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TAX REFORM ON THE HORIZON

Posted on 07/28/2011

TAX REFORM ON THE HORIZON

By Robert S. Steinberg, Attorney, CPA, CVA  

JULY 27, 2011

 TO THE TAX LAW AN ODE:

A LABYRINTH SEWED INTO A ROBE

OF SYMBOLS, THIS CODE

THAT TORTURES OUR BRAINS,

WHILST OUR POCKETS IT DRAINS -

REFORM IT, NAY, KILL IT I SAY!

Who hasn’t felt that sentiment when facing an unexpected tax liability in April?  Congress continues to waltz with the debt ceiling as the band begins to play: “It’s the last dance, we’ve come to the last dance… the orchestra’s yawning…” (Song: “The Last Dance” by Sammy Cahn and Jimmy Van Heusen, featured on Frank Sinatra concept album “Come Dance with Me,” (Capitol Records).  We’ve all grown weary of congress’ dysfunction. Whatever the outcome of this political Greek Tragedy, however, everyone agrees that the Internal Revenue Code is in need of serious repair.

 REVENUE RELATIONSHIP TO DEFICIT

Tax revenue is one side of the deficit coin, the other side is spending. Which is heads and which is tails is irrelevant.  Some like to say that the deficit is due to spending more than revenues. But, a deficit also will result from collecting less revenue than is spent.  In fact, our present deficit and debt are attributable as much to declining revenue as to increases in spending.  FactCheck.org reports (July 17, 2011) that spending in 2009 was 25% of GDP, the highest since 1945.  Revenue was 14.9% of GDP, the lowest since 1950 when it was 14.4% of GDP.  In 1950, the US population was 151.6 million; today it is about 318 million.  Thus, increased spending is at least to some extent due to more services being needed for more people; declining tax revenue stems largely from tax policy decisions although the sluggish economy and changes in cultural attitudes towards voluntary compliance may also contribute. TV personality Arthur Godfrey (41St on Miami Beach bears his name) once quipped, “Heck, I don’t mind paying taxes, it’s patriotic; but I’d feel just as patriotic at half the cost.”

Federal revenues for fiscal year 2010 were $2.2 trillion generated mostly (80%) from individual income and payroll taxes with corporate taxes only comprising about 8% and excise, estate and gift and other taxes making up the remaining 12% (Congressional Research Service report to Congress, April 26, 2011). 

THE PRESENT TAX LAW

The “tax law” is comprised of a plethora of separately enacted tax bills last amended wholesale and codified in 1986. Now, this rather bulky volume of tax law is referred to as The Internal Revenue Code of 1986, as amended (The Code). Backing up The Code are even larger multi-volumes of IRS Regulations, Revenue Rulings, procedural guidelines, IRS internal guidance materials (e.g., Internal Revenue Manual) and court cases interpreting the ever growing and evolving, complex body of tax law and rules.

WHAT NEEDS FIXING?

Complexity:  The National Taxpayer Advocate’s 2010 Annual Report to Congress, Executive Summary states: “The most serious problem facing taxpayers – and the IRS – is the complexity of the Internal Revenue Code.” Apart from cost to comply, the complexity of the law brings about perverse results: An honest taxpayer may suffer indignities at the hand of IRS from an inadvertent reporting error; while, sophisticated taxpayers find every loophole to minimize taxes.  The Code today has too many deductions, credits, retirement exclusions, phase-out limitations, penalties and tax brackets.  Many Code provisions are pages long, read like a maze and give headaches to even seasoned tax professionals. Courts are often in disagreement about how to apply portions of the tax law to real world transactions. Author Alice Munro, although not referring to taxes said, “The complexity of things - the things within things - just seems to be endless. I mean nothing is easy, nothing is simple.” She writes about relationships which are confusion; but, why should the system we employ to pay our tax debt to society have become a convoluted monstrosity? 

Efficiency: Tax provisions that cause a change in market behavior are considered inefficient.  Thus, if one responds to an increase in income taxes by working less, the tax increase is inefficient.  Taxes should flow seamlessly into the market economy.    Nonetheless, a tax that changes behavior can be efficient if it brings about a desired result, e.g., the federal excise tax raises gasoline prices and reduces gasoline consumption. 

Equity: This refers to fairness which deals with a number of concepts:

  1. Redistribution of wealth – some feel the progressive tax system used in this fashion is a tool for equity.  Those who argue for redistribution cite the role that whims of good fortune play in our lives.  Success they say is not virtue and the affluent should be grateful to share and narrow the fast growing wealth gap (“wider than at any time in past 4 decades,” Stephen B. Cohen, “Inequality and the Deficit,” 132 Tax Notes 273, July 18, 2011) between rich and the middle class and poor. They believe our tax structure is telling about what kind of society we are.  Others call this a class warfare view of tax reform.  They argue that our poor are better off than anywhere else in the world and the most successful deserve to keep the fruits of hard work and donate to charity if and as they please.  This concept refers to both progressive tax rates and the phase-out of deductions for high earners which indirectly pushes up progressive rates. Using The Code for redistribution of wealth is a controversial public policy choice that goes beyond tax efficiencies.
  2. Vertical Equity: Suggests that groups who have a greater ability to pay should pay more taxes. Our progressive income tax structure meets this criteria while a consumption tax like a national sales tax, regressive in character, would not.
  3. Horizontal Equity: Suggests that those in similar situations should be taxed similarly.  For example, this is not the case with homeowners who can deduct mortgage interest and taxes versus home renters who are allowed no home related deductions.

