the bill, in size of
tax changes. The individual tax package is roughly revenue neutral, but it
redistributes tax burdens. The sections below discuss the revisions and some of the
issues associated with them. The final section summarizes the overall distributional
Revisions in the AMT
The AMT has become a major issue and eliminating it and paying for the
resulting revenue cost is the most important feature of the bill in terms of revenue.
The objective of the AMT was originally to impose taxes on higher-income
individuals who were otherwise paying low taxes because of tax preferences (i.e., tax
benefits). Because AMT exemptions were not indexed for inflation, and because of
other revisions, the AMT began to affect individuals in the upper middle incomes,
2 CRS Report RS21817, The Alternative Minimum Tax (AMT): Income Entry Points and
“Take-Back” Effects, by Gregg Esenwein.
3 H.R. 3996 includes some other relief provisions, including eliminating tax on mortgage
debt forgiven and ending the private debt collection program for the Internal Revenue
Service. It also includes revenue raisers, among them taxes on investment managers and a
delay of the worldwide interest allocation rule for the foreign tax credit, discussed below.
and no longer affected the very highest income individuals.4 Increasingly the AMT
is a tax that is triggered by provisions that it was not originally focused on, such as
personal exemptions and certain itemized deductions.
The bill’s AMT provisions are in two parts: an extension of the “patch” for 2007
(costing $49.6 billion) which increases and indexes the exemption from the AMT and
extends allowances of certain credits, and the subsequent repeal of the AMT (costing
$797.7 billion). Without the patch, the AMT, which initially applied to less than
20,000 taxpayers, and applied to 3.5 million in 2006, will affect 24 million taxpayers
in 2007. These amounts will grow over time.
Tax Benefits for Lower-Income Individuals
H.R. 3970 contains three provisions targeted at lower-income individuals that
cost $86 billion overall: an increase in the standard deduction; an increase in the
earned income credit for families without children; and an increase in the
refundability of the child credit.5 The revenue cost of the components is shown in
Table 2. Provisions of H.R. 3970 Affecting
Earned Income Credit-29.1
Source: Joint Committee on Taxation.
4 For a general discussion of the AMT, see CRS Report RL30149, The Alternative Minimum
Tax for Individuals, by Steven Maguire. See also CRS Report RL34382, The Alternativeth
Minimum Tax for Individuals: Legislative Activity in the 110 Congress, by Steven Maguire
and Jennifer Teefy, and CRS Report RL33899, Modifying the Alternative Minimum Tax
(AMT): Revenue Costs and Potential Revenue Offsets, by Jane G. Gravelle.
5 For further discussion of these issues see CRS Report RL33755, Federal Income Tax
Treatment of the Family, by Jane G. Gravelle, CRS Report RL31768, The Earned Income
Tax Credit (EITC): An Overview, by Christine Scott, and CRS Report RS21860, The Child
Tax Credit, by Gregg Esenwein and Maxim Shvedov.
The bill would increase the standard deduction by $850 for married couples,
$425 for singles, and $625 for heads of households. The standard deductions for
2007 are currently $10,700, $5,350, and $7,850 respectively. This change would
increase the number of lower-income taxpayers who do not pay taxes, and also
decrease the share of taxpayers that itemize, a change that would simplify tax
compliance. This increase in the standard deduction accounts for $47.9 billion of the
The proposal would also increase the earned income tax credit for single
individuals and married couples without children, as well as the credit’s phase out
range. These families receive a small earned income tax credit of 7.65% on income
up to $5,590, compared to a 34% credit for families with one child and 40% for
families with two children, both applicable to larger incomes. The credit phases out
(for 2007) at $12,590 for singles and $14,590 for childless couples. The proposal
would increase the amount eligible for the credit from $5,280 to $10,900 and the
credit rate to 15.3%. This provision costs $29.1 billion.
Some might resist the expansion of the earned income credit to families without
children, taking the view that the program is a welfare program run through the tax
system and thus should be directed at the more vulnerable population as are many
other welfare programs (such as Medicaid and general income support programs).
From the viewpoint of tax equity, however, the restricted benefits for those without
children cause poor families without children to pay taxes while families with
children that have a much higher standard of living have tax subsidies, which are
enhanced by the child tax credit.
The third proposal would increase the refundability of the child tax credit, that
is, the rebate of the tax for families with little or no tax liability. Currently, the child
tax credit is refundable for 15% of income over $11,300; hence the credit is not
refundable or fully refundable to low-income families. The proposal would decrease
the threshold to $8,500 and no longer index it, so it would continually decline in real
value over time. This provision costs $9.1 billion.
