Growing income inequality and the federal tax system

Laura Tyson of the Haas School of Business at UC Berkeley has a post on the Economix blog of the NY Times for 11/18/11 - "Tackling Income Inequality." She summarizes and analyzes data on changes in income and its elements (such as wages and capital gains) and how the income of the top 1% has "soared." She notes that there is reason for the Occupy Wall Street folks to focus on this topic.

The data is from a recent Congressional Budget Office report - Trends in the Distribution of Household Income Between 1979 and 2007 (10/11).

Tyson focuses on taxation of capital gains. She notes that when she was President Clinton's economic adviser, she led a study on the effects of reducing the capital gains rate. Per Tyson: "We concluded that a cut would decrease future tax revenue, would contribute to rising inequality and would not increase saving and investment as its advocates asserted." She also reminds readers that to reach a compromise on the budget, President Clinton signed legislation that dropped the top capital gains rate from 28% to 20% in 1997. That rate was dropped to 15% and also for qualified dividends, a few years later by President Bush and today, many believe it should stay at that rate.

Tyson also notes what is an income inequality issue and what becomes a federal revenue issue: "Capital and business income are much more unevenly distributed than labor income and have become more so over time. Capital gains income is the most unevenly distributed — and volatile — source of household income."

I have blogged on this before to offer another perspective to consider with respect to the concern some raise that many individuals with income under $50,000 don't pay federal income tax (for example, 5/8/11 post). (For more on data from Tax Policy Center that for 2011 46% won't owe federal income tax - see their blog post of 7/27/11.) A 15% capital gains rate versus a 20% capital gains rate provides a $3,000 tax savings to someone with $60,000 of capital gains. So why a focus on someone with $50,000 of income perhaps not owing $3,000 of tax rather than the higher income person (with capital gain income) saving - and it is an even greater savings if the capital gains rate had stayed at 28%.

Back to the Tyson article - she suggests to address budget problems and reduce growing income inequality, to return ordinary and capital gains tax rates to what they were when Clinton left office, taxing some carried interests as ordinary income, adding a progressive consumption tax (no details of what it might be), and lowering the corporate tax rate (paying for it with the increased capital gains rate).

I encourage reading of both Dr. Tyson's article and the CBO report - interesting data and ideas.

What do you think?

Unofficial IRS Guidance and Transparency and Possible Solutions to This Taxpayer Rights Issue

An October 31, 2011 article in Tax Notes - "Olson Says Informal IRS Guidance Lacks Transparency" ties to an issue I've been highlighting for the past year. The issue is the growing amount of "guidance" being issued by the IRS that is not official guidance that could be relied upon to avoid taxpayer or preparer penalties. The items issued include FAQs and form instructions. In addition, some appear in Chief Counsel Advices (CCA) which is also not "authority" for purposes of, for example, having "substantial authority" to avoid penalties.*

Per the Tax Notes article, National Taxpayer Advocate Nina Olson observed that "the lack of high-level policy input can unintentionally harm taxpayers." (p. 564) She also observed that under the FAQ system, taxpayers do not know "what comments are submitted; there is no real deliberative process." Olson's comments were made at a panel presentation at the ABA Tax Section meeting in Denver.

Why does the informal guidance process continue? Can't Nina Olson raise this as a taxpayer's rights issue? IRS time spent on issuing informal guidance on substantive topics where there is no official guidance? Subsequent to writing an article, "How Heavy is an IRS FAQ?" in the AICPA Tax Insider in November 2010, I submitted the issue to the National Taxpayer Advocate website for submitting issues. I suggested they work to resolve this guidance problem with one way being to make the FAQs official guidance, such as by publishing them in the Internal Revenue Bulletin. The response was telling me basically, that such guidance does not avoid penalties - the exact issue I was raising. Hopefully Olson's comments at the ABA Tax Section meeting may mean that she is going to pursue this.

