Tax Reform - What's on the Table and What Might It Mean for You and Your

Clients?

Annette Nellen, CPA, Esq.San José State University

December 14, 2005

Agenda Why tax reform? Income tax versus consumption tax Design features versus type of tax Advisory Panel’s 2 proposals How to evaluate Impediments to reform Where to find more information

Why Tax Reform is on the National Political

Agenda

President Bush not happy with current tax system

January – formed the President’s Advisory Panel on Federal Tax Reform

Tax reform discussions occur every decade anyway

Work of the Advisory Panel

Gather and analyze information Hold public hearings Solicit public comments

“The Panel received thousands of comments describing complexities and burdens, unfair aspects and distortions in the current tax system, in response to its first request [for public comments].”

Report issued 11/1/05

Why are President Bush and others unhappy?Our current federal tax system is …1. Too complex (!)2. Anti-savings3. An impediment to international competitiveness4. Ineffective in collecting all tax that is owed5. Not neutral6. Not perfect in measuring income7. Violates the equity and fairness principle

Here is some evidence of these hypotheses …

Complexity Nat’l T/P Advocate - the “confounding complexity

of the tax code” is the most serious problem facing taxpayers

2003 – 56% of individuals and over 70% of those claiming EITC had a paid preparer

Only 16% of individuals know how long to live in a home to get an exclusion

Code and regs – over twice as long today as 20 years ago

High costs of complexity

Level of U.S. Savings is Low

Taxes earnings from savings (but not all)

Household net savings rates for 2003: France 11.1% Germany 10.7% U.S. 1.4%

Impedes Int’l Competitiveness of U.S. Firms

U.S. tax system different from many trading partners:

1. Worldwide rather than territorial2. Not border adjustable3. No VAT

The world has changed since U.S. int’l provisions created:

1. U.S. share of world GDP declining2. Int’l operations by all size of firms

The Tax Gap is Too Large Difference between taxes owed and taxes paid

on time Between $312 and $353 billion annually for all

types of federal taxes Translates to a non-compliance rate of 15% -

16.6% Individual taxpayers pay, in effect, $2000

annually to “subsidize” non-compliance Size of tax gap is increasing More and more people think it is ok to cheat

The Tax System is Not Neutral View that tax system can fix anything! Often non-tax alternatives are not considered. Often, rule is broader than what is needed:

Home mortgage rule Charitable contributions

Or too many attempts to help: Child credits Education preferences

Result – complexity + often, higher costs to economy and gov’t

Advisory Panel on Neutrality

“We have lost sight of the fact that the fundamental purpose of our tax system is to raise

revenues to fund government.”

4/13/05 statement

Measure of Income has Imperfections Double taxation of corporate income Preference for debt over equity Limitations on capital losses Taxation of inflationary gains Lack of conformity with GAAP Depreciable lives not always tied to actual

life Marriage penalty Preferences for some types of income

Equity and Fairness Problems Why are some things deductible and not

others even though important and affects ability to pay?

If have ER provided health insurance – much better tax deal than buying your own

If live in state with high income and property taxes – you get a subsidy from states with lower taxes

Some Impending Problems AMT taxpayers growing per Advisory Panel:

Today – about 4 million Next year – about 20 million 2015 – 50 million (45% of taxpayers)

Many favorable provisions from Economic Growth and Tax Relief Reconciliation Act of 2001 expire after 2010

Continuing concerns over tax shelters Deficits

Income Tax Versus Consumption Tax

“Major” – “Fundamental” Often a call for replacing income tax

with a consumption tax Or could be significant changes to the

income tax

Consumption

Tax on spending Tax income when spent, not when

saved Various forms: sales tax, VAT, flat

tax, consumed income tax

Consumption Tax Perspectives

Exempts savings Businesses currently deduct investment in

capital (no depreciation) Removes expected future income from the

investment from taxation Doesn’t penalize t/p who earns and saves in

early years and then consumes in later years. Taxes people the same regardless of when they consume. So, encourages savings.