Tax Increases on High-Income Individuals
Three revenue raising provisions apply to high-income individuals and roughly
offset the losses associated with the repeal of the AMT: a tax on high adjusted gross
incomes, a restoration of provisions that phase out personal exemptions and itemized
deductions for high-income taxpayers, and an increase in the floor for miscellaneous
itemized deductions. The revenue impact of the provisions is shown in Table 3.
By far the largest of these provisions, an $831.7 billion revenue gain, is a
proposal to impose a surtax of 4% on adjusted gross income above an amount that
would be set by the Treasury Secretary where 90% of individuals above that amount
would otherwise be subject to the AMT. This amount would, however, not be less
than $200,000. There would be an additional 0.6% tax on incomes above $500,000
($250,000 for singles), for a total additional tax of 4.6% on such income. Unlike an
ordinary rate increase, these increased taxes would apply to adjusted, not taxable,
income. Thus they would increase tax rates on all income whether or not it is eligible
for preferences such as itemized deductions or lower rates (Capital gains and
dividends are taxed at a maximum rate of 15% through 2010; after that point the
dividend preference will end and the capital gains tax will rise to 20%).
Table 3. Provisions of H.R. 3970 Affecting
Tax on High Adjusted Gross Incomes831.7
Restoration of Itemized Deduction and Personal28.6
Increase in Miscellaneous Itemized Deduction Floor7.1
Source: Joint Committee on Taxation.
The second provision would restore the phase out of personal exemptions and
itemized deductions for high-income individuals, commonly referred to as PEP and
Pease. Under the terms of the 2001 tax cut, these phase outs were to be gradually
eliminated. This provision has no effect on revenues after FY2012 because this
phaseout’s elimination occurs only through 2010, as the 2001 tax cuts sunset in 2010,
but overall would raise $28.6 billion.
The third provision would increase the current 2% floor under miscellaneous
itemized deductions to 5% for income over $500,000 ($250,000 for single returns).
This is a deduction that was not allowed under the AMT. It raises $7.1 billion. Also
included in the table is an interaction term to cover the relationships among these
provisions and with the AMT repeal.
The rationale for these increases is that the AMT was aimed at higher-income
individuals and thus taxes should be raised on these individuals to pay for AMT
repeal. The use of adjusted gross income as a base imposes the tax on items such
itemized deductions and preferentially taxed dividends and capital gains, the latter
a very significant share of income at high income levels. When the original AMT
was imposed, the major preference subject to the AMT was excluded capital gains.
But when capital gains preferences, which were eliminated in 1986 when the capital
gains exclusion was eliminated, were restored and expanded in 1997 and 2003 via
a lower rate, they were not included as preferences. That is, capital gains, and
subsequently dividends, are still taxed at the lower rate of 15% as they are under the
regular tax, rather than the 26% (or 28%) AMT rate.
At the same time, there is some resistance to increasing marginal tax rates, and
also resistance to increasing taxes on dividends and capital gains which form part of
the double taxation of corporate income (although the corporate rate is lowered in the
proposal as well). In addition, some economists believe that higher capital gains
taxes significantly deter capital gains realizations and may even lose revenue; other
researchers have, however, found a negligible response.6
Individual Base Broadening
The bill also includes several individual provisions that are virtually all base
broadening provisions and raise revenue. As shown in Table 4, only one of these
individual provisions, which affects taxes on tax exempt organizations, loses
The first provision addresses the tax treatment of investment managers, such as
managers of hedge funds, and would treat investment income that is currently treated
as capital gains as ordinary income, based on the view that this income is not
investment income, but compensation for services. This income is commonly7
referred to as “carried interest.”
Table 4. Individual Base-Broadening Provisions of H.R. 3970
Treat Investment Managers Income as Ordinary Income25.7
Deferred Compensation for Investment Services22.6
Elimination of Unrelated Business Income Tax for-1.3
Tax Sharing Sales, Gain Treated as Ordinary Income0.1
Employment Taxes of S Corporations9.4
Basis Reporting for Brokers4.3
Source: Joint Committee on Taxation.
6 See the discussion of effects of increasing taxes on capital gains and dividends as a
revenue offset for AMT reform in CRS Report RL33899, Modifying the Alternative
Minimum Tax (AMT): Revenue Costs and Potential Revenue Offsets, by Gregg Esenwein
and Jane G. Gravelle. The appendix to that report contains a review of the literature on the
empirical evidence for a realizations response, with more recent studies finding lower
7 See CRS Report RS22717, Taxation of Private Equity and Hedge Fund Partnerships:
Characterization of Carried Interest, by Donald Marples.
