Who will fix California's tax weaknesses?

In a May 20, 2010 article in the San Francisco Chronicle - "Candidates' plans to solve $19 billion deficit," none of the three candidates (Brown, Poizner or Whitman) makes any mention of tax reform. The solutions include cutting 40,000 jobs (Whitman), cutting spending and hiring freezes (Poizner) and public forums (Brown). As noted in the article, none of these measures is completely feasible or realistic to solve the deficit problem.

The deficit problem has many causes and I'll just focus on structural tax system problems which I've been writing about for some time now. The weaknesses include:

1. An out-dated sales tax system that only applies to tangible personal property (and not even all of it). For some time now, our personal consumption of taxable tangible personal property has declined while our consumption of non-taxable services, entertainment and digital items has increased. Thus, we don't tax the same amount of consumption as we did years ago and the situation continues to worsen with new ways of doing business and living (such as buying digital music rather than on a taxable CD). We need to modernize our sales tax system while also reducing the very high rate and transitioning away from imposing the sales tax on businesses.
2. We need to transition out various deductions, exemptions and credits of our personal income tax that do not serve a valid purpose or are outdated. For example, there is no reason for California spending to include the cost of subsidizing individuals with interest on a second home, a mortgage greater than $500,000 or home equity debt. There is no reason to give all seniors a tax exemption regardless of income level.
3. The gasoline excise tax should be increased and different funding model pursued. To meet the state's greenhouse gas emission reduction targets, we all need to be incentivized to buy less gasoline. And with cars getting higher mileage per gallon, we buy less gas so there is less gas tax revenue to maintain roads.
4. We might as well have an oil severance tax. Oil companies are used to them because most other states impose them and the purpose ties to our ambitious GHG emission reduction targets and brings in needed revenue.
5. We should reinstate the vehicle license fee that Governor Schwarzenegger reduced when he came into office. The tax is progressive in effect because the tax is higher for higher cost cars. The tax is easily administrable because it is based on the year and model of the car and assessed on the annual vehicle registration form.
6. We need to review the application of Prop 13 property valuation rules as applied to businesses. The current valuation approach favors older businesses over newer ones and encourages companies to engage in buy-sell arrangements that avoid ownership changes as defined under the law.

I've got a short paper on California weaknesses - here, and papers on most of the topics I've noted above. The papers provide background on the issue, possible solutions and evaluates those solutions against the principles of good tax policy - here.

The longer politicians and elected state officials ignore the need to improve and modernize our tax system, the worse the problems will get and the harder they might be to fix.

What do you think?

Forbes article on Our Tax Expenditure Problem

YES!! Bruce Bartlett's column in Forbes this week is entitled "Spending Through The Tax Code" and points out that spending in the tax code is just as "bad as direct spending." I encourage you to read the article as Mr. Bartlett highlights and problem and goes through a nice history of the term "tax expenditure."

I've written about this problem for some time now. Tax expenditures for the most part, are no different than spending in some agency's budget.

Except that one big different is that the spending in the tax law is buried and doesn't get annual budget review. That's true really even of temporary tax provisions because the temporary federal provisions (and those of most states) do not also require collection of appropriate data to see if the expenditures are meeting their intended purpose or are still needed, so when they get renewed (which is typical), there is really no review.

Some tax expenditures are more tied to ability to pay, such as personal exemptions, but the vast majority are tax "breaks" - the mortgage interest deduction, charitable contributions, energy credits, etc. Many likely serve some important purpose, such as encouraging home ownership and the work of charitable organizations, but often go beyond their purpose. For example, what is the purpose of allowing mortgage interest deductions on a second home or on a home equity debt? There is none. When that is the case, we have costly, unnecessary and hidden spending that increases our deficit and debt, creates inequities in the law (others are paying for someone else to get the unnecessary spending benefit) and they make the tax law more complicated.

I've got more, including a review of some California spending buried in the tax law that should be on the cutting table along with the direct spending that legislators instead focus on - here. And, I had an op ed in the San Francisco Chronicle on the topic - 'Spending problem?' - some of it's hidden in our tax laws (2/10/08). This problem has been raised by many for many years, but unfortunately, until more members of the public know that spending is just not what we see in government agency budgets, we'll keep on having deficits, a growing debt, inequities and a complicated tax system.

