This country badly needs serious and comprehensive tax reform but it is not likely to get it.
The Republicans couldn’t get health reform or immigration reform and they are not likely to get tax reform. Their bills are always flawed by insisting on proposals without Democratic participation. Although the Republicans have a majority in both the House and Senate, they don’t have the 60% of the votes they will need to pass their tax reform proposals.
Our income tax originated in 1913 with the 16th Amendment to the Constitution. The Federal government received the right to levy a tax on income to supplement the existing Federal revenue from tariffs and excise taxes. There have been many past efforts at tax reform, each of them always meeting some strong resistance.
Reviews of recent Republican tax proposals concluded that they are (1) bad for the deficit, (2) biased toward the rich, and (3) of little or no help to the middle class.
The problem is further complicated in that Trump’s proposals and those of the House GOP (via the House Ways and Means Committee) do not agree. Both agreed on reducing the number of brackets from the current 7 to only 3. President Trump’s original tax plan called for the three tax brackets to be 10%, 20%, and 25%. Trump revised them later to 12%, 25%, and 33% to be identical with the House GOP plan. Note that Trump initially wanted to cap the highest income tax at 25% which would give a huge windfall to the rich, but he later agreed to a 33% tax on the highest incomes, still much below today’s 39.6% tax on the rich.
Anyone who wants to understand the real potential of a nationwide-disaster should ask the Kansas GOP for their opinion on tax reform.
The White House and the Republican Congress will have to hammer out one plan and then face the Democrats’ many objections. My sense is that the Republican’s tax reform bill will be headed for another Congressional defeat. This could lead to the Democrats winning more seats in the 2018 election and doom the Trump’s Presidency to one of zero accomplishment.
Anyone trying to put together a tax reform package will face a hornet’s nest of difficult problems. Should the maximum tax rate on the rich be lowered, left where it is at 39.6% or be raised higher? Should the estate tax be terminated, left where it is, or even be raised? Should the poor receive a living supplement modeled on the earned income tax credit (EITC)? Should taxpayers still be given a choice between a standard deduction or an itemized deduction? Should the Minimum Alternative Tax be continued? Should the home ownership and charitable gift tax deductions be continued? Should the government raise the tax rate on capital gains to a normal income tax level? Should the corporate tax rate be lowered from 35% to 15-20%?
The need for sound thinking on tax reform issues has never been greater. Our policies will inevitably have an impact on our economy and on our sense of economic justice and fairness.
Trump has described his tax plan as “The Biggest Individual and Business Tax Cut in American History.” The plan has four goals:
- Grow the economy and create millions of jobs
- Simplify our burdensome tax code
- Provide tax relief to American families—especially middle-income families
- Lower the business tax rate from one of the highest in the world to one of the lowest
The lay reader has enough trouble computing his or her annual income tax each April to read this further. According to The Tax Foundation, Americans collectively spent $147 billion last year to prepare business income tax returns and $99 billion preparing individual income tax returns. The IRS estimates that Americans spent a total of 8.9 billion hours complying with tax-filing requirements.
This alone suggests that Americans should have a strong interest in the simplification of our tax code. Here I would like to review the top eight tax issues that are drawing proposals and add my judgment of their soundness in enabling passage of the Republican tax reform plan.
1. Reduce the 7 tax brackets to 3 tax brackets of 10%, 25%, and 33%. The top rate of 33% would kick in at $225,000 for married couples, or $112,500 for individuals.
This proposal immediately and nakedly benefits the rich. It reduces the tax rate for the rich from 39.6% to 33%. Currently there are three high income tax brackets of 33%, 35 and 39.6%; Trump wants to collapse them into 33%.
In 1954, the superrich had as high a tax rate as 91%. This clearly is too high but the case can be made that the tax rate should be graduated with a rising number of brackets for the rich and superrich. Why should two persons, one earning $300,000 a year and another earning $3,000,000 a year both pay 33%? Wouldn’t a progressive income tax system, where higher income earners pay higher income tax rates, be fairer? A 33% cap on taxes for the rich (down from 39.6%) is tantamount to losing billions in tax revenue that could be used to reduce the tax rate on the middle class.
