What's So Special About Tips to Make This Income Non-taxable?

Both presidential candidates offered a tax law change to make tips non-taxable. A few days after the inauguration, President Trump was in Las Vegas at a rally for "No Tax on Tips."  What is so special about tips to justify a law change to make then non-taxable?  I can't think of any, but offer these observations to remind us that tips are income just like wages and business income and there is little reason to provide a tax break to these workers - why not provide a tax break to all workers?

1. Tips are income: Income is defined by the US Supreme Court as "an undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion" (Glenshaw Glass, 348 US 426 (1955)). Some people suggest tips are gifts so are not taxable. A gift is defined by the US Supreme Court as something given with "detached and disinterested generosity" where the donor expected or expects nothing in return (Duberstein, 363 US 278 (1960)). Someone who receives services at a restaurant, hotel, hair salon, or similar establishment, might offer a tip because they appreciated the service and the amount likely varies by how much they liked the service. It is not a gift. If the giver wants to make a gift to someone they should go up to a stranger and give them money with no expectation of anything in return - that is a gift.

2. More than tipped workers need tax relief: H.R. 8785, Tax Free Tips Act (118th Congress) would have changed the law to say that wages do not include tips and make them not subject to income or payroll taxes. The sponsors offered as a rationale that many people getting tips might be "working a second job to make ends meet" so should be able to keep their money. That sounds reasonable if we are talking about raising the standard deduction for ALL low-income workers, but why single out or assume that only tipped workers are in need of tax relief.

3. Challenges of defining tipped workers: It looks like the key proposal in the 119th Congress based on the number of sponsors is No Tax on Tips Act. It would exempt cash tips from income tax (not payroll tax) and has "guardrails to ensure only traditionally tipped employees will benefit from" the proposal (see 1/16/25 sponsor press release). Do note that it says employees. Thus, contractors, such as your Uber driver and owner of a business, would not benefit from the tip deduction. The deduction is limited to $25,000 for the year and would not apply if the worker's income exceeds $160,000 (this is the amount per the reference to §414(q) in the bill). "Qualified tips" for the deduction are defined as "any cash tip received by an individual in the course of such individual's employment in an occupation which traditionally and customarily received tips on or before December 31, 2023, as provided by the Secretary." Thus, the Treasury and IRS would have to define this employee group.  I think that means that there isn't already a list of traditionally tipped industries.

4. Tip versus Service Charges: Some restaurants including ones in DC, automatically add a charge to restaurant bills such as because it was for a group of 6 or more (in DC, even 1 customer gets a 20% fee added). Is that a tip or something else (the DC one appears to be a service charge)? For tax purposes today for rules relevant on tip reporting, a service charge is not a tip (Rev. Rul. 2012-18). The fee is wages if distributed to employees. Will any legislative proposal address whether "forced" tips or service charges are the traditional and customary tips to be non-taxable? Arguably, I think yes, but to me it just doesn't seem like a tip when the business adds the amount to your bill automatically. But this should be addressed in any legislative change (in defining "tip").

5. Challenge of excluding tips from Social Security/Medicare taxes and state income taxes: Any tax big tax bill this year will likely be accomplished via the Budget Reconciliation process so that only 51 votes are needed in the Senate. This process does not allow for changes to Social Security so any tip exclusion in the bill can only remove income taxes (as proposed with No Tax on Tips Act (see 3 above)). Also, I think most states will opt not to conform to a federal exclusion or deduction if enacted due to the loss of revenue and the inequity of providing a tax cut to only a small number of employees. The Budget Lab at Yale estimates that 2.5% of workers earn tip income. At the 1/25/25 rally in Las Vegas, President Trump said over 4 million workers receive tip income and that about 25% of a typical restaurant worker's pay is from tips. Will a state enact a tax change to let about 3% of employees exclude 25% of their pay from taxes with no break to other employees who are at the same pay levels? I don't think so.

6. Permanent or temporary: Will any exclusion or deduction for tip income be a permanent change or temporary? I think if the extension of TCJA expiring tax cuts is temporary, the change for tip income will also be temporary, but who knows.

So, there is a lot to consider on this topic that affects a relatively small number of employees. Given the tax cut for a small number, will other employees, particularly those making minimum wage or a bit more also ask for an equivalent tax cut?  I think they should to improve the equity of the proposal - that is, similarly situated taxpayers based on income should be treated similarly. If a tipped employee making $70,000 including tips gets a tax cut, a non-tipped employee also making $70,000 should also get the same tax cut.

What do you think?

Tax System Changes Can Help Reduce Poverty

Today I received information from the National Academies on their new report, Reducing Intergenerational Poverty, Sept 2023. It defines "intergenerational poverty," provides demographics of this poverty, describes education and health issues associated with continual poverty, and makes recommendations. 

The introduction reminds us of the relevance of this topic to us all (page 1):

"Capable and responsible adults are the foundation of any well-functioning and prosperous society. Yet low-income families struggle to offer their children the same advantages and necessities that better-off families can offer. As a result, throughout their childhoods children living in families with low incomes face an array of challenges that place them at much higher risk of experiencing poverty in adulthood as compared with other children."

"The costs of perpetuating this cycle of economic disadvantage fall not only on low-income individuals and families themselves, but also on society as a whole. Poverty reduces overall economic output and places increased burdens on the educational, criminal justice, and health care systems. Understanding the causes of intergenerational poverty and implementing programs and policies to reduce it would yield a high payoff for children and for the entire nation."

One of the recommendations is to increase and expand the Earned Income Tax Credit (EITC). Per the researchers: "The strongest direct evidence on the likely intergenerational effects for children is found for programs that increase both family income and parental employment during childhood and adolescence." [page 133]

IRS data reports that in 2020, 26 million filers claimed the EITC with the aggregate credit at $59.2 billion (Table A of Individual Income Tax Returns Complete Report 2020).

Where could the money come from to increase and expand the EITC? We can and should reduce various tax breaks that reduce the tax liability of high income individuals by far more than a taxpayer can currently claim as the EITC. The OMB reports that the "cost" of the exclusion for employer-provided health insurance is $224 billion per year. It is not uncommon for this exclusion to be about $10,000 (or even lots more) for one of the roughly 64% of employees who get this tax break (their employer pays all or a portion of their health insurance premiums). Assuming $10,000 of excluded income, this tax break is worth the following at each individual marginal tax rate as follows (the savings is similar to a tax credit of the amount listed below):

   10%     $1,000 tax savings
   12%     $1,200 tax savings
   22%     $2,200 tax savings
   24%     $2,400 tax savings
   32%     $3,200 tax savings
   35%     $3,500 tax savings
   37%     $3,700 tax savings

The average EITC for a taxpayer claiming it is, per the IRS, $2,043. Thinking of the above tax savings as similar to a tax credit, individuals with $10,000 of employer-provided health insurance who are at a 22% bracket or higher are getting a larger credit than the average EITC claimer.  And this is quite a tax savings because someone in these higher brackets can afford to pay their health insurance without the tax subsidy. Unlike the Premium Tax Credit, there is no income threshold or affordability limitations on claiming the exclusion for employer-provided health insurance (see blog post of 5/14/23).

