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January 2007

Government Affairs

Tax Cuts:
Paying the Price

The tax cuts passed by Congress and signed into law by President Bush in 2005 seemed to be a blessing for everyone. However, unbeknownst to many members of Congress, as well as the general public, a sweeping new requirement was added at the last hour to provide an offset and make up revenue that would ultimately be lost by cutting taxes. Had this new requirement been through the proper vetting process, it is likely that Congress would never have passed the bill. This new requirement, which is due to take effect in 2011, will be detrimental to mason contractors and construction companies across the United States.

Inserted in the Tax Increase Prevention and Reconciliation Act of 2005 (H.R. 4297), Section 511 is a sweeping, new requirement mandating that all government entities — federal, state and local — deduct and withhold from all payments made to any individual or business providing any goods or services an amount equal to 3 percent of the total payment. Thrown in as a "revenue raiser," this new withholding obligation affects all government contracts, as well as any payment to any person for a service or product provided to a government entity. Section 511 was in neither the original House- nor Senate-passed bills.

Recently, Sen. Larry Craig (R-ID) introduced legislation in the Senate, titled the Withholding Tax Relief Act of 2006 (S. 2821). Craig's important piece of legislation would repeal Section 511 of the recently enacted Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222). In addition to Craig's efforts, Rep. Wally Herger, (R-CA) has introduced companion legislation in the House of Representatives to repeal this potentially damaging tax policy.

Mason contractors, as well as any company that receives contracts or other forms of payment from the government, should have deep concerns regarding the impact and unintended consequences of Section 511. Among other concerns, the costs to governments at all levels to administer the program will be substantial, and the process exceedingly complicated to implement. In May 2006, the Congressional Budget Office released a report stating the withholding provision constitutes an unfunded mandate on state and local governments, exceeding the annual threshold established in the Unfunded Mandates Reform Act of 1995.

Advocates of Section 511 argue that withholding payments to contractors is one way of closing the "tax gap" — the difference between what taxpayers should pay and what they actually pay on a timely basis. And since they allege that government vendors are among the most egregious abusers of tax filing and payment obligations, they reason it's only fair to impose this new requirement.

The central problem with this thinking is that it wrongly assumes that 3 percent of the gross payment on a contract will match the contractor's tax liability on that particular project. Consider a contractor who signs a $1-million contract to perform work on municipal property. Section 511 would require the municipality to withhold 3 percent, or $30,000, of the $1-million payment. And for argument's sake, let's assume the contractor earns a 3-percent profit — which approximates the national average in construction contracts — on the project. That means the contractor would expect a profit of $30,000, or 100 percent of the amount withheld. Let's further assume that the contractor is taxed at the top corporate income tax rate — currently 35 percent. Because businesses are taxed only on their profits, the tax liability on this $1-million project would be $10,500. So in effect, the contractor would float the Federal government an interest-free loan for $19,500 on this particular project.

While all industries are subject to the withholding, the negative toll on construction is grossly disproportionate. Three percent may not sound steep, but it's larger than the profit margins permitted under many government contracts and will significantly impede cash flow, thereby jeopardizing a firm's ability to compete for business or even complete projects. With the price increases the industry has been subjected to in recent years from suppliers, materials and labor, many firms simply will choose, or be forced, to withdraw from public-sector work.

Another concern is the impact this will have on the ability of contractors to secure bonding. When evaluating the health of a contractor, surety companies look for a healthy cash flow, strong margins and timely payments. To suddenly strip a contractor of 3 percent of his or her working capital increases the risk of performance failure and potentially jeopardizes performance bonding. Similarly, payment bonds are likely to be affected.

Section 511 is seriously flawed. It hits honest taxpayers in an attempt to get at those underreporting income. It's antithetical to competition; fewer firms will be able to bid on government contracts, as companies with tight margins or irregular cash flows would lose vital funds for day-to-day operations and would be at a competitive disadvantage in the bidding process. Section 511 also is inflationary; as the cost of doing business with all levels of government is raised, many contractors will have to assume higher levels of debt or equity to ensure regular cash flows necessary for operations. The cost of this increase in capital structure will be passed on to the government through increased price of goods and services, and ultimately will be borne by the taxpayer.

There will be a large number of harmful, unintended consequences if the provision is not repealed prior to 2011. Section 511 hurts honest, taxpaying businesses by essentially forcing companies to provide the government interest-free loans with their hard-earned profits and company equity.







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