There are two provisions relating to the investment in offshore hedge funds by
tax exempt investors. Earnings of domestic tax exempt investors are exempt from
income tax, but there is an unrelated business income tax (UBIT) which applies to
certain investments not related to their tax-exempt purpose. Currently, debt-financed
investments are subject to the these taxes. In the case of partnership investments, the
flow through of attributes can result in an imposition of the UBIT. In the case of
domestic corporations there is no flow through, but a tax is imposed at the corporate
level. Offshore investments in some cases use corporate “blocker” firms that are
structured to avoid corporate tax but prevent the flow through of attributes, so no tax
is applied to tax exempt investors at any point. They also attract non-taxable foreign
investors. The first of these two provisions relating to offshore investments by tax
exempt entities would require investment managers who have deferred compensation
through these operations to be taxed currently. Normally, where deferred
compensation benefits are paid, the employee is not taxed but the firm is not able to
take a deduction. The lack of a corporate deduction, which gains revenue, offsets the
failure to tax the employee, which loses revenue. This offsetting revenue gain does
not occur when the effective employer is tax exempt, and the bill’s current taxation
of deferred compensation restores the tax.
The second provision relating to tax exempt hedge fund investment (the third
provision listed in Table 4, which loses revenue) would eliminate the UBIT for
partnerships, which would remove the differential tax treatment that encourages
offshore investment in corporate blocker hedge funds relative to domestic
partnerships. The revenue loss may be small because very little investment involves
domestic partnership investments. There is some disagreement about the direction
to take for UBIT. The provision is this bill mirrors H.R. 3105, introduced by
Congressman Levin. Supporters of this view may wish to reduce the incentive to
invest through offshore entities, or may view the inclusion of debt financed passive
investment as too broad a scope for the UBIT. An alternative approach would be to
conform the offshore treatment to the domestic investment by taxing these
investments under the UBIT. The Senate Finance Committee, which held hearings
on offshore investments on September 26, 2007, included witnesses that discussed
the growth of educational institution endowments in part via these offshore8
investments because they continued low spending rates out of these returns. This
hearing also considered direct requirements for spending as an alternative to
addressing the offshore UBIT issue.
The fourth provision in Table 4 refers to sales of depreciable property between
related parties, where any gain on the sale is taxed as ordinary income. The provision
treats as a sale between related parties any sale where there is a payment from the
buyer to the seller for depreciation-related tax benefits realized by the transferee.
The fifth provision in Table 4 would impose the same payroll treatment on
Subchapter S service firms (Subchapter S firms are incorporated as businesses but
elect to be taxed as partnerships) that apply to ordinary partnerships and
proprietorships in active business, namely that all income is subject to the payroll tax.
Currently, Subchapter S partners are required to pay payroll taxes on an amount that
8 Witness statements are posted at [http://finance.senate.gov/sitepages/hearing092607.htm].
in theory should reflect the value of their labor services, while ordinary partners and
proprietors must pay tax on all income. S Corporations have an incentive to evade
the payroll tax by understating the value of labor services for their shareholders. The
tax would apply to all income received as shares relating to service income and there
would be conforming changes to limited partners of service partnerships.
The final provision in Table 4 would require brokers to report the basis of sales
of securities to the Internal Revenue Service (IRS). Basis is generally the amount
originally paid for the security and is subtracted from gross proceeds to measure
capital gains. Currently only gross proceeds are reported. Basis reporting should
help reduce evasion of capital gains taxes because the IRS currently has no third
party information on the basis of assets which is necessary to determine capital gain.
The package of individual changes in the individual tax portion of the bill would
be roughly revenue neutral (a slight revenue loss) but would redistribute tax burdens.
Table 5 shows the change in tax liability and the percentage change in after tax
income (a measure of the effect on income distribution, due to the broad based
individual provisions) reported in a study of the broad based individual provisions9
by the Urban Institute-Brookings Institution Tax Policy Center. The distributional
effects would change over time, so the initial and final years are shown.
As Table 5 indicates, the tax burden would be reduced on lower, middle, and
upper middle income taxpayers, but increased on very high incomes. The reduction
at the lower incomes is due to the set of low-income tax provisions: the standard
deduction, earned income credit, and refundable child credit. The reduction in the
middle and upper middle classes is due to the repeal of the AMT, while the increases
at the top reflect the surtax on adjusted gross incomes.
In terms of dollar amounts (not shown here but available in the Tax Policy
Study) even the $200,000 to $500,000 income class on average receives a tax cut;
on average tax increases do not begin until the $500,000 to $1,000,000 income class.
9 Greg Leiserson and Jeffrey Rohaly, Distributional Effects of the Major Individual Income
Tax Povisions of H.R. 3970, The Tax Reduction and Reform Act of 2007, Tax Policy Center,
October 26, 2007, posted at
[ ht t p: / / www.t a xpol i c ycent e r .or g/ publ i cat i ons/ ur l .cf m?ID=411564] .