Even if this one tax break for employer health insurance were cut in half to $112 billion per year, that would enable the EITC on average to be increased by about $4,000.  I note this example just to illustrate that there are tax breaks that can be reduced or eliminated, particularly where they provide a tax break much larger than a typical ETIC, but to people with far greater means for whom the tax break doesn't make a life-changing difference where it would improve the life of a low-income worker and improve economic conditions and living standards in the U.S. for everyone. There are over 100 other tax breaks that could be reduced, particularly where they provide significant subsidies and tax breaks to higher income individuals, whose well-being and that of our society is not improved much by them due to their income levels.

So, why don't we reduce some tax expenditures and use the funds in ways that will truly help people who need the assistance more and will benefit our society and economy as a whole?

What do you think?

16th Anniversary of the 21st Century Taxation Blog

Today marks the 16th year after I started this blog in 2007 while I was a fellow with the New America Foundation. My goal with this blog continues to be to analyze proposals and discuss ideas for helping our tax system to reflect how we live and do business today and to meet principles of good tax policy.

There are many inequities in our tax system such as special tax deductions, exclusions and exemptions that provide a larger benefit to higher income taxpayers relative to others. Examples include the mortgage interest deduction, exclusion of gains that exist at death, and the exclusion of employer-provided health insurance subsidies.

I think many of these exist because the vast majority of people don't understand how they work. Tax literacy is low in the U.S. because we don't teach about taxes in K-12 and even in college, accounting majors are likely the only ones to take a tax course. And tax and budget policy should be taught along with basics of how taxes work.

Today, let's look at how the government, via our tax law, provides tax breaks for health insurance. The largest and more favorable tax benefit for obtaining health insurance is the exclusion for employer-provided health insurance. According to OMB and Treasury, the annual cost of this tax break (cost as in tax revenue not collected) is $237 billion for FY2024 (Table 3). At least 57% of individuals get health insurance from an employer. CBO estimates that 58% of employees under age 65 (156 million people) have health insurance from their employer or a family member's employer.

This health insurance subsidy for employees is very favorable for many reasons:

1. Regardless of the employee's income level and ability to pay for their own insurance, they still get the tax break.

2. Per CBO, the exclusion tends to cause employers to offer more favable coverage - it "encourages firms to offer health coverage with lower cost sharing (such as plans without a deductible), more covered services, and broader provider networks."

3. The higher one's income, the larger the tax savings due to being in a higher tax bracket. So, although a lower income person would need a larger subsidy, the larger subsidy goes to the higher income persons.

Now for contrast, compare the employer-provided health care exclusion to the Premium Tax Credit (PTC). This is available to individuals who don't get affordable coverage from an employer, are not eligible for any government coverage such as Medicare, have household income below 400% of the federal poverty line (this is waived through 2025), and purchase coverage from an exchange.  

What isn't highlighted though is that a PTC eligible person will only get the PTC if based on their annual income they cannot afford the second lowest cover silver plan. For example, using the calculator from Covered California, a 30-year old with $61,400 of income will get a $12 PTC for the year because they are deemed able to afford a silver plan that costs $435 per month (other than $12 of that annual cost). If their income is $61,500, no PTC.

In contrast, if that person with roughly $60,000 of income gets a platinum plan where the employer covers the entire cost, the employee has no out-of-pocket cost and no taxes to pay on the benefit.

Where is the equity in these two tax rules? While removing the 400% of FPL income cap temporarily from the PTC helps a bit, it doesn't change the fact that the exclusion for employer-provided health coverage is far more favorable. A single person with over $61,000 of income gets no PTC but if they work for an employer providing health insurance subsidy, they get a tax break. And that employer-provided subsidy also increases the cost of health coverage for everyone.

The CBO has some solutions regarding the exclusion - here as does the Tax Policy Center such as converting the benefit to a tax credit.

Why was the PTC designed in such an inequitable manner compared to the employer-provided health insurance exclusion?

What do you think? 

Are special state tax refunds taxable? Maybe; it depends!

For COVID relief, both the federal government and some state governments had funds for individuals/households. Congress created Economic Impact Payments (recovery credits) which were specified as not taxable and states followed that. Some states such as California had additional relief such as the Golden State Stimulus payments where were labeled as a one-time tax refund and available only to individuals below $75,000 of income or who received certain aid. California law (R&T 17131.11) was clear the funds were not taxable for California. For federal purposes, as a tax refund they were not taxable and even if not truly a tax refund, they likely fell under the general welfare exclusion to be non-taxable.

Last summer some state lawmakers created additional grants or refunds likely due to a surplus and increased gasoline prices hurting some individuals. California enacted the Better for Families Tax Refund (AB 192, Chapter 51, 6/30/22). This is also called the Middle Class Tax Refund (MCTR) on the FTB website (it's not clear where that name came from).

The preamble to the bill states that "existing law authorizes various forms of relief for low-income Californians." The relief provided though is available to married couples or head-of-household filers with 2020 income (AGI) up to $500,000 or single up to $250,000.  These are not low-income levels because those high levels represent less than 2% of the California population. In addition to being below the stated AGI levels per the 2020 return, recipients had to have filed their 2020 return by 10/15/21 (before AB 192 was enacted) and be a California resident for six or more months of 2020 and not be eligible to be claimed as a dependent.

AB 192 is very clear that the "refund" is not taxable in California (R&T 17131.12(a)). While it sounds like a non-taxable refund for federal, there is a provision in AB 192 at Welfare & Institutions §8161(d) that states that the payment "shall not be a refund of an overpayment of income taxes ..."

So, perhaps it is not a non-taxable tax refund (although some bill language makes it sound like it is a refund of various California taxes, but why deny it then to someone without a need to file a 2020 California income tax return; everyone in CA certainly pays a variety of taxes including renters who indirectly pay a lot of property taxes, as well as sales and excise taxes).

Does the general welfare exception apply to make the MCTR non-taxable? The IRS describes this income exclusion as requiring the income recipient to satisfy the following (see Information Letter 2019-0024):

1. funds paid per a government program - met

2. not a payment for services - met

3. for promotion of the general welfare meaning it is based on need - I think not met

How can funds given to about 97% of Californians be a needs-based program? How can payment given to people well above the federal poverty line be based on need? How can $400 given to a married couple with $499,000 of income or $200 if single with $249,000 of income be based on need? Well, it would appear that the general welfare exception doesn't apply - the refunds/grants are taxable for federal purposes.

