Tax reform has been on the congressional agenda for the past few years with an emphasis on base broadening to allow for lower rates in a revenue-neutral manner. Challenges to reform include what deductions to cut as part of base broadening, whether more significant changes are needed, the effect on the economy, and reaching a meeting of the minds to allow a tax act to be enacted.
This article summarizes and critiques the latest significant proposal for reform, offered by the House Republicans and likely to be considered in the House and turned into legislative language. While the plan won't be enacted in the current 114th Congress, the time and thought that went into the plan makes it a likely focal point for the next Congress.
On June 24, 2016, Speaker of the House Paul Ryan, R-Wis., released the last of the House Republicans' six-part vision, called "A Better Way." They describe this vision as "a full slate of ideas to address some of the biggest challenges of our time." The first five plans address issues and propose solutions for upholding the Constitution, growing the economy, fixing health care, improving national security, and fighting poverty.
While the 35-page tax plan is described as a blueprint, it is a narrative rather than legislative language. Although several changes and rates are specified, a lot of pieces are missing. At 15 places in the blueprint, the House Ways and Means Committee is instructed to draft the details, usually for quite significant areas, such as the treatment of individuals living and working abroad. About one-third of the report explains problems with the current system and why they need to be fixed. The final three pages of the report explain how the plan can grow the economy.
The drafters intend to "create a 21st century tax code built for growth." The three goals for their proposal are (pp. 5 and 15):
- Stimulate job creation;
- Make the tax system simpler and fairer; and
- Transform the IRS "into an agency focused on customer service."
The plan was also shaped by asking two questions about each policy or provision (p. 5):
- Will the reform grow the economy?
- "Is it worth raising taxes on everyone else to include this provision"?
The second question seems directed at helping with the challenging task of base broadening. A broader tax base means tax preferences are eliminated or cut back—not a popular activity. But when these preferences are described as causing others to pay more, they may not be viewed as favorably. In describing one of the problems with our current tax system, the blueprint's authors further portray special tax rules in an unfavorable light that might make base broadening feasible.
Many of these tax preferences, sometimes referred to as "tax expenditures," are special-interest giveaways that are masked as tax breaks instead of direct grants. For fiscal year 2016, such "spending" through the tax code amounts to more than $1.4 trillion or almost three-fourths of the amount of revenue raised by the entire federal income tax. When Washington picks winners and losers with the tax code, the American people ultimately pay higher tax rates and keep less of their hard-earned money (p. 9).
The key changes for individuals are listed below with questions and issues noted. Some of the areas need to be resolved to move from ideas to legislation.
- A postcard-size income tax return for most individuals is highlighted in the plan.
Questions: Are income items not noted on the return repealed and not taxable (e.g., alimony, retirement income, unemployment compensation, Social Security benefits, other income)? Are deductions not listed repealed (e.g., alimony, moving expenses, educator expenses, medical expenses, casualty losses)? Are individuals allowed to have a net operating loss (NOL) carryover? Does the distinction between passive activity and nonpassive remain (Sec. 469 rules)? Why isn't the foreign tax credit (FTC) listed?
Under the plan, taxable compensation of employees is defined the same as compensation that employers may deduct. Does this mean that currently excluded fringe benefits will become taxable or that employers will not be able to deduct them?
Critique: How many attachments accompany the postcard, such as Schedules C, D, E, and F, as well as schedules for tax credits? Or, since the postcard is only for some individuals, what will the form for everyone else look like?
Also missing are a perjury statement, details on how to directly deposit a refund, and signature lines for the taxpayer and preparer. It is misleading to promote a postcard-size return as indicating the complexity (or simplicity) level of the tax system because it can mask the effort needed to calculate the listed items and the recordkeeping involved.
- Rate structure: The proposed tax structure table from the plan follows; the brackets would be adjusted annually for inflation.
Question: Is the kiddie tax repealed?
- Dependent provisions: The child tax credit and personal exemption for children and dependents are consolidated into a credit that is partially refundable. The child tax credit phases out when income of a married couple reaches $150,000.
Critique: While making the system more progressive, phaseouts harm simplicity and transparency. Use of the rate structure to help achieve desired levels of vertical equity would be simpler.
- Standard deduction: The basic and additional standard deduction along with the personal exemptions for the taxpayer and spouse are merged into a larger standard deduction of the following amounts, adjusted annually for inflation.
- Married filing jointly = $24,000
- Single with child in the household = $18,000
- Single = $12,000
The drafters estimate that this change will reduce the number of individuals who itemize deductions from 33% to 5% (p. 19).