And, I've written about this and other budget problems that lead to growing debts - Transparency and the FY 2011 Budget (AICPA Tax Insider, 2/10) - it points out the lack of transparency we often have.

What do you think?

Taxes in the Cloud

Many modern business transactions have moved or are moving to more of a services model and location becomes less important. These transactions tend to challenge many tax rules, particularly at the state level. For example, instead of buying software (either on CD or via download) to install on my computer and maintain, I might be able to just use the software while it is on the distributor's server and it doesn't matter where the server is or where I am as long as I have an Internet connection. Should that transaction be subject to sales tax - is it a service or equivalent to the acquisition of software? Where should it be taxed if taxable.

These "cloud computing" issues are slowly being addressed by state tax agencies and not always consistently, even within the same state!

I've got a short article in the AICPA Corporate Taxation Insider (5/27/10) on tax issues of cloud computing - here.

Charitable Contribution Subsidies Alter School Funding

Monday's (May 24) San Jose Mercury News included an article - "Flush with $2.2 million success, Cupertino parents share secrets." The article notes that this will prevent 100 layoffs and allow grades K-3 to continue to have just 20 students. This is an commendable effort by the parents. Cupertino is a fairly wealthy part of California where many homes cost over $1 million. I'd guess that the vast majority of the donors will claim federal and state tax deductions for their contributions. This will save them taxes - perhaps as much as 45% of the donation amount.

But who funds that tax savings? Everyone else does. Let's say on average, the federal and California governments are subsidizing or paying 30% of the $2.2 million donated (because the donors will take a tax deduction and at an average rate of 30%, have their taxes reduced by 30% of the donation amount. So, the federal and state governments, are in effect, spending $660,000 on the Cupertino schools. That is a lot of money.

What I'm describing it the effect of tax deductions and credits. While some are to measure ability to pay (such as the standard deduction and personal exemption), others are to encourage certain activities, such as donating to support non-profit organizations. Such incentives or tax breaks, reduce the claimer's tax bill and increase that of others. For the charitable contributions, you can think of the effect being that the government is really making a portion of the donation.

This skews the true amount of government dollars going to K-12. Also, it is the higher income individuals who are more likely to donate and to get a big tax break.

What would be better? Perhaps a donation to your child's school should just not be deductible because of the personal and direct benefit to be derived from the donation. Also, to equalize the tax benefit from donations, a credit could be used in place of a deduction.

What do you think?

Maine Tax Reform Shows Opportunities and Challenges of Reform

On June 8, 2010, voters in Maine will get to vote on whether they approve a tax reform law enacted in 2009. The gist of the 2009 legislation was to lower the top personal income tax rate and broaden and in some cases, raise the sales tax. The personal income tax base was also broadened by eliminating or limiting some deductions. There are summaries of the 2009 law here:

• About.com
• Federation of Tax Administrators

Observations:

• Lawmakers identified several problem areas in their tax law, such as a narrow sales tax base, deductions that favored high bracket taxpayers and a high income tax rate and acted to fix it. +++++
• While some complexity was removed by eliminating some deductions and the AMT, a few new ones were added by applying sales tax to some narrowly defined items. Generally, it would be best to tax the larger group (or exempt it) rather than try to define a subset which is not always easy to do (such as "candy").
• The sales tax was expanded to various entertainment. This is a good idea as there is no reason to exempt this type of consumption and high income individuals spend more on it than do low income individuals.
• Inflation adjustments were included for some dollar amounts - that's a good thing to include in a law from the start so the rule can continue to operate as planned going forward.
• With a reduction in income tax for high income individuals and broadening of the sales tax base, it would be helpful to see what the distributional effect of the tax changes are among different income groups.

It will be interesting to see what voters say on June 8.

