Poor Use of the Tax Law and Lack of Care of Teachers

If you incur work-related expenses that your employer does not reimburse you for and they are proper employee business deductions, you can deduct them on your return if you itemize your deductions. The Tax Reform Act of 1986 limited this deduction further by requiring "miscellaneous itemized deductions" (such as unreimbursed employee business expenses) to only be deducted as itemized deductions to the extent they exceed 2% of your adjusted gross income (AGI).

The Job Creation & Worker Assistance Act of 2003 (PL 107-147) modified the above rule for K-12 "eligible educators" (teachers, principals, counselors, and aides in a school for at least 900 hours during a school year). Under the new rule (IRC Section 62(a)(2)(D)), these educators may deduct up to $250 of their work-related education expenditures "above the line" - meaning they may deduct them even if they do not itemize and regardless of their AGI level. This was a temporary, 2-year provision. It was subsequently renewed 3 times and now expires 12/31/09. The most recent extension for 2008 and 2009 was enacted on 10/3/08 (Emergency Economic Stabilization Act of 2008 (PL 110-343)). Some educators may not have kept their expense records for spring and fall 2008 since the provision had expired 12/31/07. [Recordkeeping is important - see these two IRS announcements: 2005 and 2007]

A current proposal - H.R. 28 (111th Congress), proposes to increase the above-the-line educator expense deduction to $500 and extend it through 2011.

As evidenced by the name of this blog, I hope that actions will be taken to move tax systems into the 21st century. Hopefully any such efforts will also consider what is the tax law supposed to do and not do (something we often lost sight of in the 20th century). I do not believe the tax law is to be used to either (1) address a failure of states and school districts to adequately fund K-12 classrooms or (2) allow for an odd way to get federal dollars into select classrooms (ones where the teacher is willing to spend his/her own money). The special deduction though, is helping teachers to fund these expenses and likely discourages states and schools from worrying too much about the reality that teachers are paying for what might be basic classroom items.

The existing $250 above-the-line deduction for eligible K-12 educators was likely created to help K-12 teachers since people knew that with budget cuts, many teachers were coming out of pocket to ensure that they could effectively do their work and because of their dedication to their students. But ....

• The tax benefit continues to be small and temporary.
• The longer the special rule exists (even if temporary), the greater the likelihood that states and school districts will forget that THEY are supposed to be funding these classroom expenses - not the teachers! Also - I would not be surprised if schools might even be encouraging teachers to spend up to the $250 to help the school.
• While the above-the-line deduction is better than the normal rule for miscellaneous itemized deductions, it is still not ideal for teachers who increasingly need to cover employer costs in order to do their job effectively. The teachers are still out-of-pocket - often for basic teaching materials. The deduction just reduces the outlay by their marginal tax rate (if the teacher is in a 20% tax bracket and spends $250, the tax benefit brings that cost down to $200). Often, this tax break is labeled as a tax credit (even by one of its congressional sponsors - see the title of this press release!), but that is incorrect. A credit is a dollar-for-dollar reduction in your taxes (a nice tax break!) which a deduction just saves you your tax rate times the expenditures ($50 in the earlier example).
• Think about it... How many employees other than teachers are expected to buy supplies to do their job and help students learn? How many CPAs and attorneys working in firms have to buy their own paper and computers to do their work? How many people working in retail have to buy their own cash register and perhaps incur costs to help customers get their purchases home?
• What about fairness to students? Not all teachers can afford to purchase classroom supplies with their own funds. Students of teachers who can afford the expense reap the benefit. A Montana school teacher testifying on behalf of NEA before a Senate committee in 2007 noted: "In my school, teachers' personal expenditures range from a low of $500 a year (a new teacher with a family to support on the low Montana starting salary) to my high of over $2,000." She says she had averaged $2,200 per year! Congress should not be encouraging this inequity.
• And think about - what message is really being sent with a proposal to double the deduction (I think the message is - "the government is going to cut education more so we're counting on you teachers to spend even more of your personal funds to get your classroom ready and here is a bigger deduction to help you")!

I realize that this provision is a good deal given the alternative and the reality that state and school district budgets don't seem to be covering sufficient classroom expenses.