The Republicans are using the idea of tax simplification to reduce the number of tax brackets to three. But this is a scheme to protect and benefit the rich and superrich. Using more than three brackets does not make tax preparation harder. The tax rate will be crystal clear to every tax payer. In fact, some Republicans have been talking about adding a 4th bracket to the three to tax the superrich at a higher rate. If the Republicans stick to a maximum tax rate of 33%, they cannot avoid the charge of enriching the rich and dooming the passage of their tax reform bill.
2. End the Estate Tax
The Republicans have been clever in labeling the Estate Tax a “Death Tax.” The Estate tax goes back a hundred years and purports to prevent the concentration of wealth from worsening. The estate tax exempts assets of $5 million for an individual and $10 million for a couple from the estate tax, which should provide enough for the heirs to continue to live comfortably, especially considering that the heirs are still left with 60% of the estate.
The estate tax affects a small number of people each year. In 2015, over 2.7 million Americans died, and yet only 12,000 estate tax returns were filed. Furthermore more than half of those reported no tax due. Estate tax provisions allow transfers to spouses, charity, and other eligible purposes without any estate tax due. About 90% of collected taxes came from estates worth more than $10 million. The majority of those affected by the estate tax are high-net-worth individuals with extensive holdings of liquid financial assets. Their lives and children’s lives do not undergo any substantial disruption.
Yet the Republicans argue that a tax of (say) 40 percent on an estate puts a terrible burden on some farm families and small family owned businesses, leading some to closing their businesses and putting their workers out of work. Some of this does happen although most families normally have enough wealth to pay the estate taxes. The government can offer generous financial terms for paying the taxes due in a reasonable time period. If the current estate tax is eliminated, this will be a terrific windfall for the rich and put a big hole in tax revenue and prevent reducing the tax rates as much for working and middle class families. "This bill is about giving $270 billion in tax benefits (over 10 years) to the richest of the rich," according to Democratic Representative Rick Nolan, "and the rest of the country is going to have to pay for it."
I would argue for the government actually to consider increasing the estate tax rate in a further effort to reduce the growing concentration of wealth in the U.S.
3. Reform the Standard or Itemized Deductions
Each year in filing taxes, you can take the standard deduction or itemize your deductions. The standard deduction is a preset amount that you are allowed to deduct from your taxable income each year. This amount will vary according to your tax filing status and is indexed annually to keep up with inflation. But each year, millions of taxpayers are able to claim a larger deduction as a result of itemizing their deductions.
Choosing to itemize involves more work. The itemized deductions include:
- Unreimbursed Medical and Dental Expenses – Taxpayers who incur qualified out-of-pocket medical and/or dental expenses that are not covered by insurance can deduct expenses that exceed 10% of their adjusted gross incomes.
- Charitable Donations – Any donation made to a qualified charity is deductible within certain limitations. Cash contributions that exceed 50% of the taxpayer's adjusted gross income (AGI) must be carried over to the next year, as well as noncash contributions that exceed 30% of AGI.
- Casualty and Theft Losses – Any loss incurred as a result of a casualty or theft can be reported. Only losses in excess of 10% of the taxpayer's adjusted gross income are actually deductible.
- Unreimbursed Job-Related Expenses and Certain Miscellaneous Deductions – employees who incur work-related expenses can deduct any aggregated expenditures that exceed 2% of their adjusted gross income. These include items such as equipment and supplies, protective clothing, expenses for maintaining a home office for the convenience of the employer, vehicle expenses, dues to professional organizations and professional subscriptions.
There are other deductions known as “above the line” deductions such as self-employment expenses and student loan interest. They are a different category than itemized deductions and treated elsewhere.