The American Jobs and Closing Tax Loopholes Act of 2010

The House Ways & Means Committee has returned to and modified H.R. 4213, The American Jobs and Closing Tax Loopholes Act of 2010. As described by the committee, this bill includes provisions to:

• Promote American job creation - includes various infrastructure investments including extending the research tax credit 1 year; various energy provisions
• Provide relief for working families - includes 1 year extensions of various provisions for individuals that expired at the end of 2009 including the deduction for qualified higher education expenses, certain expenses of K-12 teachers, and the additional standard deduction for real estate taxes
• Prevent the outsourcing of American jobs
• Close tax loopholes- includes provisions that "prevent utilization of foreign tax credits unless the income on which the foreign income tax was paid is repatriated to the U.S.," taxing a portion of carried interests as ordinary income and changing the self-employment tax rule for income of certain professional services S corporations
• Ensure corporate accountability
• Maintain access to affordable health care

This 400+ page bill will make the tax law more complicated; closes "loopholes," rather than focusing on provisions that are not loopholes but are instead overly generous (and thus inequitable) such as the deduction for interest on a second home or on home equity debt; and extends temporary provisions without any discussion on whether they are needed (such as the additional standard deduction for real estate taxes).

And a big extender for which there is plenty of data showing it is needed - the AMT "patch," is missing. But even that one requires some discussion as to how it should be extended. The growth of tax breaks in the past few years has caused more individuals to not have to pay a "perceived" minimum (I'll blog on this one more later but I'm thinking of a letter to the editor in the May 3 Tax Notes (page 592) that gave an example of a family with $100K of income tax but who owed no tax due to various tax breaks - they should have a minimum tax as they are not poor).

One new provision would require certain S corporations to pay more self-employment tax. This will be a complicated provision and one that S corporations will be able to plan around (such as by broadening ownership of the corporation). It would be better to not have the rule apply to a subset of S corporations because that adds to the complexity of defining that group. I think this all raises the need to review self-employment taxation to see how it should work today given various types of entities and businesses.

We'll see what happens in the next week or so with the bill. Congress is certainly doing its best to keep tax advisers busy!

What do you think?

Again - the Ways & Means Committee has summaries and bill language at its website - here.

Rhode Island - Possible Income Tax Reform

An article in The Providence Journal of May 20, 2010 ("R.I. legislators revamping personal income tax system" by Peoples and Downing) describes some possible income tax reforms that may be introduced by some legislators next week. The article notes that Governor Carcieri is also studying some reforms.

Apparently, the concern is the 9.9% income tax rate that per the article kicks in when one's income exceeds $373,000, while many pay at a rate of 3.75%. The concern is that the high rate (6th highest among the states according to the article) harms the state's business climate. The plan might also include elimination of itemized deductions in place of a larger standard deduction and elimination of most tax credits, although an earned income tax credit would remain.

A state income tax comparison chart from the Federation of Tax Administrators notes that Rhode Islands tax rates range from 3.8% to 9.9%. IRS data for 2007 indicates that only about 3% of returns filed report adjusted gross income (AGI) of $200,000 or more. So, it is a very small percentage of Rhode Islanders who possibly owe at the 9.9% rate that applies once income hits $372,950.

Generally, a tax with a low rate and broad base is more likely to meet principles of good tax policy. For example, replacing itemized deductions with a larger standard deduction makes the system simpler and puts a cap on large deductions of high income individuals, likely increasing the equity of the system. Yet, distributional neutrality of the new system should also be examined against what legislators think people in different income levels should be paying.

California also has a high top individual income tax rate and it also tends to be a focal point in rating a state's business climate even though it applies to a small number of high income individuals. I've written about this before (here) because an additional problem in California is that a very large portion of total personal income tax which represents about half of state tax collections comes from a few thousand individuals making the system volatile - if their income drops, so do state revenues. Alternatives include broadening the sales tax base (and lowering its rate) to tax more of the consumption of high income individuals. For example, individuals in CA get a sales tax break on their home utilities because it is a necessity of life. But, where is the necessity of heating and cooling an 8,000 square foot home?!

Let's see what happens in Rhode Island.

Book Review - The Cracked Bell

Something new here - book reviews. At San Jose State, I've been directing the Campus Reading Program since 2005. We select a book of wide interest, such as The Kite Runner, and encourage everyone on campus to read it. Our goal is to help build community and build/strengthen a culture of reading. After all, reading guides the road of lifelong learning. So, why not add reviews of some books I've read that tie to 21st century taxation.

The first book was suggested to me by the publisher - and I appreciate that - thanks. I've got my review posted on the 21st century taxation website - here. At this post, I'll tie the book to 21st century taxation.

