Tax Reform Principles Part 3: Simplicity and Administration

This is the the third and final article reviewing the general principles to consider when reforming a tax system. The first principle evaluated how the tax system encourages economic growth. The second addressed fairness. This article will review concepts of simplicity and administration.

There are three points to consider in the area of simplicity and administration.

• How costly is it for taxpayers to determine their tax liability and pay their taxes?
• Can the system be easily administered by the government and does it encourage taxpayers to comply with the filing requirements?
• Are some individuals able to avoid their legal liabilities?

Without question, the tax code has become exceptionally complex. As someone who has been a practicing CPA for over 25 years, I can attest to the growing complexity of tax law and difficulty of compliance. The complexity is good business for people who make a living from tax planning and preparation, but there is certainly a cost to taxpayers. Even a person or family of modest means and little financial complexity often finds it challenging to prepare their own taxes. The plethora of possible deductions and credits, that often have very specific qualification, can be challenging to understand and apply. Thankfully there are a number of inexpensive software providers that can help, but if you don't correctly answer the questions or input something incorrectly, you can easily make an error. There have been many bills passed over the past 30+ years that were touted as tax simplification, which resulted in a more complex tax system. Deciding whether the cost of compliance is overly burdensome is a subjective matter, but there definitely is a cost and be wary when Congress promises more simplification.

The U.S. tax system is based upon voluntary compliance. This puts the primary burden upon taxpayers to timely file and properly report their income and corresponding tax liabilities. Timely filing is relatively easy. You simply have to file and pay your taxes by the requisite due date. Properly calculating the tax liability can be more difficult to ascertain. As explained above, the complexity of the tax code makes it extremely challenging to calculate the correct tax. Although few people will avoid filing returns because of the complexity, the burdens of compliance can result in people failing to report certain items because it's unlikely to be discovered by the IRS. With regards to government administration, the number of fraudulent returns that have been filed over the past few years is an indication of the difficulties the IRS has processing and administering tax returns correctly. One recent example highlights their ineffectiveness. A few years ago, several hundred fraudulent tax refunds adding up to several million dollars were mailed to the same overseas address without any questions raised by the IRS until after the checks were cashed. While it's entirely possible a a common mailing address may be used, good internal controls should have identified the number of refunds being mailed to the same address as a potential problem.

On the third point, it's important to remember that tax avoidance is perfectly legal, but tax evasion is not. Avoidance involves structuring your affairs in a manner to minimize your tax liability. Part of tax complexity is a result of years of successful tax planning that Congress and the IRS deemed inappropriate, which resulted in new laws and regulations designed to close the "loopholes". Tax evasion can range from a person who is paid in cash to avoid paying taxes to wealthy individuals who fail to report millions of dollars held in overseas financial institutions. While you may have an opinion on the severity of the crime, a willful failure to report income is illegal whether it's $100 in cash you got paid to work for someone or you have $100 million parked overseas. As technology improves, so has the ability of the IRS to identify potential fraud. The IRS has also dramatically increased certain penalties for failing to comply as an additional incentive to follow the rules. However, the basic premise of voluntary compliance ultimately means some people will be able to successfully avoid paying their taxes.

How would you evaluate the simplicity and administrative effectiveness of the U.S. tax code?

Tax Reform Principles Part 2: A Fair System

This is the second installment in a three-part series discussing the principles to consider for tax reform. In the first part, we reviewed how the tax system is able to modify behavior with the intent of increasing economic activity, and more specifically, how the tax code helps grow the U.S. economy.

The second principle for tax reform is having a fair tax system. Two criteria are typically used to assess fairness.

• Does the tax system treat similarly situated taxpayers the same?
• Does the system account for the different capacities to bear the burden of taxation?

Tax law is supposed to be administered equally, fairly and objectively. Individual persons or companies should not receive different treatment when applying the same law. Even though fairness is a general foundation of U.S. tax laws, there are two areas of concern. The first is the special tax benefits (often referred to as loopholes) for a certain class or type of taxpayer. Most of these loopholes are the result of special interest lobbying and the power of individual members of Congress to write tax law that is beneficial to their constituents. These special provisions may affect a relatively small group of taxpayers (e.g. advantageous depreciation for motor sports track owners), but they rarely apply to a single taxpayer. Thus, all taxpayers meeting the criteria are to be treated equally (i.e. all racetrack owners). The second involves the ability to hire experts to maneuver an increasingly complex tax code. Large corporations and wealthy individuals are often better positioned to hire a team of experts who scour the tax code seeking the most advantageous benefits. These experts may allow them to structure their affairs to achieve tax benefits unknown to the average taxpayer. Again, these benefits are available to everyone, but you need the ability to hire the experts to know how to utilize them.