But - how about these alternatives:

1. Until state budgets are designed to properly fund education, if the federal government really wants to help K-12 educators directly (rather than giving the money directly to the states or schools), change the deduction to a refundable tax credit. With a refundable credit, if the educator uses his/her own money to buy classroom supplies up to $250, they'd get a $250 benefit/reimbursement (of course, this would likely really lead schools to tell all eligible employees to spend $250 to help the school - free money from the federal government!)
2. Extend the deduction through 2012 with the caveat that it WILL NOT be extended beyond that.* The extension would also include a mandate that the federal government and states must find an alternative way to spend this money so it can be done more effectively - so teachers do not have to purchase basic educational supplies. This would be a more effective way to use these federal dollars (about $200 million annually). When government funds are in many different budgets or accounts, it is hard to see how much is actually being spent on something and it is difficult to generate purchasing efficiencies. In addition, when too many people have control over spending it really means that no one is overseeing it properly. There is a "cost"** to the federal government of the educator deduction, but it is not likely to be counted with other federal funding of education. Theoretically, all of these dollars could be spent more effectively by having one responsible party, such as the state, manage the spending.

* Even without the special deduction, teachers could still deduct unreimbursed employee business expenses the same way other employees can, but they would not have many such expenses because the school would pay for classroom expenses directly.

** Per the Joint Committee on Taxation's 2008 Federal Tax Expenditure report (p. 54), the "cost" to the federal government of the above-the-line deduction for teacher classroom expenses was $200 million for fiscal year 2008.

What do you think?

California's 21st Century Economy Commission Meets 1/22/09

The commission set up by Governor Schwarzenegger and the legislators is holding its first meeting this Thursday 1/22/09 in San Diego.

Here is the link to the Commission website: http://www.cotce.ca.gov/

Here is the link to the agenda for the 1/22 meeting, which per the website will be webcast:
http://www.cotce.ca.gov/meetings/documents/Agenda_1-22-08.pdf

The agenda for the first meeting looks like it will be providing some helpful background on California's tax system as well as other states.

The commission website also notes future meetings:

• 2/12/09 at UCLA
• 3/10/09 at UC Berkeley
• 4/9/09 at UC Davis (if needed)

I've blogged on this before (here).

This certainly isn't California's first tax commission. The last one - the Commission on Tax Policy in the New Economy, issued its report December 2003. I expect that these recommendations of that commission may show up in those of the new commission:

• Improve use tax collection (a line for use tax was added to the individual income tax forms) - more can be done, particularly consumer education, as well as finding ways to incentivize remote Internet vendors to collect the tax (I have a report on this one).
• Broaden the sale tax to include more services, but do so in a revenue neutral way (which I believe means lower the rate). (one of my favorite topics)
• Eliminate some sales tax exemptions (hopefully there would be no recommendation to eliminate exemptions that only apply to businesses (due to pyramiding)).
• Some type of modification to the property tax assessment system for non-residential property.
• Establish a state tax court.

It will be interesting to watch. I hope the Commission's work gets appropriate attention by the public and the lawmakers.

Complexity and the Tax Gap - We Can't Just Blame Cheaters for the Gap

When we hear that the annual federal tax gap is about $345 billion, our first thought it that is likely mostly due to tax cheaters. But, as the tax law continues to grow by leaps and bounds in terms of its complexity (and its size), complexity has to be a big part of the reason for this large amount of unremitted taxes. Lawmakers should be working to reduce the gap. While we have had a few legislative changes on that matter, they are really diminished by the massive complexity of the law which continues to grow more complex as more special provisions are added to the law.

Well over 50% of individuals hire a preparer to complete their tax return for them. In her annual reports to Congress, the National Taxpayer Advocate (NTA) continues to remind Congress that complexity is the biggest problem. (click here for the links to the annual report issued in January 2009 and here (pg vi) for the complexity comment):

"In earlier Annual Reports to Congress, we have highlighted the “confounding complexity of the Internal Revenue Code” as one of the most serious problems facing taxpayers. We do so again this year."

Yet despite the annual dire warnings about this complexity, the tax law continues to get even more complex. There are a growing number of energy incentives that operate in varying ways with numerous definitions and effective dates; economic stimulus provisions, etc. The NTA points out a new area of complexity that surpasses the complexity of AMT is cancellation of debt income affecting many taxpayers.

The NTA report also notes: "If tax compliance were an industry, it would be one of the largest in the United States. To consume 7.6 billion hours, the “tax industry” requires the equivalent of 3.8 million full-time workers." (page 3) While this "industry" employs many people, the time they spend on tax compliance isn't growing our economy.

In September, the GAO released another report on the tax gap. This one was focused on the roughly 4% of the $345 billion annual gap that is due to misreporting of rental real estate. About 53% of individuals with rental real estate had some type of misreporting on their return for 2001!! And, it really didn't matter if the return was self-prepared or a paid preparer was used. I think this really indicates a complexity problem not just a tax gap problem.

