What's Appropriate for Phaseout Rules and Refundable Credits?

Our federal tax law has several phaseout provisions designed to prevent higher income individuals from claiming certain credits and deductions. These phaseouts are mostly all different in terms of how income ("modified AGI") is measured and the amount of MAGI. I think the different dollar amounts serve to prevent someone from having a very high marginal rate when they move one dollar past any single dollar amount for the entry into "high income."

I have never understood the great variation in what items are included in MAGI. Usually the §911 foreign earned income exclusion which is $112,000 for 2022, is included. That makes sense as clearly that is income but excluded for other reasons. Rarely is tax-exempt interest income included in MAGI which is puzzling (it is included in measuring taxable social security benefits under §86). Also, exclusions are rarely added back such as gifts, inheritances and employer-provided health benefits, even though such amounts might be a significant amount of income.

Build Back Better (H.R. 5376) includes several new or revised energy credits. One example is the refundable new qualified plug-in electric drive motor vehicle credit for individuals (Sec. 136401 of House-passed bill and Sec. 126401 of 12/11/21 Senate amendments). This refundable credit might be as high as $12,500 depending on the car such as if it meets a domestic content requirement which is $500 of the total available credit).

One improvement from the existing credit for hybrid cars (§30D) is that a dollar limit is set for the cost of the car. [See my 12/13/20 post on the oddity of a buyer getting a $7,500 credit for buying a $160,000 hybrid Bentley.] The dollar limits for the BBB credit are $80,000 for vans, SUVs and pickup trucks and $55,000 for other qualifying vehicles (cars).

But, the phaseout levels to qualify for this refundable credit are $500,000 for MFJ, $375,000 for HH and $250,000 for Single. I believe that means at least 99% of individuals will qualify for this credit if they can afford the qualifying car. An earlier version of BBB had the levels even higher ($800K, $600K and $400K).

At this high MAGI level, is it worth even having the phaseout? After all, not all individuals in the top 1% measured by income will buy the qualifying car and some whi do will spend above the dollar limits so not get the credit.  I think this phaseout should be dropped for simplicity purposes. If instead, the credit was for something everyone would get, then yes, best to keep out even the top income quintile. But here, not everyone is going to buy the vehicles or at the specified dollar limits for the vehicles.

And what is the purpose of the refundable credit? Likely it is to encourage development and sales of electric cars. But GM already announced in January 2021 that by 2035 it would only have elective vehicles. So why is a $12,500 refundable credit for 10 years needed?

Also, as a refundable credit, some buyers will end up paying no tax but buying a new vehicle priced up to $80K. For some buyers, this also means borrowing. That is certainly a signfiicant part of this incentive package but I don't know if its ill effects have been considered in the design of the credit.

What do you think?

November 23 - 100th Anniversary of a Capital Gains Preference

Our federal income tax law did not have special treatment for capital gains until a much lower rate (12.5% rather than a top rate of 73%) was added by the Revenue Act of 1921 (P.L. 67-87; 11/23/1921).

So, November 23 marks 100 years of complexity, lots of discussion on why and how there should be any preference for capital gains, and fairly constant changes to these rules.

The Revenue Act of 1921 defined capital asset as “property acquired and held by the taxpayer for profit or investment for more than two years (whether or not connected with his trade or business), but does not include property held for the personal use or consumption of the taxpayer or his family, or stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year.”

The 1921 Act also

•        Repealed the excess profits tax on corporations.

•        Increased the corporate income tax rate.

•        Rejected a proposal for national retail sales tax.

Treasury Secretary Andrew Mellon supported taxing earned income “more lightly” than capital gains. He noted: “The fairness of taxing more lightly income from wages, salaries or from investments is beyond question.” At the time, middle and lower income earners were not subject to income tax. See background from Tax Analysts and CRS, Capital Gains Taxes: An Overview, 3/16/18.

The rationale for the lowered rate in the Revenue Act of 1921 is similar to today: To “stimulate sales of appreciated property.” [Treasury study, Federal Income Tax Treatment of Capital Gains and Losses, June 1951, page 2]

There were three key reasons offered for preferential treatment: [page 21]

•        Equity – to avoid treating gains generated over more than one year to the progressive rate structure that exists for ordinary income.

•        Solutions:

•        Lower rate – viewed as simple

•        Annual mark-to-market – constitutional issue regarding definition of income; complexity of measurement and verification

•        Assign the gain to the year actually accrued but don’t tax until sold – viewed as complex

•        Income averaging

•        Consider effect of inflation on the asset’s value

•        Incentive  - not explained in the 1951 report, but likely the incentive was to discourage holding of assets (lock-in effect).