Table 5. Distributional Effects of Major Individual Income Tax
Provisions of H.R. 3970
Average% ChangeAverage% Change
Taxin After-Taxin After-
Distribution byChange,tax Income,Change,tax Income,
Cash Income 2008 ($)20082017 ($)2017
Total -81 0.2 25 0.0
Source: Urban-Brookings Tax Policy Center.
Extenders are provisions that are enacted on a temporary basis and that must be
reauthorized if they are not to expire. The revenue table provided by the Joint
Committee on Taxation (JCT) divides extenders into those primarily affecting
individuals, those primarily affecting businesses, and others (excise taxes and
Historically, most tax provisions were enacted on a permanent basis. Beginning
in the early 1980s, with the temporary research credit, the number of extenders has
grown dramatically. While some provisions were enacted on a temporary basis to
permit their evaluation, budgetary constraints may be argued to be the major reason
for the growth in the number of extenders, as a temporary provision has a smaller
revenue cost than a permanent one.
In keeping with this growth, there are 37 extenders in the bill, which cost a total
of $21 billion over a 10-year period. Many of these provisions have a negligible
revenue effect. The most significant ones are the research and experimentation
(R&E) tax credit, the optional state sales tax deduction, and the 15-year depreciation
recovery period for leasehold and restaurant improvements. The R&E credit
accounts for 40% of the total cost and the three provisions together account for 75%.
A more detailed discussion of these extenders and an individual listing is
presented in the appendix.
Corporate Tax Provisions
This section includes tax revisions that largely affect corporations, although
some provisions also affect unincorporated businesses. The provisions, which
involve both a rate reduction and broadening of the base, have a small net revenue
gain. The major tax reduction is a reduced corporate tax rate (from 35% to 30.5%)
that costs $364 billion over the 10-year period. The 2001 tax cuts generally focused
on individual taxes, although there were some revisions in the corporate tax in 2004,
and the 2003 reduction in tax rates on capital gains and dividends reduced the
combined (firm and individual) tax burden on corporate investment. This proposal
is the first since 1986 to include an overall corporate rate reduction.
A proposal to cut the corporate tax and broaden the base has also been recently
discussed by the administration, which convened a conference on July 27, 2007 to
address corporate issues. Some of that discussion focused on the expectation that
other countries will lower their corporate tax rates. These discussions included the
possibility of lowering the corporate statutory tax rate and broadening the base,
although the base broadeners in H.R. 3970 are different in many cases from those
explored by the administration. In general, a lower base and a broader base tends to
lead to smaller economic distortions from a tax cut, although the merits of each base
broadener are relevant to evaluating the proposal. There is, however, a limit to the
degree to which the statutory tax rate can be lowered without transforming the10
corporation into a tax shelter for individuals.
The second provision that loses revenue involves the small business expensing
deduction. The law has a permanent provision that allows the expensing of $25,000
of equipment purchases, a provision that is phased out as income rises. A provision
that increases the deduction to $125,000 and indexes it for inflation is effective
through 2010. This provision would make the higher temporary level and indexing
permanent. While such a provision favors small businesses over large ones, it11
simplifies tax compliance for smaller firms. It costs $20.5 billion over 10 years.
10 Corporate tax issues and administration discusses are discussed in detail in CRS Report
RL34229, Corporate Tax Reform: Issues for Congress, by Jane G. Gravelle and Thomas
11 See CRS Report RL31852 The Small Business Expensing Allowance: Current Status,
Legislative Proposals, and Economic Effects, by Gary Guenther.
Table 6 lists the corporate and business base broadening provisions. The most
important provisions in revenue gain are the repeal of the production activities
deduction, a repeal of last-in, last-out (LIFO) inventory accounting, and a provision
to disallow expenses of parent corporations to the extent foreign source income is
Table 6. Corporate Base Broadening Provisions of H.R. 3970
Repeal Production Activities Deduction114.932
Allocation of Expenses for Repatriation of Foreign Income106.385
Time of Foreign Currency Translation0.002
Repeal of Worldwide Interest Allocation26.204
Foreign Treaty Shopping6.397
Repeal of Last-In, Last-Out (LIFO) Inventory Accounting106.506
Repeal Lower of Cost or Market Inventory Accounting7.146
Disallow Special Accounting Rule for C Corporations0.225
Amortize Intangibles Over 20 Years20.697
Economic Substance Doctrine3.787
Dividend Received Deduction4.596
Ordinary Income S Corporation Stock Option in ESOP0.606
Termination Of DISC Rules0.881
Gain in Spin-Off Transactions0.235
Source: Joint Committee on Taxation.