*The IRS website on Understanding IRS Guidance does not list FAQs or CCAs. It just lists IRS guidance that per Reg. 1.6662-4 is considered "authority" except the IRS website doesn't include General Counsel Memorandum (GCM) which the IRS hasn't issued in years. GCMs are included as authority in the regulation. I think the omission of CCAs from the website list is because they are not the same as GCMs. But it would be helpful for the IRS to clarify this. FAQs and CCAs are not mentioned in the Internal Revenue Manual (IRM) on researching the tax law.

I have heard that the IRS likes the FAQ approach because they can issue it quicker. That is because it is not getting the same deliberative attention and official documentation that proposed regs or revenue ruling revisions. But, this is like saying, my job is complicated and time consuming so I just skip the hard parts. Why is this tolerated?

Solutions:

• Make the time to follow the revenue ruling process or regulations process to issue guidance. If the IRS is shorthanded, ask Congress for more resources (or to stop adding so many new provisions to the law). Seek the help of tax practitioner groups. The AICPA and ABA (and others) already devote a lot of practitioner volunteer time to commenting on proposed regs - use that brainpower and donated time to draft the guidance and critique the issues.
• Make FAQs and CCAs with substantive guidance "official" by publishing them in the IRB.

What do you think?

Think Long Committee Ideas for Improving California

"The Think Long Committee for California aims to offer a comprehensive approach for repairing and renovating California's broken system of governance while proposing policies and institutions vital for the state's long term future." That all sounds good!

The Think Long Committee for California of the Nicholas Berggruen Institute released a report this week that explains many of California's problems, such as outdated and decayed infrastructure and finance system. The goal of the project leading to the report was to create an "integrated set of proposals" t0 "update and modernize the state’s broken system of governance."

The multi-faceted proposal is described as having three key components:

1. Empowering local governments by creating a structure that enables them to make and carry out decisions
   


2. An independent citizen watchdog organization to counter short-term thinking of elected officials and too much focus on special interests
   


3. A modernized tax system with broader bases and lower rates for most taxes

The tax proposals include lowering rates of the personal and corporate income tax as well as the sales tax. The sales tax would be expanded to include services. Multistate income would be apportioned using a mandatory single sales factor

PIT rates would be 0 to 8.5% (including the mental health tax imposed on individuals with income greater than $1 million). The only deductions would be a larger standard deduction and specified itemized deductions (mortgage interest, property taxes, charitable contributions and R&D). Most credits would be eliminated.

The corporate rate would be lowered to 7%.

The homeowner's property tax exemption (currently $7,000) would be doubled with a similar change to the renter's credit.

There is mention of the need to generate revenue to address deficits

The suggested sales tax rate on services would be 5% but 4.5 % on goods. Low-income taxpayers would receive a sales tax rebate.

The structure would enable additional revenues to be collected to reduce current deficits.

Comments:

• It is great to recognize the need to move California's tax system into the 21st century.


• Lowering rates and broadening bases is a good way to better enable a tax system to meet principles of good tax policy such as simplicity and neutrality.


• Why not further cut backs to itemized deductions? For example, there is no reason for either the federal government or the State of California to subsidize financing of an individual's vacation home. And, the $1 million debt limit should be reduced in recognition that the median home price is far less than that.


• Will the sales tax also be extended to digital goods? (it should be)


• Will the expanded sales tax base not apply to business purchases? (these should be exempt for businesses)


• A 5% sales tax rate on services and 4.5% rate on goods will bring unnecessary complexity to a system and increase the need for audits. For example, it is not always easy to distinguish a service from a good. Also, there are many businesses providing both. For example, an auto repair shop would be motivated to increase the markup on the parts and charge less for the services in order to reduce sales tax owed by customers.


• A doubling of the homeowner's exemption results in a $70 property tax reduction for homeowners ($7,000 x 1% property tax rate). It is probably not worth the change and homeowners are not, to my knowledge, calling for an increased exemption (I'm sure most homeowners don't even know about it).


• Increased renter's credit - how does this tie to the sales tax rebate? Are both needed?


• Will the sales tax rebate be refundable ? (it should be)


• Why not also increase the gasoline excise tax to help pay for improving road infrastructure and to recognize that California as ambitious greenhouse gas emission reduction targets?

