People who pay no income tax - persepctives

The Tax Policy Center has an interesting and informative post - "Why Do People Pay No Federal Income Tax?" (7/27/11). It notes that a family of four with income of $26,400 will pay no federal income tax in 2011 due to the standard deduction and four personal and dependency exemptions. Hopefully few people are concerned about this other than perhaps that the standard deduction should be higher. Despite this family owing no federal income tax (and probably no state income tax either), they have paid payroll taxes, sales tax, excise taxes and some portion of the corporate income tax. Most likely at least 20% of their income is paying taxes of some type.

The Tax Policy Center post goes on to help explain why those making more than $26,400 and up to $50,000 pay no federal income tax. For that group, it is due to tax expenditures (the standard deduction and exemptions are not tax expenditures as an income tax should exempt some minimal amount to leave money to live on). Key tax expenditures for this group are elderly benefits and the child credit (see the pie chart in the post).

I am glad to see the Center note that the tax savings in this group pale in comparison to the tax savings those with much higher income gain from lowered tax rates and an even larger group of tax expenditures available to them.

My example: How much federal income tax should a taxpayer with $50,000 of income pay? I'd think no more than 10% (and really less given the other taxes they pay). But assuming 10%, that is $5,000 of tax. Current tax expenditures likely prevent such a taxpayer from paying most of that $5,000. Consider someone with at least $100,000 of capital gain income. Today, at a 15% capital gain tax rate (rather than 20%), they save $5,000 of tax (and likely live far more comfortably than the individual or family with $50,000 of income. Or better yet, if a person had only $20,325 of qualified dividends, they would save $5,000 of taxes (difference between current tax of 15% and 39.6% maximum rate without the tax cuts in place).

The tax savings of lowered rates on ordinary income and much lower rate on dividends and lower rate on capital gains, in addition to other tax expenditures (such as itemized deductions and the exclusion for employer-provided health insurance), means that higher income individuals have greater tax savings. That is, focusing on the tax savings of someone with $50,000 of income while ignoring the tax savings that for those with very high incomes are much greater than that person's income, is missing a big part of the tax cut and tax expenditure debate.

Let's focus on how much we think people at different income levels should pay and how to design a simple, equitable and efficient tax system to reach that point.

Need to further lower CA sales tax rate - Mercury News op-ed

I'm pleased to have an opportunity today to share my perspective on the need to fix the California sales tax by lowering the high rate and broadening the narrow base. This will enable the tax to meet principles of good tax policy and support business activity in the state.

The op-ed is in the San Jose Mercury News (7/24/11) - "Lower the sales tax - but reform what does and doesn't get taxed."

IRS Guidance Issues - Tax Analysts Forum

As I've discussed previously here, the IRS has been issuing a fair amount of unofficial guidance, such as FAQs on its website or information in form instructions or publications that does not come directly from official guidance. By unofficial, I mean it is not published in the Internal Revenue Bulletin or as a news release. It also does not count as "authority" for purposes of determining if there is, for example, "substantial authority" for a position taken on a return. Even the IRS excludes these items in explaining "official guidance" - here.

For more information, see "How Heavy is an FAQ?" in AICPA Tax Insider (11/11/10). I thought this was also a taxpayer rights issue and raised it with the Taxpayer Advocate Office, but only heard back that, yes, it is not something that can be relied upon to obtain relief from a penalty. I was hoping they would take up the issue because not only might taxpayers rely on this unofficial guidance, but many practitioners are too. Particularly where there is no other guidance.

I think this topic is also relevant in what is expected of a practitioner - they are to follow substantive law (see IRS info on this - here). Many of the FAQs are summaries of existing substantive law in that they are summarizing the Code or regs. But not all. Some are interpretations by IRS and some are just IRS guidance - such as in explaining their program on regulating tax return preparers.

Tax Analysts held a forum on this topic on July 22, 2011 - Taxes and the Guidance Process. They discuss these issues. I'm glad to see that as this is an issue that needs more attention. You can listen to the recording of this forum - here.

FAQs are useful, but the IRS needs to make them official guidance. They could be issued as a Notice or Revenue Ruling. Then it is there forever. If the IRS modifies it, that subsequent ruling will say it is modifying an earlier specific ruling. And both the old and new guidance will be in the permanent record. That is not the case with an FAQ that is later changed or deleted. The history is gone unless you printed the FAQ before it was removed from the IRS website. This is not the way to issue guidance. The same goes for when information only appears in IRS form instructions or publications.