The production activities deduction was enacted in 2004 and allowed a
deduction for 9% of taxable income from domestic manufacturing and other
production activities (such as construction). When fully effective it is the equivalent
of reducing the top corporate tax rate from 35% to 31.85%. Trading off this
provision for a rate reduction could also be seen as exchanging a somewhat more
limited provision for a rate reduction that affects all corporations.
Some of the benefit of the deduction is received by unincorporated firms. In a
letter dated September 22, 2004 to Senate staff members Mark Prator and Patrick
Heck, responding to a query about the similar (although slightly different) Senate
version of the provision, the Joint Tax Committee indicated that three quarters of the
benefit would have gone to corporations, 12 percent would have gone to Subchapter
S firms (smaller incorporated firms that elect to be treated as partnerships) and
cooperatives, 9 percent would have gone to partnerships, and 4 percent to sole
The production activities deduction has been the subject of some criticism by
both economists and other tax professionals. It distorts investment and, perhaps
more importantly, presents difficult administrative issues which require firms that
perform a variety of activities and who import intermediate goods from related firms
to allocate profits to domestic use and to qualified activities. Aside from increasing
compliance costs, the provision gives firms an incentive to characterize their
activities as eligible (i.e., related to domestic production) and to allocate as much
profit as possible into the eligible categories. Canada adopted a similar provision
several years ago and repealed it because of the administrative complications.13
The next four base-broadening provisions relate to international tax issues.
Under current law, income from foreign subsidiaries of U.S. firms is not taxed until
it is repatriated (in the form of dividends) to the parent. At the same time, the parent
is able to deduct costs, the most important of which is interest, even though some of
that cost is associated with income that is not immediately subject to U.S. tax. Such
treatment essentially allows firms to use foreign tax havens to effectively shift profit
out of the United States and its tax system. The allocation rule would deny the
portion of deductions associated with this income until the income is repatriated and
subject to tax. Companies investing in non-tax-haven countries could avoid the
allocation rule by repatriating income.
A provision allocating deductions was included in the proposals of the
President’s Advisory Panel on Tax Reform in 2005,14 but would have been coupled
with an exemption of active dividends of foreign subsidiaries. This change adopts
the allocation rule, but not the exemption. Although there has been some support for
an exemption provision, such a change is unlikely to contribute to economic
efficiency or U.S. welfare.15
12 The text of this letter was published in Tax Notes Today, 2004 TNT 187-70.
13 For a discussion of the development of the production activities deduction and the issues,
see CRS Report RL32103, Comparison of Tax Incentives for Domestic Manufacturing:
108th Congress, by Jane G. Gravelle. The production activities deduction is also discussed
in the Senate Committee on the Budget Print, Tax Expenditures: Compendium of
Background Material on Individual Provisions, S. Prt. 109-072 (Washington: GPO),
December 2006. This document is posted at the GPO site:
[http://frwebgate.access.gpo.gov/cgi -b in/useftp.cgi ?IPaddress=22.214.171.124&filename =
14 Simple, Fair and Pro-Growth: Proposals to Fix America’s Tax System, November 2005,
which can be found at [http://www.taxreformpanel.gov].
15 For a discussion of international tax reform, see CRS Report RL34115, Reform of U.S.
International Taxation: Alternatives, by David Brumbaugh and Jane G. Gravelle.
An additional allocation provision would repeal a rule that involved world wide
interest for the foreign tax credit. When income from abroad is subject to U.S. tax
(either as branch income or repatriated income), a foreign tax credit is allowed for
foreign taxes paid up to the U.S. tax due. For firms that have more foreign taxes paid
than allowable credits, increasing the amount of income allocated abroad increases
allowable foreign tax credits and reduces U.S. tax liability. Prior to 2004, U.S.
source interest was allocated between foreign and domestic incomes based on relative
magnitude of foreign and domestic assets. The 2004 provision included interest on
foreign borrowing as well as debt-financed investment in the calculation, which
would allocate more domestic interest to domestic source income, a reduction in
interest allocated to foreign income and a resulting increase in the foreign tax credit
limit. While there is some argument to be made for a worldwide allocation in
measuring income more precisely, the allocation rules produce undesirable
Another provision relating to international tax issues is intended to reduce
“treaty-shopping.” The United States imposes withholding taxes on interest,
royalties and similar payments to foreigners, but also engages in a number of treaties
with other countries where these withholding rates are reduced. A firm in a country
without a treaty can benefit by setting up a subsidiary in a treaty country to avoid the
withholding tax, and this provision would eliminate that benefit.17
Two provisions relate to inventory accounting. Inventories are most important
in the manufacturing and trade sectors of the economy.18 The most significant is
repeal of a provision that allows last-in, first-out (LIFO) accounting for inventories.
