Challenges of base broadening

The Senate Finance Committee's Working Group Tax Reform Report on Individuals, released in July, notes the largest tax expenditures in the individual tax system. It doesn't offer any suggestions for reducing them- something that would be needed to reduce tax rates.  It does discuss some inter proposals but overall they are ones that will lose revenues!

I've got more on this report and others in a 9/15 AICPA Tax Insider article, Tax Reform: Challenges of Broadening the tax base.

Could tax reform lead to a more complex system?

Congressman Camp's discussion draft of the Tax Reform Act of 2014, released in February 2014 aims to broaden the income tax base and lower tax rates. Broadening the tax base means that some special deductions and credits could be eliminated. It also means that some deductions could be stretched out over longer periods. In the long run, that doesn't raise revenue as it is just timing. But when you only measure the effects out 10 years, it raises revenue.

One stretched out deduction would be advertising expenses of large companies. Under Camp's proposal, 50% would be deducted in the year incurred and the balance would be deducted over ten years. That might sound simple, but you need to dig deeper. This proposal will require a definition of advertising. Camp's is fairly complex. Also, the small business exception is a bit complicated.

I've got a short article in the AICPA Corporate Taxation Insider today (7/31/14). I explain the details of the proposal and include some examples that highlight some of the complexities. I also critique it against principles of good tax policy. The proposal fails.

What do you think?

Minnesota Storage Tax Problems

I've several times about the problem of states broadening their sales tax to pick up goods or services consumed by businesses. States should not do this as it exacerbates the pyramiding problem and it makes the tax more complex. A recent example of moving down the wrong path of base broadening is Minnesota. This state starts taxing some storage fees starting April 1, 2014.

For more, please see my January 24, 2014 tax policy post at SalesTaxSupport.com.

Any base broadening should only cover consumption of individuals (non-businesses).

Tax reform and base broadening

As I've noted in these posts in recent months, both political parties have mentioned base broadening as part of tax reform including how to keep the current low tax rates and other tax reductions that expire at the end of 2012. I think most people view base broadening as meaning:

1. Cutting back on corporate tax perks.
2. Eliminating deductions used by other people.

While the above can certainly be part of base broadening, it would be better to look at base broadening as meaning all of the following:

1. Removal, reduction or revision of special tax rules that come in the form of deductions, exclusions, tax credits and lower tax rates.
2. Something that affects all taxpayers.
3. Something that will mostly affect individual taxpayers because today, they use the vast bulk of the special tax rules (they also pay the bulk of federal tax revenues; the corporate income tax contributes about 6 - 9% of total revenues).
4. Addressing the largest of "tax expenditures" rather than only small ones that affect one a small number of taxpayers.
5. Changes that can also simplify the federal tax system and make it more equitable among taxpayers (by eliminating or cutting back on special rules that only benefit certain groups of taxpayers).
6. Changes that raise real dollars over the long-term rather than only timing changes (such as changing the depreciation rules). Since revenue neutrality (PAYGO) is viewed over a 10-year period, there is a risk of trying to pay for permanent tax reductions with temporary tax increases. That would not be good for long-term fiscal health.

Also, in defining a tax expenditure or special rule, the standard deduction and personal exemptions (or some combination of these into a personal deduction) should remain to reflect the fact that an individual income tax structure needs to exempt some amount of income from taxation because people need it to live on.

Bruce Bartlett has a wonderfully clear article on base broadening and what it means and possible obstacles to such broadening in this 10/31/12 New York Times article, "The Real Barrier to Tax Reform."  I highly encourage you to read it.  He lists the 10 largest tax expenditures and notes that while they are popular, that popularity can't allow them to remain completely intact as they operate today because you'll need those dollars to enable lower rates.  My analogy is to the famous quote by some bank robber when asked why he robs banks (because that is where the money is). Likewise, you have to look for funds for lower rates and deficit reduction in the larger expenditures - it is where the money is.

