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Personal Tax Review - US Tax Reform

By Tax-News.com Editorial
31 July, 2013


President Obama, when on the campaign trail in 2008, envisaged a dramatically simplified tax system whereby 40 million Americans would be able to complete their tax returns in less than five minutes without the paid help of an accountant. Clearly, this utopian vision of the US tax landscape has failed to come to pass, but as Congress begins to debate comprehensive tax reform in earnest, personal taxpayers struggling to comply with America’s dysfunctional tax system at least have some cause for optimism.

Besides cutting taxes for the middle classes, the following was pledged in Barack Obama’s 2008 Comprehensive Tax Plan: “Obama will reform our tax system to greatly reduce its complexity, consolidating several credits and giving taxpayers the option of pre-filled tax forms to verify, sign and return. Under the Obama tax plan, 40 million Americans who take the standard deduction will be able to do their taxes in less than five minutes and will not have to hire an accountant. This will save Americans more than USD2 billion in tax preparer fees and more than 200 million hours of work.”

The reality, as highlighted last January by National Taxpayer Advocate Nina E. Olson in her 2012 Annual Report to the United States Congress, is quite different: “The existing tax code makes compliance difficult, requiring taxpayers to devote excessive time to preparing and filing their returns. ... It obscures comprehension, leaving many taxpayers unaware how their taxes are computed and what rate of tax they pay.”

Olson added: “It also facilitates tax avoidance by enabling sophisticated taxpayers to reduce their tax liabilities and provides criminals with opportunities to commit tax fraud and it undermines trust in the system by creating an impression that many taxpayers are not compliant, thereby reducing the incentives that honest taxpayers feel to comply.”

The report states that the tax code imposes a “significant, even unconscionable, burden on taxpayers.” Since 2001, Congress has made nearly 5,000 changes to the tax code, an average of more than one a day, and the number of words in the code appears to have reached nearly four million, Olson observed.

In particular, Olson pointed out that it takes US taxpayers (both individuals and businesses) more than 6.1bn hours to complete tax filings; it was estimated that it cost individual and corporate taxpayers USD168bn to comply with the tax code in 2010; and around nine out of ten Americans rely on paid professionals or commercial software to prepare their tax returns (nearly 60% of taxpayers hire paid preparers; another 30% use software).

Olson considers that: “If tax compliance were an industry, it would be one of the largest in the US.”

Or, to put in another way using an oft-repeated phrase of chief House of Representatives tax writer Dave Camp (R - Michigan), the tax code “is ten times the size of the Bible with none of the Good News.”

Not that we are ascribing blame for this situation to President Obama. Congress has played its part by passing temporary fixes to the tax system which repeatedly kick the more fundamental issues about how Washington taxes and spends down the road for another day. The last-minute deal to avert the fiscal cliff last January was a prime example. Furthermore, the tax code was broken way before Obama arrived in the White House; the current state of affairs is the culmination of almost 30 years of Congress adding various special interest tax provisions to the code – “pork” in the language of D.C. – since the last major reform took place in 1986. Besides, all presidential candidates propose tax reform plans that range from the merely difficult-to-do up to utterly outlandish (see Herman Cain’s “9-9-9” plan), and Obama’s plan was probably at the more conservative end of the range. Nevertheless, Obama certainly hasn’t helped improve things. Indeed, the various temporary tax credits and other time-limited tax breaks passed since 2009, and his heavy emphasis on tax compliance, have tended to make a bad situation worse.

However, while many Americans have burned the midnight oil attempting to comply with their tax obligations, a lot of work has been taking place quietly behind the scenes in Congressional committees to prepare the way for the first clean sweep of the US tax code since President Reagan sat in the Oval Office. The Senate Finance Committee, which has jurisdiction over tax legislation, has conducted 30 hearings on a range tax reform options over the past couple of years, while over in the House, its equivalent, the Ways and Means Committee, has held 20 on mostly the same issues. Earlier this summer, the respective Chairmen of these committees, Max Baucus (D – Montana) and Dave Camp, combined their efforts and took to the road to sell the idea of tax reform in a number of US cities.

