Confusing Tax Cuts with Simplification

President Obama's tax day (4/15) press statement notes that he is committed to a simpler tax code:

"President Obama will underscore his commitment to a simpler tax code that rewards work and the pursuit of the American dream and supports a future of sustained economic growth that creates good jobs and rising incomes for all Americans."

Then the bulk of the statement lists provisions of the recently enacted stimulus bill (PL 111-5; 2/17/09) that provide tax cuts to individuals. Unfortunately, these provisions mostly add complexity to the system, most of which could have been avoided.

Here is the list and my take on what would have been a simpler way to provide the relief.

Making Work Pay Tax Credit - despite the credit being given via withholding tax table changes, many people will need to refile W-4 statements to avoid being under withheld because of the phase-out of the credit for high income individuals and the credit's interaction with other stimulus payments. For example, if Bob's wages qualify him for the credit, but his wife's are much higher such that they are not entitled to any or all of the MWPC, they should adjust their W-4 to increase their withholding to avoid owing on 4/15/2010. A simpler alternative would have just been to increase the Earned Income Tax Credit or lowered the rate for the first tax bracket.

Expansion Of The First-Time Homebuyer Tax Credit - as long as this is kept temporary, it should be fairly easy for individuals to address.

Increased Earned Income Tax Credit and Expansion of the Child Tax Credit - it is good to provide relief through existing tax provisions. The only confusing part is that the change is temporary.

American Opportunity Tax Credit - this takes an existing tax credit - the Hope Scholarship Credit and renames it for 2 years and expands it. First, it is confusing to rename something for two years. Second, why not just use the funds to increase scholarships and grants that already exist at the federal and state levels.

Benefits For Retirees, other Social Security Beneficiaries and Disabled Veterans - similar problems to the MWPC. Why not just reduce the lowest tax rate for 2 years and increase the EITC.

Auto Sales and Excise Tax Deduction - this temporary deduction provides a small benefit - particularly compared to the difference in price between a new and a used car. This provision will confuse people - it should have been skipped.

Carryback Of Net Operating Losses For Small Businesses - while it is nice to give small businesses a temporary choice of how far back they want to carryback an NOL (but no longer than 5 years), the choice leads to the need to perform multiple calculations and use your crystal ball as to how this change interacts with any possible NOL generated in 2009. It is a helpful way to get some dollars in the hands of struggling small businesses, but perhaps the choices should have been reduced to the existing 2 year carryback or a 4-year carryback to reduce compliance costs.

Let's be more vigilant in helping Congress and President Obama find simpler ways to reduce or increase taxes (I've written previously on the complications of how the President's tax plan to get more money from higher income individuals takes an approach that is more complicated than necessary).

What do you think - what are some simplifications that will enable the President to reduce taxes for 95% of taxpayers (and increase them for the other 5%) without adding unnecessary complexity to the tax system?

Let's Not Forget Simplification

Simplifying the federal tax law has been a focal point for the past several decades. Even the Tax Reform Act of 1986 which added several new and fairly complex provisions to the tax law was touted as simplification. Congress has had the Joint Committee on Taxation do studies on how to simplify the law. Every year, the National Taxpayer Advocate notes in the report to Congress that the biggest problem with the tax law is its complexity (for example, see page v of the 2008 report).

Yet, despite all of the talk, we always see more complexity added to the tax law, such as:

• The manufacturing deduction of IRC Section 199.
• More incentives and support for higher education tax breaks.
• A growing number of energy incentives with lots of definitions and special qualifications.

The latest complex proposal is the techniques used in President Obama's budget proposal to increase taxes on higher income individuals (defined as over $250,000 of AGI if married and over $200,000 if single). The budget proposal would increase taxes on this high income group in the following four ways to generate about $955 billion over 10 years. The estimated revenue effect for 2010 - 2019 in billions of dollars is shown in brackets.

• Reinstate the 36% and 39.6% top tax brackets. [$338.8]
• Tax capital gains and dividends at 20% (rather than 15%) [$118.1]
• Reinstate the phase-out of personal exemptions and itemized deductions. [$179.8]
• Cap itemized deductions such that they only provide a 28% benefit even if the individual is in a higher tax bracket. [$317.8]

The rate increases by themselves are NOT complex. Rate increases tend to be simple. It is easy to determine your marginal tax rate (what your next dollar of income is taxed at) and to calculate your tax (using a table or a rate calculator found online or in tax prep software).

It is the last two items listed above that will create complexity. There will be two different limitations on itemized deductions. That means the high income person really won't know how much of their state taxes, mortgage interest or charitable contributions are deductible until the tax return preparation software computes it. This also means that the law is not following the principle of transparency - it should be more clear what is deductible and what is taxable.

This level of complexity and lack of transparency is not needed and should be avoided. It can easily be avoided by either just eliminating some deductions completely (and keeping others without any limit). Another alternative would be to have additional higher tax brackets to raise the desired revenue. This is a more transparent approach than instead having one rule that allows a deduction and another that takes part of it away. The loss of part of the deduction increases the individual's taxes - but that could instead be done more transparently with a rate increase.

A complex tax law increase compliance costs and builds disrespect for the tax system. AND - it just isn't necessary - there are always simpler approaches and we all have to continue to remind Congress and the President to please use them.

There is a nice report from the AICPA on how to simplify the law and how to avoid making it more complex - click here.