The rules on rental real estate are complex. A variety of loss limitation rules could apply (such as Sections 280A(c)(5), 469 or 183). And a different rule could apply from year to year. If you fall under Section 280A(c)(5) and need more guidance, you'll find a few court cases and a set of proposed regulations that have remained proposed (and ineffective) for over 20 years!!

It is well past time to simplify the federal income tax law. Unfortunately, current proposals before Congress will just complicate it further. This will lead to increased disrespect for the law, frustration, and an even larger tax gap.

The NTA report lists a set of principles to help legislators move towards a simpler tax law (page 12):

"1. The tax system should not “entrap” taxpayers.
2. The tax laws should be simple enough so that most taxpayers can prepare their own returns without professional help, simple enough so that taxpayers can compute their tax liabilities on a single form, and simple enough so that IRS telephone assistors can fully and accurately answer taxpayers’ questions.
3. The tax laws should anticipate the largest areas of noncompliance and minimize the opportunities for such noncompliance.
4. The tax laws should provide some choices, but not too many choices.
5. Where the tax laws provide for refundable credits, they should be designed in a way that is administrable; and
6. The tax system should incorporate a periodic review of the tax code – in short, a sanity check."

The AICPA has long advocated for simplifying the tax law. The AICPA simplification principles can be found here.

For more on the GAO's rental real estate tax gap information and their recommendations for addressing it, as well as a few ideas of my own, please see a recent short article of mine from the AICPA Tax Insider - here.

What do you think?

Rethinking Compliance Rules - IRC Section 7216

In 2008, the IRS issued revised regulations under IRC Section 7216, Disclosure or Use of Information by Preparers of Returns. The original regulations had been written decades earlier when electronic transfers of information were not commonplace. This provision imposes a criminal penalty (misdemeanor) of up to $1,000 fine and/or up to one year in prison. The goal is to protect taxpayers from improper disclosure or use of their tax return information. Some types of disclosure and use are permissible, others require advance, specific consent from the taxpayer. For individual taxpayers, that consent must be on a form that has required language and a required paper and font size.

Unfortunately, the revised regulations raise a lot of questions that are making it difficult for return preparers to feel confident they are operating within the rules. For example, it is not entirely clear if a consent or use form signed by the taxpayer is required before a preparer can use return information for advising a client of tax planning opportunities or even mail them a firm newsletter that has tax updates in it, but also describes a variety of services the CPA firm offers.

Is this the way to move the tax system into the 21st century where electronic storage and transmission of sensitive taxpayer information is the norm? What is the balance between what individuals must do on their own to protect their information versus what others must do? How proscriptive does the paperwork need to be to ensure that taxpayer information is protected?

Why not have the client and return preparer agree among themselves as to how the preparer will protect client information and the preparer tell the client all that he will do with the information. That can all be part of an engagement letter. Many return preparers are already subject to professional rules of conduct that include protecting confidential information.

The required consent to use or disclose form specified by the IRS must include the following statement:

"If you believe your tax return information has been disclosed or used improperly in a manner unauthorized by law or without your permission, you may contact the Treasury Inspector General for Tax Administration (TIGTA) by telephone at 1-800-366-4484, or by email at complaints@tigta.treas.gov."

So, clients of compliant preparers will get this information (if a consent form is deemed needed), but how will others know? What is the role of the IRS in educating all taxpayers about protecting their confidential tax return information?

Also, Section 7216 (and its civil companion, Section 6713) only apply to federal income tax returns - not to other types of federal tax returns (and perhaps not to all state returns; you'd need to check the law in each state). So, is this enough protection?

I think this is a good example of another way we need to rethink old rules for a new era. Let's discuss what the government's role should be in protecting individuals and businesses from "improper" use or disclosure of their tax return information versus what the role and responsibility of the owner of that information is. What should children be learning in K-12 that will help them protect their confidential data in the Internet and wireless communication era? Also, what is the point of issuing overly complex, detailed rules that leave the intended users (preparers) with questions and uncertainty? Could the regulations instead just have clearly stated the purpose and left the form of compliance to preparers (the penalty aspect is the incentive to comply).

I have a short article (see link below) with more on these provisions and links to the regulations and format of the consent required for individual taxpayers. Below is a link to an AICPA website with additional information.

• New Disclosure Rules and Procedures Effective January 2009
• AICPA information

What do you think?