Said Baucus in a recent statement designed to elevate the importance of tax reform in the consciousness of his fellow Senators: “Our tax code today is inequitable, inefficient and incomprehensible to the overwhelming majority of Americans. It contains nearly four million words — four million.  If someone were to try and read the entire code aloud, it would take them more than 18 uninterrupted days. Not only is the code long, but it is maddeningly complex.  There are 42 different definitions of a small business in the code — 42. There are 15 different tax incentives for higher education.  So many that the IRS had to publish a booklet just to explain and simplify the higher education tax incentives.  And that book is 90 pages long.

“The tax code today is also inefficient and unfair,” he continued. “It is riddled with loopholes and deductions that result in more than USD1 trillion in lost revenue each year.  This complexity in the code is eroding confidence in our economy and creating uncertainty for America’s families and businesses.  It is also threatening to undermine the competitiveness of the United States in the global marketplace.”

In announcing a hearing into how the tax code burdens individuals and families on April 6, 2011, Camp echoed Baucus’s sentiments. “As the deadline for filing individual tax returns approaches, the time for simplifying and stabilizing the tax code for individuals and families is also upon us,” he observed. “With so many Americans struggling to meet their tax compliance responsibilities, Congress and the President need to work together to achieve a tax system that is fair, simple, and efficient.  While some seem to prefer a ‘business-only’ approach to tax reform, we owe it to the hard-working taxpayers we represent to ensure that they are not left out of this discussion.  This hearing will help the Committee better understand the many problems that plague our tax system as it affects individuals and families across the country.”

In addition to the 20 separate tax reform hearings since January 2011, the Ways and Means Committee has released a series of discussion drafts, covering mainly business topics, and created 11 tax reform working groups in February 2013, each led by one Republican Member serving as Chair and one Democratic Member serving as Vice Chair. These working groups covered the following areas of taxation: charitable/exempt organizations; debt, equity and capital; education and family benefits; energy; financial services; income and tax distribution; international; manufacturing; pensions/retirement; real estate; and small business/passthroughs.

Meanwhile, the Senate Finance Committee has also been busy advancing the cause of tax reform this year, having released a series of 10 tax reform options papers. These papers include: Simplifying the Tax System for Families and Businesses; Business Investment and Innovation; Family, Education and Opportunities; Infrastructure, Energy and Natural Resources; International Competitiveness; Economic and Community Development; Economic Security; Types of Income and Business Entities; Tax-Exempt Organizations and Charitable Giving; Non-Income Tax Issues and Related Reforms.

An examination of all these hearings, as well as the numerous discussion and tax reform option papers issued by both Congressional tax writing committees would fill up many volumes. Therefore, issues discussed and options proposed in three of the Senate Tax Reform Option Papers affecting mainly individual taxpayers are outlined below:


Senate Tax Reform Option Papers

Simplifying the Tax System for Families and Businesses Paper

Presented on March 21, 2013, this paper dealt with the administrative and compliance burdens placed on both the taxpayer and the IRS. The paper set out broad principles for reform in this area, including:

  • Reducing the cost to taxpayers of complying with the tax code;
  • Improving the ability of the IRS to administer the tax law efficiently;
  • Reducing tax evasion and inadvertent mistakes;
  • Providing taxpayers with better service;
  • Protecting taxpayers from identify theft and privacy invasions; and
  • Ensuring that all taxpayers are treated fairly and similarly situated taxpayers are treated similarly.

Options put forward for achieving these aims included the following:

  • For taxpayers with relatively simple returns, requiring the IRS to pre-fill the returns with information it has received from third parties and preliminarily calculate tax liability; the taxpayer could either accept and sign this return or make needed changes (this mirrors California’s “Ready Return” Program).
  • Repealing provisions that require taxpayers to calculate their tax liability multiple times, including:
    • the Alternative Minimum Tax (AMT)
    • the personal exemption phase-out (PEP)
    • the phase-out of itemized deductions (Pease)
    • the corporate AMT
  • Establishing uniform definitions of terms such as “qualifying child”, “modified adjusted gross income”, and “related party”;
  • Repealing provisions that are no longer necessary including, for example, the more than 100 “deadwood” provisions identified by the Joint Committee on Taxation;
  • Enabling the IRS to verify information on taxpayer returns against third-party information as returns are processed; and
  • Establishing a system of filing deadlines that ensures timely receipt of reliable third-party information by taxpayers and the IRS, for example by changing due dates for returns.