I think this is all a positive step for improving California's budget, financial and infrastructure weaknesses. The tax proposals are a good start and the focus on broader base with lower rates should make for a much better tax system.

What do you think?

USA Today - story on shopper's use tax responsibility

One approach for increasing use tax collection that I have noted frequently is better education for consumers so they even know the tax exists. I think if you ask most people if their online sales where sales tax was not charged if they know they owe use tax, they would be surprised.

A 11/22/11 USA Today article - Your Money: E-shoppers' sales tax responsibilities, by Sandra Block, reminds shoppers that they likely owe tax on such purchases even though the vendor has not charged it. The article even mentions the 1992 decision of the US Supreme Court (Quill) that held that a vendor is only legally obligated to collect sales tax if it has a physical presence in that state.

What about reminders from states being published in places where shoppers will see them? I haven't seen any such reminders? Have you?

More on affiliate nexus - Amazon-style + possible federal action

If you are looking for background on the affiliate nexus ("Amazon" type) legislation that has been enacted in varying forms in eight states to date, as well as legal issues and compliance considerations, see my article in the CA Bar Tax Network newsletter for November 2011:
From Website Links to Collection Points

Also, don't miss the National Retail Federation's ad - "Why you should care about online sales tax legislation." The ad encourages retailers not involved in online sales to support federal legislation to enable states to require remote vendors to collect sales tax. The NRF notes that states would gain about $24 billion. Here is a line I like: "It’s NRF’s view that businesses need a 21st century tax system that works with 21st century retail. And now is the time for Congress to act."

NRF notes that there are 3 federal proposals but does not take a stand on any particular version. Instead, NRF notes: "NRF strongly supports federal legislation that would make it easier for states to require all Internet retailers to collect sales tax in the same way as local stores."

I think something is going to pass - probably S. 1832 (112th Congress) because it helps states that adopted the SSUTA as well as states that have not and probably will not. If non-SSUTA states enact the simplifications specified in S. 1832, they would be able to get remote vendors (but not de minimus ones) collect sales tax. With states eager for funds and Congress unable to give them much given federal budget problems, passing S. 1832 would be a way to indirectly get money to states.

What do you think?

Too much bipartisanship for tax and budget reform - too bad for federal finances

It is unfortunate that the Select Committee is unable to reach a compromise to find $1.5 trillion to budget changes to reduce the deficit over a ten year period. It is unfortunate for many reasons such as:

• We really need bigger changes than just the $1.5 trillion.
• If members cannot work together it is unlikely that the serious budget and tax problems we have can get resolved in a productive manner.
• Many of the changes that are needed should not be tied to politics. There are many areas of spending that defy logical explanation.

Regarding that last point, let's hear from politicians as to why the tax law:

• allows a interest expense deduction for the mortgage on one's second home.
• allows an interest deduction on up to $1.1 million of debt on a principal residence when the median home price in the US is under $250,000
• allows employees to exclude all of the health insurance benefit they get from their employer (why not tax at least 20% of it as a starting point - that would result in about $800 of tax for a $10,000 policy - good deal!)
• allows a capital gains rate of 15% (although temporary through 2012) - after the TRA86, the capital gains rate was 28%

And there is more. For example, why are across the board cuts better than targeted ones that get at areas of waste?

For a story on the impasse - see the Wall Street Journal, Debt Panel Folds Its Tent (11/21/11).

What do you think?

Spending, recession and sales tax

The California Board of Equalization Economic Perspective report for November is on Impacts of the Recession by Income Class and Type of Purchase. The report analyzes U.S. Bureau of Labor Statistics data on spending and income. Some findings:

• Form 2007 to 2010, spending in all income quintiles is down except for the lowest quintile where spending increased which the BOE expects is due to prices increases for rent and food.
• As shown in Chart 3 posted here, spending on items not subject to sales tax increased while spending on non-taxable items decreased. Per BOE: "This pattern of larger declines in spending on taxable goods than nontaxable goods and services partially reflects the design of the tax system, which excludes from taxation spending on necessary items such as food for home consumption."
  