Each deduction will draw debate in discussions of tax reform. Most people support the idea of uncovered medical expense deductions because these bills can be big and threaten to bankrupt families or individuals. Some groups challenge the idea of mortgage interest deduction. Mortgage interest deduction was set up to enable more people to own housing rather than pay rent and this would contribute to economic growth. And some groups challenge charity deductions. This was set up to support museums, performing arts organizations, religious institutions, and other civilizing institutions that would face financial difficulty in the absence of write offs for charitable giving.
Many Republicans favor eliminating itemization and favor a standard deduction varying with the income level. This would simplify the tax code and tax administration and preparation. To make this palatable to voters, Republicans favor doubling the standard deduction to replace itemized deductions. President Trump would consolidate the standard deduction and personal exemptions into a single, larger standard deduction of $15,000 for individuals, and $30,000 for married couples.
4. The Alternative Minimum Tax (AMT)
In 1969, Congress noticed that many taxpayers with high incomes were legally using so many deductions and other tax breaks that they were paying absolutely nothing in federal income taxes. So Congress instituted the AMT with the aim of making the tax system fairer. The AMT disallowed many deductions that had been allowed under the itemized tax deductions system. Higher income earners end up having to pay the alternative minimum tax rate rather than the amount indicated by the itemized deductions rates.
The AMT had not been indexed to inflation—as the regular income tax rate was each year. This resulted in involving more middle-income taxpayers in a tax originally targeted at the rich. The AMT exemption amounts are now indexed to rise with inflation.
Some Republicans prefer to repeal the AMT in order to leave more high-income earners benefitting from more itemized deductions.
5. Taxing Capital Gains
Anyone who sells a capital asset – stocks, bonds, property, a car, (but not a home) -- should know that capital gains tax rates may apply. If you sell the item for more than your cost, the difference is a capital gain that you need to report on your taxes. That gain will be taxed at a lower rate than one’s normal tax rate on work income.
If you held a stock for less than a year and sold it at a profit, you will pay the normal tax. If you held the stock for more than a year, this is called a long-term capital gain and the gain will be taxed at 15%, not at your normal income tax rate. The purpose of this lower tax rate is to encourage investors to buy and hold stock longer and not to speculate.
What about a capital loss? It can be used to offset capital gains. So if you have $60,000 in long-term gains from the sale of one stock, and $20,000 in long-term losses from the sale of another, then you may only be taxed on $40,000 worth of long-term capital gains.
If capital losses exceed capital gains, you may be able to use the loss to offset up to $3,000 of other income. If you have more than $3,000 in capital losses, the excess can be carried forward to future years to offset income in those years.
President Trump’s proposal is that the capital gains tax should be either 0, 15%, or 20%, depending on the income bracket of the person. A person in the lowest income bracket will pay zero on long term capital gains, in the middle bracket will pay 15%, and in the highest brackets will pay 20%.
Some of us would like to repeal the capital gains tax in favor of taxing everything at the person’s normal income tax rate. There are two problems with taxing capital gains at a lower rate. First, it removes a substantial amount of tax revenue that might be needed for government operations. Second, it means that a whole class of investors who are not involved in producing actual goods are paying less taxes than working class people who are putting in a full day of work.
We often hear that many wealthy people are paying a lower income tax percentage on their income than their secretaries. Granting a lower tax rate on capital gains is a concession to the finance industry. Many people view the finance industry as having grown too big as a percentage of our GDP.
6. Providing Tax Relief For Families With Child And Dependent Care Expenses
Many families have to deal with dependents, whether younger children or aging parents. This takes a toll on their family’s income and savings, possibly leaving many families without much funds for retirement. This is especially hard on lower income families. As a result, the tax codes should try to reduce taxes for families in this situation.
The first would be an above-the-line deduction for child care expenses, available for up to four children. The deduction would only be available for kids under age 13, and would be capped at the average cost of child care in the state for a child of that age. In addition, the deduction would apply for both third-party child care facilities, and still be deductible if care is provided by stay-at-home parents or (unpaid) relatives serving as caretakers. This above-the-line deduction would phase out at income levels above $250,000 for individuals, or $500,000 for married couples.