Further proposals were made in the area of collection and enforcement including, among other ideas:

  • Reducing tax fraud and ID theft by limiting access to personal identifying information;
  • Reducing the “tax gap” by restructuring and simplifying the penalty system to improve voluntary compliance and ease the administrative burden of the system, for example, by consolidating similar penalties;
  • Improving, automating, and enhancing information-reporting by third parties to the IRS; and
  • Improving the taxpayer experience in IRS audit and collection procedures by making it easier for taxpayers to structure payment plans with the IRS.

Families, Education and Opportunities

This paper, presented on April 18, 2013, examines those areas of the tax code that have been deliberately put in place to influence individual behaviour, chiefly those that affect decisions about whether to work, marry, have children, and pursue an education. 

The paper lists the following potential broad principles for reform in this area:

  • Accounting for the costs of raising children in a manner that is equitable, efficient, simple, promotes opportunity, and takes spending programs into consideration;
  • Ensuring that the tax code does not create large disincentives to work, taking into account tax rates, the phase-out of tax expenditures and means-tested transfer programs, and dependent care costs;
  • Carefully considering the existing tax incentives and disincentives to marry;
  • maximizing the effect of education incentives on educational attainment, if such incentives are to be retained in the tax system;
  • Carefully considering the implications of demographic trends; and
  • Simplifying the tax code and providing certainty by making temporary provisions permanent, eliminating them, or allowing them to expire.

Some specific concerns stated in the paper about this complex area of the US taxation system include the following:

  • Complexity:  There are a large number of tax provisions related to children, work, and education.  Many have different requirements and definitions, and some are temporary. This complexity and uncertainty results in confusion, unintended errors, large costs to taxpayers of complying with the tax code, and a weaker response to any tax provisions that policymakers intend to influence taxpayers’ decisions.   
  • Work disincentives:  The effective marginal tax rate at many income levels is sometimes surprisingly high because of various phase-outs (e.g., Earned Income Tax Credit, personal exemptions, child tax credit, Supplementary Nutrition Assistance Program, Temporary Assistance for Needy Families, and Medicaid) as well as the explicit statutory rates in the income and payroll taxes.  A recent Congressional Budget Office (CBO) analysis found that some workers near the poverty line face effective marginal tax rates as high as 60%, and closer to 100% when one also considers phase-outs in the transfer system.
  • Work disincentives for primary caregivers and secondary earners:  Primary caregivers are adults with primary responsibility for caring for a dependent, such as a child or elderly parent.  Some research suggests that primary caregivers have less of an incentive to work than others earning similar wages because of the cost of child and dependent care.  According to the US Census, in 2011, the average cost of full-time child care was about USD7,400 per year, while median household income was USD50,100.  In addition, among married couples, joint filing and the graduated structure of the income tax system reduce the incentive for the lower-paid spouse (sometimes called the “secondary earner”) to work.  This is because the lower-paid spouse’s earnings are effectively taxed at a higher marginal rate because of the other spouse’s earnings.
  • Marriage incentives and disincentives:  Marriage penalties and bonuses exist in the current tax code, meaning that, depending on their marital status, individuals may pay more or less income tax.  As long as the tax code is progressive and married couples are taxed jointly rather than as individuals, there will be marriage penalties, marriage bonuses or both.  According to the Congressional Research Service (CRS), roughly 20% of married couples pay a marriage penalty, while roughly 60% receive a marriage bonus.
  • Low “bang-for-the-buck” for tax incentives: Some argue that tax incentives in this area, for example for higher education, could achieve more at a lower cost.  For example, research by the CRS suggests that education tax incentives are smaller for those least likely to attend college.  In addition, students often do not receive tax benefits for college until months (or even years, for example, in the case of the student loan interest deduction) after their tuition is due.  The delay may result in education tax benefits having less impact on the decision of whether to attend or complete college than some would like.
  • Increasing cost of higher education:  Some are concerned that the existence of federal subsidies for education, including tax expenditures, drives up the cost of college and post-graduate education.  According to Moody’s, the cost of tuition and fees has more than doubled since 2000, outstripping the growth of real estate during the housing bubble.
  • Duplication with spending programs:  Some argue that the tax system should not subsidize the cost of children or education because direct spending programs can be more narrowly targeted and are more transparent.  At a minimum, many believe that tax benefits and direct spending benefits should be more coordinated.
  • Fairness:  Some think that the tax code should do more to address increasing income disparities in the US. Others think the tax code is not a significant cause of increasing income disparities and should not be used to reduce these disparities as the tax code is already too progressive.  Similarly, some think that the tax code should treat taxpayers raising children more favourably than it currently does compared to taxpayers who are not raising children.  Others believe that the current tax code provides sufficient resources for the costs of raising children or should be revised to reduce or eliminate such tax benefits. 