How to tax consumption

1. At point of consumption (sales tax, credit invoice VAT)

2. Consumption = Income less savings A. Cash flow approach – use formula to

determine annually how much money was used for consumption (can be complicated)

B. Tax prepayment approach – exclude income from investments from the tax calculation Example – the “flat tax”

Consumption Tax Considerations Is education consumption or investment? Should there be exemptions (food, medical

care, anything)? What is best type of consumption tax for the US

- Flat tax? National retail sales tax? Some form of VAT? Formula approach? Hybrid income and consumption tax?

Design features vs. Type of tax Problems noted earlier can exist with any type

of tax EX – does income tax have to be complex? (no) Is tax gap unique to income tax? (no) Can income tax fit on a postcard? (yes)

So, really need to ask – Why would/should we replace the income tax with a consumption tax? And how can our system avoid the problems noted earlier?

Advisory Panel’s Final Report

The Panel’s Instructions Options for reform proposed by Panel

must: Be revenue neutral Simplify to reduce administrative and compliance

costs and burdens Have progressivity Recognize importance of home ownership and

charity Promote LT economic growth and job creation Strengthen U.S. competitiveness in global market

by encouraging work effort, saving and investment. Include one option based on the income tax

A few observations

1. Some specific proposals rejected – VAT and national sales tax

2. Flat tax rate structure rejected Revenue neutral rate = 21% (p 55) Not distributionally neutral

3. No call to completely move to a consumption tax

4. Tax design query – what is better, a deduction or credit?

A few observations - 25. Proposes to consolidate many

overlapping provisions in our current system

Could be done w/o the other pieces of the proposals

6. Revenue neutrality was tough Assumed that 2001 and 2004 tax cuts

would be made permanent What to do with AMT?

7. Several commonalities among the two proposals, particularly for individuals (see chart in handout)

A few observations - 3

8. Plans designed to help improve savings and investment by:

1. Provisions to allow for ways to save tax-free

2. Simplification for small businesses should save them lots of compliance dollars

3. Moves tax system towards corporate integration (less double taxation)

4. Improves int’l tax rules

The Panel’s Final Report

2 proposals: Simplified Income Tax

“streamlined version” of our current system (p 59)

Growth and Investment Tax Moves us in a “new direction” by reducing

burden on savings and investment so as to boost economic growth w/o fundamentally changing how the tax burden is distributed. (p 59)

Moves us closer to a consumption tax.

The Two Proposals

Some similarities among the two proposals (see chart in outline)

Many differences – see overview + Panel’s summary table in the outline

Basics of the Simplified Plan

Base broadened Double taxation almost completely removed Business taxation depends mostly on the size based on gross

receipts Businesses with $10 million or less of GR must use

“designated bank accounts” Attempt to have only a single layer of tax at entity level Simplified cost recovery system – 4 categories of assets Territorial rather than worldwide for active business income Only tax preference for business that remains is accelerated

depreciation. Credits, §199, and even state and local tax deduction and exclusion for tax-exempt income gone.

Basics of Growth & Investment Tax Plan Moves us closer to a consumption tax. Dividends, capital gains and interest income (other than

tax-exempt) subject to 15% rate for individuals. Business cash flow base; subject to 30% rate (other

than sole proprietorships) All business purchases are immediately expensed International transactions taxed on destination basis

(tax rebated on exports and imports not deductible from base)

Losses not refundable. Panel recommends interest factor be added to loss carryforwards.

Transition rules suggested.

Missing pieces

How much does federal gov’t need to raise? Need to look at spending? Need to consider the appropriate

baseline – should it be one producing deficits? One that expects that proposed tax cuts will happen?

Missing pieces - 2

How progressive should a system be? Simplified plan removes very top and very bottom brackets. W/o changes, top bracket in 2011 will be 39.6%, so 33% top rate in plan is low.