What do you think?

What Tax Reform Should Really be Focused On

I have a second guest post on the FranchiseHelp website. It addresses some of the reasons why federal tax reform is needed. I hope you'll check it out - here.

Creating More Sales Tax Collectors - More "Amazon" Laws

In 2011, 5 more states joined the existing three that had enacted so-called "Amazon" nexus laws to try to get more Internet vendors to collect sales/use tax. New York started this in April 2008. I have a short article with the background and details of the five states that joined in this year - see Creating More Sales Tax Collectors, AICPA Tax Insider, 7/14/11.

The California legislation (ABX1 28; 6/29/11), had a few modifications from the NY version. First, the CA affiliate nexus rule only applies if the vendor with the affiliates has over $500,000 of sales to CA customers. This was to prevent, apparently, creating a collection burden for any eBay seller with over $10,000 annual sales to California customers. Since eBay earns a commission on the sale, the sellers would be subject to collection.

Second, the California law also expands "retailer engaged in business in this state" to include "Any retailer that is a member of a commonly controlled group, as defined in Section 25105, and is a member of a combined reporting group, as defined in paragraph (3) of subdivision (b) of Section 25106.5 of Title 18 of the California Code of Regulations, that includes another member of the retailer's commonly controlled group that, pursuant to an agreement with or in cooperation with the retailer, performs services in this state in connection with tangible
personal property to be sold by the retailer, including, but not limited to, design and development of tangible personal property sold by the retailer, or the solicitation of sales of tangible personal property on behalf of the retailer." This is another way to apparently try to get Amazon to collect sales tax even if it cancels all of its affiliate arrangements in the state (which it did - see my 7/4/11 post).

Per a CNet article, "California targets Kindle lab in Amazon tax spat" by McCullagh (6/29/11), Amazon has two subsidiaries in California that developed and work on Kindle and other items.

A few interesting items related to this topic:

1. A 7/12/11 news release from California Board of Equalization chair Jerome Horton on how the BOE will enforce the new Amazon/affiliate nexus law in California. He also notes that a referendum petition to repeal the law was filed (still needs to get signatures to get it on the ballot). He also states that "“Once the public learns that non-California companies who currently fail to comply with the law and play by the rules are costing California approximately $12.5 billion in sales and $1.1 billion in use taxes which translates into 37,000 jobs, $52 million in property taxes, and $48 million in income taxes." No details on how these figures were determined.

2. The California Retailer's Association, a supporter of these affiliate nexus laws, issued a press release in March 2011 calling for Overstock.com to stop bullying Californians. Like Mr. Horton, they note that not collecting the sales tax results in the loss of thousands of jobs. The CRA also notes that the New York legislation did result in Amazon and a few other vendors starting to collect the sales tax. But in the other 7 states that enacted similar legislation, Amazon did not start collecting the tax but instead canceled the affiliate contracts so it was no longer subject to the law (but see earlier comment that this may not get them off the collection hook in California).

But - of the 8 states that have enacted the affiliate nexus rule, only New York offered amnesty for prior possible liabilities to those who started collecting. How important was that amnesty to Amazon and why haven't other states also offered amnesty?

I think California should continue to ramp up ways to get buyers to self-assess use tax and join with other states to get Congress to address this matter. California will likely need to join the Streamlined Sales and Use Tax Project at some point.

For more on use tax collection, see my February 2011 testimony for the CA Assembly Revenue & Taxation Committee.

What do you think?

Debt Free America Act

Congressman Fattah (D-PA) has once again introduced the Debt Free America Act (H.R. 1125) (in the 111th Congress, it was H.R. 4646). This proposal calls for a 1% fee (really a tax) on "every specified transaction." That is any transaction where payment is made by cash, check, credit card, or transfer of stock or other financial instrument. A "transaction" is any retail or wholesale sale, purchase of intermediate goods, and financial and intangible transactions.

There would be a credit for low income individuals based on their adjusted gross income. The individual income tax including the AMT would be repealed after 2021 (the credit would end then as well). The stated goals are to promote economic prosperity and eliminate the debt (as well as interest on it). The text of H.R. 1125 notes that the fee is different from a sales tax and a VAT. The proposal also calls for an 18-member task force to study and make recommendations to address the country's fiscal imbalance.