The options suggested in the paper to simply this area of taxation including the following:

  • Eliminating all tax expenditures for children and work;
  • Simplifying or consolidating tax provisions related to children and work;
  • Better targeting of tax benefits for child care;
  • Reducing work disincentives created by phase-outs of tax expenditures and means-tested transfer programmes;
  • Reducing the marriage penalty and/or marriage bonus;
  • Creating parity for non-traditional households;
  • Providing targeted marriage penalty relief;
  • Repealing all education tax expenditures, except the exclusion for scholarships, fellowships, and grants;
  • Consolidating and simplifying tax expenditures for education;
  • Providing education tax credits at the time tuition is due in an attempt to heighten the effect on educational attainment;
  • Better targeting tax expenditures for education to those least likely to attend college;
  • Providing a tax credit to help pay for some private school and post-secondary school costs; and
  • Expanding educational access through tax credit for certain “K-12” (first to last grade) teachers.

Types of Income and Business Entity

This paper, released on June 6, 2013, examines the patchwork of inconsistent rules regarding the taxation of income, investments, and tax structures. It considers how the tax code could be made more neutral by reducing or eliminating differences in overall tax burdens across different types of entities, owners, and income, and reducing or eliminate differences in the tax treatment of debt and equity.

The paper lists some specific concerns about the taxation of income and business entities as follows:

  • Overall complexity:  The different treatment of various types of income and business entities is confusing for taxpayers and lacks coherence.  Some business earnings are subject to two levels of income tax, while others are not.  Some types of income are eligible for preferential rates, while others are not.  Some types of passthrough income are subject to the payroll tax, while some are exempt.
  • Differences in the treatment of different types of business entities:  A general goal in tax policy is that similarly situated taxpayers should be taxed in a similar manner.  However, different types of entities often pay tax at very different rates.  For example, the earnings of a C corporation are subject to two levels of tax, while a single level of tax applies to the earnings of passthrough businesses.  This does not necessarily mean that the earnings of C corporations are taxed more heavily than the earnings of passthrough businesses.  The individual and corporate income taxes have different rate structures and, in some cases, only a single level of tax or no tax is actually imposed on the earnings of a C corporation or passthrough business.  But the tax rate on business earnings does vary significantly depending on whether it is a C corporation or passthrough, how it is financed, and who its investors are.  According to a 2005 Congressional Budget Office report, the effective tax rate on corporate investment was 6 percentage points higher than similar non-corporate investment. Some believe that a business’s earnings should be taxed at the same rate regardless of whether it is a C corporation or pass-through, a goal that some refer to as “integration” of the individual and corporate tax systems.  Doing so would treat C corporations and passthroughs more neutrally.  It would also treat decisions by businesses about whether to finance with debt rather than equity, or to retain earnings rather than distributing earnings, more neutrally.  Others believe that certain businesses should pay tax at higher rates, for example, if the business is accessing public equity markets.          
  • Tax bias on debt or equity financing:  The current tax system generally taxes equity-financed corporate earnings more heavily than debt-financed corporate earnings because corporations can deduct interest payments but not dividend payments.  According to the same 2005 CBO report, the effective tax rate on debt-financed corporate investment was -6%, while the effective tax rate on equity-financed corporate investment was 36%.  Some are concerned that the bias between debt and equity financing creates risk in the economy and may hinder economic growth.
  • Lock-in incentives: Corporations generally have an incentive to retain earnings, rather than distributing earnings through dividends.  Retaining earnings allows shareholders to avoid the investor-level tax until they sell their shares.  In addition, investors have the incentive to hold appreciated assets rather than sell in order to avoid paying immediate tax on the gain.  These twin incentives are sometimes referred to as “lock-in.”  Some believe lock-in incentives reduce investment in new, higher-producing assets and, as a result, hamper economic growth.  Others believe that non-tax incentives may mitigate or cancel out these tax incentives.
  • Fairness:  Income from services is taxed at higher rates than some income from capital.  For example, wages are taxed at a top income tax rate of 39.6% whereas long-term capital gains are taxed at a top income tax rate of 20%.  Some argue that all income should be taxed the same, for example, because the different tax treatment for income from services and capital income creates economic distortions, complicates the tax code, and provides room for gaming.  Others argue that capital income should be taxed at a lower rate than income from services, for example, in order to reduce the bias against savings, mitigate incentives to hold on to underperforming assets, and account for the effects of inflation.
  • Distinguishing service income from capital income:  When owners of a privately-held business contribute both services and capital to the business, it can sometimes be difficult to distinguish how much of their income from the business is attributable to each.  This matters because compensation for services is taxed as ordinary income and subject to payroll taxes, while income from capital may be taxed at the preferential capital gains rates and subject to little or no payroll tax.  The different tax treatment can create incentives for taxpayers to characterize income from services as investment income.  For example, some S corporation shareholders may avoid payroll taxes if they characterize income they receive from the business as returns on their capital investments instead of reasonable compensation.  According to the Government Accountability Office, in 2003 to 2004, about 13% of S corporations did not pay adequate wages to shareholders for their labour. 
  • Differences in the treatment of economically-similar financial instruments:  The taxation of financial instruments is based on the categorization of the instrument.  As the financial products markets have evolved, tax categories of financial instruments have been created or expanded.  These rules often depend on a particular description of the economic characteristics of an instrument.  Financial instruments may be structured with existing law in mind to allow taxpayers flexibility in controlling the timing and character of income from the instruments.  Therefore, economically similar investments may have dramatically different, and largely elective, US tax consequences.  The principal goals of financial product tax reform could be to provide uniform rules for broad classes of financial products and risk management activity that would simplify the area and provide for consistent tax treatment.

Reform options put forward in the paper that could greatly affect individual income taxation include the following:

  • Treating all or most types of income the same, while maintaining the two levels of tax on the earnings of C corporations;
  • Partially or fully integrating the corporate and individual income taxes; and
  • Redrawing the line between passthroughs and C corporations.

Where are We Now in the Tax Reform Process?

Earlier this year, John Boehner (R – Ohio), the Speaker of the Republican-led House of Representatives, announced that he had symbolically set aside the bill H.R.1 for comprehensive tax reform legislation, while Baucus has been talking up the chances of a tax reform bill being introduced into Congress by the end of this year. So it is not out of the question that we could see such a bill in the flesh, so to speak, within the next few months. However, despite Baucus and Camp demonstrating that Democrats and Republicans can work well together on certain issues, important divisions remain that could ultimately block a reform bill’s path. The most important one in this regard is whether new revenue should be generated by tax reform legislation, predominately from the rich and large corporations, to pay down the deficit (the Democrat position), or tax reform should be revenue-neutral – in other words money saved by axing tax expenditures should be used to cut tax rates (the Republican position). This ‘elephant in the room’ has not been discussed in the various committee papers and hearings, because the process of preparing the way for tax reform would have stalled very early on if it had. Hence, the following rider was appended to the introduction of each of the Senate Finance Committee’s Options Papers: “Members of the Committee have different views about how much revenue the tax system should raise and how tax burdens should be distributed.  In particular, Committee members differ on the question of whether any revenues raised by tax reform should be used to lower tax rates, reduce deficits, or some combination of the two.  In an effort to facilitate discussion, this document sets this question aside.”

All the work achieved so far suggests that the will is there within Congress for tax reform. But the political reality might prevent it from happening, at least in the current Congressional period, which runs until January 2015.




 

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