Subject: tax reform
Comment: April 28th, 2005 Ron Stram
3108 Village 3
Re: Tax Reform.
Dear Panel Members;
I have just read an article in last Sunday's L.A. Times about your solicitation of public input for tax reform with a Friday email deadline. I have recently retired from the business of preparing income tax returns for the public after 31 tax seasons, and I have a BA in economics from UC Santa Barbara class of 1970. Also, I have always had a keen interest in tax reform and I will try to give you my ideas in this limited space and time.
Apparently the ground rules are: simplicity, progressive rates, and protecting home mortgage interest and charitable deductions. These parameters already create their own problems. Simplicity and progressive rates do not go hand in hand, although I will try to consolidate these approaches (see wages below). I don't think anyone has a problem with a home mortgage interest deduction, but keeping charitable contributions is politically motivated and therefore biased. Bias is what keeps the tax code so complicated. I will attempt to give you my line-by-line analysis of 1040 highlights as briefly as such a complicated subject will allow, with alternatives where possible to stay within your parameters. Also, I do not have all the facts and figures I would need to be truly detailed, so I will try to state my position in general terms wherever possible.
Presidential Election Campaign
Matching funds are not determined by answering this question. This is just some kind of poll. It can be eliminated.
All the juggling of deductions and exemptions and various limits put on single, married, married filing seperately, head of household and qualifying widow(er) can be eliminated by getting rid of the joint return. Several non-community property states do this already, allowing married people to combine their numbers if they want, without penalty. The standard deduction and personal exemptions should be adjusted higher in any case (see below), and this would make the advantage of the Head of Household and Qualifying Widow(er) status unnecessary.
All taxes are regressive by nature. Some hurt the economy more than others. A tax on earned income is the most regressive of all. When you start out in life working, that's the time you can least afford to pay tax. This tax was last instituted to fund WWI, and should be fair game during national emergencies, but otherwise it shouldn't even exist whenever we can afford not to have it.
Their are two major schools of thought on how the American people should be taxed:
A. The wealthier citizens have benefited the most from our system and should pay a progressive tax rate; and
B. It's prejudicial to tax different citizens at different rates (flat tax).
I believe it's possible to incorporate both these positions by taxing different kinds of income at different rates, and adding a limited national sales tax. The rate on earned income should be as low as possible, to be determined by tax revenue collected from other proposals (see items below).
Interest and Dividends
Interest on the national debt is about 12% of the federal budget. A flat tax on interest and dividends could be collected by banks and brokerage houses, perhaps at a rate that would pay for this part of the budget. If a taxpayer doesn't have adjustments in this category this income may not have to be on the return at all. That would be most people.
For others, schedule B should be a place where they can deduct investment interest. Investment interest is a business expense, and it should be treated as such.
Taxable State Refunds
States have three main ways of collecting revenue: income taxes, sales taxes, and property taxes. You used to be able to deduct any and all of them, and that was fair because each state levied each type of tax differently. Then the sales tax was eliminated, advantaging some states at the expense of others. Recently the sales tax deduction has been reintroduced in a limited way as an option in lieu of income tax, but this still is not a fair solution, especially if you live in New Hampshire where there is no property tax. The argument for this whole category is one of double taxation; using previously taxed income to pay other taxes. It's not a good argument, however. We pay all kinds of excise taxes and 'fees' that are not deductible. And these taxing agencies are state, not federal. To properly compute the amount of income to report you need to go through a complicated tax benefit calculation which most people will not know or care to do; instead they just report the whole thing. The best solution for this category is not to allow a deduction for state taxes at all.
Alimony, Business, Rentals
Alimony has been ajudicated into the class of earned income. You can fund an IRA based on alimony income. It should be a schedule C item, allowing legal expenses, etc., and the net subject to social security tax.
One of the most complicated parts of schedule C is depreciation. I have never met one lay person that understands it. Tabulate all assets into narrow life ranges with some wiggle room, and allow straight-line, 150% remaining balance, or 200% remaining balance with optional mid-year convention and leave it at that. Use the old investment tax credit to stimulate the economy when that's what's needed instead of fiddling with depreciation. Also, remove the luxury auto limits; they're completely antiquated and were too low even back when they were first initiated.
Owning and operating a rental property is in reality an active business. Net profit is not subject to social security tax, but it should be. Owners argue that it's their capital investment that's doing the work, but it's no different from a factory that uses machinery to manufacture widgets. Allow rental property owners to amortize their land investment and then tax the net profit like any other business.