Congressman Fattah's office asked me for comments on the proposal back in January 2010, which I provided. It doesn't appear that any were incorporated - oh well. I applauded his effort to reduce the debt which I noted doesn't really seem to get much attention; instead, we just keep hearing about tax cuts and more deductions and credits.

Below are the comments I provided in February 2010 on the proposed transaction fee. I believe it needs reform to improve transparency, equity and efficiency. One glaring problem is to repeal the individual income tax but keep the corporate income tax and have businesses pay the transaction fee along with individuals - often on the same transactions (there is a pyramiding problem in the proposal). The text of my earlier comments:

1. Fee versus tax: A fee is generally viewed as something paid for particular services to be received. On the other hand, a tax is something charged that is not tied to services received, but is used to generally fund government operations. Given the use of the transaction fee, it should be called a tax.

2. Base: Transactions to be taxed include retail and wholesale sales, purchases of intermediate goods and financial and intangible transactions. Why not also include services and rent? It seems that payment of a mortgage is a financial transaction, so would be taxed (and the purchase of the home also would have been taxed). It seems that rent should also be taxed as equivalent to a mortgage payment or purchase of an asset. Since it sounds like the goal is to apply the tax to any transaction, it would be inequitable and economically distortive to only apply the tax to transactions involving property and financial transactions and not also services and rents.

3. Digital: Given the varied ways some goods can be transferred today, it would be helpful to clarify that goods refers to both tangible and digital goods.

4. Double taxation: The definition of transactions seems quite broad such that the same funds could be taxed multiple times to the same individual. For example, assume an individual receives a paycheck of $300 and cashes it at a check cashing store. That sounds like a financial transaction upon which the proposed tax applies. When the individual spends the net proceeds at the store, a tax is imposed again. If this is not intended, the definition of transaction should be clarified. If this is the intent, employees might request that they be paid in cash rather than a check (assuming that avoids a transaction tax, and if it does, that seems too easy of a way to avoid the tax).

5. Pyramiding: A problem with most sales taxes as well as gross receipts taxes is that when businesses pay them, all or a portion of that tax is added to the sales price upon which the buyer also pays the tax. This results in a tax on a tax or "pyramiding." The amount of pyramiding can vary from industry to industry and company to company depending on the amount of vertical integration in the company and the complexities of the manufacturing and distribution chains. Because the transaction tax is paid by everyone with no refund to businesses, the tax will pyramid and that should be avoided. One way to avoid that is to only have the transaction tax apply to the final non-business consumer. This is how a credit invoice VAT operates.

6. Tax gap: While the rate is likely to be low because the base is so broad, there is likely to be efforts by some taxpayers to find ways to avoid or evade the tax. Appropriate compliance and penalty provisions are needed to help reduce this reality.

7. Bartering: While application of the tax to bartering transactions is to be studied and a report issued after implementation of the tax, this is likely too late. Under the income tax, bartering transactions are usually subject to tax and people figure out how to value the bartered services. Thus, there seems to be no reason not to stress that the tax applies to bartering transactions from the start.

8. EITC: The EITC is a significant social welfare program administered through the tax law. Its repeal will represent a tax increase for many working individuals who today pay little or no federal income tax, but who would be subject to the transaction tax as well as payroll taxes. Also, since the transaction tax is a regressive tax (while the income tax is progressive), some relief should be provided to low income taxpayers who will likely be burdened by the new tax. In addition, while both the transaction tax and income tax are in place, the proposed §25E credit will not be the equivalent of the EITC even if it is refundable. Consideration could be given to providing payroll tax relief to individuals currently subject to the EITC.

9. AMT repeal: While the AMT for individuals is repealed, there is no mention of whether it is also repealed for estates and trusts. Also, the minimum tax credit (MTC) of §53 appears to remain. Even when (if) the income tax is phased out, something specific should be said about MTCs that some individuals are carrying forward to use against future regular tax liability. The MTC carries forward forever and because it represents a prepayment of regular tax, individuals will expect that they can use it someday. Either it should be terminated or allowed to be used against the transaction tax (although perhaps not able to offset 100% of it in any year). Either way, it should be clear what happens to the MTC carryfoward.