In this form of inventory, the good being sold is assumed to be the last acquired and
since, in general, prices tend to rise over time, this method increases the cost of the
good sold and reduces profit (and therefore tax liability). The other inventory method
is first-in, first out (FIFO), where the good sold is assumed to be the first acquired
and thus includes any price increases in income. Firms must use the same inventory
method for tax and book purposes, and as a result many firms that would find LIFO
advantageous nevertheless use FIFO because profits reported to shareholders would
be lower under LIFO. LIFO accounting may on average result in a more accurate
measure of income because it has the effect of indexing cost and not capturing
increases in value due to inflation. At the same time, when relative prices are
changing, such as oil prices, it allows firms to avoid tax on windfall gains. In
general, the economic consequences of taxing the return to inventories at a higher or
lower rate are probably not very important: because of the short holding period for
most inventories, the tax on the return is a very small part of the cost.
16 These distortions are relatively complicated to explain, but are discussed in more detail
in Jane G. Gravelle, “The 2004 Corporate Tax Revisions as a Spaghetti Western,” National
Tax Journal, vol. 58, September 2005, pp. 347-366.
17 There is also a provision with a negligible revenue effect that alters the time of foreign
18 See Jane G. Gravelle, The Economic Effects of Taxing Capital Income (Cambridge, MA,
The MIT Press), 1994, p. 300.
A second inventory provision eliminates the option to value inventories at
market value rather than cost. Allowing this option permits the recognition of losses
in inventory even though the items have not been sold, a treatment inconsistent with
the general realization principle for gains and losses.
Aside from the domestic production activity deduction and the foreign and
inventory provisions, three other provisions with significant revenue gains are
amortization of intangibles, the economic substance doctrine, and the dividends
received deduction. Under current law, acquired intangibles (the excess of the value
of a business over the value of its physical assets) are deducted over a 15 year period.
The provision in H.R. 3970 increases the period to 20 years. The treatment for
intangibles was enacted to simplify compliance and end disputes about the proper
recovery period for intangibles which were not easily classified or separated from
good will, which was assumed to be non-depreciable. At the time the issue was
discussed, there was an argument that most intangibles for which depreciation was
being argued to be appropriate by taxpayers (such as customer lists) were not really
depreciable, since they were either self-generating or expenses undertaken to generate
them were currently deductible. Thus, for most intangibles, recovery of acquired
intangibles on acquisition is more appropriately regarded as a reduction in the capital
gains tax, rather than a depreciation issue. In any case, there is likely to be relatively
little effect on the decision to undertake the original investment, since the
depreciation by subsequent purchasers is far in the future and subject to uncertainty.
Firms that enter into tax savings arrangements that are found not to have
economic substance can have their tax benefits disallowed by the courts under what
has become known as the economic substance doctrine. Proposals to introduce
legislative standards into the doctrine, which is sometimes interpreted differently by
different courts, have been included in a number of recent legislative proposals,
especially by the Senate Finance Committee. In a manner similar to other proposals,
H.R. 3970 would require a transaction to meet both an objective test (profit was
made) and a subjective test (profit was intended). Penalties are also imposed.
Supporters argue that the stricter test will not only reduce tax avoidance but also
make treatment more consistent across the courts. Some tax attorneys are concerned
that more specific rules might provide a roadmap to structuring arrangements that
will pass the test. The U.S. Treasury disputes the revenue gains projected by the Joint
Committee on Taxation and the current administration opposes the change, while the
Clinton Administration supported it.
The third provision relates to inter-corporate dividend deductions. To prevent
too much double tax at the corporate level, while still discouraging chains of partially
owned corporations (which allows one corporation to exert control over many others)
current law allows a partial, but not full, deduction for certain dividends paid
between corporations. For a firm 80% owned, there is a 100% dividend deduction,
for firms with 20% or more ownership, there is an 80% deduction, and for firms with
less than 20% ownership there is a 70% deduction. The bill would reduce the 80%
and 70% deductions to 70% and 60% (other than wholly owned subsidiaries). This
provision would prevent a reduction in the intercorporate tax burden as a result of the
rate cut. These taxes would actually rise slightly. For 20% owned the tax rises from
7% (0.3 times 35%) to 9.15% (0.2 times 30.5%); for less than 20% owners, the tax
rises from 10.5% (0.3 times 35%) to 12.2% (0.4 times 30.5%).
The remaining provisions are relatively small in revenue impact. They include
a provision that would prevent corporations from currently excluding payments from
tax that may be uncollectible in the future, rather than taking these losses into account
in the future. The stock option provision is aimed at taxpayers who hold options in
Subchapter S corporations (corporations that elect to be taxed as partners) in
combination with a large share of the stock held by a tax exempt employee stock
ownership plan (ESOP). This treatment allows much of the S corporation to avoid
tax while taxable shareholders accumulate value through options. Another provision
would eliminate benefits for the remaining domestic international sales corporations
(a form of organization that was eliminated in general many years ago). The final
provision relates to tax free spin-offs of subsidiaries by parents, where tax is imposed
on the parent if the parent receives value in excess of their tax basis in the subsidiary.