The FTB must have reached the same conclusion because they have stated that they are and will be issuing 1099-MISC to anyone receiving an MCTR or $600 or more.  Of course, even if someone received a payment under $600, it is still taxable despite not receiving a 1099. Also note that these are Form 1099-MISC for miscellaneous payments rather than 1099-G for a refund of income tax paid (which makes sense because you could get the payment even if no income tax was owed in 2020).

Oddities:

1. Why were these funds given to people who don't need them? And it is not just the funds, but the costs of issuing so many "refunds."

2. Why were the funds not available to people who do need them, such as people with income below the filing threshold so did not file a 2020 return by 10/15/21? (these folks also lost out on the Golden State Stimulus if they did not file a 2020 return by 1015/21)

3. Why did AB 192 include a law change to say that the "refund" is not an income tax refund?

4. Why do California lawmakers want residents to give some of their payments to the federal government?

5. What about the reality that higher income individuals who get a refund under $600 won't have a 1099-MISC and may just forget to report it on their return, versus the lower-income folks getting a 1099-MISC that they must report? Now the amount might not cause a federal liability for low income taxpayers, but it is likely to result in some tax owed by many recipients.

All recipients should note what they received and put it in their tax records so all recipients report it on their 2022 or 2023 return (refunds are issued in Nov 2022 through January 2023). 

For more:

• My 7/10/22 post on some MCTR issues.
• FTB websites on the MCTR - here and here

What do you think?

Prop regs fix a PTC issue 7 years later

The Affordable Care Act enables individuals to not only purchase insurance on an exchange but to also get a subsidy for it if they qualify. That subsidy is the Premium Tax Credit (PTC). There are eligibility criteria such as purchasing the coverage on an exchange (such as Covered California), if the person is employed the employer does not offer affordable coverage and the household income is below 400% of the federal poverty level.

When regs were issued in 2014 at the start of the PTC, section 36B(c)(2)(C)(i) that includes this clause:

"This clause shall also apply to an individual who is eligible to enroll in the plan by reason of a relationship the individual bears to the employee."

Reg. 1.36B-2(c)(3)(v)(A)(2) interpreted that clause to mean that if the coverage offered to the employee was affordable, no one in that employee's household would qualify for a PTC even if the coverage offered to the family was not affordable.

I always thought that was an odd interpretation of the vague clause and contrary to the purpose of the ACA - to help more people get affordable coverage.  I think a possible reason for the odd interpretation is that the ACA is designed to encourage employers to offer affordable coverage to employees AND family members. So perhaps the thought was that employees would encourage employees to ask the employer to provide affordable coverage. Unfortunately, that is unrealistic, particularly where employees are low paid (such that their household income if below 400% of the federal poverty level (about $43K for a single person)).

Well, this month, the IRS issued proposed regs to fix this (REG-114339-21 (4/7/22)). A 4/5/22 Tweet from the Treasury Dept indicates that this change should enable about 1 million people to save hundreds of dollars per month on their coverage. Why is this finally being fixed? Apparently it is Executive Order 14009 (1/29/21) where Treasury was directed to find ways to strengthen the ACA via administrative actions. This is a good fix.

What about other needed fixes? One major one is that the PTC includes a cliff rather than a phaseout. So once household income exceeds 400% of the FPL, the taxpayer must pay back all of the PTC it received for that year. That can easily be $1,000 to over $10,000. That is harsh.  Also, the measure of household income is based on the entire year. So, if someone is out of work, say for the first 7 months of the year and can't afford health insurance, they can get the PTC, but if the job they get for the last 5 months of the year puts them above 400% of the FPL, they have to pay back the PTC even though they needed it for the first 7 months to buy health insurance.

That will need a legislative fix though.

And, before I leave this topic, in case anyone is thinking that this PTC subsidy of thousands of dollars is too good of a tax break, millions of individuals get tax breaks on health insurance. About 65% of employees have an employer who pays all or some portion of their health insurance. That benefit is tax free to the employees. So, if someone's employer contributes $10,000 to their health insurance and is in the 24% tax bracket, they save $2,400 in taxes. BUT, they also save shelling out $10,000 for the coverage paid by the employer. This is the most expensive tax break in the tax law in terms of reduced tax collections (see page 33 of this JCT tax expenditure report). And not all employees get this subsidy and it is worth more to those in a higher tax bracket.

What do you think?

#letsfixthis

Certain Tax Increases and Fixes Needed for Equity and Fairness

Tax reform discussions in Congress for the week of October 17 have included possibly not including tax increases. Are taxes too high already? Perhaps. But they are also quite uneven in their application.  Here are a few examples:

• Vastly different rates exist for capital gain versus ordinary income for very high income individuals. A wage earner with over $400,000 of earned income will enter a 37% marginal rate today (39.6% after 2025). In contrast, a person with capital gain and dividend income will be in a marginal rate of 23.8%. This is a frequent question I get from both students and practitioners - why are capital gains taxed lower than ordinary income. There are reasons, but I don't think it supports a difference once income passes the $500,000 level.* Tax it all the same after some high level such as $400,000 or more.  And that high income wage earner will have 2.9% Medicare tax on income above $147,000 (figure for 2022) and an additional 0.9% on income above $200,000 ($250,000 if MFJ).  So a capital gain rate of 37% (or 39.6% once AGI exceeds $1 million as President Biden proposes (see page 8 of this table)), causes the high wage earner and high capital gain recipient to both be at a marginal rate of 43.4%. Note that I am only talking about very high income individuals (less than half of the top 1% of individuals).
  
  Yet, 43.4% is a high rate. I think it would be good to include with Biden's plan, repeal of the extra 3.8% net investment income tax (NIIT) which would also simplify the tax system.  That though would cause the wage earner to still be paying an extra 2.9% on all of their wage income, so perhaps add that to the high capital gain person. Or, keep the top rate at 37% + the 2.9% extra to equalize the high wage earner and high capital gain person. Or even a lower rate could be used along with reduction in some of the tax breaks for high income individuals, such as capping the tax benefit of itemized deductions and exclusions at 28%.
  
  We are talking about far fewer than 1% of individuals. But these few thousands of individuals have lots of income which for some is in the hundreds of millions of dollars annually.
  
  
• A big income tax break for those who die with millions or billions of gains (and their heirs). Tax reform should include a provision to tax all income including gains that exist at date of death for those with assets above a specified amount. Biden uses $1 million (see page 8 of this table). If that were $3 million, there would be far fewer affected by the tax or some of the complexity.  And a good portion of this untaxed income today are appreciated stock gains of multi-billionaires such as Zuckerberg, Musk and Bezos. I think few people can justify why their unrealized gains should disappear and never be taxed under our current income tax system. President Biden's proposal with backstops to prevent having to sell a family business to pay the tax should be discussed in Congress. While that is a tax increase compared to today's system of letting these gains be untaxed, it should be viewed as fixing a longstanding, inequitable flaw in the system.**
  
  
• Tax breaks are worth a lot more to high income taxpayers. Let's raise taxes by reducing some tax breaks that don't make sense and are inequitable. Today, less than 10% claim a mortgage interest deduction. Perhaps this is the time to repeal this tax subsidy that primarily helps a higher income person buy a more expensive home. Reduce the exclusion for employer provided health insurance. Perhaps make some percentage of it taxable with that percentage higher as income goes up. This subsidy benefits about 65% of employees and reduces tax collections by about $200 billion annually. 
  