• "One component of consumer spending that seemed to be relatively “recession proof,” was spending on pets, hobbies, toys, and playground equipment."

The spending patterns affect sales tax collection as recession spending affected spending on taxable and non-taxable items differently. But the greater spending on non-taxable items versus taxable ones is a longstanding trend where consumption of services and intangibles has been growing for decades which spending on goods has declined. With movement of some purchases from tangible goods to the digital equivalent (software, music and books for example), the California sales tax base erodes. See June 2011 BEA report, table 1 - here, showing that from 1959 to 2009, personal consumption spending on goods dropped 22% and spending on services increased 22%.

As I've discussed here many times, it is well past time for California to modernize its sales tax base to cover 21st century consumption. The sales tax should be expanded to personal services and digital downloads purchased by consumers (not businesses) and the rate lowered.

See:

• Nellen, sales tax base is too narrow - here
• California Budget Project, Budget Backgrounder - Should California Extend Its Sales Tax to Services (October 2011)

What do you think

Problems with small business health insurance credit

To help more people have health insurance, the health care legislation enacted in March 2010 included a new credit for small employers. This provision at Internal Revenue Code Section 45R - Employee health insurance expenses of small employers, is complex. Just look at what it takes to describe this credit:

• IRC Section 45R


• IRS website on the credit


• IRS 1-page fact sheet showing 3 simple steps (note the number of terms you need to know and the data you need to gather, such as the average employee wage)


• 36 FAQs from IRS
  


• Notice 2010-44 (20 pages) explaining how it works


• Notice 2010-82 (19 pages) expanding on Notice 2010-44

The target audience for the credit - small employers, measured by number of employees and their average full-time equivalent wage. They will face an added expense of either having an employee figure out the credit, which also involves getting information from the insurance company, and/or paying a tax adviser to compute it.

A TIGTA report Affordable Care Act: Efforts to Implement the Small Business Health Care Tax Credit Were Mostly Successful, but Some Improvements Are Needed (11/7/11), noted:

“despite IRS efforts to inform 4.4 million taxpayers who could potentially qualify for it. According to the IRS, as of mid-May 2011, just more than 228,000 taxpayers had claimed the Credit for a total amount of more than $278 million. The IRS plans to conduct focus groups to determine why the claim rate was so low. The Congressional Budget Office estimated the Credit would cost $37 billion over 10 years and that taxpayers would claim up to $2 billion of Credit for Tax Year 2010.”

On November 15, the House Ways & Means Committee held a hearing on the credit. The complexity of the credit and its low usage were highlighted by the witnesses. For a brief summary, see Journal of Accountancy article (AICPA Tax Division Chair Patricia Thompson testified for the AICPA).

Why these problems with the credit? There are a few:

• Special rules intended to apply to a target, narrow population require detailed terms to define that population and what qualifies for the credit and what does not.


• Existing definitions were not used. Throughout the federal income tax there are definitions of "small" yet none of those definitions were used to for the health care credit.


• The premise is flawed - why perpetuate a decades old circumstance that led employers to provide health insurance to employees? When will health care reform break this model that increases health care costs, provides a competitive disadvantage to US employers, makes the tax law inequitable in that employees with health insurance coverage from their employer get a BIG tax break while those who have to buy their own get little, it adds complexity to the law. (See a 2008 article of mine on this - "Pot of Gold in the Employer-Provided Healthcare Exclusion.")

What do you think? Should Congress try to simplify the credit or repeal it and find another solution to reduce health insurance costs to broaden coverage?

Rough Road to Even a 28% Corporate Tax Rate

We have heard suggestions for dropping the corporate income tax rate from its current 35% to perhaps even as low as 15%. Typical suggestions seem to be for 28% or 25%. President Obama and others will require that any decrease be revenue neutral.

Democrats on the House Ways and Means Committee asked the Joint Committee on Taxation to estimate what the rate could drop to if all tax expenditures were repealed either just for corporations or for all business taxpayers. The JCT's preliminary data was released earlier this month. It indicates that the lowest rate would be 28%, although it a longer budget window is used, it likely has to be higher.