Let’s Reform Capital Gains Taxes, Not Just Tinker with the Rate - Guest Post

The following article was contributed by Professor Jonathan R. Kesselman* of Simon Fraser University Vancouver. He makes five suggestions to simplify, modernize and rationalize the taxation of capital gains. He offers creative ideas that should be considered before any rate change, estate tax reform or other tax changes are made in contemplation of dealing with the 2001/2003 expiring tax cuts.

Let’s Reform Capital Gains Taxes,
Not Just Tinker with the Rate

Capital gains taxation has been a perennial political football, from Carter to Reagan to Bush to Clinton to Bush II. And now it’s Obama’s turn. His meandering path over the campaign trail and post-election has included: raise the rate to “no higher than Reagan’s 28%” … hike it to “no more than Clinton’s 20%” … and leave the rate at Bush’s 15% until that sunsets at the end of 2010 and returns to 20%.

Debates over capital gains tax have always focused on “the rate,” but that feature plays only a limited role in the tax’s inequities, complexity, and distortions. It would be unfortunate if policy failed to consider more sweeping reforms to remove the most damaging aspects of the tax for investor decision making, efficient capital allocation, and economic growth.

A five-point reform agenda for capital gains taxation should be pursued by the incoming administration, and the current economic setting is uniquely propitious for these reforms. These five points are not mere theoretical, untested provisions; they reflect the tax treatment of capital gains in Canada since 1971, when that country instituted capital gains taxes in exchange for abolition of estate taxes.

As will be shown, these reforms offer significant advantages of improved equity, simplicity, and incentives relative to current US federal tax provisions.

1. Holding period Unlike in some other countries, the US tax system distinguishes between short-term and long-term holdings. Only assets held for over one year receive the lower, preferential tax rate on capital gains. This has several adverse effects. It complicates record keeping and tax reporting; it distorts investment and portfolio decisions; and it encourages various “gaming” maneuvers such as hedging an accrued gain until it becomes long-term(albeit using an imperfect hedge to avoid the prohibition on “selling short against the box”).

Abolition of the minimum holding period would treat all realized gains and losses identically. This approach eliminates all the cited complications and distortions, and it permits individual investors to concentrate on their primary role: allocating capital to yield the greatest economic returns. Abolishing the holding period is the most vital reform for taxing capital gains, but its benefits are compounded with other reforms.

2. Cost basis Taxable gains on partial sales of stock or mutual fund holdings are computed using a complex cost basis. Stock investors can choose to earmark particular shares for sale or otherwise must use a first-in, first-out method. Mutual fund investors have the same options and additionally can elect to use an average-cost method. These choices complicate record-keeping, tax-reporting, and enforcement; they further permit gaming the tax system.

Alternatively, investors could be required to use the average-cost method for all shares or units held of each equity or fund, regardless of when they were bought and when they are sold. That would simplify matters for both the investor and the tax authority; it would also eliminate gaming for purely tax deferral purposes. If all the investor’s securities are held with a single brokerage, its reporting of average-cost bases suffices. Simplified rules along with information reporting on cost bases would also reduce the scope for non-compliance, estimated to cost the Treasury more than $250 billion over ten years.

3. Death taxes When an individual dies while holding appreciated assets, their cost basis to the heir is raised to market value; all the previously accrued gains are fully freed of capital gains tax. This provision poses inefficient incentives for older and ailing individuals to hold onto assets with low expected future returns. It is also a major reason for imposing high estate tax rates—a salient issue for the wealthiest decedents, whose estates are laden with accrued gains on long-held assets. Unrealized gains represent about 56 percent of the value of estates worth at least $10 million.

An appropriate reform would impose “deemed realization” of accrued capital gains on assets held at death. If the assets pass to a surviving spouse, they retain their original cost base and bear tax on all the gains when eventually sold. This approach avoids perverse, inefficient incentives for holding onto poorly performing assets purely for tax purposes. Importantly, it also opens the way for reforming the estate tax with lower, less distorting rates.

4. Capital losses Capital losses exceeding capital gains in any year can offset other income up to $3,000, and any remaining capital losses must be carried forward to offset future years’ capital gains. This provision encourages year-end tax-loss selling, which distorts capital markets with “turn-of-the-year” effects, and it disadvantages investors with large current capital losses relative to their capital gains realized in recent years.

A simple reform is to permit individual investors to carry back any net capital losses to offset capital gains realized in the previous three years and thus to obtain tax refunds (capital loss carry-backs are already allowed for corporate taxpayers). This change would reduce the incentive for year-end tax-loss selling and other investor timing contortions. It would also be fairer to small and midsize investors who have uncertain prospects for future capital gains sufficient to offset current capital losses.