•        Revenue yield  - not explained in the 1951 report; but likely this meant to encourage sales to generate tax revenues.

Note: The capital loss limitation was added in 1924 but tightened after large losses of 1929.

A preferential rate or deduction existed until the Tax Reform Act of 1986 which taxed all income under a two-rate system: 14% and 28%. The logic for no lower rate for capital gains was that the rate had been lowered so much already. The Joint Committee on Taxation's Bluebook on the TRA86 observed that using the same rates for all income would "result in a tremendous amount of simplification for many taxpayers since their tax will no longer depend upon the characterization of income as ordinary or capital gain. In addition, this will eliminate any requirement that capital assets be held by the taxpayer for any extended period of time in order to obtain favorable treatment." [page 178]

Discussions on the best way to tax capital gains continue.  I think the question I get most often from students is why capital gains are taxed at a lower rate than wage and business income. That is a good question. I think part of the issue is we hear more about the reasons why we have to have a lower rate without hearing much about weaknesses in such positions (there are strengths and weaknesses to the issues for taxing capital gains more lightly than ordinary income). 

For example, a common argument for the lower rate is to address inflationary gains. But that is a weak argument today when tax prep software can easily be designed to adjust basis for inflation based on how long the asset was held. 

Another argument for the lower rate is the bunching effect in that the entire gain is reported in one year rather than over the time the asset was held. The solution is to mark to market each year. While this adds complexity, it would address the issue. And to reduce complexity, it could only be required for individuals with AGI above a certain level such as the magic $400,000. Again, technology we have today that we did not have in 1921 simplifies the recordkeeping and calculations for mark-to-market.

Another argument for lower rates on capital gains is to stimulate investment.  This is also weak because not all capital assets generate investment such as a start-up company might produce. In fact, this is why a more targeted approach was used in 1993 with enactment of Section 1202 for qualified small business stock.  

The bulk of the benefit from the lower capital gains rate structure does go to very high income individuals who tend to have a lot more capital gain income than ordinary income. This is why Warren Buffet noted years ago that his secretary had a higher marginal rate then he did. An October 2021 report by the CBO on the distribution of tax expenditures indicates that the preferential rate on capital gain and dividends provides 95% of the benefit to individuals in the top quintile and 75% to the top 1% [page 14]. 

With Build Back Better, President Biden proposed to tax capital gains at the top regular rate for individuals with income above $1 million [Greenbook, page 61]. The House Ways and Means Committee suggested replacing the 20% top capital gain rate with 25%. The bill that passed the House on November 19 has a surcharge of 5% for individuals with income above $10 million and another 3% when income passes $25 million [Sec. 138206, page 2237]. This affects a very small percentage of the top 1%, but for capital gains is still below the top rate of 37%.

Regardless of what capital gains change ends up in the final Build Back Better Act, one thing is certain - it won't be the last time we'll see congressional discussions on what the rate should be or changes made.

What do you think? Are you doing to celebrate or at least acknowledge the 100th anniversary of the capital gains preference on November 23?

Cheers!

And - Happy Thanksgiving!

Let's Avoid Unnecessary Costs and Complexities

Let's skip a tax credit subsidy for electric bikes;
buy a less expensive one instead;
don't make the tax law any more complex.

The House Ways and Means markup of the Build Back Better Act (H.R. 5376) has over 120 tax changes included. This includes a lot of energy credits. Subtitle G on Green Energy is laid out in 257 or the 2466 pages of legislative text. The cost estimate over ten years from the Joint Committee on Taxation is $235 billion. In comparison, the social safety net provisions in Subtitle H cost almost four times as much, but will likely provide benefits to those more than in need than for the energy credits.

For example, there is a new refundable credit proposed at new IRC §36E for the purchase of an electric bicycle costing up to $5,000 (for a $750 credit) but the bike can't cost more than $8,000. My Google search indicates that these bikes cost under $2,000. While there likely are ones costing more, if the buyer needs the $750 credit to buy it, why not skip the credit and the complexity it will add to our tax law and the buyer can instead buy one that costs $750 less.

Here is a summary of this one credit, which easily illustrates the complexity. It is also inequitable in that the people who will claim this likely have the funds to buy the bike even without the credit. That makes it a poor use of funds - giving money to reward behavior likely to occur anyway.  And, isn't it better to have a non-electric bike and get some good exercise and use the existing bike lanes?  I assume electric bikes can't use bike lanes for safety reasons and it likely isn't that safe to have them in the vehicle lanes.

