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?

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?

Tax System Challenges of Odd Budget Processes

Congress has passed H. J. Res. 45, the Statutory Pay-As-You-Go Act of 2010 (2/4/10). While it sounds good - basically, tax cuts should be offset by certain types of spending cuts or other tax increases, it has an enormous whole in it. PAYGO won't apply to tax changes that are considered part of "current policies."

Here is the section of the resolution: "ADJUSTMENT FOR CURRENT POLICIES.
(a) Purpose- The purpose of this section is to provide for adjustments of estimates of budgetary effects of PAYGO legislation for legislation affecting 4 areas of the budget--
(1) payments made under section 1848 of the Social Security Act (referred to in this section as `Payment for Physicians' Services');
(2) the Estate and Gift Tax under subtitle B of the Internal Revenue Code of 1986;
(3) the AMT; and
(4) provisions of EGTRRA or JGTRRA that amended the Internal Revenue Code of 1986 (or provisions in later statutes further amending the amendments made by EGTRRA or JGTRRA), other than--
(A) the provisions of those 2 Acts that were made permanent by the Pension Protection Act of 2006 (Public Law 109-280);
(B) amendments to the Estate and Gift Tax referred to in paragraph (2);
(C) the AMT referred to in paragraph (3); and
(D) the income tax rates on ordinary income that apply to individuals with adjusted gross incomes greater than $200,000 for a single filer and $250,000 for joint filers."

These are some costly provisions - 2 years of the AMT patch (2010 and 2011) and reinstatement of the tax cuts for individuals with income under $250,000 ($200,000 if single).

This doesn't really seem quite honest. It also enables Congress to enact lots of tax cuts that are not paid for. This means the deficit will go up as will the debt and interest expense and someday, someone will have to raise taxes to pay for this. Enacting PAYGO with big holes in it is like someone saying they are going to only spend within their income level, while at the same time running up their credit cards to pay for extra spending.

I was really thinking that the high cost of keeping any of the 2001/2003 tax cuts would cause Congress to have to enact some major (or at least significant) reforms of the income tax. Such reforms would "mask" the reality that when the tax cuts expire after 2010, there is, in effect, a tax increase for everyone. Reform could have included a thorough review of all special deductions, credits and exclusions to see if any are not needed or can be cut back to better meet their intended purpose and to be made more equitable.

This deceptive PAYGO provision is really a way to run up an already high deficit and debt, and avoid the tough job of modernizing and improving our federal tax system.

What do you think?