Repeal of 3 percent contractor tax withholding gathers steam

The House is gearing up for a scheduled Oct. 27 vote to repeal a six-year-old congressional mandate that agencies withhold 3 percent of contractors' payments in order to improve tax compliance -- a continually postponed requirement that isn't due to take effect until 2013.

A bill (H.R. 674) introduced by Rep. Wally Herger, R-Calif., cleared the Ways and Means Committee by voice vote on Oct. 13 with bipartisan backing, and a similar Republican bill was only narrowly defeated in the Senate on Oct. 20.

The Obama administration has criticized the requirement as burdensome during a time of high unemployment, though disagreements persist on how to offset the prospective revenue losses estimated at $11.2 billion over 10 years if the withholding is repealed.

Originally enacted in 2005 at the behest of Senate Republicans, the 3 percent withholding requirement wasn't fleshed out as a final Internal Revenue Service rule until this May. The idea has long been unpopular among contractors, and its history is one of shifting partisan attitudes.

"Small businesses bring more competition and reduced prices to federal contracting, so we should make sure the federal government pays them in a timely manner," said Rep. Sam Graves, R-Mo., chairman of the Small Business Committee, before the Ways and Means panel acted.

"This rule is disconnected from any tax liability that contractors may or may not have," said co-sponsor Rep. Earl Blumenauer, D-Ore. "Not only does it impose costs indiscriminately on businesses large and small, it also imposes costs on governments and agencies across the country. The Defense Department alone has found that merely complying with the new mandate will cost more than $17 billion over the first five years -- over $10 billion more than the Joint Committee on Taxation estimated the provision generating."

Arguments favoring the 3 percent requirement were updated this summer in a Congressional Research Service report summarizing analysis from the Joint Taxation Committee and the Government Accountability Office. "IRS empirical research has consistently shown that withholding and information reporting substantially improve tax compliance and thus reduce the tax gap," CRS said.

"The government has estimated that federal contractors owe billions in unpaid tax debts," Scott Amey, general counsel of the nonprofit Project on Government Oversight, told Government Executive. "Ironically, the IRS awarded contracts to at least 20 companies with delinquent taxes totaling $5.2 million. Although the tax withholding provision might be burdensome for a few contractors, it will help reduce the tax gap and prevent the government from chasing down debts."

Contractor groups and business associations have organized to push for repeal -- the Government Withholding Relief Coalition has 143 members. They argue that other regulations put in place since 2005 are sufficient to prevent tax-delinquent contractors from winning new federal work. They also warn of infringements on company privacy.

Roger Jordan, vice president of government relations for the Professional Services Council, said, "unless this policy is repealed, companies will be underpaid for the work they do for the government while still having to pay their employees and suppliers in full, keep their businesses up and running, and invest in new technology. Such underpayments would make it difficult, especially for small businesses, to invest in job creation and innovation."

Andy Howard, a partner in the construction and government contracting group of Alston+Bird law firm, told Government Executive that the initial requirement was "a bad idea at an even worse time. Good contractors could end up shouldering the burden for a handful of unscrupulous ones," he said, adding that it could be "potentially crippling" for the cash-flow-dependent construction industry.

TechAmerica, an information technology trade group, warned in an analysis that companies are likely to pass along the added costs to customers, and it challenged the estimated revenue gains, saying most of it would come "solely due to accelerated tax receipts and not an actual revenue increase from improved tax compliance."

The American Institute of Certified Public Accountants said in congressional testimony in May that its members report that state and local governments, whose contracts the law also covers, "are concerned about the cost to reprogram their systems to comply with the law."

The administration's position has evolved. The 2009 Recovery Act delayed implementation of the withholding provision until Jan. 1, 2012, a deadline since moved to 2013 by the IRS. But the problem of uneven contractor tax compliance persisted. This April, GAO estimated that at least 3,700 recipients of Recovery Act contracts and grants -- including prime recipients, subrecipients and vendors -- are estimated to owe more than $750 million in known unpaid federal taxes as of Sept. 30, 2009.

On Oct. 20, the Office of Management and Budget issued a statement backing repeal, saying such a change would "avoid a decrease in cash flow to these contractors, which would allow them to retain these funds and use them to create jobs and pay suppliers. This would complement the administration's other efforts to help small businesses."

But the same OMB statement objected to the version of the bill (S. 1726) offered on the Senate floor by Minority Leader Mitch McConnell, R-Ky., whose "unspecified rescission of $30 billion in appropriated funds would cause serious disruption in a range of services supported by the federal government," OMB said.

McConnell stressed that he was drawing from Obama's current jobs bill and argued that leaving the cash in the hands of businesses rather than the government would create more jobs. The vote on his motion was 57-43, three short of the 60 votes required to begin consideration of the bill.

Sen. Max Baucus, D-Mont., chairman of the Finance Committee, said on the floor, "we all agree that the contractors who contract with the federal government should pay their taxes . . . There is also agreement that we should not overburden small businesses which are paying their taxes. Still, Baucus said, there are two flaws in McConnell's proposal. "It lets all government contractors off the hook, even those who refuse to pay taxes," he said. "Those contractors would not be subject to the mechanism to make sure they pay.

"Second," he said. "this is paid for by rescinding $30 billion of appropriated funds, which is, frankly, contrary to the agreement reached with the president on the deficit reduction."