  And let's rationalize tax deductions. In a personal income tax, deductions should be allowed to remove some income from taxation (standard deduction and personal exemptions enable this) and for the costs of generating income.  And some would argue that the state and local income tax should also be deductible as that money is not available to pay federal taxes (but note that states don't allow a deduction for federal taxes) [see my 2008 article on reasons for and against state tax deduction]. But, some taxes are more in the voluntary category. For example, personal property taxes on more than one vehicle per person. And real property taxes on more than one home and when that home exceeds the median home value in the region.  Tax reform should include discussion of all these tax reductions (credits, exclusions and deductions) to be sure they make sense and are not providing breaks to people who don't need them or much larger ones to the highest income individuals.

#letsfixthis

What do you think?

*I'll cover pros and cons of lower taxes on capital gain income in my blog post for November 23, 2021 which is the 100th anniversary of the Revenue Act of 1921 that created a preference for capital gain income.

**There is a good deal of support for taxing gains at date of death and removing this odd and very large exclusion, usually with some threshold, such as President Biden's $1 million of assets per decedent.  That likely should be $2 or $3 million to be sure step up repeal is aimed at those holding the types of assets that might great appreciate providing significant income tax breaks to multimillionaires and multibillionaires. Think about the founder's stock that several billionaires have.

One of the founders of Facebook, Chris Hughes, a multimillionaire and author of Fair Shot, explaining and supporting universal basic income (UBI) states in this book: "we should adjust our tax code so that the wealthy ay the same tax rates on their investment income as hardworking Americans do on their wages. ... Second, we should cap deductions at 28 percent for the wealthiest Americans and close tax loopholes, like the one that allows for the gains on inherited assets to be be excluded from taxable income."

Also see a March 2021 press release from Senator Van Hollen and others on the rationale for eliminating the tax exclusion of gains at date of death and letting heirs get the assets at FMV.

Also see my September 2020 op ed in The Hill on not using a wealth tax to generate revenue but fixing the big leaks and inequities in our income tax.

Fixing the SALT $10,000 Cap

Source: JCX-35-19 (6/24/19) for the House Ways and Means Committee hearing on problems with the SALT cap.

On June 25, 2019, the House Ways and Means Committee held a hearing on the SALT cap with the majority's views on it clear from the title of this hearing: How Recent Limitations to the SALT Deduction Harm Communities, Schools, First Responders, and Housing Values. Testimony was provided by some state and local elected officials and the Tax Foundation.

I agree that this is a flawed provision that was addressing what was already a flawed provision. There were no hearings held for the Tax Cuts and Jobs Act so it was difficult to get broad input into the process.  The AICPA Tax Section did submit a few letters during this process including one that made a very important point. If individuals would have a cap on their state and local tax deduction when claimed as an itemized deduction, an additional change had to be made to treat all business entities the same. Since a C corporation continues to get to deduct all of the state and local income taxes it pays, so should a sole proprietor, partner and S corp shareholder. That could have been accomplished by making a change to a 1944 law to allow state and local income taxes on that business income to be deducted above the line (for AGI) rather than only as an itemized deduction. [See AICPA letter of 11/21/17 and letter of 9/25/18 submitted when the House was discussing Tax Reform 2.0]

My observations regarding the policy of deducting state and local taxes:

1. There should be equity among different types of business types (see above paragraph).
2. Prior to the TCJA, only 30% of individuals itemized deductions and many of these folks lost their SALT deduction due to owing AMT. Thus, this was not a widespread deduction.  Many elected officials including governors of New York and New Jersey have issued statements since the change was introduced in fall 2017 that make it sound as if all of their residents are losing a big deduction. But, again, prior to the TCJA, less than 30% of individuals deducted their personal SALT.
3. Why allow a deduction for state and local taxes not related to a business? After all, there are lots of personal expenditures we can't deduct such as car insurance, 100% of child care, 100% of tuition, and lots more. Well, one argument is that you must pay state and local taxes so it does represent dollars not available for paying federal taxes. But, this is not completely true.  For example, if Jane decides to buy a large home for $1 million rather than a modest one representing the median home value in Jane's area of $300,000, she will owe more property tax. Should she be allowed to deduct property tax on the $1 million home which is far above the median home price in her area?
   
   Bear in mind that special tax rules (deductions, exclusions, credits and favorable lower tax rates) reduce someone's taxes with the "cost" borne by others.  Why should others bear the cost (tax deduction) of Jane's decision to buy a more expensive home than the median home price. A great example of an extreme on this is evidenced by Mitt Romney's return for 2011 showing he paid property taxes on his personal residences of $214,728.  I'm not singling him our to pick on him, it is just that his return is publicly available from when he ran for President and voluntarily disclosed it. Many high income/high wealth individuals own multiple homes of high value and thus pay a lot of property tax. Many of these high income individuals also used to get a full deduction for these taxes before the $10,000 SALT cap because their regular tax rate was high enough to not be subject to AMT. [Thanks to Tax Notes (and the candidates and elected officials) for making these returns available to the public.]
   
   Note: Limit or repeal of the SALT deduction is not new. It was addressed in Treasury's 1984 Blueprint for Tax Reform which led to the Tax Reform Act of 1986 and repeal of the sales tax deduction. For more, see my May 2008 article - here.
4. Repeal of the SALT cap will provide a significant benefit to high income individuals. After all, it's a deduction and bigger deductions reduce taxes the most for individuals in high tax brackets. Per data from the Joint Committee on Taxation released for the June 25 hearing (JCX-35-19, Table 4), for 2019, repeal of the $10,000 SALT cap would reduce individuals' taxes by $77.4 billion with $40.4 billion of this savings going to individuals with income over $1 million (less than 0.5% of the public). All told, $73 billion or 94.3% of the benefit would go to individuals making over $200,000 of income.

It is puzzling why so much attention is being paid to repealing the $10,000 SALT cap (and mostly from Democrats who tend not to be fighting for additional tax cuts for high income taxpayers), rather than taking a policy perspective to reforming this flawed deduction and cap.  And better yet, why not look at other weaknesses in our tax system as well, and work to fix them, with the result that we'd have a more understandable (simpler) and equitable system, most likely with lower rates.