The Cracked Bell - America and the Afflictions of Liberty by Dr. Tristam Riley-Smith, points out and explains many paradoxes of American beliefs and practices. For example, we are likely to say that liberty and freedom are key values of ours yet some neighborhoods don't welcome everyone and we sometimes turn our heads to inequities.

I think another area where we have paradoxes or even support some is via inequitable tax rules. One example I've written about is the strong fight against broadening the California sales tax base to bring in today's types of consumption - much of which is by high income individuals (services and digital goods), yet raising the rate on this regressive tax. How is that fair? Another example of a paradox is perhaps our longstanding discussion and study of weaknesses in our tax system, without addressing them. Why can't we use all of the studies and take action? Dr. Riley-Smith's analysis of the American political system helps explain part of this question.

If you've read the book - please post some comments. If you've got book recommendations relevant to the topic of 21st century taxation - please post them as well. Thanks.

Tax Oddity - Complicated Washington Sales Tax Exemption

I previously wrote about Washington expanding its sales tax to cover candy and bottled water. While exemptions might serve a public policy purpose, they tend to make the law more complicated because the exemption must be carefully defined. For example, what is the difference between candy and non-taxable food. In the prior post, I include the Washington definition of "candy." One thing that makes something not be candy is having flour. So, a Kit-Kat bar is not candy!

The oddity of these exemptions is that lawmakers don't realize the amount of time and frustration that accompanies them. The Seattle Times reported that the drafter of a table listing all types of things people might think are candy and whether the particular product is taxable or not, spent two months on it ("Candy man's job can be taxing" by Nicole Brodeur). The table is amazing - you should spend a few minutes scrolling through the numerous tables on different types and manufacturers of these food items.

A better approach is to either tax or exempt an entire category rather than subsets. For example, tax all food or exempt all of it. Or if you want to start taxing some of the exempt item, select a category that is easier to identify and define, such as canned items or liquids (although the rationale for doing so might not otherwise make sense). Washington could have just taxed all food along with lowering the overall rate (due to the base broadening) and adding a refundable income tax credit for low income taxpayers.

What do you think?

Spending cuts should include those in the tax system

Governor Schwarznegger's efforts to cut spending to address the California budget shortfall will avoid tax increases (see AP story in San Diego Union Tribune, 5/14/10). The problems with this limited approach include:

1. Fixing some inequities in the tax law would legitimately raise some revenue even if the rate were lowered a bit too. For example, it is time to tax digital goods purchased by consumers. The sales tax base is eroding as some types of tangible personal property (such as music CDs) become intangible digital property. We should also start taxing some personal services such as hair salons, tanning salons, trainers, etc. The tax rate could also be lowered.
2. There is a lot of spending buried in our tax law. For example, there is no reason for California to allow a tax deduction for mortgage interest on a second home or a mortgage exceeding $500,000 or on home equity debt. The federal government offers these subsidies, but California doesn't have to as well. Also, the senior exemption should be changed to be based on income level rather than age - why give a tax break to a wealthy senior? I've got more on this here. Lawmakers should remember that some of the spending cuts we need are in the tax law. Unfortunately, when placed there, they are easily overlooked (they are not in some agency's annual budget that gets regularly reviewed) and they are subject to the 2/3 vote requirement to remove. Tax expenditures (spending buried in the tax law) can get out of control. Last year, Oregon lawmakers noted that the "cost" of the expenditures - over $30 billion per biennium, was greater than spending for education, health care and public safety combined. (see my 8/19/09 post)
3. Look for spending inefficiencies. For example, can more things be done on line. A few months ago, in helping my parents get ID cards, I discovered that it could not be done online. I'm sure all agencies have ways they can cut costs and increase efficiencies (I include my employer in this too - the CSU).

Why this blog? Third Anniversary!

I started this 21st Century Taxation blog on May 14, 2007 (first post is here). I'm amazed that I've been posting ideas, critiques and articles on the topic of tax policy and reform for three years. I'm not amazed though that in 2010 we still have a desperate need to modernize our tax systems.