A similar above-the-line deduction would be available for “elder care” expenses for a dependent parent living in the home. The deduction for eldercare expenses would have a dollar cap of (say) $5,000/year. Both measures – child care and parent care – will provide a desirable tax deduction for working class families to meet their expenses.
7. Reducing Corporate Taxes from 35% to 15-20%
President Trump’s tax reform framework aims to help American businesses regain their competitive edge in a globalized economy. It advises lowering the top corporate tax rate to 20 percent from the current 35 percent. The U.S. taxation rate on corporate profits earned abroad is far higher than the rate charged by other countries. As a result, many American multinationals – such as Apple and General Electric – keep their money abroad rather than bringing their money home to invest in the U.S. The money held abroad is estimated to be as high as $2.1 trillion dollars! Both political parties agree that the corporate tax rate should be reduced to 15 or 20 percent. What remains a question is whether returning earnings would actually be invested in U.S. job creation or largely used to buy back corporate stock and increase management pay.
8. Miscellaneous Tax Issues
Tax reform also has to include removing a large number of tax loopholes and tax subsidies. One of the most egregious is allowing members of private equity firms to earn carrying interest and be taxed at a low tax rate when these members are not producing anything. Another area to re-examine is tax breaks for special interests and industries.
The Democrats will most likely vote against the Republican tax reforms, especially if they are not invited to participate and negotiate. While the Republicans do have a majority in both the Senate and House, they do not have the infamous 60 votes required to avoid a filibuster. To avoid a filibuster, the President and Congressional Republicans will need to engage in further compromises whether on individual tax reform, corporate tax reform, or perhaps conceding their attempt to repeal the estate tax.
It’s important to note that President Trump’s proposals are projected to create a substantial increase in the Federal deficit. Trump denies that this will happen using the argument that tax reform will boost the growth rate of the economy and more than cover the increase in the deficit. Economists agree that there is very little evidence of the Republican position that major growth occurs with cutting taxes.
The House Republicans are more inclined to keep their tax reforms revenue neutral. This means that the Republican party may not be willing to vote in favor of Trump’s proposals as they currently stand, necessitating some further compromises. Current reform proposals are looking at both corporate tax reform and individual tax reform. It’s not clear whether some of the President’s individual tax proposals might have to be compromised to win corporate tax reform concessions.
The final Republican tax reform package might end in one of four forms, each with a different probability of passage. The least likely to pass would be a package involving a deep deficit and a very large benefit to the wealthy. The second with a little better chance would be a package that was revenue neutral and with a large benefit to the wealthy. The third with a stronger chance of passage would involve a deep deficit but with a major benefit to the middle class and little benefit to the wealthy. The fourth would have the best chance to pass and be revenue neutral and deliver a major benefit to the middle class and little benefit to the wealthy.
Unfortunately, the package that has the best chance to pass is not consonant with the objectives of the Republican Party which is to create a large benefit for the wealthy. Congress is typically more responsive to business interests than to citizens’ interests. But Congress has to be aware that 51 percent of Americans said they thought that Trump’s current plan favored the wealthy over the middle class. The same poll found that just 33 percent of Americans wanted to reduce taxes on the wealthy, while 62 percent were opposed.
The Democrats are likely to rage against giving one penny more in tax cuts for millionaires and billionaires. Democrats will insist first that every America should be ensured affordable, quality health care and adequate public schools and better roads, bridges and infrastructure, and more investment in clean and renewable energy, and every American having a secure wage.
They will argue that taxes are the price we pay to live in a civilized society. Taxes pay for protecting our environment and our food, water, and health. Taxes pay for rescue workers in the time of earthquakes and hurricanes. Taxes cover our schools, bridges, firefighters and teachers. And the wealthy should pay more because they have benefitted more.
Clearly the country is split between two ideologies, one believing that government must play a positive role in making life better for its citizens and the other believing in minimum government. This accounts for the dysfunction of our government and its inability to pass any positive legislation. This paralysis will continue until one side starts gaining more votes than the other side.
One more time: Remember Kansas!
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