10. Individual versus corporate income tax: Repealing only the individual income tax while apparently maintaining an income tax on corporations, estates and trusts can cause some problems. For example, the tax law will play too large of a role in business form. Small businesses, in particular, will be inclined to avoid the corporate form (unless S corporation status is retained and available to them). Also, individuals will still indirectly pay income tax because the corporate tax is ultimately paid by individuals – employees, investors and customers.

11. Study: Additional items to include in the study along with the EITC, AMT, child tax credit and mortgage interest deduction, include the impact on charitable contributions, fringe benefits and retirement savings planning. The study might also include whether any tax relief should be provided for spending attributable to certain casualty losses.

12. Equity: A transaction tax is regressive in that it will represent a higher percentage of the income of lower income taxpayers relative to higher income taxpayers. Unless it is clear that the proposed transaction tax will apply to deposits and investment growth, it seems that high income taxpayers will have lowered tax liabilities with the transaction tax when it entirely replaces the income tax. While it appears that if a wealthy person were buying and selling investments, the tax would apply to the purchase transactions, what if assets sit and earn interest and dividends that are not spent? Those earnings would have been subject to the income tax (at a rate greater than 1%), but do not appear to be subject to the transaction tax until there is a transaction. Data should be gathered on the distribution of the transaction tax among different income groups. It might be that the income tax should remain for individuals above a certain income level.

13. Effect on states: States tend to rely upon the Internal Revenue Code for the foundation of their income tax. Repeal of the individual income tax at the federal level may pose challenges for many states, perhaps even leading them to also adopt a transaction tax which would increase the amount of regressive taxes imposed upon individuals.

14. VAT: Why not a VAT? The U.S. is the only industrialized country that does not use a VAT. While that is not reason enough to adopt one, a VAT has some advantages over a transaction tax. These include: (1) structured as a credit invoice VAT like other countries use, it would not be a pyramiding tax; (2) the VAT is designed to minimize non-compliance; and (3) it might help the states improve their sales tax structures by converting them to a credit invoice VAT.

For more from Congressman Fattah - here.
Commentary from the Tax Foundation (7/14/11) - here.

What do you think? Is this proposal good as it is? in need of improvement? worth fixing?

Subsidyscope.org by Pew Now Has Tax Expenditure Database

Yesterday (July 13, 2011), the Pew Charitable Trusts announced something new in its efforts to bring more attention to four types of subsidies issued by the government (that is, all of us!). The four categories:

1. Grants
2. Contracts
3. Tax Subsidies
4. Loan and Loan Guarantees

The Pew efforts began in 2008 with periodic reports on various subsidies, such as Amtrak.

The database launched this week allows people to look at the cost assigned to tax expenditures by the Joint Committee on Taxation and Treasury Department. Due to differing approaches to measuring the costs, the amounts are not the same, but each certainly shows the tremendous spending for these items such as housing.

For more on tax expenditures and what that means, why government agencies report different figures and some limitations on using tax expenditure reports, please see my recent article on Rethinking the Income Tax Calculation (2/10/11).

Also, for more on tax expenditures, don't miss the Center for American Progress Tax Expenditure of the Week program - here.

Why look at tax expenditures? A few of the reasons ...

• They are a form of spending that is buried in the tax law. Any discussions about cutting spending that don't consider these is overlooking one of the largest spending parts of any federal or state budget. The federal spending in the tax law is about $1 trillion per year.
• Many of these expenditures are inequitable (such as deductions that provide more benefit to higher income taxpayers than to lower income taxpayers).
• They are special deductions, exclusions and credits that make the tax law complex.

I encourage you to try out the Pew tax expenditure database - use the box that says search. I typed in "elderly" and found a special deduction, credit and a few other items. Here is the link.

Colorado's Efforts Towards Greater Transparency

Recently, Colorado enacted SB 11-184 which includes a requirement for a specific tax expenditure report. This legislation provides that by 1/1/13, and every odd-year thereafter, the Department of Revenue is to prepare a "tax profile and expenditure report" that includes

• the legal reference for the tax expenditure
• when enacted
• description
• revenue effect for most recent four years
• for income tax expenditures, the effect by income classes
• purpose

In addition, after 2011, any proposal for a new tax expenditure or to extend an expiring one must "include a legislative declaration stating the intended purpose of the tax expenditure."

While better than just providing the "cost" of the tax expenditures which is what is done now, the additional information will be better. But for greater transparency and accountability, it would be best to do what a company would do to see if resources devoted to a project are panning out. A company would (should) identify the goals for the project and appropriate assessment measures based on those goals.