Included in the definition of value is debt of the parent assumed by the subsidiary.
This provision would apply that tax to debt assumed prior to the spin-off.
Appendix: A Discussion of Extenders
Most of these extenders are discussed in a CRS Report RL32367, Temporary
Tax Provisions (“Extenders”) Expiring in 2007, by Pamela Jackson and Jennifer19
Of the individual items in Table 7,20 the most significant in revenue impact is
the optional deduction for state and local sales taxes.21 The state and local deduction
for sales taxes was repealed in 1986; in 2004 it was reinstated as an optional
alternative to the deduction for state income tax and primarily benefits taxpayers in
those states with no income tax.
The second largest in revenue cost of the extenders is the deduction for tuition,
which covers some individuals who are not eligible for the permanent tuition tax
credit.22 There is also another education provision, allowing deductions for
classroom teachers.23 Three other provisions cost more than $100 million. The
provision allowing individuals to contribute to charity from their Individual
Retirement Accounts without including distributions in income and then deducting
them was enacted in 2006. This provision was part of President Bush’s original
charity proposals and was contained in a number of legislative proposals relating to
charitable deductions.24 It benefits older individuals who do not itemize, those whose
taxable social security benefits rise with their adjusted gross income, and persons
19 They are also discussed in the Joint Committee on Taxation’s Description of the
Chairman’s Amendment in the Nature of a Substitute of H.R. 3996, The Temporary Tax
Relief Act of 2007,JCX-106-07, November 1, 2007, posted at
[http://www.house.gov/jct/x-106-07.pdf]. Many of these provisions are also discussed in
Senate Committee on the Budget Print, Tax Expenditures: Compendium of Background
Material on Individual Provisions, S. Prt. 109-072, Washington, DC, U.S. Government
Printing Office, December 2006, posted at [http://frwebgate.access.gpo.gov/cgi-
bin/useftp.cgi ?IPaddress=162.14 0.64.88&filename=31188.pdf&directory=/diskb/wais/da
20 Table 5 also includes three provisions not described in the CRS extenders report that are
related to mutual funds. The fourth item allows certain interest income held by foreign
persons that would not be taxable if held directly to be exempt if channeled through a
mutual fund if designated as interest related. The next to last provision provides that assets
not invested in the United States and not included in the estates of foreigners would not be
considered invested in the United States because they are invested though a U.S. Mutual
21 See CRS Report RL32781, Federal Deductibility of State and Local Taxes, by Steven
22 See CRS Report RL31129, Higher Education Tax Credits and Deduction: An Overview
of the Benefits and Their Relationship to Traditional Student Aid, by Linda Levine and
Charmaine Mercer, and CRS Report RL32554, An Overview of Tax Benefits for Higher
Education Expenses, by Pamela Jackson.
23 See CRS Report RS21682, The Tax Deduction for Classroom Expenses of Elementary
and Secondary School Teachers, by Linda Levine.
24 See CRS Report RS21144, Tax Incentives for Charity: An Overview of Legislative
Proposals, by Jane G. Gravelle.
who are subject the charitable contribution limits. The provision relating to combat
pay addresses a problem created when, as a simplification measure, Congress did not
allow tax exempt income to be considered in calculating the earned income tax
credit. After the September 11 attack, many lower-income enlisted soldiers serving
in combat zones lost the earned income credit and were actually harmed by the
combat pay exclusion. This provision allows them the option of including their
combat pay in determining the earned income credit. The provision relating to
mortgage revenue bonds of veterans provides an exception to the requirement that
tax exempt mortgage revenue bonds must be used essentially for first time home-
Table 7. Extenders that Primarily Affect Individuals: Revenue
Cost of H.R. 3970’s One-Year Extension
Deduction for Private Mortgage Insurance-0.017
Deduction for State and Local General Sales Taxes-3.584
Deduction for Qualified Tuition and Related Expenses-1.389
Treatment of Certain Mutual Fund Dividends-0.067
Parity in the Application of Certain Limits to Mental Health-0.025
Contributions of Property Interests for Conservation-0.052
Tax Free Distributions from IRAs to Charity-0.452
Deduction for Classroom Expenses for Teachers-0.191
Election to Include Combat Pay for Earned Income Credit-0.019
Mortgage Bonds for Veterans Residences-0.159
No Penalty on Retirement Plan Withdrawals for Those-0.001
Called to Active Duty
Estate Tax Look Through for Mutual Fundsnegligible
Treatment of Mutual Funds Under FIRPTA-0.010
Source: Joint Committee on Taxation.