What social policies do we want in the tax law? How much benefit for low-income?

Missing pieces - 3

Int’l tax policy discussion – not there How do the plans tie to needed

reforms in Social Security and Medicare?

Is ability to pay met? It appears that medical, casualty and unreimbursed EE business expenses are eliminated.

How to Evaluate Proposals - Principles of Good Tax Policy

AICPA’s Tax Policy Concept Statement 1 – Ten Principles

1. Equity and fairness

2. Certainty

3. Convenience of payment

4. Economy in collection

5. Simplicity

Principles of Good Tax Policy 2

6. Neutrality

7. Economic growth and efficiency

8. Transparence and visibility

9. Minimum tax gap

10. Appropriate government revenues

10 principles - Questions

Equity and Fairness What is the distributional effect? How does the mix of tax on labor and

capital change? Is there transitional relief? Is it regressive? Less progressive? What will be the likely perception of

fairness among different groups of taxpayers?

Certainty

Are key principles stated so taxpayers can determine how the system applies to all transactions?

What is the relationship of the effective date and when the IRS can issue forms and guidance?

Convenience of Payment

Will there be more taxpayers or fewer required to file returns?

Have technological solutions been considered for collection and assessment?

Economy of Collection

Is there an estimate of compliance costs and gov’t administrative costs?

Have less expensive alternatives been considered?

Simplicity Has a complexity analysis been

performed? Have practitioners been consulted? Have consistent definitions been

used? If states don’t also conform, will

simplification be achieved?

AICPA Tax Policy Concept Statement #2 - Simplification

Neutrality

Does the proposal favor one type of taxpayer or industry over another? Or one type of income over another?

Have the direct and indirect effects of the proposal been considered in determining if any type of t/p is favored or disadvantaged?

Economic Growth & Efficiency

Economic analysis to show impact to all types of t/ps, federal and state governments?

If states don’t conform, will economic goals be achieved?

How will transition impact the economy? Are preferences targeted narrowly to achieve

the intended purpose? How do tax liabilities move in relationship to

changes in economic conditions?

Transparency and Visibility How will t/ps know how much of the tax they are

paying and when it is being imposed upon them? Is t/p’s effective marginal tax rate same as

statutory rate? (example – no phase-out provisions) Have deceptive provisions, such as AMT, been

avoided? Have multiple effective dates and sunset dates

been avoided?

AICPA Tax Policy Concept Statement #3 - Transparency

Minimum Tax Gap

How will compliance be enforced? At what cost?

Will the tax gap likely go up or down?

Appropriate Government Revenues Revenue neutral? Which levels of gov’t will be impacted? Impact to state and local gov’ts if provisions

are eliminated that produce direct or indirect benefits to them, such as muni bond interest exclusion, enterprise zone credits, etc.

Will states be able to conform? Will revenues likely be stable over time? Will revenues grow as economy grows?

Impediments to major reform The significance of the change Transition rules – should there by any? Cost?

Any benefit of income tax carryovers? What about previously taxed funds that will

get taxed again when consumed? What about debt financing for massive

consumption before consumption tax starts? Every current provision has a group that will

fight to keep it. Concerns of state and local governments

Impediments to major reform 2

Impact to current systems and ways of thinking – will taxpayers want a major change?

Personal financial planning Employee benefits Debt financing strategies Form of entity Many others

Uncertainty of impact on economy now and later Lack of specific goals for change

Impediments to major reform 3

How to do the revenue estimate under a vastly different system? What if we get it wrong? What is the

impact to the economy? Dealing with the missing details

(business vs investment, reorganizations, accounting rules, etc.)

Politics

Where to Get More Information

Numerous reports exist – JCT, CBO, CRS, trade associations, AICPA, others

Advisory Panel website Tax Reform Website with more

information + many links: http://www.cob.sjsu.edu/nellen_a/