Feb 26 2014, 3:35pm CST | by Forbes
Earlier today, House Ways and Means Committee Chairman Dave Camp released his long-awaited and highly anticipated proposal for tax reform. The proposal promised to present the most thorough, sweeping changes to the law since the 1986 Act, and it didn’t disappoint.
Before we begin our analysis of the plan let me start by saying that while I clearly admire Chairman Camp for his tireless push to simplify the industry in which I ply my trade, I’d be remiss if I didn’t point out the irony that in the tax world, even a proposal for “simplification” stretches to nearly 1,000 pages.
Because there’s so much to take in, we’ll be separating our analysis into two parts
Part 1: Proposal for individual tax reform
Part II: Proposal for business tax reform
Let’s get to it with Part 1, Chairman Camp’s proposal for individual tax reform.
Streamlining of Individual Income Tax Rates
Effective January 1, 2013, we now have seven income tax rates that are applied against so-called “ordinary income,” (i.e. income from wages, business income, interest, etc…): 10%, 15%, 25%, 28%, 33%, 35%, and a top rate of 39.6%. If you’ve ever wondered how efficient this type of structure is, consider that in 2013, the 35% rate was only applied on single taxpayers with incomes in excess of $398,351 but less than $400,000. Yes, we had a tax bracket that was $1,649 wide.
Because our tax system is a progressive one, taxpayers don’t pay a flat rate of tax on all earned income; rather, as income increases, so does the tax rate applied to the income. Thus, when someone proclaims that they are in the “39.6% bracket,” that does not mean they paid 39.6% on all of their income; rather, it means they paid 39.6% on their last dollar of income. It also means that they are likely insufferable.
No matter how you slice it, a system with seven brackets – and a high of nearly 40% — is far from ideal.
Camp’s proposal would consolidate the current seven brackets into three, consisting of 10%, 25%, and 35% rates. Generally, the new 10% rate would replace the old 10% and 15% brackets, meaning it would cover all income earned up to approximately $73,800 if married, $36,900 if single (for simplicy’s sake, from this point on I will refer to married versus single thresholds or limitations like so: $73,800/$36,900).
The new 25% bracket would replace the former 25%, 28%, 33% and 35% brackets, meaning single taxpayers with taxable income between $36,900 and $400,000 would pay a 25% rate on that income, while married taxpayers with taxable income between $73,800 and $450,000 would pay a 25% rate on that income.
If you happen to earn taxable income in excess of $450,000/$400,000, then you will pay a rate of 35% on the excess, as opposed to 39.6% under current law.
Excluded from this top rate of 35% — meaning it would be taxed at a top rate of 25% — would be any income earned from “domestic manufacturing activities,” which is defined as “any lease, rental, license, sale, exchange, or other disposition of tangible personal property that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, or (2) construction of real property in the United States as part of the active conduct of a construction trade or business.”
This excluded manufacturing income does not include any income subject to self-employment tax. Finally, the exemption of manufacturing income from the 35% bracket would be phased in over three years, with only one-third of the income being excluded from the top bracket in tax year 2015, and two-thirds being excluded in 2016, with full exclusion arriving in 2017.
Surtax on Deductions
In addition, certain tax deductions will only be allowable to offset 25% income, meaning the maximum tax benefit that can be derived from the deduction is 25%, even if the taxpayer is otherwise in the 35% bracket. This includes:
This 10% “surtax” on high-earners will be computed by taking the taxpayer’s adjusted gross income, adding back the expenses listed above and subtracting any domestic manufacturing income, and then multiplying the sum by 10%. The effect of the surtax is phase out the benefit of the lower 10% bracket for those who earn in excess of $450,000/$400,000.
As I mentioned earlier today, one of the hallmarks of an efficient tax system is fewer rates with a modest maximum rate. Chairman Camp’s proposal certainly accomplishes just that. A tad surprising, however, is Camp’s willingness to tax – even if at only 10% and to only 1% of taxpayers – long-protected preferences such as employer-provided health care, retirement contributions, and state and local bond interest. Given that this is revealed only a few pages into the proposal, it reflects that Camp is not holding back and preserving special interests, which promises that the remaining provisions of his proposal will be sure to ruffle some feathers.