I suggest that for fairness and equity and better ability to keep rates low, as part of reform of the SALT cap that it be replaced with a cap on Schedule A property taxes to only allow a deduction for property taxes on a principal residence costing 110% of the median home price for the area. In addition, state and local income taxes attributable to business income should be deductible above the line (for AGI) just like a C corporation is allowed to do. Property taxes on business property (including rental property) would continue to be deducted above the line as they have been in the past (and still today). And the individual AMT should be repealed so there is just one set of rules rather than two with two tax calculations.

What do you think?

“Abolish the IRS” Distracts from Needed Reforms

Republican presidential candidates Senators Ted Cruz and Mike Huckabee would like to abolish the IRS. They are not saying they want to abolish taxes, just the agency that collects them. Even if either is able to simplify taxes to the point that no taxpayers have questions or need guidance, we still need a tax collector, as well as an auditor to ensure compliance.

A call to abolish the IRS is a distraction. That’s too bad because there are significant improvements needed to our federal tax system – a system that includes not only the income tax, but also employment, excise and estate and gift taxes.  Tax reform must be the focal point, not termination of the entity that collects revenues to fund schools and roads, provide national defense, and much more.

The IRS is an easy scapegoat for complaints about our tax laws. But those laws come from Congress. Yes, the bills must be signed by the President to become law. But if no tax bill arrives at the President’s desk, no statutory change is possible. For reform, let’s first look to where Senator Cruz resides – Congress.

Reforms are needed. Here are just three examples to illustrate problems in our federal tax system. Resolving these types of problems can enable our tax system to be simpler, more equitable and better promote economic growth.

First, our federal tax system is too complex resulting in excessive compliance costs and errors. According to the IRS National Taxpayer Advocate, businesses and individuals devote over 6 billion hours annually to tax compliance – the equivalent of over 3 million full-time jobs. Examples of this complexity include a 43-page instruction book for Form 1040-EZ and over eight rules for tax benefits for college costs, explained in a 96-page publication from the IRS (Pub. 970).

Second, our tax system is inequitable. For example, for decades, employees have been allowed to exclude the value of employer-paid health insurance from their income, thereby lowering their income and employment taxes.  Employees get this exclusion regardless of income level (and employers deduct what they pay for the health coverage). Starting in 2014, the Affordable Care Act (“Obamacare”) provides a refundable tax credit to individuals without employer-provided health coverage who buy insurance on the exchange (such as Covered California). However, these individuals losethat subsidy if their income exceeds 400% of the federal poverty line ($45,960 for a single person for 2014). 

Take for example, Jane and Sara, each 50 years old, single and having $100,000 of taxable income for 2014. Jane obtains health coverage from work with her employer covering the entire cost of $6,000. Jane is allowed to omit this $6,000 benefit from her taxable income. Sara obtained her insurance from Covered California at a cost of $6,000, paid out of her own pocket. Because Sara’s income exceeds $45,960, she obtains no tax subsidy. Meanwhile, Jane gets a tax subsidy of $1,680 (based on a marginal tax rate of 28%). Sara is out-of-pocket $6,000 while Jane gets a $1,680 subsidy (and has no out-of-pocket costs for health insurance). Why does this inequity exist? This is just one of many tax system inequities where some individuals receive tax reductions while others at similar, or even lower income levels, do not.

Finally, our tax system has not kept up with technology and new business models. Today, most countries only tax businesses on income earned within their borders rather than the U.S. approach of taxing worldwide income. Corporate tax rates in other countries are lower while also supporting R&D on a permanent basis rather than the temporary approach used in the U.S. since 1981. Also, today, any size business likely has international operations yet tax rules can be as complex for small ventures as they are for large companies. And, technology should be used to make tax compliance for most people as easy as ordering goods online.

We need to improve our tax system, focusing on all federal taxes, not just the income tax. Our tax system can be simpler, more equitable and better support today’s ways of living and doing business.  Let’s focus on these important issues and not be distracted by absurd rhetoric about abolishing the tax collector.

More to come - "abolish the IRS" is not the only odd tax reform coming from candidates.

What do you think?

10th Anniversary of Bush Tax Reform Report

In January 2005, President Bush created his Advisory Panel on Federal Tax Reform. It was tasked to examine the tax system and propose simplified options that were revenue neutral, pro-growth and internationally competitive. One option was to be a consumption tax. The report was due and was issued on November 1, 2005.

The panel held public hearings, reviewed lots of data and studies and suggested reforms. One of their initial findings was the high cost of tax system complexity which they estimated to be $140 billion per year. Per the panel:

"To put this amount in perspective, it is roughly the same as giving $1,000 to every family in America or the amount of money needed to fund all of the following: the Department of Homeland Security, the State Department, NASA, HUD, the EPA, the Department of Transportation, the United States Congress, our Federal courts, and all foreign aid."

I think this type of information needs to be better publicized.  Most individuals will tolerate complexity if it gets them a deduction. But, they are not usually considering the cost to them and the aggregate cost to all taxpayers and the IRS of the provision. They are often not thinking that perhaps the deduction can be replaced with a higher standard deduction amount at no additional complexity cost.

I like the report because I think the panel did a great job getting at the problems with our federal tax system in terms of complexity, inequity, inefficiencies and lack of accountability and transparency. Unfortunately, the report really died upon issuance in November 2005 most likely because they proposed improving the mortgage interest deduction contrary to what "conventional wisdom" says it should be. The panel proposed that the home mortgage interest deduction be replaced with a credit equal to 15% of the interest paid with the debt limited to the average regional home price (about $227,000 to $412,000).

If that is what killed the report before it could get its hearing, I hope things have changed, but I suspect they have not. The panel's proposal would make the credit available to all homeowners with debt rather than only to the 1/3 of individuals who itemize deductions.  Also, as a credit, it is worth the same to everyone (although higher income individuals tend to have bigger mortgages). It likely would also reduce one of the largest tax expenditures in the tax code (about $80 billion per year) and distribute this amount more equitably among taxpayers.

Here is an excerpt of the panel's chart showing some of the changes and how incorporated into their two key proposals:

Source: Executive Summary, page xvii.

I also like Figure 5.5 below showing the effective tax rate on different types of investments. The many tax preferences for housing produces a zero effective tax rate. This highlights another problem with our tax system - it distorts investments leading to over investment in some areas and under investment in other areas. What would the economy look like if we did not over invest in housing (perhaps had fewer expensive homes and more investment in businesses)?

Source: Panel Report, Chapter 5, page 71.

I hope the report is not completely forgotten and will be considered in ongoing discussions on tax reform. It raises some good issues and observations necessary for reform to happen.  We can't keep talking about lowering the rates in a revenue neutral manner without talking about reducing or eliminating the largest tax expenditures, the costs of complexity and the distortions caused by a tax system that causes investment inefficiencies. Reform also needs to recognize the tremendous income gaps we have (relevant in determining just how low the rate can go), and the reality that much of our tax system does not reflect today's ways of living and doing business (the subject of my 21st century taxation website and blog).

What do you think?