The many complex rules to make this new credit possible include:

• Equipped with: “(A) fully operable pedals, (B) a saddle or seat for the rider, and (C) an electric motor of less than 750 watts which is designed to provided assistance in propelling the bicycle and—(i) does not provide such assistance if the bicycle is moving in excess of 20 miler per hour, or (ii) if such motor only provides such assistance when the rider is pedaling, does not provide such assistance if the bicycle is moving in excess of 28 miles per hour.”
• Original use must start with taxpayer; must be used in US.
• Acquired for use rather than resale.
• Made by qualified manufacturer (includes requirement that they have agreement with IRS) with appropriate label.
• VIN must be reported on return.
• Limited to 2 per MFJ; otherwise 1, but reduced by any taken into account for 2 preceding tax years.
• Modified AGI (MAGI) phaseout starts when MAGI exceeds $150K (MFJ), $112,500 (HH), $75K (S).
• Recapture if bike no longer eligible (per regs to be provided by IRS).
• Reduce basis by credit amount.
• Terminates for bikes placed in service after 12/31/31.

Let's look at all of the new credits and be sure they meet principles of good tax policy including equity, neutrality and simplicity. Also, let's be sure each has three good reasons why it is needed and that there is no alternative other than providing a tax rule. I think this exercise will reduce the size of H.R. 5376.

#letsfixthis

What do you think?

Build Back Better Plan and Observations on Small Business Provisions

Tax items in President Biden's Build Back Better plan were modified a bit by the markup that passed in the House Ways and Means Committee on 9/15/21 (24-19 with one Democrat voting no). I just want to comment now on a few relevant to "small business" including a reminder of the need to apply critical thinking to understand changes and commentary on them including from elected officials.

1. Corporate Rate Change: President Biden proposed to increase the TCJA rate of a flat 21% to 28%. The Ways and Means markup doesn't got that high and brings back a graduated rate structure which includes a rate cut for corporations with taxable income of $400,000 or less. The markup rate structure is:

  $1 to $400,000             18%
  $401,000 to $5 million   21%
  $5,000,001 and above   26.5%
  $10,000,001 and above a surtax applies at 3% to phaseout the benefit of the graduated rates. At almost $20 million or more of taxable income, the corporation has a flat rate of 26.5%.

So, interesting that the markup partially reverses the corporate rate increase of the TCJA that occurred when the graduate rates as low as 15% were replaced with a flat 21% rate. But there are likely not a lot of C corporations with taxable income of $400K or less as they likely operate in as a different business entity type.

2. QBI Deduction: The TCJA temporarily added a qualified business income deduction for non-corporate entities to provide some equity for the rate cut that most C corporations got. This deduction at Section 199A exists for 2018 through 2025. While campaigning, President Biden proposed to reduce this for individuals with income above $400,000 but no change is included in his proposal of earlier this year. The markup caps the 199A deduction at $400,000 ($500,000 if MFJ). At a deduction rate of 20%, that means that once the business reaches $2 million ($2.5 million if MFJ) of qualified business income (income not gross receipts), it gets no more Section 199A deduction.

That is a high level of QBI and likely affects less than 1% of owners of non-C corporation entities. This seems like a high level and helps improve progressivity of our tax rates. That is, if someone in the top rate also gets a 20% deduction against their business income, that does bring the effective tax rate down.

3. A reminder of the need to be critical thinkers: A 9/22/21 press release from the House Ways and Means Republicans offers ten reasons to oppose the markup. Reason #3 says the markup will "hammer" small businesses struggling after COVID. It states:

"Higher 39.6 percent income tax rates (which is where most small businesses pay taxes)..."

I can't help but say "wow!" That is not the tax rate for the vast majority of small businesses. Less than 2% of individuals are in the top tax bracket. The markup imposes the 39.6% (rather than the TCJA top 37% rate) once a married couple filing jointly has over $450,000 of taxable income. Most small businesses don't have that much income. If they did, they really don't fall into the "small" category (as then, what is a medium or large business?). And again, less than 2% of individuals reach the top levels. The IRS reports that the top 1% of individuals had AGI, on average in 2018, of $540,009 (this is before itemized deductions and tax credits). The top 10% had AGI of $151,935.

Note: I realize that misstatements come from members of both parties. It is unfortunate since they have good access to correct data and many people believe they are using that data correctly.

Lets Fix This: There is a lot in the markup including various tax credits. I think there is a lot of new complexity added, perhaps as much as we had with the TCJA (a lot of which we have gotten used to by now though - but not a reason to add more). Missing from the bill, as with the TCJA, are stated goals of what are we trying to do and will this bill meet those goals? I attribute this to the process and having just one party craft the bill and then enact it via budget reconciliation which limits what all can go into the bill, and limits useful discussion and public comment.

Let's keep pushing for true simplification, neutrality and equity. There are a lot of complex, inefficient and inequitable provisions in our current law and they will still be there after this tax bill is enacted.

