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Friday, March 6, 2009

Let's Not Forget Simplification

Simplifying the federal tax law has been a focal point for the past several decades. Even the Tax Reform Act of 1986 which added several new and fairly complex provisions to the tax law was touted as simplification. Congress has had the Joint Committee on Taxation do studies on how to simplify the law. Every year, the National Taxpayer Advocate notes in the report to Congress that the biggest problem with the tax law is its complexity (for example, see page v of the 2008 report).

Yet, despite all of the talk, we always see more complexity added to the tax law, such as:
  • The manufacturing deduction of IRC Section 199.
  • More incentives and support for higher education tax breaks.
  • A growing number of energy incentives with lots of definitions and special qualifications.

The latest complex proposal is the techniques used in President Obama's budget proposal to increase taxes on higher income individuals (defined as over $250,000 of AGI if married and over $200,000 if single). The budget proposal would increase taxes on this high income group in the following four ways to generate about $955 billion over 10 years. The estimated revenue effect for 2010 - 2019 in billions of dollars is shown in brackets.

  • Reinstate the 36% and 39.6% top tax brackets. [$338.8]
  • Tax capital gains and dividends at 20% (rather than 15%) [$118.1]
  • Reinstate the phase-out of personal exemptions and itemized deductions. [$179.8]
  • Cap itemized deductions such that they only provide a 28% benefit even if the individual is in a higher tax bracket. [$317.8]

The rate increases by themselves are NOT complex. Rate increases tend to be simple. It is easy to determine your marginal tax rate (what your next dollar of income is taxed at) and to calculate your tax (using a table or a rate calculator found online or in tax prep software).

It is the last two items listed above that will create complexity. There will be two different limitations on itemized deductions. That means the high income person really won't know how much of their state taxes, mortgage interest or charitable contributions are deductible until the tax return preparation software computes it. This also means that the law is not following the principle of transparency - it should be more clear what is deductible and what is taxable.

This level of complexity and lack of transparency is not needed and should be avoided. It can easily be avoided by either just eliminating some deductions completely (and keeping others without any limit). Another alternative would be to have additional higher tax brackets to raise the desired revenue. This is a more transparent approach than instead having one rule that allows a deduction and another that takes part of it away. The loss of part of the deduction increases the individual's taxes - but that could instead be done more transparently with a rate increase.

A complex tax law increase compliance costs and builds disrespect for the tax system. AND - it just isn't necessary - there are always simpler approaches and we all have to continue to remind Congress and the President to please use them.

There is a nice report from the AICPA on how to simplify the law and how to avoid making it more complex - click here.

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