Supreme Court Premium Tax Credit Decision - 4 thoughts

IRS Flowchart on whether you qualify for the PTC - from Pub 974. Also see IRC Section 36B.

As we all know by now, the US Supreme Court upheld the government regulations that provide that an otherwise qualified individual who obtains health insurance through the federal exchange (rather than a state exchange) is entitled to a Premium Tax Credit (PTC). This is the 6/25/15 decision in King v Burwell. I think this is the logical ruling because the Act does provide that if a state doesn't create an exchange, the Department of Health and Human Services (HHS) is to establish one. Also, since this is the "Affordable Care" Act we are talking about, the PTC is a key part that helps make insurance affordable for many who have household income at or below 400% of the federal poverty line (more so for younger people in regions where the cost of living is not high - not for all individuals).

Four quick thoughts about the PTC and ACA:

1. It seems that states with exchanges should consider ending them to save costs and let people go to the federal exchange.  This seems to be an unintended consequence of the decision and the feds might not have sufficient resources to handle this possible action.
2. This survival of the PTC should lead Congress and President Obama to fix it.  It is too complex (see the flowchart above and the Section 36B and regulations). Also, the IRS likely does not have the resources to determine if people properly claimed it.
3. Address policy issues with the PTC and other tax benefits tied to health insurance: The PTC unrealistically behaves as if individuals of all ages and all geographic regions can spend about 8% of their income to obtain health insurance.  Because insurance costs more as you age and housing costs a lot more in some regions, that assumption is unrealistic.  Health insurance tax rules should be examined as a whole to try to better equalize the treatment among different ways to obtain health insurance.  The best deal is to get employer-provided coverage because it is tax-exempt to the worker - no income or payroll tax. And you get this benefit regardless of your income level - whether your household income is at the federal poverty line of 100 times or more of the federal poverty line. In contrast, you can only get a PTC if your household income is at or below 400% of the federal poverty line.  This is a completely unfair way to subsidize health insurance costs.
4. Why not take the bold step of divorcing health insurance from employment?  It drives up costs, it creates unfair tax advantages for those who have it, and the cost to employers helps make them uncompetitive in the global market.  The tax cost of the employer-provided health insurance exclusion is over $200 billion per year.  Why not use this money to lower rates and improve and expand the PTC?  Also - note that the King ruling also affects the employer mandate.  With more individuals eligible to avail themselves of the PTC, it is more likely that an applicable large employer can have at least one full-time employee claiming it thereby possibly exposing the employer to the employer mandate penalty.

What do you think?

Tax Day - April 15, 2014 - It Can Be Easier

The complexity of completing one's federal and state income tax returns is not necessarily tied to one's income level. One of the more complex federal tax rules is the Earned Income Tax Credit (EITC) for low-income workers. Could the individual income tax be simpler? Yes.  Here are some ideas.

• Make all income you received subject to tax. What is income? Let's say it is anything that increases your wealth. So, it would be any payment from the government, debt forgiveness, gross wages, employer-provided health insurance, scholarships, gains from selling assets, etc. What would not be income? Borrowing money (it does not increase your wealth because you have an offsetting liability). Receipt of expense reimbursements from your employer (it makes you whole for what you, in essence loaned to your employer when you incurred the expense).  The simplification comes from not needed to determine if something you received is taxable; generally, it would be.
• Allow very few non-business deductions.  It should just be personal and dependency exemptions that, in effect, remove from your income what it takes to live. The rationale is that you need some portion of your income to live and it should not be available for paying taxes. The amount should be tied to some multiple of the poverty level based on family size and your address to reflect that it costs more to live in some parts of the U.S. 
• Allow business deductions including an inflation-adjusted expensing amount (Section 179) that would provide simplification and incentives to small to medium sized businesses. Expensing should apply to both tangible and intangible personal property.
• Address equity issues with simple rules. For example, the state condemns your personal or business property resulting in you realizing a gain. But, you want to (or need to) buy replacement property. If you have to pay tax on the gain, you may not have enough for replacement property. So, keep a simplified Section 1033 on involuntary conversions that allows for gain deferral. Perhaps also allow for deferral of cancellation of debt income for insolvency or bankruptcy (to help with a fresh start for the person). The balance of the current, lengthy and complex cancellation of debt income exclusion rules could be removed. Others? There will be situations where someone has had some unusual, bad, expensive event, such as a casualty or large medical expense, that prevents them from having sufficient funds to pay their income tax. Some simple, limited rules for these types of events should be provided. We'd also need simple rules to ensure that income earned outside of the U.S. was not taxed by two countries. A foreign tax credit not to exceed what the U.S. tax on the income would be should work.
• Retirement plans and savings - this is a bit more challenging. Individuals should be saving for their retirement.  The money you put into your retirement is money not available for paying taxes.  Also, if you pay tax on the income when earned and again when withdrawn, that doesn't seem fair (except for what you pay on the income earned while the money was in the retirement account). Also, lower income individuals will need an incentive to fund a retirement account due to limited funds. So, should they get a deduction for putting funds in a retirement account?  Retirement rules is an area of our tax law in need of significant reform. The current rules primarily benefit higher income individuals as they can take better advantage of the rules. The rules are also complex due to the number of different types of retirement plans.
• Education incentives - today there are at multiple, duplicative, complex provisions offering various tax savings for higher education costs. I think that for the most part, this should all be taken care of outside of the tax law because there is already a system in place, such as for Pell Grants. When these rules are brought into the tax law, they primarily benefit those with enough income to owe tax - individuals who likely don't qualify for Pell Grants. But, what about my earlier point that the student receiving the scholarship will include it in income? Should they get some tax relief?  Or should we expect them to work to get the money to pay tax on the scholarship or seek a gift from family and friends?  Perhaps some version of the current American Opportunity Tax Credit (AOTC) should remain. It would also help the student without a scholarship or Pell Grant who is working to pay for tuition. It would not need to be refundable because once your tax is down to zero due to your personal exemption, you are not paying tax on the scholarship. Tax rules for higher education also need attention for simplification and equity issues. For example, the current AOTC is for the first 4 years of college, providing a maximum annual credit of $2,500.  That has differing results for these two students: (1) Ann who attends a private university for 4 years; gets a $10,000 benefit from the government. (2) Barbara who attends community college for 3 years where the annual tuition is less than the AOTC amount so she doesn't get full benefit of the credit and then she attends public university for 3 years to complete her degree and where the tuition is higher.  Her total benefit is less than $10,000.  This needs to get fixed.
• Other changes?  
• Lower tax rates to reflect that the tax base is larger with the above changes. With lower tax rates, capital gains should be taxed at those same rates. 
• The net investment income tax (3.8% Medicare tax for high income individuals) should be repealed (an adequately progressive income tax rate structure would take care of it). 
• AMT should be repealed because there should be only one minimum tax and removal of most of the special deductions, exclusions and credits would leave no need for it.
• Some replacement should be made for the current income exclusion for state and local bond interest income. This exclusion benefits higher income individuals who buy the bonds and it helps state and local governments. Whatever the average annual "cost" to the government has been for the exclusion for the past five years should become a fund that the federal government would make available to state and local governments to replace the lost benefit of the exclusion.  And add the caveat that they can only get the funds if they conform their state income tax to the new, simplified federal income tax system (to better ensure true simplification for individuals).
• More simplification such as fewer penalties and clearer rules on worker classification.

