Even though the Plan proposes many significant changes to the income tax, these changes are not such to make the Plan a serious income-tax reform proposal. The Plan’s retention and addition of new tax breaks would leave the tax base too narrow to permit a simple, efficient, and low-rate income tax. The Plan even seems oblivious to the corrosive effect which embedded tax breaks have upon the integrity of an income tax system. Like graffiti, they beacon the addition of more tax breaks, fueled by high tax rates giving them value.
By James K. Jeanblanc l June 3, 2015
Senators Mike Lee and Marco Rubio have recently co-authored the “Economic Growth and Family Fairness Tax Reform Plan.” It is one of several proposals to reform the income tax and has been given considerable publicity. Copycat plans are likely to follow. Well-timed for the 2016 Presidential election cycle, it appears more as a political document than as a proposal to meet the ambitions and goals of most income-tax reformers. It would not result in a greatly-broadened income tax base; it would leave marginal tax rates still too high; and despite its proposing to end most tax breaks, it would add more of its own. An early criticism of the Plan is that it would not be revenue neutral to the Treasury, suggesting its marginal tax rates might have to be made even higher.
Taxation of Business Income
Under the guise of income tax reform, the Plan would eliminate existing special tax breaks for business, but this guise is not so strong to prevent its proposing a new one to spur investment and economic growth. True income-tax reformers can only regard this as taking reform in the wrong direction, even affirming use of the income tax for incentives and subsidies.
This new tax break would allow businesses to expense the cost of their investments in the year when made and not be required to depreciate that cost over the life of the investment. As an anti-reform measure, it would run counter to generally-accepted accounting principles used to measure true income, where the cost of an investment is matched against the revenue it produces.
The proposal is an admission that high taxes, which the break is intended to offset, operate as a disincentive for new investment. So, if the goal of the tax break is to incentify new investment, then why not simply reduce the disincentive? Why aren’t business market forces and the profit motive incentive enough? One might see the practice of embedding tax breaks in the income tax like running the air-conditioner and heating system at the same time.
Will this proposed tax break to spur investment work as intended? Take the case of the investment tax credit first added in the 1960s as an incentive for investment in new machinery and equipment. Beyond this sounding good, many studies have concluded that this tax credit never created an investment need and have suggested the credit served only to reward and subsidize investments which would have been made anyway.
The Lee-Rubio Plan identifies and seeks to address two major problems with the income tax. The first is that of the double taxation of income, mainly seen when corporate earnings are distributed as dividends to the shareholders and taxed again (because corporations are not allowed to deduct dividends paid). The second, related to the first, is the tax bias in favor of debt-financing verses equity-financing because interest expense paid (unlike a dividend payment) is deductible.
The Plan adopts a somewhat backward solution. It proposes that business interest expense no longer be deductible, and that interest income, along with dividends paid to shareholders, be exempt from taxation. The justification for this is that business income (with interest expense and dividends not to be deductible) would already be fully-taxed and what is paid out should be tax-free to the recipients.
This solution is not without difficulties. For example, how should bank and financial earnings be taxed? On this, the proposal punts with the suggestion that financial institutions should be exempt from the proposed changes regarding the deductibility and taxability of interest. But, what about other cases, such as retailers extending on credit on lowered-price customer purchases? The profit on business sales would be taxed at 25%, but a price reduction (and corresponding reduction in the profit) paid for in the form of interest income would be tax-free under the Plan.
In the end, this solution may be incompatible with the Plan’s proposed repeal of the Alternative Minimum Tax (the “AMT”). Wealthy taxpayers having large amounts of what will be exempt dividend and interest income, may come to be seen as not paying their “fair share” of the income tax, leading to resurrection of the AMT on this income, and an undoing of the Plan’s goal to end the double taxation of income.
Might there be a better way to accomplish the Plan’s goals? Why not leave unchanged the current tax treatment of interest expense and interest income and simply allow corporations to deduct as an expense the dividends they paid to shareholders? This would end the double taxation of corporate earnings and the tax bias favoring corporate debt over equity financing. And, there would be no need for special tax rules for financial institutions, plus the AMT repeal would not face the “not-paying-your-fair-share” backlash.