The other takeaway, of course, is that dropping rates in this manner would significantly reduce federal tax revenue when compared to current levels. Thus, if Chairman Camp intends to fulfill his promise to make the proposal revenue neutral, there must be some big changes coming to the tax base.
Let’s keep going and find out.
Doing Away with Preferred Rates on Capital Gain and Qualified Dividends
Under our current system, long-term capital gains and qualified dividends are taxed at a maximum of 15% for those with taxable income less than $450,000/$400,000, and 20% if taxable income exceeds those amounts. Tack on the new Obamacare 3.8% surtax imposed on certain net investment income that took effect January 1, 2013, and those top rates rise to 18.8% (if AGI exceeds $250,000/$200,000 but taxable income is less than $450,000/$400,000) and 23.8% (if taxable income exceeds $450,000/$400,000). These preferential rates, when compared to ordinary income, are expected to save taxpayers some $540 billion over the next four years.
Taxpayers would no longer pay a preferential rate on long-term capital gains and qualified dividends. Instead, those forms of income would be taxed at 10%, 25%, or 35% depending on income levels. To replace these preferential rates, Camp’s proposal will allow all non-corporate taxpayers to take an above-the-line deduction equal to 40% of their long-term capital gains (less any collectible gain) and qualified dividends.
All proposals for tax reform promise to cut rates and broaden the tax base, i.e., eliminate deductions and preferences. That way, even though the government is collecting tax via smaller rates, they are assessing the tax on more income, which is what allows a proposal with dramatic rate decreases to remain revenue neutral.
But there is a third characteristic of a sound tax system (my opinion, maybe not yours) that must also be achieved in any plan for reform – the system must maintain its progressivity. Stated in another manner, as a taxpayer’s income goes up, they should pay more tax, or looking at it as a collective, those who earn more money should pay more total tax as a group than those who earn less. When a change is made, the change should add to the tax bill of those making more than $500,000 more than it does than making less than $500,000, and so on..
Many previous proposals – most noticeably, the one pitched by presidential candidate Mitt Romney – are able to retain revenue neutrality, but fail to remain as progressive as the current system. Why? Because while the proposals lower rates for all taxpayers, they also typically preserve the preferential rates afforded capital gains and dividends. And the simple fact is that approximately 85% of the benefit of those preferential rates is enjoyed by the wealthiest 2%.
If you lower rates on ordinary income for all taxpayers but continue to provide preferential rates on investment income, the wealthiest 2% tends to derive much more benefit from the proposed changes than the other 98%. And this is how a system loses its progressivity.
Previously, the Bowles-Simpson plan for reform, which proposed rates of 10%, 22% and 28%, would have allowed capital gains and dividends to be taxed at those same ordinary rates, with no offsetting deduction. This allowed their proposed system, which also lowered rates and did away with deductions, to remain as progressive as the current system.
The Camp proposal maintains this benefit afforded long-term capital gains and dividends in the form of a 40% above-the-line deduction of the gain or dividend against income. In fact, the preference provided by the deduction will actually be greater than the one provided by the current lower rates. To illustrate, a taxpayer with income in excess of $450,000 will now pay a top rate of only 35% on that income, as opposed to 39.6% under current law. And on his capital gains, he will pay 35% of only 60% of the total gains, or an effective rate of only 21%. In comparison, under current law the same taxpayer would pay a maximum rate on the same gain of 21.2%, comprised of the 20% income tax rate plus the 1.2% effective tax increase caused by the phase-out of itemized deductions known as the Pease limitation.
When you consider that the wealthiest 0.1% of all taxpayers typically recognize about 75% of all capital gains, I have to wonder if the Tax Policy Center’s inevitable analysis of this plan will reveal that the average tax reduction for those earning in excess of say, $250,000, dwarfs that for all other taxpayers.
[Ed note: to be fair, the JCT has done their distributional analysis of the changes, and it looks pretty darn good. See below]
Increased Standard Deduction and Elimination of Personal Exemption
Each taxpayer is entitled to reduce adjusted gross income by the greater of 1) the standard deduction, or 2) the total of the taxpayer’s itemized deductions. The standard deduction is currently $12,200 for married taxpayers and $6,100 for single taxpayers.