I have heard some lawmakers and news commentators say that the mortgage interest deduction has to be off the table.  I disagree. That is the largest tax expenditure that is a deduction.  It has many flaws that I and many others have pointed out. These include:

• The mortgage interest deduction allows individuals who itemize deductions to deduct interest on mortgages on their principal residence and vacation home and a home equity loan. The maximum loan amounts are $1 million for acquisition and $100,000 for equity loans. This subsidy is way out of line with logical social and fiscal policy. Why should the tax system subsidize a debt on a vacation home or home equity loan?  Why the $1 million debt limit which is much higher than the average and median home price in all parts of the US?
• The deduction is only available to the roughly 1/3 of individuals who itemize and not all of those filers have a mortgage. So this big deduction is used by a minority of individuals.
• Studies show that the deduction primarily enables higher income to purchase a more expendixe home.
• Home ownership rates in the US are comparable to those in countries without the mortgage interest deduction.
• The favorable rules lead to overinvestment in housing (and underinvestment in other ventures).

I am not advocating for elimination of the home mortgage interest deduction. It should be pared back though with the freed up funds used to allow for lower tax rates, pay down the deficit and to help people who cannot afford to buy a home to buy one.  The $1 million should be gradually phased down to perhaps $350,000 or as suggested by President Bush's Tax Advisory Panel, based on the regional home price.  The home equity and second home deductions should be phased out for existing claimers and disallowed for new mortgages.

Also, while phase-outs can cause some complexity, perhaps they should be used more broadly as a possible base broadener. I only suggest this because they have been used for many provisions for years, such as for child credits, education credits, and more.  Why not use them for the exclusion for employer-provided health insurance and tax-exempt interest and a lower capital gains rate?

Base broadening will be a tough sell because, as Mr. Barlettt points out, people will step forward to argue for keeping the special rules. I think that is even true for deductions that are used only by a minority of filers, such as the home mortgage interest deduction. What will it take for the over 2/3 of individuals who do not claim a home mortgage interest deduction to argue that some of the funds to pay for it should instead be used for deficit reduction and/or a larger standard deduction?

Perhaps as part of upcoming tax reform, we need to see a "unified budget" that lists the tax expenditures right in the budget. For example, suppose the budget for the Department of Housing and Urban Development (HUD) had a line item for the following:

   Subsidy for middle-to-high income individuals to pay mortgage interest on their vacation home

 If that line was in the HUD budget, I feel quite confidant that the subsidy (deduction) for mortgage interest on a second home would be gone! 

So perhaps a different presentation is needed for tax expenditures so the public can see how they would look if instead of providing these special benefits via reduced tax bills, they were provided by checks written to the beneficiaries.

What do you think?

Tax rate increases and relevance to revenues and the economy

A March 2012 article in Journal of Economic Literature, by economists Saez, Slemrod, and Giertz: "The Elasticity of Taxable Income," provides an analysis of the economic effect of changes in marginal tax rates. It's a detailed analysis of data across many years.  I'll note two of several statements I found interesting:

1. "A tax system with a narrow base and many deductions and avoidance opportunities is likely to generate high elasticities and hence large efficiency costs. In that context, broadening the tax base and eliminating avoidance opportunities such as to reduce the elasticity is likely to be more efficient and more equitable than altering tax rates within the old system." (pages 4 - 5)
2. "there is compelling evidence of substantial responses of upper income taxpayers to changes in tax rates, at least in the short run. However, in all cases, the response is either due to short-term retiming or income shifting. There is no compelling evidence to date of real responses of upper income taxpayers to changes in tax rates." (page 35)

The second statement and the evidence (and more) from these economists and others should be part of the discussion of tax reform as well as the effect of keeping or not keeping any of the 2001/2003 tax cuts that expire at the end of 2012.

Also, the above should not be too surprising in that revenue estimates of the effect of letting the tax cuts expire or of increasing marginal tax rates, show that revenue is generated rather than lost. For example, see a Joint Committee on Taxation analysis of the effect of increasing marginal rates for various categories of high income individuals that was proposed in H.R. 3200 (111th Congress) (it would impose a surcharge on such individuals).

For more on this topic including several references to other literature on the effect of tax rate changes on behavior and the economy as well as debunking various statements about tax increases or changes, see an April 2012 report by Chye-Ching Huang of the Center for Budget and Policy Priorities - "Recent Studies Find Raising Taxes on High-Income Households Would Not Harm the Economy Policy Should Be Included in Balanced Deficit-Reduction Effort."

What do you think?  Why do we sometimes hear that a tax rate increase, particularly one on capital gains (such as is produced when you sell your stock at a gain) will harm the economy or harm job growth?  Have you seen job creation tied to the current 15% tax rate on capital gains?  Will selling Apple stock at a gain create jobs?