Critique: Despite the claim that this plan merges the exemption for children with the standard deduction provision, the $18,000 deduction seems to provide an extra benefit to a single taxpayer with a child. The larger standard deduction makes the mortgage interest and charitable deductions less significant to more individuals. This change might reduce charitable contributions.
- Investment income: Only 50% is subject to tax.
Questions: Will the existing rules for netting capital gains and losses remain? What about the capital loss limitation? Will the Sec. 121 gain exclusion for sale of a residence be modified?
The plan states that no income group will have a tax increase (p. 16). However, based on the rate changes, the 50% exclusion for investment income, and repeal of the 3.8% net investment income tax (the health care plan repeals the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148), higher-income individuals will have a tax decrease. Will other changes offset this decrease (does the plan distribute taxes neutrally among taxpayers)? If not, how are the tax cuts distributed among different income groups?
- The alternative minimum tax (AMT) is repealed.
Question: What happens to any minimum tax credit (MTC) carryover?
- The estate and generation-skipping transfer taxes would be repealed.
Questions: There is no mention of repealing the gift tax. Would it also be repealed? What happens to the basis of assets at the date of death? Would gains at date of death be taxable to the decedent on the decedent's final income tax return?
Corporations and other businesses
- The corporate rate would be a flat 20%. The drafters note that taxing only 50% of individuals' dividends and capital gains reduces the effect of double-taxation. The corporate AMT would be repealed.
Questions: Sen. Orrin Hatch, R-Utah, chair of the Senate Finance Committee, is examining corporate integration (eliminating double-taxation on corporate earnings) as an approach to reduce corporate taxes (see his April 26, 2016, statement at a Senate Finance Committee hearing on business tax reform). What are the varying economic effects of corporate integration versus only lowering the corporate tax rate? What happens to a corporation's MTC carryover?
- Active business income of sole proprietorships and passthroughs would be taxed at no more than 25%. The plan also states (p. 23):
Under this new approach for taxing small businesses, sole proprietorships and pass-through businesses will pay or be treated as having paid reasonable compensation to their owner-operators. Such compensation will be deductible by the business and will be subject to tax at the graduated rates for families and individuals. The compensation that is taxed at the lowest individual tax bracket rate of 12 percent effectively will further reduce the total income tax burden on these small businesses and pass-through entities.
Questions: What is considered "active business income"? Why is the top rate for this income higher than for corporate income? Are changes to self-employment tax anticipated? What does it mean to say these businesses will be treated as paying reasonable compensation to owners? Will individuals file separate business returns, as is called for by the flat tax (see H.R. 1040 and Hall and Rabushka, "The Flat Tax," Hoover Institution (Jan. 1, 2007))?
- Business assets other than land would be expensed. This represents a cash flow approach and "a move toward a consumption-based approach to taxation" (p. 15).
Questions: Why isn't land expensed as is common with a consumption tax? Will businesses be allowed to expense the remaining basis of assets that exists under the current system?
- Sec. 199 domestic production activities deduction would be repealed.
- Interest expense would only be deductible to the extent of interest income; excess interest expense would carry forward indefinitely. This change ties to the expensing of business assets.
- Business credits other than research credit would be repealed. The research credit might be modified.
Question: What happens to credit carryforwards?
- NOLs would carry forward forever, increased by an annual interest factor to account for the effects of inflation. The carryforward could not reduce taxable income by more than 90%.
The plan creates a territorial system for businesses, instead of the current worldwide system. A 100% exemption would apply to dividends of foreign subsidiaries. Accumulated foreign earnings at date of enactment would be taxed at 8.75% if held as cash or cash equivalents; otherwise they would be taxed at a 3.5% rate. This tax would be payable over eight years. The foreign personal holding company rules would continue to help prevent shifting passive income to low-tax countries.
The move to a consumption tax approach is to allow for a border adjustable tax where exports are not taxed but imports are (pp. 27–28).
Questions: Will there be any restrictions on the use of existing foreign earnings (as with the last repatriation holiday)? What happens to foreign tax credit carryovers? How is the border adjustment handled (e.g., by excluding exports from revenue)? Will the business tax be viewed as a border adjustable consumption tax under World Trade Organization standards? Will there be any changes for individuals with foreign business and investment activities?
House Republicans have a separate plan for health care. It includes the following tax-related items:
- Repeal PPACA;
- Provide a tax credit to help individuals purchase health insurance; and
- Preserve employer-sponsored health insurance but cap the exclusion benefit for individuals: "To help lower the cost of coverage, our plan proposes to cap the exclusion at a level that would ensure job-based coverage continues unchanged for the vast majority of health insurance plans" (p. 15).