There are lots of other issues in this category, but I do not have time here to cover them all. You get the idea, though. Make rules uniform, apply them equally, and simplify procedures wherever possible.
Capital Gains and Losses
This is another category that should be subject to a flat tax. The only fair way to report long-term gains, however, is to reduce them by some sort of inflation factor before computing the tax. Also, the $3,000-/year capital loss limitation should be eliminated. A loss in this area is a loss from an activity that was conducted for profit, and it should be deducted in totem, just like any other business loss. I would add here that employee stock options might be recharacterized as capital transactions and subject to this flat tax if tax rates on earnings end up being less.
All pensions are made up of original contributions and accumulated interest that has been allowed to compound without the handicap of annual taxation. I propose that all pension withdrawals be tax free up to the amounts of the original contributions, similar to the old "three-year rule" of computing the taxability of pensions, except without the three-year part. Then the remaining distributions could be taxed at the flat interest rate. The standard deduction and personal exemption would still protect lower income seniors from paying any tax.
This would work with social security, too. In fact, when it comes to 'ownership' of your social security account, the original contribution amount could be refundable to a person's estate if they didn't survive long enough to collect it. The average social security account consists of about 15% of original contributions.
Social security, medicare and medicaid are all hot button issues right now. Without trying to sound political, the bottom line is that these programs are supposed to be self-sustaining. These monies should remain segregated and not go into the general fund. The number of people covered, the income levels subject to tax, and the distribution of benefits can all be tweaked to keep the program solvent.
In addition, all programs that exist for the benefit of employees should be funded by those employees. That would be all of social security (not just half), and unemployment insurance. This would create a more fair system less subject to employer abuse, and make it easier for small businesses to start and operate. Corporate tax rates could be adjusted upwards to recoup an employer windfall until the market readjusts to a different wage structure, and taxpayer rates could be adjusted down to compensate and make this transition revenue neutral.
The biggest problem with taxing this is that it's usually not subject to withholding, and by the time a taxpayer files their return they've been out of work for some period of time and are less able to pay their tax or they won't receive a much needed refund. If you're going to tax it, it should be subject to mandatory withholding.
Adjustments to Income
All job and investment related expenses should be allowed above the line, similar to the old 2106 rules but with investment expenses added. Some kind of small deductible could apply, like $500- or $1,000-, to eliminate the paperwork needed to claim minor expenses.
Pension rules are very complicated and applied unfairly in the tax code between working people and business owners. A salaried person has all kinds of limits to follow to determine if they can even have an additional plan outside of work, whereas a business owner can use defined benefit plans and the like to deduct up to 30% of net profit, even more in some cases. Create a fixed percentage of income for everyone that can be set aside for retirement; then, if an employer isn't allowing that much in their plan, a person can open a deductible IRA for any part of the balance that they feel they can afford. Eliminate defined benefit and defined contribution plans; make all payments voluntary and flexible.
If you want to promote health insurance, allow everyone to deduct their health insurance premiums in total here. Also, allow all health insurance plans to qualify for HSA accounts.
Eliminate the penalty on early withdrawal of savings by having banks report CD interest as earned according to constructive receipt rules, i.e. the amount of interest actually earned if the taxpayer had withdrawn it.
You can't get rid of the medical deduction as long as the medical industry is operated by the private sector. People are always going to have major medical expenses that they have to pay, and they must be able to deduct them from their taxable income.
Nobody wants to get rid of the home mortgage interest deduction. Everyone should have systemic help in acquiring and holding on to a home of their own. But a second home? And what about the QMI rules, limiting the home equity loan interest deduction to the interest generated by the first $100,000-, regardless of rates. A more than fair approach would be to limit debt service to $750,000- in mortgages ($1.5M for combined returns), but applied to all homes of the taxpayer(s), and eliminate the QMI rules.
This administration's bias is to let religious organizations do the government's social work and to subsidize them. In addition to that, subsidies are only being given to protestant Christian churches, another bias. I believe in the separation of church and state, and that charity is just that, charity. There shouldn't be any deduction for it at all, except on estate returns. This is not one of the choices however. I therefore propose that a 10% AGI limit be imposed on this deduction, similar to casualties. This would eliminate most taxpayers taking a deduction in this category, except those that tithe more than 10%. This is also probably the most abused deduction, as the fair market value of donated property is extremely subjective.