I have a short article in the AICPA Corporate Taxation Insider (11/10/11) on the data and its implications. The vast majority of the "pay for" are timing items, such as using slower depreciation. That doesn't really raise revenue (at least in the long run). Some of the repealed tax expenditure are really simplifications, such as allowing small C corporations to use the cash method rather than the accrual method.

Links to the report and critique of this approach to pay for a lower rate, are included in the article. Also see 11/2/11 post.

Need to Fix Sales Tax Collection Problem

A headline in today's Chicago Sun Times is a good reminder of the need to address the issue of sales and use tax not getting collected on a lot of online shopping done by consumers. The story title - "Tax-free shopping doomed?" by Kyong M. Song (11/13/11).

There has never been tax-free shopping on the Internet. It has only seemed tax-free because most consumers do not know about the use tax or don't pay it. And, states have had difficulties enforcing it (and done little to really educate consumers about the use tax).

There are currently three bills in Congress calling for some way to get more remote vendors to collect the tax, which would be the easiest way for the states to collect it and for consumers (no need to track what use tax you owe if the vendor collected it from you).

For a quick summary of the three proposals, see "Federal Proposals" - here.

I am doubtful if anything will be passed this year unless Congress feels that it a necessary option to help states gain some revenues.

What do you think?

Pushing for specifics on tax reform proposals

There are quite a few vague tax reform proposals being touted by presidential candidates today. We have 9-9-9, variations of a flat tax, a reformed income tax and a corporate down to at least 20%. What is missing are the specifics of the proposals. Without fairly complete legislative language, it is impossible to really understand what is being suggested.

I have an article in this week's AICPA Tax Insider that summarizes most of these proposals based on what candidates have said so far or posted to their website (which are all still fairly general). The short article includes some suggestions for what additional information is needed and how to critique the proposals. A reference list (link) is included with links to the various proposals.

Check it out - Pushing For Specifics on Tax Reform Proposals.

What do you think?

AICPA suggests that Select Committee follow principles of good tax policy

I am pleased to see the AICPA Tax Division send a letter to the Joint Select Committee on Deficit Reduction (the one to create a plan to reduce the deficit by $1.5 trillion). The letter suggests the importance of following principles of good tax policy. Per the introduction of the letter:

"The public meetings of the Select Committee have evidenced an interest on the part of at least some members in addressing tax reform as part of your process. The AICPA has published four Tax Policy Concept Statements which discuss various principles of good tax policy, which we believe can frame any discussion of tax reform. This letter contains a high level summary of each of these statements, as well as links to the complete documents on our website."

It is a nice summary of four sets of policy statements the AICPA has released on principles of good tax policy. This work started in the 1990s when the AICPA was looking at what it might be able to add to the tax reform discussions underway in the mid-1990s. I was serving on the AICPA's tax policy and legislation committee at the time and got the opportunity to take the lead on the tax policy statement.

I encourage reading of the letter - it is a nice reminder of principles that can help bring some objectivity to tax reform discussions. Click here for the letter.

Economy continues to hurt states

A Reuters article (11/3/11) by Nanette Byrnes - "Analysis: Economy's shifts erode states' tax bases" notes some new and continuing woes for state budgets:

• Growing pressure on volatile personal income taxes for revenues.
• Figuring out how taxes apply (or don't apply without legislative change) to new economy transactions such as Groupon and Living Social coupons and e-commerce in general.

States have been in tough times for several years now. Some of their woes were covered via tax shifts, such as suspending the use of net operating losses and credit carryovers. Temporary tax increases were also used, such as in California. But the temporary tax increases may have expired, such as is the case in California, under the initial thinking that the economic downturn would have reversed by now.

What should California and other states do to address continuing budget woes caused by weakened revenue collections due to the weakened economy? What do you think?

California Budget Problems and Possible Solutions

This is a slide from a 10/27/11 presentation by the Legislative Analyst's Office on California's Budget Woes. I encourage you to look at the entire slide deck to get a better understanding of some of California's significant budget problems that include current revenue shortfalls and large future liabilities such as over $150 billion of unfunded pension and retiree health benefits.