What do you think?

Broken Tax Code Offered as Reason for Reform

House Ways and Means Tax Reform Website

The House Ways and Means Committee has a new website to promote tax reform. There is also a two minute video. The three reasons for reform are interesting as to what they might mean.

1. Make the Tax Code simpler and fairer. The video notes that the getting "rid of junk" in the Tax Code would reduce it by about 25%. So, what does "junk" mean?  I think there are several special rules that do not need to be in our tax law, but I'm doubtful as to whether they are considered part of the "junk." For example, there is no reason to allow for interest expense deductions for a home equity debt or debt on a vacation home. These are also costly deductions. But, they seem to be popular, even though they are claimed by less than one-third of individuals.

2. Get rid of "handouts." There is a reference in the video about make the system more efficient. So, this would imply that rules that benefit special industries might go away, such as special tax rules for the oil and gas industry.

3. Make the system more accountable. This includes closing "loopholes."  I'm not sure there are many loopholes in the tax law - that is, rules that are being used in unintended ways. However, the term also tends to be used to describe something lawmakers want to get rid of.

Besides making the system simpler and fairer, one more goal offered "is to strengthen the economy so there are more jobs and bigger paychecks for American families." That all sounds good, but details are needed.

Tax reform was reported to be an important agenda item at the January retreat of the House Republicans (see Tax Analysts' article).

So, despite an upcoming leadership change in the Senate Finance Committee with Senator Baucus becoming ambassador to China (see 2/6/14 USA Today article), it looks like tax reform is alive and well.  I expect though that the timeline has been extended.  We'll likely see more details about the generalities laid out in the new video.  We'll see.

The San Jose State MST Program is co-sponsoring a tax policy conference on February 28 in Santa Clara to help attendees get a better handle on what's happening with tax reform and how to figure out what it might mean to your company. For more information on that, see http://www.tax-institute.com.

What do you think about the video messages?

Distribution of individual tax expenditures

The Congressional Budget Office (CBO) recently released a report - The Distribution of Major Tax Expenditures in the Individual Income Tax System. The CBO examined ten of the largest "tax expenditures" (special deductions, exclusions, credits and rates) used by individuals. They are, as categorized by the CBO:

Exclusions from taxable income—

• Employer-sponsored health insurance,
• Net pension contributions and earnings,
• Capital gains on assets transferred at death, and
• A portion of Social Security and Railroad Retirement benefits;
   

Itemized deductions—

• Certain taxes paid to state and local governments,
• Mortgage interest payments, and
• Charitable contributions;
   

Preferential tax rates on capital gains and dividends; and

 

Tax credits—

• The earned income tax credit, and
• The child tax credit.

While there are about 250 tax expenditures in teh federal income tax, the ten listed above account for the bulk of the dollars. For 2013, the "cost" of the above tax expenditures is $926 billion out of about $1.1 trillion for all tax expenditures. CBO notes that these expenditures total about 5.7% of GDP. In contrast, CBO reports that Social Security spending is also about 5.7% of GDP, defense spending is about 4% of GDP, and individual income tax revenues are about 8.2% of GDP. So, these ten tax expenditures are a significant cost.

 

In addition to the significance of these ten tax expenditures in terms of cost, CBO points out that the benefit derived from these items (tax savings) is skewed to higher income individuals. Per CBO:

 

"For 2013, CBO estimates that 51 percent of the total benefits from the 10 major tax expenditures analyzed in this report will accrue to households that make up the one-fifth of people with the highest before-tax income, 13 percent will accrue to households in the middle quintile, and 8 percent will accrue to households in the bottom quintile."

 

This skewed distribution is due to the progressive rate structure. So, some may argue that this is all appropriate because if you are in a higher tax bracket, of course your deductions will be worth more to you, but you are still in the higher tax bracket.  But, to counter that argument, bear in mind that the government has selected certain expenditures for tax-favored treatment and several on the list above do not have any limits, such as the exclusion for employer-provided health insurance and the lower rate on capital gains. The greater the benefit you have, the greater your tax savings. The greater your tax savings, taxes on others go up to help cover that cost. 

 

Why not just eliminate or cut-back on most of the 250 tax expenditures and lower the tax rates?  That would enable the tax system to better meet principles of good tax policy. That is also noted in the following list by the CBO of problems caused by tax expenditures. 

 

The additional problems noted by CBO (besides their cost) pertain to most tax expenditures. The CBO lists five such problems:

 

1. "Tax expenditures may lead to an inefficient allocatio nof economic resources by encouraging more consumption of goods and services receiving preferential treatment."
2. "Tax expenditures increase teh size an dscope of federal involvement in teh economy."
3. "Tax expenditures reduce the amount of revenue that is collected for any given set of statutory tax rates—and thereby require higher rates to collect any chosen amount of revenue. All else being equal, those higher tax rates lessen people’s incentives to work and save and therefore decrease output and income."
4. Tax expenditures make the tax system more complex.
5. As indicated in this CBO report, "tax expenditures affect the distribution of the tax burden in ways that may not always be recognized, both among people at different income levels and among people who have similar income but differ in other ways."

I encourage you to take a look at the report. It includes some charts (one is produced below) that help illustrate the cost and distorted distribution of the tax expenditures. This report should prove useful to the congressional tax committees because a big part of their tax reform effort will be to reduce corporate and individual tax rates in a revenue neutral manner. That means they will need to cut back and eliminate tax expenditures. Much of this CBO report provides good reasons for doing so beyond just lowering rates, but to add fairness to the tax system and reduce its impact on the economy and decision-making. The tax system should be used primarily for revenue generation.

 

What do you think?

 

 

 

 

 

 

 

 

 

 

 

  

 

 

 

 

Romney's "Bucket" Idea

In a Fox News interview before the first presidential debate, Governor Romney referred to a "$17,000 bucket" as part of his tax reform plan that includes lowering tax rates below the 2012 levels. He said people can fill the bucket with mortgage interest deduction, charitable contributions, etc.  He also suggested that higher income folks might get a smaller bucket. See "Romney pitches 'bucket'-list tax reform plan ahead of debate," 10/3/12. Details are sketchy. For example, does the bucket include personal exemptions?

Today, only 1/3 of individuals itemize their deductions, meaning they have deductions greater than these 2011 standard deduction amounts:

  Single     $5,800

  Head of household  $8,500

  Married filing jointly  $11,600

The personal exemption amount in 2011 was $3,700. For data on itemized deductions, see a recent Tax Policy Center addition on distribution of itemized deductions - here.