For a state creating a new jobs credit to increase employment, the legislature should also mandate that the appropriate state agency gather data on changes in jobs among different industries and probably something about those jobs. For example, did they end up with more part-time jobs at minimum wage, or ones requiring a college degree? Without identifying the goals and measurable objectives, Colorado might not get as useful information that they are looking for.

What do you think?

Federal Return Preparer Competency Examination

I submitted comments today per the IRS request for them on various aspects of the return preparer examination they are designing that will be required of preparers of Form 1040 who are not an attorney, CPA, Enrolled Agent or a "supervised/non-signing" preparer (Notice 2011-48). Given that the IRS has told all preparers that they need to know substantive law and exercise due diligence in applying it, I think that some how needs to be built into the exam.

My comments letter follows:

Comments per Notice 2011-48
Registered Tax Return Preparer Competency Examination
Submitted by
Annette Nellen, CPA, Esq.
Professor
San José State University
http://www.21stcenturytaxation.com/
annette.nellen@sjsu.edu
July 7, 2011

I am a tax professor and director of a graduate tax program. I have prior experience in the tax department of a Big 4 CPA firm and the IRS (four years as a Revenue Agent and one year as a lead instructor). I am also an attorney and CPA (so not subject to the competency testing). I have researched and written [1] on the Internal Revenue Service initiative to regulate paid return preparers which has led me to consider what appears to be expected of a return preparer based on various statements issued by the Service, and how that is relevant to the content and design of the competency tests.

Areas to Cover

The Internal Revenue Service website on "Responsibilities of a Tax Return Preparer" (http://www.irs.gov/businesses/small/article/0,,id=231827,00.html), states:

"Tax return preparers are expected to be knowledgeable in tax law and to prepare accurate returns. As a tax return preparer, you must take all necessary steps to prepare accurate Federal tax returns on behalf of your clients. These steps include reviewing the applicable tax law to ensure all income has been reported on the return, and only credits, expenses and deductions allowed under the Internal Revenue Code are taken. Tax return preparers are required to exercise due diligence in preparing or assisting in the preparation of tax returns and claims for refunds. As a general rule of thumb, that means knowing the underlying substantive law affecting an item of income or deduction."

Given this expectation of return preparers, consideration should be given to verifying and testing this expectation. Possible questions that can indicate a person's knowledge of the tax law and ability to review and apply applicable substantive law include the following:

1. Asking what resources the person has available to find answers to questions about how particular amounts and transactions should be reported on an individual client's income tax return.
2. Questions based on reading a Code section and related regulations provided as part of the examination.
3. Due diligence questions such as providing a possible client fact pattern and asking what questions they should ask of the client.
4. Due diligence questions about appropriate preparation and review procedures for a tax return.

Format
In addition to multiple choice questions, there should be a few short answer questions to address some of the questions noted above.

Other Matters
Consideration should be given to reviewing the test design, administration and questions that are used in states, such as Oregon, that already require certain preparers to pass a competency exam.

Submission Information
These comments are submitted by Annette Nellen and not on behalf of her employer or any professional organization of which she is a member.
Contact Information: annette.nellen@sjsu.edu (408) 924-3508

[fn 1] A list of articles can be found at http://www.21stcenturytaxation.com/Federal.html#Compliance.

--What do you think should be on the exam (and not on the exam)?

Senator Rockefeller Tax Proposal

On June 30, 2011, Senator Jay Rockefeller (D-WV) offered a tax proposal primarily designed to address the deficit by increasing taxes on the wealthy. He offers "18 specific proposals to shave $1.29 trillion from the deficit over 10 years with a balanced mix of options to close corporate tax loopholes, rein in tax abuses, and eliminate special tax breaks for wealthy Americans and big companies." Changes include - with my commentary:

• Eliminate the home mortgage interest deduction on yachts treated as second homes. Why not eliminate the home mortgage interest deduction (via a phase-out) for all second homes? There is no reason for the tax law to offer a subsidy for financing a second home.


• Reduce the depreciable life for race horses to be the same as what farmers would get. There is a lot more that can be done in the depreciation area to update depreciable lives to better reflect reality (these would not all be measured as revenue raisers though because some lives are too long).


