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

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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

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Agenda

• Why tax reform?
• Income tax versus consumption tax
• Design features versus type of tax
• Advisory Panels 2 proposals
• How to evaluate
• Impediments to reform
• Where to find more information

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Why Tax Reform is on the National Political
Agenda

• President Bush not happy ? with current tax
  system
• January formed the Presidents Advisory Panel
  on Federal Tax Reform
• Tax reform discussions occur every decade anyway

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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

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Why are President Bush and others unhappy?

• Our current federal tax system is
• Too complex (!)
• Anti-savings
• An impediment to international competitiveness
• Ineffective in collecting all tax that is owed
• Not neutral
• Not perfect in measuring income
• Violates the equity and fairness principle
• Here is some evidence of these hypotheses

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Complexity

• Natl 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

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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

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Impedes Intl Competitiveness of U.S. Firms

• U.S. tax system different from many trading
  partners
• Worldwide rather than territorial
• Not border adjustable
• No VAT
• The world has changed since U.S. intl provisions
  created
• U.S. share of world GDP declining
• Intl operations by all size of firms

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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

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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 govt

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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

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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

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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

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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

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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

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Consumption

• Tax on spending
• Tax income when spent, not when saved
• Various forms sales tax, VAT, flat tax, consumed
  income tax

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Consumption Tax Perspectives

• Exempts savings
• Businesses currently deduct investment in capital
  (no depreciation)
• Removes expected future income from the
  investment from taxation
• Doesnt 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.

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How to tax consumption

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

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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?

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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?

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Advisory Panels Final Report
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The Panels 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

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A few observations

• Some specific proposals rejected VAT and
  national sales tax
• Flat tax rate structure rejected
• Revenue neutral rate 21 (p 55)
• Not distributionally neutral
• No call to completely move to a consumption tax
• Tax design query what is better, a deduction or
  credit?

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A few observations - 2

• Proposes to consolidate many overlapping
  provisions in our current system
• Could be done w/o the other pieces of the
  proposals
• Revenue neutrality was tough
• Assumed that 2001 and 2004 tax cuts would be made
  permanent
• What to do with AMT?
• Several commonalities among the two proposals,
  particularly for individuals (see chart in
  handout)

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A few observations - 3

• Plans designed to help improve savings and
  investment by
• Provisions to allow for ways to save tax-free
• Simplification for small businesses should save
  them lots of compliance dollars
• Moves tax system towards corporate integration
  (less double taxation)
• Improves intl tax rules

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The Panels 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.

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The Two Proposals

• Some similarities among the two proposals (see
  chart in outline)
• Many differences see overview Panels summary
  table in the outline

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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.

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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.

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Missing pieces

• How much does federal govt 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?

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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?

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Missing pieces - 3

• Intl 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.

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How to Evaluate Proposals - Principles of Good
Tax Policy

• AICPAs Tax Policy Concept Statement 1 Ten
  Principles
• Equity and fairness
• Certainty
• Convenience of payment
• Economy in collection
• Simplicity

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Principles of Good Tax Policy 2

1. Neutrality
2. Economic growth and efficiency
3. Transparence and visibility
4. Minimum tax gap
5. Appropriate government revenues

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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?

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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?

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Convenience of Payment

• Will there be more taxpayers or fewer required to
  file returns?
• Have technological solutions been considered for
  collection and assessment?

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Economy of Collection

• Is there an estimate of compliance costs and
  govt administrative costs?
• Have less expensive alternatives been considered?

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Simplicity

• Has a complexity analysis been performed?
• Have practitioners been consulted?
• Have consistent definitions been used?
• If states dont also conform, will simplification
  be achieved?
• AICPA Tax Policy Concept Statement 2 -
  Simplification

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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?

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Economic Growth Efficiency

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

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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/ps 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

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Minimum Tax Gap

• How will compliance be enforced? At what cost?
• Will the tax gap likely go up or down?

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Appropriate Government Revenues

• Revenue neutral?
• Which levels of govt will be impacted?
• Impact to state and local govts 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?

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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

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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

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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

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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/