#letsfixthis  [my new hashtag]

What do you think?

Vehicle Miles Traveled Tax Study Versus Action

Seven years ago I blogged about California's new legislation to study a vehical miles traveled (VMT) tax as an alternative to the gasoline excise tax (10/4/14 post). Oregon had already been studying one.

In July 2015, a Senate Finance Committee working group - working on tax reform, discussed a VMT in its report on infrastructure in reference to issues with the gasoline excise tax and Highway Trust Fund. Basically, with people driving more fuel efficient cars including electric cars that don't use any gasoline, not enough money goes to the HTF. And the gasoline excise tax has been 18.4 cents per mile since 1993!  It is not adjusted for inflation and hasn't been increased. The HTF has needed General Fund contributions since at least 2008 (the 2015 Senate report notes that over $65 billion had been transferred since 2008).

The 2015 report suggests a VMT as long-term option to fund the HTF. The working group noted that a VMT "has the potential to imprve the efficiency of highway financing because the tax can be calibrated closely to the costs that vehicles impose in terms of rod damage an dcongestion. Additionally, the tax coud be calculated based on time of day, congestion, type of road, type of vehicle, etc."

The Senate working group noted that it "take up to a decade to fully implement" a VMT. BUT, unfortunately, nothing was started!

I had this topic on my calendar for a while because I was going to note that the Build Back Better plan doesn't address the problems with the gasoline excise tax or suggest implementing a VMT.  A lot of study has already been done on a VMT by Oregon and California, academics and think tanks. We should move on it.

But new news - H.R. 3684, INVEST in America Act, the infrastructure bill passed by the Senate on 8/10/21 by a vote of 69-30, includes at Sec. 1630, a requirement that the GAO do a study on "per-mile user fee equity" within 2 years of enactment. This study would look at various issues of a per-mile user fee system including its effect on low-income individauls and the ability to access jobs and services.

Given use of the term "fee" and no reference to the gasoline excise tax, sounds like if such a fee were implemented, it would be in addition to the gasoline excise tax.

So, it is good that the concept of a VMT at the federal level is not completely forgotten, but more is needed to replace the out-dated gasoline excise tax with something more appropriate for funding the HTF. Let's see if something more comprehensive gets into the infrastructure bill. I think we need action rather than just more study.

What do you think?

Tax and Biden's Build Back Better - What's Included and What is Missing?

The tax provisions included in President Biden's Build Back Better plan are mostly similar to what he campaigned on, such as repealing tax preferences for fossil fuels and providing tax breaks for most families. 

I have posted a table listing the tax provisions in the Administration's FY2022 Greenbook. There is a lot there relevant to all individuals, wealthy people with lots of appreciated assets, alternative energy companies, oil companies,and more.

I think it is also interesting what is not there such as:

• Limiting the QBI Section 199A deduction for individuals with income above $400,000.  I guess this is because 199A automatically goes away after 2025 so why waste political capital trying to reduce it for less than 1% of individuals.
• Capping the benefit of itemized deductions at 28%.
• No change to the estate tax exemption or tax rate. Again, this is likely because we automatically revert to the lower exemption and higher rate after 2025 (one of a few built-in tax increases in the Tax Cuts and Jobs Act, the temporary 199A).
• Fixing Section 174 so we don't start using the TCJA provision after 2021 that R&D must be capitalized and amortized rather than expensed. Expensing has been in the law since 1954. While the BBB plan mentions helping R&D, there isn't anything specific to fix the TCJA change.
• Reducing the over 100 special rules that don't need to be in the law such as the mortgage interest deduction, various education provisions, the exclusions for employer-provided health insurance, and more. These provisions are called tax expenditures and result in reduced revenues of about $1.8 trillion per year. Now would be a good time to phase out the mortgage interest deduction because only about 11% of individuals itemize deductions today and not all of them have a mortgage. This subsidy for higher income individuals doesn't belong in the tax system. If there is desire to use the tax law to help individuals purchase a home, a first-time homebuyer credit would be better. (more on this another time)
• An increase to the gasoline excise tax that has been at 18.4 cents/gallon since 1993.  Of course, this would represent a tax increase on individuals with income below $400,000, but with the outdated figure and a desire to reduce greenhouse gas emissions, seems like an oversight (and a reason why the campaign promise of no tax increases for those with income under $400,000 should have had some caveats).  And no mention of initiating efforts to shift from the gasoline excise tax to a vehicles miles travelled tax so that all vehicles contribute to the Highway Trust Fund rather than only gas-powered vehicles.
• Numerous simplifications and improvements. I started listing some of these in a recent blog post and will continue to and hope readers will add in their ideas in the blog comments.

What do you think?