• Let the "Bush tax cuts" (now also the 111th Congress tax cuts) starting in 2012 (rather than 2013) for those with over $1 million of income. He also proposes new brackets that are 3% higher for millionaires and billionaires. I think this will be a tough sell to accelerate this one year, but I agree there needs to be more brackets in the high end because in our economy, a couple with $250,000 of income certainly doesn't feel as wealthy or live similarly to people making over $1 million. But, why $1 million, why not have a bracket at $500,000 and above and then $1 million and above.


• Cap the tax value of itemized deductions at 28%. President Obama has also proposed this. It violates the simplicity and transparency principles because there are already reductions in itemized deductions and having multiple rules rather than just one cut back adds complexity. Also, the effect is really a higher marginal tax rate. Why not just raise the tax rate? Also, this adds some equity, but converting some deductions, such as for charitable contributions, to a credit worth the same to all tax brackets, would be more equitable.


• Enact H.R. 62 to support US jobs by treating certain foreign corporations managed in the US as US corporations. I think that instead of making piecemeal changes to how the US tax law applies to international operations, it would be good to look at the whole topic along with business tax reform including integrating the corporate tax.


• Replace the corporate AMT with a 10% tax on profits over $25 million. I don't understand exactly how this is intended to work. We already have a graduated corporate tax structure with the highest rate of 35% kicking in when taxable income exceeds $10 million. Is this just adding another corporate bracket? If intended to get to a bracket of 45% (and I am not sure this is what is intended), that is too high even though in the 1980s, the rate was 48%.


• Discuss a temporary 3 cent soda tax. This is described as a way that the middle class helps pay down the deficit. From the description, it appears it would only be on sugary sodas. But why on just that? Why not the other sugary drinks we consume - juice, flavored water, milkshakes, etc.? I'm not sure the administrative and compliance costs justify this tax.

There are a few more items in the list of proposals - here. I don't think it is the answer to reducing the deficit, but it is another example that there are ways to generate a trillion dollars over ten years. The ideas should get into the debate along with those of President Obama's deficit commission and others.

What do you think of Senator Rockefeller's proposal?

Amazon Cancels California Associates Contracts

As promised and expected by most, Amazon has cancelled its contracts with California-based Associates. I set up an account for my daughter, which we never activated for payment of commissions, so got an email on June 29, 2011 that reads as follows:

"Hello,
Unfortunately, Governor Brown has signed into law the bill that we emailed you about earlier today. As a result of this, contracts with all California residents participating in the Amazon Associates Program are terminated effective today, June 29, 2011. Those California residents will no longer receive advertising fees for sales referred to Amazon.com, Endless.com, MYHABIT.COM or SmallParts.com. Please be assured that all qualifying advertising fees earned before today will be processed and paid in full in accordance with the regular payment schedule.
You are receiving this email because our records indicate that you are a resident of California. If you are not currently a resident of California, or if you are relocating to another state in the near future, you can manage the details of your Associates account here. And if you relocate to another state in the near future please contact us for reinstatement into the Amazon Associates Program.

To avoid confusion, we would like to clarify that this development will only impact our ability to offer the Associates Program to California residents and will not affect your ability to purchase from Amazon.com, Endless.com, MYHABIT.COM or SmallParts.com.

We have enjoyed working with you and other California-based participants in the Amazon Associates Program and, if this situation is rectified, would very much welcome the opportunity to re-open our Associates Program to California residents. As mentioned before, we are continuing to work on alternative ways to help California residents monetize their websites and we will be sure to contact you when these become available.
Regards,
The Amazon Associates Team"

As I noted in a March 9, 2011 post, the California legislation is not the same as the New York legislation in that NY offered amnesty for complying (see post). I also questioned the revenue estimates and why California doesn't do something more productive like work with the other states and Congress for a federal solution applicable to all states and all remote vendors. One good thing that California did in 2011 was enact SB 86 which will enable consumers to use a look-up table to determine their use tax liability (rather than have to keep records). This is a start towards improved use tax compliance, but without education and a law requiring taxpayers to make an entry on the use tax line on their state income tax form and indicate whether they filed a separate use tax form, it won't be as powerful as it otherwise could be (3/19/11 post).

I wonder if Amazon will find an alternative way for California residents to monetize their websites. It seems that one solution would be to change the arrangement to be cents per click rather than getting a commission. While I am not convinced that the payment arrangement is enough to distinguish advertising from sales commissions, it is likely to help as the Associate would get paid even if no sales are made (maybe).

