Tax Reform Is Calling

by Steve Stofka

December 17, 2016

On our journey on the sea of life, we sometimes hear the siren call of politicians who promise simple taxes. “File your taxes on a postcard” their voices echo across the waters as they invite us to their island. Our journey is long and treacherous, so we are drawn to the prospect of simple tax filing.

Some taxpayer boats weave through the sharp rocks that lay just off the sandy shores of the simple tax island. They are greeted by the politicians who give them postcards to celebrate their arrival. Many boats are caught in the turbulent waters and are swallowed up by the tax monsters lurking in the sea.  “Alas!” they wail as they curse themselves for their attraction to the politicians’ call.

So the story goes with the tax bill that Republicans hope to pass next week. I didn’t think that the bill would get this far.

Many paycheck employees will find the new tax rule simpler. Student loan interest will continue to be an “above the line” deduction from income. The child tax credit will be doubled to $2000. To satisfy Republican Sen. Marco Rubio’s demands, more of this credit will be refundable to those taxpayers who pay little or no income tax.

Those in high tax states will suffer under the new tax bill, which allows only $10,000 in combined deductions for state, local and property taxes (SALT). Deductible mortgage interest will be capped as well. Tax policy has long subsidized homeowners over renters and favored those in coastal states (NY Times article).

Many taxpayers will find it more advantageous to take the newly doubled standard deduction of $24,000.  Under the new law, 529-college funds can now be used for K-12 tuition and qualified expenses.

Caught in the rocks and turbulent waters are professionals and business owners, who have adopted “pass-through” ownership structures to legally minimize taxes under current law. This group accounts for 30% of all business income. As this Journal of Accountancy article notes, court rulings and IRS guidance can be complex and contradictory. The new tax bill only complicates the familiarity of the existing complexity.

These non-paycheck earners receive all or part of their business income through a Sub-S corporation, an LLC, or partnership. Unlike a conventional C-corporation, these businesses “pass through” their profits to the owner/partners who pay at a personal tax rate. Under the new tax bill, some of that income may be subject to a 20% exclusion from taxes.

Under the new tax bill, the tax rate for C-corps will be reduced to 21%. Depending on individual circumstances, some owner groups may find it advantageous to adopt a C-corp ownership structure.

25 million sole proprietors  account for 11% of non-farm business income. Many are low-profit or part-time businesses which will remain sole proprietors. Higher volume businesses may want to revisit their ownership strategies with their accountants.

Corporations will benefit from the reduced tax rate but the accountants for publicly held corporations are dreading the prospect that the new tax law will be signed before the new year. Under GAAP accounting rules, those corporations must estimate the effect of the tax changes and present those estimates at the next earnings announcement which are scheduled for late January or February. Number crunchers can cancel that Cabo vacation during Christmas week.

The rich benefit because they pay an outsize portion of income taxes. According to the IRS (2016 tax stats on this page) , taxpayers with adjusted gross incomes (AGI) above $500K were only .8% of the 150 million individual returns. Their AGI was 19.4% of the $10 trillion in income reported, but they paid 36.5% of the $1.4 trillion in Federal income taxes.

TaxSumByAGI2016

These high incomes will get a reduction in taxes from 39.6% to 37%. The very rich – those with an AGI above $10 million – get half of their income from capital gains, which are not affected by the new tax law. Despite promising to do so, lawmakers did not reduce or repeal the 3.8% Obamacare tax on investment income for high income taxpayers. Based on 2016 tax data, they probably could not forgo the tax revenue and keep the ten-year cost of the bill under $1.5 trillion.

In short, the new bill will create two classes of taxpayers – the postcard and non-postcard payers. Some tax preparers and accountants may worry that the new law will reduce their business. Rest assured – Congress does not know how to write tax laws that are not complex. Thank God for politics!

Income Tax Revenues

Conservatives have repeatedly argued that even though tax rates were cut during the Reagan administration, federal tax revenues have increased in almost every year.  Is this true?  YES.  The Tax Policy Center presents a history of federal tax revenues from the Office Of Management and Budget (OMB).

BUT, what conservatives don’t acknowledge is the effect that Social Security revenues have had on total tax revenues. Combining a history of Social Security revenues with the history of total Federal tax revenues, I created a chart to show the effect that increasing Social Security revenues have had on total federal tax revenues.

As you can see, it has been dramatic.  When we subtract Social Security revenues from total federal tax revenues, we see that, contrary to what conservatives maintain, income tax revenues in constant 2000 dollars have not increased almost every year since the Reagan era tax cuts.

The larger income tax revenues of the 1990s was due not to a decrease in tax rates but to an increase in tax rates on the upper income brackets.  As the stock market experienced the “irrational exuberance” of the 1990s, capital gains taxes increased dramatically. 

Have the Bush tax cuts of 2003 contributed to more tax revenues?  Yes, BUT most of the revenue gains were again from capital gains taxes.  As the stock market dramatically declined in the latter part of 2008, capital gains and the taxes on those gains evaporated.

The decrease of income tax revenues accelerated in 2009 and although the chart does not show it, the constant dollar income tax revenue in 2009 was about the same level as 1980.