The issue of capacity to bear the burden of taxation is a subjective assessment of fairness and is open to a wide range of opinions. Fairness in taxation is very much like beauty; it's in the eye of the beholder. For some people, fairness is a very progressive tax structure whereby the more you pay a higher rate of tax when you make more money. The rate could be as high as 70-90%, which could be considered as confiscatory. A progressive tax system is designed to restrict income inequality and wealth accumulation. There is still a lot of subjectivity in a progressive system to determine how much is too much, and who gets to decide the limits. On the other end of the spectrum are those who believe in a flat tax, where everyone pays the same rate of tax, no matter how much you make. For them, the same rate of tax treats everyone fairly and equally. Our current system is a mixture of both a progressive and flat tax structure. 

Considering these two factors, do you think the U.S. tax system is fair? 

Tax Reform Principles Part 1: Promoting Economic Activity

The Joint Committee on Taxation (JCT) recently published a report providing an overview of the U.S. federal tax system and certain policies to consider for tax reform. If you're interested, you can read the entire report here. https://www.jct.gov/publications.html?func=startdown&id=5015

The report identified three questions to ask when evaluating a governmental tax system.

1. Does the tax system promote or hinder economic efficiency?
2. Is the tax system fair?
3. Is the tax system simple and easily administered?

In the evaluation of economic efficiency, one criteria considered is how the tax system changes, or potentially distorts, taxpayer behavior. You have probably heard people say that they don't want to work overtime or make more money because they lose too much in taxes. Given the current maximum federal tax rates of approximately 45%, this doesn't make economic sense. Even if you have to give up 45%, you still get to keep 55%. For example, if you earned an extra $1,000,000 and had to pay $450,000 in taxes you would still have $550,000 after taxes. Would be be better off making the extra $1,000,000 or not? However, the truth is the tax code does alter behavior, some good, and some not so positive. 

Another aspect is the extent to which the tax code promotes economic growth. This factor includes effective and marginal tax rates, but it also includes the vast number of incentives contained within the code. Advantageous depreciation provisions and solar energy credits are two examples. Certain depreciation rules allow taxpayers to deduct all, or a significant portion, of the cost of new equipment in the year of acquisition rather than recouping the cost over several years. Solar energy credits reduce the after-tax cost of the equipment and make the overall cost of solar energy more competitive to cheaper fossil fuels. Not only are these incentives designed to benefit the purchaser, but they are also intended to spur economic growth and manufacturing activity by helping to create demand for products. Tax rules also help achieve certain public policy goals, such as creating more green energy.

The final measure is the encouragement to produce domestic goods and services. As many barriers to global business enterprises have been removed in the past 50 years, there has been a lot more focus on how the U.S. is competing with foreign businesses. This was a major issue during the 2016 election cycle and was probably the key to President Trump's victory. Many people have felt the negative impacts of a global economy, especially in the manufacturing sector and are looking for Washington to encourage domestic manufacturing and production. There is a general consensus within Washington that U.S. tax policy is making it more difficult for manufacturers to complete with foreign companies. Since politicians across the political spectrum favor some type of corporate tax reform, it's reasonably likely corporate tax changes will be enacted in the near future.

The next articles will focus on fairness and tax administration.

Given these three criteria, do you think the U.S. tax system promotes or hinders economic activity?

Proposed Income Tax Changes - Part I

President-elect Trump campaigned on lowering tax rates as part of his plan to spur economic and job growth. There are a lot of details to his plan, which are far more extensive than what can be covered in a single article. Below is a summary of some the essential changes.

Tax Rates for Married-Filing Jointly taxpayers

• 12% for income less than $75,000
• 25% for income $75,001 - $225,000
• 33% for income over 225,000

The brackets for single taxpayers will be 50% of the above amounts and the head-of-household status will be eliminated. An unmarried person who has a qualified dependent (e.g., single parent with child) is an example of a head-of-household taxpayer.

The current preferential rate of 20% for long-term capital gains will be maintained using the above tax brackets. The 0.9% Medicare surtax on wages in excess of $250,000 and the 3.8% Medicare tax will be eliminated, assuming the Affordable Care Act is repealed.

For corporate taxpayers, the rate will decrease from 35% to a flat 15%. 

It's estimated that U.S. multi-national companies (e.g., Apple, Microsoft and General Electric) have more than $3 trillion of earnings attributable to non-U.S. sales that have not been subject to U.S. taxation. There will be a one-time 10% tax assessed for the deemed repatriation of foreign earnings by U.S. corporations. This is an incentive for U.S. companies to bring the money back to the U.S., which is intended to spur economic growth through business expansion, acquisitions and buying back company stock.

It's difficult to predict which, if any, of the above provisions will enacted, but these changes form the foundation of President-elect Trump's tax plan.