5. Tax rates Long-term capital gains are taxed at preferential rates relative to short-term gains and other income, as they have been for most of US history. However, since the Bush tax cuts of 2003, long term gains are taxed at a flat 15 percent rate for all taxpayers in the 25 percent bracket and higher—the great majority of those with capital gains. So a single tax filer with $33,950 or a couple with $67,900 of taxable income pays capital gains tax at the same flat rate as a multi-millionaire.

Taxing capital gains using a fixed inclusion rate, a method the US utilized over most of its history, would restore a sense of fairness to the tax system. With 50 percent of capital gains included in taxable income, most middle earners would pay at 12.5 or 14 percent—less than the current 15 percent rate—and earners in the top two brackets would pay at 16.5 and 17.5 percent—not far above the current rate. (Those preferring higher or lower taxation of capital gains could opt for either a 60 percent or a 40 percent inclusion rate, respectively.)

Even if the Obama administration simply waits for the top bracket rate to revert to 39.6 percent in 2011, a 50 percent inclusion rate would limit the top effective rate for capital gains to 19.8 percent—meeting the “no higher than 20 percent” commitment. Capital gains are highly concentrated among top earners; in 2006 more than 80 percent of the $340 billion of net long-term capital gains went to the 4 percent of households with taxable incomes above $200,000.

But the reform of capital gains taxation should be much more about improving the simplicity, efficiency, and incentives of tax policy than just extracting more revenues from the “rich.” With the proposed reforms, high wealth investors would be able to make much simpler, more profitable choices—and ones more conducive to economic growth—even while paying a bit more in taxes.

Comprehensive reform of capital gains taxation would also save scores of millions of hours each year for taxpayers at all income levels as well as for tax advisors and administrators; over 15 million taxpayers had to deal with computing gains and losses on asset sales in 2006. Tinkering with the tax rate alone would not reduce time and effort for anyone.

Settling capital gains tax policy early in the new administration would give investors greater clarity—invaluable in the current volatile financial and economic setting. A sensible reform package for capital gains taxation goes well beyond the single-minded issue of “the rate” to address matters of equity, efficiency, and simplicity as well as facilitating estate tax reform.

References and Further Reading

• Auerbach, Alan J., Leonard Burman, and Jonathan Siegel (2002) “Capital Gains Taxation
  and Tax Avoidance: New Evidence from Panel Data,” in Joel B. Slemrod, ed., Does Atlas Shrug? The Economic Consequences of Taxing the Rich (Harvard University Press), 355-88.
  
• Dodge, Joseph M. and Jay A. Soled (2005) “Inflated Tax Basis and the Quarter-Trillion-
  Dollar Revenue Question,” Tax Notes, January 24, 453-62.
  
• Internal Revenue Service (2008) Statistics of Income—2006: Individual Income Tax Returns (Washington, DC). (Figures on distribution of capital gains and filers with capital gains or losses were derived from this source.)
  
• Ivkovic, Zoran, James Poterba, and Scott Weisbenner (2005) “Tax Loss Trading by
  Individual Investors,” American Economic Review, 95, 1605-30.
  
• Kesselman, Jonathan R., (2005) “Capital Gains Taxation: Augmenting the Advisory Panel’s Report,” Tax Notes, December 26, 1687-90.
  
• Kesselman, Jonathan R. (2005) “Reform U.S. Capital Gains Taxation à la Canada,” The
  Economists’ Voice, August 15, http://www.bepress.com/ev/vol2/iss3/art1
  
• Poterba, James M. and Scott J. Weisbenner (2001) “Capital Gains Tax Rules, Tax-Loss
  Trading, and Turn-of-the-Year Returns,” Journal of Finance, 56, 353-68.
  
• Steuerle, Gene (2005) “Improved Information Reporting for Capital Gains,” Tax Notes,
  August 8, 697-98.
  
• Stiglitz, Joseph E. (1983) “Some Aspects of the Taxation of Capital Gains,” Journal of
  Public Economics, 21, 257-94.
  
• Weisbenner, Scott and James Poterba (2001) “The Distributional Burden of Taxing Estates and Unrealized Capital Gains at Death,” in James R. Hines, Jr., Joel Slemrod, and
  William G. Gale, eds., Rethinking Estate and Gift Taxation (Brookings Institution Press),
  422-49.

* Canada Research Chair in Public Finance and Professor, Graduate Public Policy Program, Simon Fraser University Vancouver, 515 West Hastings Street, Vancouver, BC, Canada V6B 5K3; kesselman@sfu.ca.