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Tax Reform Delayed

delaysDid you notice anything missing during the partisan squabbling that led to the government shutdown and debt ceiling brinksmanship?  Why was nobody talking about reforming our tax laws, which have gotten so complicated that professional tax preparers are taking courses on how the 3.9% healthcare tax on nonwage income, deduction and credit phaseouts and higher capital gains rates apply to people who have to take required minimum IRA distributions, and whether that impacts the decision to make a fractional Roth conversion and drive income going forward below the thresholds.

Doesn’t that sound like a situation that is ripe for simplification?

While the government shutdown was in its early stages, Bruce Bartlett was explaining the tax reform situation in a keynote presentation to an audience of financial advisors, at the Fall conference for the National Association of Personal Financial Advisors in Philadelphia.  Bartlett, author of “The Benefit and The Burden: Tax Reform,” and a former assistant secretary for economic policy at the Treasury Department under the George H.W. Bush Administration, noted that our income tax turned 100 during the shutdown–the first U.S. income tax became law on October 3, 1913.  Happy belated birthday!

Today, roughly 40% of all citizens pay the income tax, which is almost exactly the same percentage as it was right after World War II, when the highest marginal tax rate was 91%.  The law has become so complicated because the last true simplification effort was the Tax Reform Act of 1986, which dropped marginal rates from 50% to 28% and eliminated a lot of loopholes, credits and deductions.  In the intervening 27 years, thousands of pages have been added to the Tax Code, and very little of the underbrush has been cleared away.

So why didn’t the Democrats or Republicans throw tax simplification on the table as a bargaining issue during the shutdown debate?  Bartlett said there were two reasons. The first is that the Republican party may have boxed itself into a corner.  “Republicans are very keen to reduce the top tax rate on both corporations and individuals to 25% if they possibly can,” he told the audience, “but they have also said that this has to be done in a revenue-neutral manner, and they want to ensure that no income class would pay more taxes or a bigger share of taxes than they pay right now.”

The only possible way to achieve that goal is to eliminate deductions.  That would mean eliminating at least five and possibly seven or eight of the ten biggest tax breaks.  Here’s the list.  See if you would vote for a candidate who proposed eliminating most of these:

Exclusion for employer-provided health insurance premiums (Cost: an estimated $760.4 billion over the next four years),

  • Retirement savings deduction ($708.6 billion)
  • Reduced rate on capital gains and dividends ($616.2 billion)
  • Mortgage interest deduction ($379.0 billion)
  • Earned Income Tax Credit ($325.9 billion)
  • Child tax credit ($291.6 billion)
  • Deduction for state and local taxes ($277.6 billion)
  • Tax deferral on foreign subsidiary income (the only item on the list that applies to corporations: $265.7 billion)
  • Exclusion of capital gains at death ($258.0 billion)
  • Charitable contributions ($238.8 billion)

Lowering the corporate tax rate is desirable because–largely due to tax reductions in other competing nations–the U.S. marginal rate is now among the highest in the world.  Bartlett noted that today U.S. corporations have stashed $1.5 trillion in offshore accounts using a variety of tax loopholes; much of that money would be repatriated back to the U.S. if those loopholes were closed, and if the tax rates were were lower.  But lowering those rates would require the government to collect more tax revenues from individuals–a political non-starter.

What’s the other reason why tax reform isn’t happening?  Bartlett said that the Constitution specifies that all revenue bills must originate in the House of Representatives, where the Ways & Means Committee is chaired by David Camp (R-MI), a tax reform enthusiast.  Trouble is, Camp’s 6-year chairmanship will expire at the end of this year, and many believe that the next person in line for the powerful position is somebody named Paul Ryan (R-WI).

“Put yourself in the shoes of Paul Ryan,” Bartlett suggested.  “Do you really want to help Dave Camp pass tax reform when you might, instead, want to put your name on the next major piece of tax legislation?  Put another way, do you want the final legislation to be called the Camp-Baucus bill, when instead it might be called the Ryan-Wyden bill?”

At the same time, the Senate Finance Committee is now chaired by Sen. Max Baucus (D-MT), who has announced his retirement.  Standing next in line is Sen. Ron Wyden (D-OR)–who happens to have his own tax reform proposal.  Bartlett suggested that Wyden is not inclined to help the tax reform process this year, because, like Ryan, he would like his name on the final piece of legislation.

Is this the way Congress is supposed to work?  Obviously not.  But Bartlett told the professional audience that we shouldn’t look for a meaningful effort to simplify the tax code until soon after the 2016 Presidential election, after two candidates have had a chance to debate various proposals before the American public.

The way things are going now, that could be several debt ceiling debates from where we stand today.

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