WHAT IS BEING DISCUSSED?

It is unlikely near term that reform will involve replacement of the progressive income tax with a flat tax or consumption tax (retail sales tax or value-added) as exists in most of the world.  Thus, reform is likely to center on base broadening by eliminating most preferences and reducing the number of tax brackets and lowering effective rates. Some corporate preferences may be reduced in response to tax haven abuses and the perception that recent extravagant bonuses are viewed by the public as undeserved rewards for incompetence. The estate and gift tax regime, not a significant revenue enhancer, will remain in some version of its present form. The most visible change will involve personal income taxes and some or all of the following benefits (tax cost in billions to government in brackets) may be reduced or eliminated:

  • Exclusion of employer provided health care ($659): The excise tax on high cost health plans does not go into effect until 2018. The 2012 election will likely decide the fate of President Obama’s Health Care Law.  If he is re-elected he could veto any attempted repeal.  If he is defeated and the Republicans retain the House and control the Senate the law will certainly be repealed or amended. Effect would impact middle class most.
  • Home mortgage interest deduction ($484):  Again, the fate of this tax benefit will hinge on election results.  Republicans do not favor reducing tax benefits called tax expenditures.  If the stalemate in congress continues, however, some compromise limiting the deduction to homes not costing more than a ceiling amount (e.g., $500,000) and eliminating the deduction for second homes may fly. This is a fairness issue versus home renters but the housing industry strongly opposes change. Change would impact middle class most because deduction makes home ownership more affordable.
  • Lower tax rates on dividends and capital gains ($403): Republicans, pushed by Tea Party members, will not approve any tax increase. Effect: benefit is more important to wealthy who accumulate capital. Raising the capital gains rate may not generate substantial tax revenue as individuals will postpone sales.
  • Exclusion of Social Security benefits ($173): Already taxed above certain income levels up to 85%.  Tax more and you are essentially taxing individuals on their own contributions. Key is income threshold.
  • Tax favored Defined Benefit Pension Plans ($303):  Many private non-unionized companies have eliminated these plans but they still are a tax drain on revenue. With the hit 401(k) plans took in the recession, one wonders if congress will de-incentive these plans by taxing current contributions. Some more stringent limitation on contributions is possible.
  • Earned income tax credit ($269): Eliminating these benefits would increase revenue but decrease the progressivity of The Code and hurt the most vulnerable in our community.
  • Deduction for state and local taxes ($237):  Eliminating this deduction would hit high income tax states the hardest and increase the marginal tax rate of residents in such states.
  • Pretax contributions to 401(k) plans ($212):  Represents a significant worker savings vehicle for retirement.  Discouraging savings could spur a greater need for government services in the future. Like DB plans, some additional limit on contributions is possible.
  • Exclusion of capital gains at death ($194):  Presently, a decedent’s estate and beneficiaries obtain a cost basis equal to the estate tax value of property inherited. Unless the estate tax is eliminated requiring carryover basis could result in a double tax. 
  • Deduction for charitable contributions ($241): More stringent appraisal rules have already discouraged gifts of appreciated property in excess of $5,000.  Long term discouraging donations might require government expenditures down the line to replace work performed by many charities.  Are we ready to favor the Red Cross over Art Museums? I don’t think so. 

Doubtless The Code is complex and making it less so is itself a complicated matter.  In the end American computer scientist Alan Perlis said: “Fools ignore complexity. Pragmatists suffer it. Some can avoid it. Geniuses remove it.” Well, where are the geniuses?

IMPACT OF MANDATORY EXPENDITURES (CALLED ENTITLEMENTS BY SOME)

The reality of the federal budget is that 55% of all federal spending is non-discretionary.  Of this amount, 63% is for Social Security, Medicare and Medicaid.  The baby boomer retirements will exacerbate the fiscal problem.  Apart from these mandatory expenditures interest costs could rise dramatically if there is a loss of confidence in the U.S. Treasury which might occur in the event of a technical default by the U.S. on its obligations. There is also the problem of an aging infrastructure (roads, bridges, trains) that needs to be upgraded. Military expenditures have been diverted to insurgency wars that do not represent an existential threat to our country at the expense of strategic military assets which may be needed one day to defend against such a threat. All of this points to not being able to eliminate the deficit with spending cuts alone.  Thus, it seems inevitable that more revenue will be needed.  Historically, supply side theories of generating greater tax revenue from the economic growth created by lower tax rates have not proved true.

POLITICS OR REAL NECESSITY

Since 1980 the federal debt ceiling has been increased from $706 billion to $13,529 trillion. These debt ceiling increases correspond with federal debt levels.  Of that increase, 16 debt ceiling increases totaling $3,361 trillion occurred during democratic administrations; and, 34 increases totaling $9,462 trillion occurred during republican administrations. The increase during President Obama’s term thus far has been $1,653 trillion (Miami Herald, July 27, 2011).  One wonders at the timing and necessity of this debt ceiling stalemate.   Debt ceiling increases have been a routine congressional matter in the past.  No one doubts the urgent need to address the budget deficit and federal debt but no one seems willing to approach the problem in a truly non-partisan debate and compromise session.  Tax reform, therefore, an important part of the deficit discussion is relegated to the status of a poor relative as both parties arm wrestle for leverage in the next election.  The real loser in this power- grab struggle is the American people left without a functioning government.  Woe to us if the rest of the world loses faith in the stability of our political system.

© 2011 by Robert S. Steinberg, Esquire

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