I started the blog as part of my work as a fellow with the New America Foundation. That work was focused on improving California's tax system, which is why the 21st Century Taxation website has a lot of reports on California tax reform. My term with the New America Foundation ended a few years ago, but my passion for the topic, which also stems from my work with the AICPA, ABA and California Bar Tax Sections, my teaching and research and my professional and civic duty to help improve our tax systems, has not dropped. I hope my posts are helping to broaden understanding of principles of good tax policy and ways to improve our tax systems and encouraging dialogue on the topic.

I welcome any suggestions for improving the blog.

Thanks for reading and commenting!!

While You Were Filing ...

The tax law "suffered"** some significant changes during this past filing season. The HIRE Act and 2 health care bills contain significant tax changes. A few of the provisions in HIRE are temporary though. The tax changes in the health care acts go into effect from 2009 through 2018.

This is on top of the numerous temporary changes in the American Recovery & Reinvestment Act and other economic stimulus laws of the past few years.

**I say "suffered" because the vast bulk of the changes do not improve our tax law. They make it more complicated and in some instances less equitable. While there were some changes that may help reduce the tax gap, such as 1099 reporting for corporations, the bigger part of the tax gap - underreporting by sole proprietors, remains unaddressed.

I have a short article in today's AICPA Tax Insider - "While You Were Filing" that summarizes some of the key changes of significance (from all three branches of government) that arose during this past filing season.

State of California - Broken State

The Mercury News' Election 2010 Guide in today's paper (5/12/10) has a great picture of the "state" of California - here.

Yes - the state needs a lot of work - including tax reform - here

Small Business Council State Tax Rankings Report

On April 27, 2010, the Small Business & Entrepreneurship Council released a report, "Business Tax Index 2010: Best to Worst State Tax Systems for Entrepreneurship and Small Business." This report ranks the states and the District of Columbia using 16 factors. The factors:

"1) state’s top personal income tax rate, 2) state’s top individual capital gains tax rate, 3) state’s top corporate income tax rate, 4) state’s top corporate capital gains tax rate, 5) any added income tax on S-Corporations, 6) whether or not the state imposes an alternative minimum tax on individuals, 7) whether or not the state imposes an alternative minimum tax on corporations, 8) whether or not the state’s personal income tax brackets are indexed for inflation, 9) property taxes, 10) consumption-based taxes (i.e., sales, gross receipts and excise taxes), 11) whether or not the state imposes a death tax, 12) unemployment taxes, 13) whether or not the state has a tax limitation mechanism, 14) whether or not the state imposes an Internet access tax, 15) gas tax, and 16) diesel tax."

The top 3 states in this ranking:

• South Dakota
• Texas
• Nevada

The lowest 3 states in the ranking:

• New Jersey (50) (DC was 51st)
• Minnesota (49)
• California (48)

The report includes the rankings for each of the 16 factors and the summary for each state. It is an interesting comparison of the various factors among the states.

Is it enough? Some additional factors to consider:

• Number and cost of tax expenditures (tax breaks) - not only can they be costly, but typically lead to a high tax rate and greater complexity.
• What is the degree of income tax conformity with federal rules?
• Does the sales tax pyramid (impose a tax on a tax because businesses are required to pay sales tax)?
• Is there a balanced mix of key taxes?
• Do appropriate accountability measure exist to ensure that any tax breaks are working as intended and are not outdated?

What else would you want to know about a state's tax system that would be of significance to small businesses?

Tax Administration and the Internet

We do a lot of things with the Internet - search and find lots of information, order goods and services, pay bills, transfer funds, apply for a job or for college, and e-file. With respect to tax administration, we can probably do more. For example, our W-2 and 1099s are computerized. Why can't they be transmitted to the recipient's tax file so they are already on our electronic return - whether that return is self-prepared or to be given to a paid preparer? Why are we typing information into tax prep software that has already been stored elsewhere electronically?

The IRS has been doing more with the Internet. For example, did you know about their website for checking whether you received an economic recovery payment - here? At the site, a person is asked to input their Social Security number and date of birth. They can also call a toll-free number if they prefer.

The IRS Strategic Plan for 2009-2013 includes: "We must become more technologically sophisticated to meet increased taxpayer expectations and maintain data security – modernizing our systems, improving our training, and continually enhancing our safeguards."

A recent report from Pew Internet - Government Online (4/27/10) states that 61% of American adults have used the Internet to get information from the government. The report notes that government use of social websites can further increase participation.