Table 8 lists the extenders that primarily affect businesses. By far the largest
of these provisions is the tax credit for research and experimentation (R&E)
expenditures, which was initially adopted in the early 1980s and has been extended
numerous times. There are justifications for subsidies for research investments,
given evidence that the social returns to this investment exceed the private returns,25
but the credit is criticized as being poorly targeted and subject to abuse.
Table 8. Extenders that Primarily Affect Businesses: Revenue
Cost of H.R. 3970’s One-Year Extension
Tax Credit for R&E Expenses-8.998
Indian Employment Tax Credit-0.059
New Markets Tax Credit-1.322
50% Tax Credit for Railroad Track Maintenance-0.165
15-Year Recovery Period, Leasehold and Restaurants-3.466
7-Year Recovery Period Motorsports Racetrack Property-0.027
Accelerated Depreciation, Indian Reservations-0.148
Expensing “Brownfields” Remediation Costs-0.192
Deduction for Domestic Production Puerto Rico-0.116
Modify Unrelated Business Income Tax Treatment of-0.023
Payments to Tax Exempt Organizations
Extension of Qualified Zone Academy Bonds Benefits-0.156
Tax Incentives for Investment in the District of Columbia-0.158
Economic Development Credit for American Samoa-0.016
Enhanced Charitable Deduction for Food Inventory-0.072
Enhanced Charitable Deduction for Book Inventory-0.031
Enhanced Charitable Deduction for Computers-0.218
S Corporation Basis Adjustment for Charitable-0.054
Source: Joint Committee on Taxation.
25 CRS Report RL31181, Research and Experimentation Tax Credit: Current Status and
Selected Issues for Congress, by Gary Guenther.
The second largest provision, measured by revenue loss, shortens to 15 years
from 39 years the recovery period for improvements in real property made to
accommodate lessors and restaurant improvements. These expenditures are likely
to have shorter lives than industrial and commercial structures in general and there
is some evidence that depreciation rules currently favor equipment over structures.26
The third largest provision is the new markets credit, a provision targeted to lower-
Other provisions costing at least $100 million include a tax credit for railroad
track maintenance enacted in 2004 and designed to assist short line railroads; tax
benefits for investments in Indian reservations and the District of Columbia, areas
that targeted for economic development assistance; a provision allowing costs of
cleaning up brownfields to be deducted immediately rather than over time as
depreciation, a provision with an environmental objective; provisions allowing a tax
credit for bonds used to financed certain special schools (zone academies)28; and a
provision allowing a charitable deduction in excess of the basis of donated property
to the firm (which is the cost or depreciated price) for computers. There are two
other provisions that allow contributions in excess of basis: food inventory and for
books. The enhanced food inventory provision for corporations is already a
permanent part of the tax code; the temporary aspect of this food inventory provision
is the extension of it to unincorporated businesses.29
Two provisions not included in the CRS summary of extenders are the provision
to extend the production activities deduction to Puerto Rico (this provision is
repealed after 2007 elsewhere in the bill and discussed previously), and a provision
that limits the imposition of the unrelated business income tax to rents, royalties and
other passive income received by tax exempt entities from controlled organizations.
Table 9 summarizes other extenders that do not fall naturally into “individual”
and “corporate” categories. Four of these provisions extend the authority to provide
information to other government agencies to facilitate certain activities, and one
extends IRS authority for undercover operations; these provisions have no revenue
effect. A disclosure provisions relating to veterans raises a negligible amount. The
other provision continues a temporary increase (from $10.50 per proof gallon to
$13.50 per proof gallon) the payments made to Puerto Rico and the Virgin Islands
to cover the U.S. excise taxes imposed on distilled spirits produced in those countries
and imported into the United States.
26 See CRS Report RL34229, Corporate Tax Reform: Issues for Congress, by Jane G.
Gravelle and Thomas L. Hungerford, which shows effective tax rates on equipment of about
27 See CRS Report RL34402, New Markets Tax Credit: An Introduction, by Donald J.
28 See CRS Report RS20606, Tax Credit Bonds: A Brief Explanation, by Steven Maguire.
29 See CRS Report RL31097, Charitable Contributions of Food Inventory: Proposals for
Change, by Pamela Jackson.
Table 9. Other Extenders: Revenue Cost of H.R. 3970’s
Disclosure Provisions (tax return information to facilitateNo Effect
combines employment tax reporting; return and
information to address terrorist activity, and return
information to facilitate repayment of student loans);
Authority for Undercover Operations
Rum Excise Tax Payment to Puerto Rico and the Virgin-0.093
Disclosure Provision (tax information for veterans)0.001
Source: Joint Committee on Taxation.