I've hardly seen a casualty loss deduction since the rules were changed to apply a 10% AGI deductible for each event. The 10% AGI deductible is probably okay, but I have seen clients with multiple events in one year and I do believe the per event limitation should be removed.
The phase-out on schedule A for high income people should be eliminated. There are already limitations built in to the medical, mortgage, and casualty sections. If you eliminate state taxes, put investment interest on schedule B, put a deductible on charity, and move miscellaneous job and investment related expenses above the line you don't need a phase-out.
Standard Deduction & Personal Exemption
The standard deduction and personal exemptions should be set at such a level that someone living below the poverty line does not have to pay any tax. Now you say, that's about what it is currently, but that's not true. The original 'poverty level' was calculated by a clerk who figured out how much it cost to eat in a year, and this figure has been adjusted for inflation ever since. The reality is that a single person working full time for minimum wages cannot afford a studio apartment in almost all metropolitan districts and still have enough money left over for the basics of life. Redefine what the poverty line should be and then compute what the standard deduction and personal exemptions should be. Don't phase out personal exemptions for high income people; they all consider this very unfair.
(Note: inflation adjusters are out of whack, too.)
Net Operating Loss
This should be based on the bottom line, after deductions and exemptions and without regard to business applicability. After all, as far as Uncle Sam is concerned, you are the business. You should also be allowed to carry it forward indefinitely.
The alternative minimum tax was instated to make sure wealthy people paid some tax. The common misbelief was that some savvy investors could invest in things with so much write-off that they ended up not ever owing any tax. Well, the economic reality of this is that the money goes directly into stimulating the economy (except for obviously fraudulent schemes). So what if a few people don't owe any income tax in a particular year; their money is probably doing more good for the economy as venture capital than channeling it through government. It's not even necessary to discuss bracket creep and a plethora of unbelievably complex rule changes. Abolish the AMT.
Foreign Tax Credit
Foreign taxes paid should be a 100% credit of U.S. tax rates if the same income is being taxed, without the complicated formulas tied to deductions. You should be able to carry unused credit forward indefinitely. You should also be allowed to claim some amount without having to file form 1116 as many people have minor amounts reported through mutual funds with foreign holdings. There actually is a way to do that now up to $400, but you have to file a separate piece of paper to do it quoting the regulation; that shouldn't be necessary.
Child Care Credit
If you want to be family friendly, don't limit the credit to two children; and increase the limit per child to accurately reflect actual child care costs for two full-time working adults.
Additional Tax on IRAs
The early withdrawal penalty on IRAs is draconian. I've seen families in real binds having to use these funds and then get saddled with federal and state income and penalty taxes up to 50% of withdrawals when they can least afford it. They know it's their retirement account; that's why they funded it in the first place. It's enough to tax the proceeds.
Same argument regarding seniors who don't take enough money out of their IRAs after age 70 1/2. It's hard enough being old and it's their money; let them handle it.
Household Employment Taxes
The rules for household employees are too complicated for the general public. Most people ignore them; and a lot of people just pay cash and forget about it. It's not hard to give someone a form 1099, however, and let them figure their own taxes. Change the rules to allow people to issue a 1099 to household help, even if they are their only employer. The wage versus tax situation will sort itself out, and compliance will go way up.
Earned Income Credit
This program was supposed to rebate a low income worker's social security tax if they had children while still crediting their social security account. Since it's inception it has been expanded and naturally made more complicated, so that now a low income person generally has to pay for professional help to get what they're entitled to. Go to the basics on this one. Rebate actual social security tax withheld, with some kind of simple phase-out based on redefined poverty lines.
It's unfair and unreasonably complicated to use different parameters for calculating next year's estimates for high income people. 100% of last year's tax or 80% of what you end up owing should be good enough for everybody.
I saw the value added tax at work in England many years ago. It was very high, about 35%. It would have to be very high here too to replace the income tax; I've seen estimates of 25%. It was extremely regressive in England, putting hard brakes on all new purchases. The second-hand market, however, was thriving, where there were no taxes at all. I do believe a national sales tax has a place, but to be enforceable and accepted it has to be in the same range as states use today. Perhaps the rate could be tied to expenditures in social-aid programs, about 8% of the budget.
In conclusion, the above just touches the surface of the problem. This is a very large and complex economy. It would be to everyone's benefit to eliminate all special interests in the tax code. If that's not possible, keeping them down to the barest minimum will delay the inertia of future complications that always result from some people getting favored treatment. I hope my contribution is of help.