Some people are not concerned with the volatility of the personal income tax (PIT) saying that just means the tax is tracking the economy. That is, incomes go up, so does the tax base. But as the LAO indicates on the slide above, the PIT is more volatile than the economy. That harms the ability of this tax to fund government expenditures, which is the key purpose of a tax. Worse yet for California is that the PIT provides over half of state revenues. This is far greater than the role it played in 1969-1970 as shown in the following LAO slide.For my list of California tax system weaknesses - check out this page.

The last slide (#36) notes that tax reform is a possible solution, but that it is "an incredibly difficult task with no clear consensus on what to do." That's sure true. Unfortunate but true. And, after Prop 26 (Nov 2010), any tax reform will need a 2/3 vote of the legislature. Any tax bill that needs a 2/3 vote will be labeled as a tax increase which will lead many Republicans who have signed the no new tax pledge to not vote for the measure even though it would help the state tremendously.

Here are a few tax and budget reforms that California needs:

1. Expand the sales tax base to include digital goods and personal services. Transition in the changes, provide vendors with a refundable credit to help cover their new compliance costs, and don't apply the tax to purchases by businesses. Use some of the new revenue to cover our deficit and the rest to lower the sales tax rate.
2. Work with Congress to get legislation passed that allows the state to collect sales and use tax from remote vendors.
   
3. Phase out the mortgage interest deduction for debt on a second home, for home equity debt and for acquisition debt greater than $500,000.
4. Change the senior exemption to be based on income rather than age.
5. Eliminate the choice of apportionment to move to a single sales factor with all sales sourced based on market.
   
6. Increase the gasoline excise and tobacco excise taxes.
7. Enact an oil severance tax with the revenues to go into the General Fund with no earmark.
   
8. Create a rainy day fund to start in 2 years. Funding of it should include 10% of taxes paid on capital gains.
   

What do you think? What would you suggest for California tax reform?

The Tax Law with a Revenue Neutral 28% Corporate Tax Rate

Over the past few years, various numbers have been suggested for a lowered corporate tax rate. Typically, the range from 20% to 28%. This week, the Ways and Means Committee Democrats released a "very preliminary" (JCT words) estimate of what revenue-neutral rate is possible if all tax expenditures (special deductions and credits) are eliminated for corporations. The rate would be 28%. The Democrats are apparently touting this because Chairman Camp released a work-in-progress proposal called the Tax Reform Act of 2011. His proposal calls for a 25% corporate rate and a move to a territorial system (rather than worldwide) along with a few other international tax changes. He promises individual reforms and additional corporate ones at a later date.

I'll have more on this later, but a few things to consider now:

1. Would Congress really repeal ALL tax expenditure for corporations? The largest revenue raiser by far in the list of replacing MACRS depreciation with ADS depreciation (straight-line with longer lives). Just over 70% of the revenue raised to cover the "cost" of a 28% rate (about $71 billion per year) is from this MACRS change. Won't less favorable depreciation than we have now harm international competitiveness?

2. Won't there by some transition rules? They cost extra.

3. What will be the cost of other business entities that have a rate higher than 28% converting to C corporations?

4. Some tax expenditures, such as allowing small C corporations to use the cash method rather than the accrual method are for simplification purposes? What is the purpose of removing them?

5. Other than some credits that would go away, the changes mostly appear to be timing differences. This really doesn't raise any revenue in the long run. In fact, the JCT points out that if you look beyond a 10-year budget estimate, the revenue neutral rate is likely higher than 28%. Note that many credits are not included in the list because the projections cover 2012 - 2021 and many credits, such as the research credit expire before 2012.

For more information (again, I'll have more soon when an article of mine is published), see

• "Break-Free Corporate Tax Code Misses Republican Rate Goal," by Steven Sloan and Richard Rubin, Bloomberg, 11/2/11
• Democrats press release (11/2/11)
• JCT release with the "very preliminary" data
• Chairman Camp's Comprehensive Tax Reform proposal

What do you think?