Changes to the IRS
The IRS would be redesigned "into a modern and efficient 21st century administrator" (p. 29). There would be three key units:
- The families and individuals unit, with a service focus;
- The business unit, staffed with experts to help small business and U.S.-based global businesses; and
- The small claims court unit, independent of the IRS, to resolve "routine disputes" quickly.
"The new agency must be forward looking and must continually adapt to the ever changing economy" and follow the principle of "Service First" (p. 31).
Questions: Will sufficient funding be provided to enable the IRS to provide services and modernize its technology? Will there be any changes in enforcement and collection activities?
Work specified for the House Ways and Means Committee
The plan specifically delegates 15 design tasks to the House Ways and Means Committees:
- Improve the refundable aspect of the child tax credit to "reduce fraud and erroneous overpayments" (p. 19).
- Reform the earned income tax credit to "reduce fraud and erroneous overpayments" and provide "a more effective and efficient incentive to work" (p. 20).
- Consolidate education provisions to improve effectiveness and efficiency and to cover costs of college and vocational training. Such changes are to include a savings incentive such as 529 plans and tax relief for low- and middle-income families, such as with the American opportunity tax credit (p. 20).
- Eliminate most itemized deductions, but retain tax incentives for retirement savings (p. 20).
- "Evaluate options for making the current-law mortgage interest provision a more effective and efficient incentive for helping families achieve the dream of homeownership." The changes are not to affect individuals who currently itemize deductions and will not affect any existing mortgage or refinancing of that mortgage (p. 21).
- "Develop options to ensure the tax code continues to encourage [charitable] donations, while simplifying compliance and record-keeping and making the tax benefit effective and efficient" (p. 22).
- Explore ways to promote savings using models similar to retirement plans, such as a Universal Savings Account (see H.R. 4094) (p. 22).
- "Consolidate and reform the multiple different retirement savings provisions in the current tax code to provide effective and efficient incentives for savings and investment" (p. 22).
- "Develop special rules with respect to interest expense for financial services companies, such as banks, insurance, and leasing, that will take into account the role of interest income and interest expense in their business models" (p. 26).
- "Evaluate options for making the treatment of inventory more effective and efficient in the context of this new tax system" while keeping the last-in, first-out (LIFO) inventory method (p. 26).
- "Evaluate options for making the R&D credit more effective and efficient" (p. 27).
- "Consider the appropriate treatment of individuals living and working abroad in today's globally integrated economy" (p. 29).
- Create appropriate transition rules to bridge from the old to the new system, considering input from stakeholders (p. 31).
- Consider even "bolder" reform ideas "that will best accomplish the objectives of creating jobs, growing the economy and raising wages" (p. 31).
- Draft the legislation required for the "policies and provisions" in the blueprint in time for legislative action in 2017. The committee is also to have "ongoing dialogue with stakeholders—including families, workers, and job creators" (p. 31).
At 35 pages, the blueprint cannot describe all aspects and details of the tax plan. As noted, 15 items were specifically assigned to the House Ways and Means Committee for further design. Beyond that, though, numerous pieces are missing, such as:
- Permissible accounting methods and periods;
- Whether there would be any change to consolidated return filings;
- Whether there would be any changes for tax-exempt entities; and
- Whether there would be any changes to excise and employment taxes.
Observation: Given that one goal of the plan is fairness, any later changes to employment or excise taxes might alter any fairness achieved through income tax reform.
Various areas that have been included in past hearings and proposals on tax issues are not mentioned in the blueprint, such as the following:
- While aiming for a 21st century tax system, the blueprint makes no mention of the sharing and digital economies and their tax issues. For example, clarification and modernization of worker classification rules and possible simplification of business reporting for small businesses, should be considered.
- Identifying whether or how the tax system should reflect an energy policy. Our current system includes incentives for both fossil fuels and alternative energy.
- Penalty reform.
- Ways to reduce the tax gap, such as through improvements in information reporting.
The plan aims to be revenue-neutral. The revenue target is the baseline that assumes current temporary tax provisions will not expire. This allows the target to be $400 billion less than the Congressional Budget Office baseline, which assumes that the temporary provisions expire on schedule (p. 16). Dynamic scoring would be used to consider the macroeconomic effects of the changes.
Tax reform is a significant task frequently discussed by Congress. The House Republican plan brings together suggestions from many members and is part of a bigger "vision." It lays out tasks for the House Ways and Means Committee, including to seek wide input. There is still the need to coordinate with counterparts in the Senate and "across the aisle" in both houses. Legislative language would make further analysis more meaningful and be a helpful starting point for achieving reform in the 115th Congress.
Annette Nellen, Esq., CPA, CGMA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, CalCPA, and California State Bar. She is a member of the AICPA Tax Executive Committee (vice chair) and Tax Reform Task Force. She has several reports on tax policy and reform and a blog.