This is an interesting idea. I'm not sure what the reasonable dollar amount should be, it also depends on the rate. I think that the "bucket amount" should at least be equal to what a family of four would get today from the standard deduction + personal exemptions. Having that dollar amount drop as income rises brings some vertical equity into the system that should help bring greater equity than what would be the case with Romney's proposed fewer bracket, lower rate structure.

Romney avoids having to say what deductions he would eliminate or reduce. He leaves it to individuals to decide what do deduct within the dollar limit. Of course, given that more itemizers likely have more than $17,000 of deductions, why not just convert the bucket idea into a very large standard deduction (that might phase down as income rises). That brings simplification in that no one would need to track there deductions.

The bucket idea is unlikely to be popular among charitable organizations concerned that the change might reduce charitable contributions. Realtors, home builders and home owners with debt also might no like the idea as the "bucket amount" may be less than their mortgage interest. They would need to see how that interacts with the lower tax rate Romney is proposing.

What do you think?

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Equity, improve investment and reduce the mortgage interest deduction

This is a follow up on my post of 8/23/12 on various reasons to reform (and reduce) the mortgage interest deduction. In June 2012, the OECD (Organization for Economic Co-operation and Development) issued an Economic Survey of the United States. Per an OECD summary:

"The Survey also highlights rising income inequality in the United States. The trend owes mainly to rising skill premiums and disproportionate income growth for top earners over the past two decades. ... Providing equal access to high-quality elementary and secondary education is essential to addressing this challenge. The Survey also notes that the U.S. tax and benefits system is much less effective in reducing relative poverty than that of other OECD countries. This is largely the result of the limited and poorly targeted financial transfers to low-income households. The Survey suggests that broadening the tax base through reduced tax expenditures, such as for mortgage interest, as well as harmonizing the tax treatment of different forms of capital income while simultaneously lowering the corporate tax rate could help to reduce income inequality and at the same time boost investment and long-term growth."

I suspect that the mention of the home mortgage interest deduction as one tax expenditure to be reduced is because the deduction is broader than in other countries and a significant cost in terms of reduced tax liabilities less than 1/3 of individuals get due to the deduction. The cost is about $90 billion per year which, along with dollars from other reduced tax expenditures could be used to reduce the deficit, provide more equitable benefits, such as to education as suggested by the OECD, and improve investment in other industries (besides housing) by equalizing the after-tax cost of all types of investments.

What do you think?

Who Pays Taxes in California?

In April 2012, the California Budget Project released a report - Who Pays Taxes In California? It is a reminder that while we sometimes here people say that low-income individuals do not pay taxes, that is not true.  In fact, their data - likely obtained from the US Census Bureau on what percentage of one's income is used to pay state and local taxes, show that the percentage is larger for lower-income taxpayers than for higher income taxpayers. This is true even though higher income pay more income taxes. But, sales tax and excise taxes paid directly as well as the share of other taxes paid in products and services tends to represent a greater portion of a lower income individual's income.

Per the CBP report, the average percent of income used by the bottom 20% of individuals to pay state and local taxes, based on income is 10.2% while it is 7.4% for the top 1% of income generators. That is, if income is represented by a pie, the slice lower income individuals have that is labeled state and local taxes is larger than that pie slice for higher income individuals. That means that the remaining slice of pie to pay federal taxes and living expenses and anything for savings is smaller than it is for higher income individuals.

A similar misperception about how much of one's income is paid in taxes happens with federal taxes too. People sometimes forget that workers are paying 15.3% payroll taxes in addition to a variety of excise taxes, in addition to income taxes.

All of this should be considered in evaluating tax reform at the federal and state levels. We cannot usually just look at a single tax, but need to consider the entire mix.

Cleaning up the tax mess - PBS show

On March 9, 2012, PBS had four commentators, including Bruce Bartlett, address the issue - "Cleaning up the tax mess."  It is posted on the PBS website - here.

A few things I found interesting, with my commentary added:

• The host asked what the panelists thought about a flat tax. The next question was what they thought about a consumption tax such as a VAT. The "flat tax" as promoted by Steve Forbes in the past and others, IS a consumption tax, it is not an income tax. The flat tax was created by Professors Hall and Rabushka in the early 1980s.  It is a modified subtraction method VAT. The modification is that businesses can deduct wages (but not fringe benefits). Under a standard VAT, there is no deduction or exemption for wages because wages are the "value added" by the business that are subject to tax. The flat tax allows the wage deduction to business but then taxes the wage to the employee at the same flat rate. Thus, the wages are still taxed as they would be under a VAT, but to the employee. Taxing wages to the employee allows the employee to claim a large standard deduction and personal exemptions to address regressivity of a consumption tax.  For more on the flat tax, you can see Hall and Rabushka's book (the third edition). So, when someone mentions flat tax, you should ask if they mean the Hall-Rabushka-Forbes flat tax with few deductions and an exemption for income from savings, or an income tax with only one tax rate - they are two different types of taxes.
• A suggestion that perhaps the income tax rate structure should be more progressive - more brackets, so that someone with $250,000 of income isn't in the same top bracket as someone with over $1 million of income.  I agree.  We often hear about the top 1 or 2% of income earners, but we should really stratify this further with such brackets as $200,000, $500,000, $1 million, $5 million, and beyond up to probably $250 million. Per IRS data on the top 400 earners, the average AGI for 2008 was $270 million (that's about $31,000 per hour 24/7)! Let's move at least these 400 into a new bracket. Placing them in the same bracket and phase-outs as a single person making $200,001 (only about $23 per hour 24/7) is crazy.
• Non-renewal of all of the 2001/2003/2010 tax cuts would address the current deficit problem.  Of course, if Congress and the President can't agree on a tax bill before 12/31/12, this is what will happen because the cuts are automatically set to disappear at the stroke of midnight December 31, 2012.
• The system would be better with a broader base and lower rates.  YES - this helps any tax better meet principles of good tax policy, including simplicity and equity.
• The home mortgage interest deduction primarily serves to help people who can afford a home (or even a second home) to buy a more expensive home. This is one of the more expensive tax expenditures (the cost is about $90 billion per year and only benefits the 1/3 of taxpayer who itemize deductions and not all of them even have a home mortgage). That $90 billion could be used in a way to benefit more individuals and more types of industries.
• People running for office often say they will get rid of loopholes or tax expenditures, but usually never say any specific ones that they will get rid of. I think if people better understood our tax system and realized that they themselves and their children would be better off in the short-term and long-term with a broader base and lower rates, they would demand that the politicians be specific as to what "loopholes" they are going to terminate and then push them to do so if elected.

The PBS website has both a 22 and a 62 minute version of the show. My comments above are based on the 22 minute version.

What do you think?