Tax Rate Structure
The Lee-Rubio Plan would deserve high marks if it were a simple, low-rate, flat-tax proposal, but it is not. Instead, it introduces a dual, two-bracket taxing system, with the first set of tax brackets applicable to business income, and the second, to non-business income.
Under both bracket systems, income below the thresholds of the top brackets would be taxed at 15%. Business income would have a top-bracket threshold of $75,000 ($150,000 in the case of individuals with business income filing jointly), above which business income would be taxed at 25%. Non-business income would have the same threshold, above which the taxpayer’s non-business income would be taxed at a higher 35% tax rate.
Regular corporations (“C” corporations) would use the business-income bracket system to compute their taxes. Individuals receiving business income from pass-through entities (“Subchapter S” corporations, LLCs, and partnerships) and earned from sole proprietorships would report this income in their personal tax returns to be taxed using the business-income tax bracket system. Non-business income would be separately reported in the same return and taxed using the non-business tax rates.
This dual taxing system is certain to lead to complication and controversy. In particular, individual taxpayers with high salaries will want their employers to recast them as business consultants or business contractors. The IRS is certain to challenge this, and taxpayers will resist. An aggressive IRS likely will want to treat existing businesses rendering consultant and contractor services, even if organized in “C” corporate form, as having non-business income. And, those engaged in a renting activity (not normally considered to be a business activity under current tax law) will want to add and appear to be rendering business services to their lessees so as to pull their rental income from the non-business category. Add to all this the “two-bracket bonus” for taxpayers good at tax-finagling, who will arrange to have large portions of their income split between the bottom 15% tax levels in both bracket systems.
Taxation of Non-Business Income
The Plan’s proposals for the taxation of non-business income are a major disappointment to serious income-tax reformers. Essentially, the Plan would re-arrange and even increase the personal tax breaks for individuals and families. The Plan seems almost contemptuous of the goal for a broadened income-tax base and lowered tax rates.
Specifically, the Plan would repeal the personal exemptions, standard deduction, and most itemized deductions. Its next step would be to add a new personal tax credit of $2,000 ($4,000 for joint filers) to offset repeal of the personal exemptions and the standard deduction. The Plan would retain and not repeal the itemized deductions for home-mortgage interest and charitable contributions, to be made available to all taxpayers.
The Plan would retain various child and dependency tax credits, and add a new $2,500 per-child partially-refundable tax credit to compensate for perceived inequities with the payroll taxes. The Plan claims the payroll taxes are too high on parents raising children. Unclear is whether this is an actual problem when viewed in the context of the payroll tax system and the benefits derived from paying into the system. Regardless, this new tax break would have the non-income tax purpose to effect amendment of the payroll tax system without doing so in a direct and forthright manner.
The Plan would not repeal the exclusion of employer-paid premiums for employee health-insurance coverage. Even though the Plan admits this income exclusion for employees is responsible for a huge erosion of the tax base, the Plan justifies continuation of the exclusion on grounds that there first must be a broader reform of the health care system which would “include modification of this exclusion.”
Serious income-tax reformers will regard this justification totally unacceptable, seeing the exclusion as one of the many tax breaks, running counter to the revenue-raising purpose of the income tax, which should be on the chopping block. Not repealing it limits tax-reform rate reduction otherwise possible.
Moreover, its retention and linking any change to health-care reform, suggests that the authors of the Plan may see health-care reform likely moving in the direction of more freedom of choice in health-care coverage. They may envision the addition of new tax incentives and tax subsidies (such as expanded tax-free medical savings accounts) and modifying the exclusion to foster coverage for everyone. The entanglement of new tax breaks with government programs, and making programs dependent upon those tax breaks, will make them even more difficult to curtail (and rates lowered) at a later time.
The Plan would retain another costly tax break, the popular Earned Income Tax Credit (proposed in the Plan to be “retooled” and coordinated with other welfare programs), further limiting income-tax rate reduction. This EITC program is popular because money is so easily dispensed (and does not come from any agency’s budgeted appropriations). But, it is yet another example of a non-revenue-raising program entangled with, and undermining, the revenue-raising functions of the Treasury Department. That point aside, the IRS is ill-equipped to have the responsibility over any welfare program, much less this one, which has been the subject of considerable waste and abuse.