In addition, a taxpayer may deduct a personal exemption for the taxpayer, his or her spouse, and any dependents. The amount of the personal exemption was $3,900 in 2013.
Chairman Camp would raise the standard deduction to $22,000 for joint filers and $11,000 for all others. Single filers with at least one child could claim an additional $5,500 deduction, regardless of whether they deduct the standard deduction or itemize.
The standard deduction – or the equivalent amount of itemized deductions – would phase out by 20% for every $100 adjusted gross income exceeds $517,500/$357,750. The additional standard deduction of $5,500 for a child would phase out, however, by one dollar for every dollar adjusted gross income exceeds $30,000.
Camp would also eliminate the deduction for personal exemptions. The theory goes that the increased standard deduction would substitute for a personal exemption for the taxpayer and spouse, while the increased child tax credit (see below) would substitute for the lost personal exemptions related to any dependents.
By raising the standard deduction, we would achieve a measure of simplicity, as far more taxpayers would take the standard and far fewer itemize. In fact, the JCT estimates that under current law, nearly 33% of all taxpayer’s itemize their returns, which forces them to use the more complicated Form 1040. Under Camp’s proposal that number would dip to only 5%, meaning 95% of taxpayer could prepare their return on the much simpler Form 1040A.
Streamlined Education Credits
Under current law, there are approximately 80,244 education incentives.*
*may not be actual number.
Chairman Camp would consolidate the existing American Opportunity Tax Credit, Hope Scholarship Credit, Lifetime Learning Credit, and the above-the-line tuition deduction into one $2,500 American Opportunity Tax Credit. The first $1,500 of the credit would be refundable, and would phase out once income exceeds $86,000/$43,000.
Let’s make it happen. I’m tired of trying to optimize between all the different incentives.
Other Education Items
Here’s the good news – the above-the-line tuition deduction has been replaced by the expanded credit as discussed above.
Here’s the bad news – Chairman Camp would repeal the deduction for student loan interest. Oh, and any future contributions to an Educational IRA – which are nondeductible but come out tax-free as long as used for education expenses – would be disallowed. And lastly, the exclusion from the 10% penalty tax for distributions from a retirement plan that are used for qualified education expenses would go away. The theory being that this will encourage people to leave money in their account for retirement rather than use it for their kid’s college tuition, as if any parent (other than me) would choose the comfort of their own Golden Years over their child’s educational experience.
Other Individual Items
There are a host of other items impacting individual taxpayers, and the most noticeably among them are summarized below. As you can see, the tax base will indeed be broadened, as very few deductions and preferences will remain should Camp’s proposal become law.
The combined effect of the repeal of so many itemized deductions, when coupled with the increased standard deduction proposed earlier, will be to eliminate the need for most taxpayers to itemize. Under current law, the moment in a taxpayer’s life that usually tips the scale from taking the standard to itemizing is usually the purchase of a home because of the resulting deductions for mortgage interest and real estate taxes. With that deductible debt limit dropped to $500,000 and the deduction for real estate taxes repealed, this will no longer be the case.
Add in the repeal of the deduction for state and local taxes, medical expenses, and casualty losses and most taxpayers, even very wealthy ones, will be hard pressed to scrounge up enough itemized deductions to exceed the now-inflated $22,000 standard deduction. And this is a good thing, because fewer itemized deductions means more streamlined tax filings, relieving pressure on taxpayers to produce records, tax advisers to make sense of it all, and the IRS to police the deductions.
From a policy perspective, these changes are quite obviously going to leave a lot of special interest groups pissed. I can say this with confidence, because in the two hours I’ve been writing this, my email has been inundated with no fewer 15 angry emails from groups that feel they’ve been wronged by the Camp proposal.
Below is just a short list of those groups that are – or that I expect to be – outraged, and the reason they are lighting up my inbox.
That’s a lot of bitterness when you consider that we haven’t even gotten to the business tax proposals yet. We’ll do that next, so come back for Part II.
Follow along on twitter @nittigrittytax
Source: Forbes Business
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