Some think all of this will hurt Amazon's sales. I don't think so. The Amazon decision in January 2009 in New York noted that Amazon generated less than 1.5% of its NY sales from the Associates.* Today, people have heard of Amazon and can easily type Amazon.com into their browser and get there. Also, as long as the prices are better than other places (ignoring the sales tax even), they will do well. And, free shipping for orders over $25 is a good marketing approach.

But, are people fed up with Amazon and willing to go to other sites to make their purchase? Good question. I must admit, although I really like using the Amazon site for purchases, I have also checked prices at bn.com and if similar, have on occasion, purchased there (collecting sales tax is not a big deal for me as I have been keeping my records for many years and always pay my use tax!).

* Per the case (available free from The Public Library of Law), "Amazon further states that Associates' referrals to New York customers are not significantly associated with its ability to establish and maintain a market for sales in New York because they account for less than 1.5% of its New York sales (Amazon Mem at 27)."

What will you do - keep buying from Amazon or go elsewhere? What do you think California should do to reduce its use tax gap?

Mortgage Interest Deduction is a Subsidy in Need of Reform

The Pew Charitable Trusts released a study, The Costs and Benefits of Housing Tax Subsidies (6/30/11). It lays out mostly what has been known and previously studied and reported - the mortgage interest deduction primarily benefits higher income individuals and helps them to purchase a more expensive home than they otherwise would have purchased. While noting that home ownership improves communities, there is a downside. As noted in the executive summary to the 48-page report:

"these tax subsidies also distort the housing market and affect the allocation of capital across the economy. The current housing tax subsidies—for example, the mortgage interest deduction in particular—leads people to borrow more money and buy larger homes than they would otherwise, making the overall economy more leveraged. By effectively lowering the price of owner-occupied housing relative to other goods and services, housing tax subsidies encourage investment in and consumption of housing, particularly owner-occupied housing, over other types of investments, goods and services. The resulting distortion in the allocation
of capital likely lowers overall output and leads Americans to have personal assets that are more heavily skewed toward housing at the expense of diversification in other investments."

The report notes three housing subsidies:

1. mortgage interest deduction
2. deduction for property taxes
3. imputed value of home ownership that is not required to be reported as income

For fiscal year 2010, Pew says the total subsidy is $304 billion. That is, the government could have collected that much more tax revenue (roughly) if these special tax rules did not exist.

While the subsidies benefited 84% of home owners, but the amount of benefit differs from a low of $370 to a high of about $18,000. It is not clear why the report says the benefits are to 84% of homeowners. Subsidy #3 above benefits all homeowners, but perhaps the value of that benefit still puts the homeowner's income below the filing threshold. For subsidies 1 and 2, a home owner needs to itemize deductions to claim the deduction and only 1/3 of individuals itemize deductions.

The Joint Committee on Taxation (JCT) issues an annual tax expenditure report, but doesn't include #3 above. For FY2012, JCT estimates the "cost" of the mortgage interest deduction as $94.1 billion and for property taxes $26.5 billion (page 39 of 2010 report). In addition, a subsidy omitted from the Pew report is the exclusion for gain from sale of a principal residence which the JCT estimates costs $17.5 billion.

Is "subsidy" the right word? Yes. When a taxpayer claims a deduction, exclusion or tax credit that is a special provision - that is, something not key to defining the tax base, it is a subsidy. Instead of having his federal tax bill reduced for a home mortgage interest deduction, the taxpayer could instead be getting a check from the federal government for the savings. The tax law is just a different way to deliver that benefit. (For more on this, see a 7/1/11 post of the Center for American Progress.)

There are many issues of delivering the benefit (subsidy) via the tax law including:

1. The subsidy is buried in the budget in the form of reduced revenue. It does not show up as a line item as does the spending by the Housing & Urban Development Department (HUD). This also means that it is not subject to annual review or limitation. For example, if this year, 20% more individuals than expected, took out mortgages, this federal spending would increase even though not "authorized" by Congress and the President (other than that they allow the deduction). This is hidden spending. When President Obama or Congress says they are cutting spending, they are almost never talking about the $1.1 trillion dollars of spending buried in the tax law - which is far larger than many other categories of discretionary spending visible in the budget.*
2. As a deduction, the benefit is skewed to those in higher tax brackets. For example, if two individuals each have $5,000 of mortgage interest. The tax savings (subsidy) to the person in the 15% bracket is $750 which the subsidy to the person in the 30% bracket is $1,500. One way to equalize the benefit would be to convert the deduction to a credit worth the same amount to each person.**
3. The subsidies are difficult to measure. If the government just wrote checks to homeowners, it would be simple to determine the amount. As tax expenditures it is more difficult. One illustration of this the varying figures used by different groups in measuring the "cost" of the subsidies. For example, the JCT says the cost of the gain exclusion is roughly $17 billion annually while the White House budget report says it is $35 billion (see page 252 of FY 2012 budget report).