Even though the Plan proposes many significant changes to the income tax, these changes are not such to make the Plan a serious income-tax reform proposal. As already noted, the Plan’s retention and addition of new tax breaks would leave the tax base too narrow to permit a simple, efficient, and low-rate income tax. The Plan even seems oblivious to the corrosive effect which embedded tax breaks have upon the integrity of an income tax system. Like graffiti, they beacon the addition of more tax breaks, fueled by high tax rates giving them value.
Tax breaks are sometimes called “tax-expenditures.” They are a diversion of government tax funding to some other purpose. Embedded in the tax law, they function as spending programs independent of the Congressional budget and review process. They represent not only bad tax policy, but also terrible budgetary policy with this form of government spending left on auto-pilot and insulated from other budgetary spending programs competing for priority. And, as pointed out above, the IRS simply is not suited to be monitoring the effectiveness of these unbudgeted spending programs.
In addition to failing as a base-broadening proposal, the Plan ignores an important design principle for an income tax to be fair and simple in its application that all income should be taxed the same. The Plan draws a distinction between business and non-business income for its dual-tax-bracket system. The present income tax does not draw this distinction, but employs a recipient-based distinction by having different tax-rate brackets depending upon whether the taxpayer is a corporation, an individual, or a trust.
In its second departure from principle, the Plan would continue the design flaw of the present income tax that, in cases where the recipient’s total income is above certain levels, portions of that income are to be taxed at higher rates. This disparate tax treatment is euphemistically called “progressive” taxation, ironically being highly regressive in terms of its adverse impact upon tax simplicity, tax-neutrality, and system efficiency. This disparity causes the income tax to be seen more as a tax on people rather than on income, as is evident in the demagogic assertions that “the rich aren’t paying their fair share.” This view also comes out in the debate over how to reform the income tax when people resist reforms that would take away their deductions and tax credits.
Blissfully, the Plan would build upon this “progressivity” theme. It claims that upper-income taxpayers are tax-favored in deriving a “lessened” tax burden from their deductions. It then proposes having the retained home mortgage deduction “reformed,” this suggesting a capping or having an income-phase-out limitation placed on the deduction. Such deduction limitations function to increase the “progressive” effect on the taxes which the taxed person must pay. And, the Plan’s conversion of exemptions and deductions into tax credits is a design feature to make a tax system more “progressive.”
The Plan’s claim that upper-income taxpayers derive a “lessened” tax burden from their deductions is a cute spin on the fact that all taxpayers derive a lessened tax burden from their deductions. This claim is a further illustration that the income tax is seen by many as a tax aimed at people. If upper-income taxpayers are regarded as deriving an undue benefit from their deductions, this is only because they are already paying taxes at higher rates than other taxpayers. If the other taxpayers were to be taxed at the same higher “progressive” tax rates, they too could derive and enjoy that same tax benefit.
As structured, our income tax system is antiquated and beyond repair. Its very design clouds reaching a consensus on what it would take to make it right. Tax-tinkering reforms – those built upon the existing income-tax platform, without change from existing taxation concepts and design, and where the curtailment of this deduction or that exclusion is traded for percentage-point reductions in the tax rates – is not the way to go. This was the Tax Reform Act of 1986, a major tax reform very much trumpeted at the time, only to be followed by the addition of more tax breaks and higher tax brackets. The aftermath demonstrates that, for there to be true and lasting income tax reform, the focus must be upon redesign as a “good tax,” one which is simple, easy to understand and easy to comply with, not burdensome, tax-efficient, and tax-neutral. It is a “bad tax” which requires an intrusive and punitive IRS to keep it running.
Our existing income tax is called a “progressive” income tax. It seems to be well-described because the term “progressive” is used by physicians to describe a disease that only gets worse!
But, there’s a cure, from a medicine heretofore not taken. Lasting tax reform can only be achieved by taxing all income the same and at the same low tax rate, such that all income – whatever its source, whoever is the payor, whoever is the recipient, and however it might be spent – bears the same fair share of the income tax burden.
James K. Jeanblanc is a CPA and Tax Counsel to the law firm Grove, Jaskiewicz & Cobert in Washington, DC. He is also Senior Fellow for Tax Policy at the Selous Foundation for Public Policy Research, author of The FreedomTax and a contributor to SFPPR News & Analysis.