It would not just be the IRS that could make better use of secured Internet tools, but also state tax agencies. Why don't states create software for their citizens to help them track their online purchases for which sales tax was not collected, but is owed, with that software producing a year end statement of use tax owed (and the citizen would have an option to add in its mail order and travel sales for which use tax is owed). Privacy would not be an issue because the state would just provide the software, it would not monitor or operate it.

How else might tax administration be improved and simplified via the Internet, assuming it can be done securely? What do you think?

Tax Oddity - Casualty Loss Deduction Related to Drunk Driving

Here is one to add to my list of "tax oddities" - a taxpayer was allowed a casualty loss stemming from a car accident where he was legally drunk. The court noted that the taxpayer's alcohol level was only slightly over the legal limit! The IRS tried to deny the casualty loss deduction on the basis of wilful neglect and that a deduction would be contrary to public policy. The Tax Court did not agree.

I find this a bit shocking given how drunk driving is something that is against public policy - just look at state laws, public awareness campaigns and our society's mantra of having a designated driver when drinking outside of the home.

BUT, it seems that based on this case, a law change is needed. I recommend one that specifically says that losses and deductions related to violations of the law are not deductible. This would prevent having the government (that is, taxpayers) from subsidizing improper behavior. There are better things the government can do with these dollars.

For more on this case - go to the "Tax Oddities" website - look for "Casualty Loss Related to Drunk Driving."

What do you think?

Incentivize clean energy?

There are a few bills in Congress that would provide some type of tax benefit for some form of clean energy production or development. Why? They are all intended to encourage such clean energy activities and to help subsidize costs such as are likely in new industries or investments.

For example, H.R. 5142 would provide a 30% investment tax credit for "qualified property which is part of a qualified cellulosic and algae-based biofuel facility."

These provisions complicate the law. They also tend to be narrow such that one type of clean energy activity is subsidized or encouraged which means that others are not (thus, the proposals are not neutral - they can affect decision-making and they harm economic efficiency by distorting investments).

I don't expect this practice to stop anytime soon because we have all come to expect this and lawmakers are eager (it seems) to provide tax breaks (see my prior post on at least one member of Congress bragging in a mass email about the $800 billion of tax cuts made (with no mention of the large deficit and additional debt they create)).

To best meet principles of good tax policy, lawmakers should consider:

• Is the incentive truly needed? Is there evidence that certain viable clean energy production activities are not taking place due to costs or taxes?
• If a subsidy is warranted, couldn't it be administered through the Dept. of Energy where companies would request a grant for eligible projects?
• If they believe it has to be a tax break, can it be done without modifying existing rules. For example, one benefit of the ITC is it leaves the depreciation rules intact (but depreciable basis likely has to be reduced by the credit claimed).
• Is it clearly temporary? What is temporary today when so many provisions are renewed even retroactively? But if it is worded to provide that it is intended to help get an industry or process underway and will terminate within 2 or 3 years, perhaps that will help in truly making it temporary.
• Can the benefit be written broadly so that it doesn't benefit just one narrow type of activity within a broader field, such as encouraging just one type of biofuel when there are many natural substances that can be made into a biofuel.

Hopefully these items will be discussed when any of these bills get a hearing.

What do you think?

Survey Indicates Majority Not Willing to Reduce Deficits with Higher Taxes

A Rasmussen survey of 1,000 adults conducted at the end of April found that to address the deficit:

• 18% are willing to pay higher taxes
• 69% are not willing to pay higher taxes
• 13% are not sure

Men and Democrats are more willing to pay higher taxes than the total survey population.

So, a majority prefer spending cuts. I wonder what the poll results would be if the spending cuts on the table included such things as:

• shorter unemployment payment periods
• no COBRA subsidy
• no deduction for interest on home equity debt
• no deduction for interest on a second home
• no deduction for state and local taxes
• repeal or reduction of the child credit

I just list the above because I don't think people think of such spending when the word spending it used. It would be nice to hear about the type of spending people think should be cut. Unfortunately, without budget reform, one item of spending that grows is interest on the national debt.

President Obama's National Commission on Fiscal Responsibility and Reform certainly has a challenging task before it and probably isn't surprised by the survey results.