* HUD's budget indicates it spent $259 million (yes, million) on certain housing initiatives in FY 2010. That really pales in comparison to $300 billion (yes, billion) for homeowners. HUD's total budget for FY2010 was $49.3 billion (some of this money also benefited homeowners).

** The JCT has more on how the mortgage interest deduction is used among different income levels of taxpayers. For example, about 1/3 of taxpayers claiming the deduction had income between $100,000 and $200,000 and claimed 39% of the tax benefit. Those with income of $200,000 or more represented about 10% of the claimants, but claimed almost 30% of the benefit (due to their higher tax rates).

There are also issues of a housing subsidy in that it favors (encourages) investment in housing over other investments. A report by President Bush's Tax Reform Advisory Panel (2005) noted that the effective tax rate on housing investment was zero, but 26% on corporate investments (page 71 of final report).

One of Pew's recommendations is to convert the mortgage interest deduction to a credit. President Bush's Tax Reform Advisory Panel also suggested converting the deduction to a 15% credit with the mortgage amount capped based on the regional home prices (page 61). They also recommended that the deductions for mortgage interest on a second home and on home equity loans be eliminated (page 73). This is something also often overlooked or unknown regarding the mortgage interest deduction.

The mortgage interest rules allow a deduction for interest on up to $1.1 million of debt on a personal residence or combination of personal residence and second home (such as a vacation home). Or it can include interest on up to $100,000 of home equity debt where proceeds were used for personal purposes. This also creates inequities in the tax rules. For example, if you borrow $100,000 on credit cards, you may not deduct the interest, but borrow the same amount as a home equity loan and you can deduct the interest. Also, while people say the mortgage interest deduction is needed to encourage home ownership, it also applies to debts on vacation home and home equity borrowing. Also, data shows that home ownership rates in the US are no different than in countries without the tax subsidies.

Will the Pew report bring more attention to the cost of the home mortgage interest deduction, its inequities and possible improvements that can help reduce the deficit? Perhaps their report will catch more media attention that those of academics (for some of this research, see references cited in a report of the Tax Policy Center of May 2010 and the Center for American Progress).

What do you think?

July 1 tax rate reductions

Today, the California sales tax rate drops 1 percentage point to a state rate of 7.25% (BOE Notice). The federal unemployment tax (FUTA) tax rate drops from 6.2% to 6.0 (IRS info).

Both reductions are due to expiration of temporary increases that were not renewed. The California sales tax temporary increase dates back to 2009 when it was increased to help address the deficit. The FUTA tax dates back to 1976 and had been renewed eight times (Accounting Today article of 6/30/11).

The FUTA tax decrease is arguably intended to help employers (who are the ones that pay this tax), but given high unemployment rates, the fund likely needs the money.

The California sales tax rate drop is a good thing. The 8.25% rate (higher in most areas because of additional local sales tax) is too high. The next highest state rate is 7% (see table from the Federation of Tax Administrators). And, the California sales tax applies to all equipment purchases of businesses (unless for resale), making it a high burden on businesses and a pyramiding problem.

The improvement needed to the California sales tax is not a rate increase, but base broadening. The California sales tax never left the 20th century and assumes that personal consumption consists primarily of tangible personal property. It does not. Since about 1970, consumers have been a growing amount on services and a declining amount on tangible goods, leading to an erosion of the California sales tax base - which is part of the reason for California budget deficits.

It is way past time to modernize the California sales tax - extending it to include most types of personal services (likely continuing to exclude medical services), entertainment and digital goods purchased by individuals. This would enable the rate to be lowered further and for some of it to be used to start exempting business inputs. For more see my reports on this topic and reasons why California tax reform should focus on tax bases rather than raising rates (which exacerbates the problems).