This column originally appeared on TaxVox.
Among the most complex provisions of the Tax Cuts and Jobs Act (TCJA) is its special tax deduction for income earned by pass-through businesses. In an attempt to prevent the new tax break from turning into an unmitigated revenue loss for the Treasury, Congress created a set of complicated “guardrails” to limit its use. Almost all tax experts agree that many businesses will need to consult tax lawyers and accountants for years to come to minimize taxes and insure compliance with the new law. Perhaps millions will change their form of ownership. Some taxpayers will also find it desirable to create multiple layers of corporations, partnerships, and other pass-through businesses, with varying degrees of ownership, to minimize their tax burden.
Yet, the official “complexity analysis” that accompanies the just-passed TCJA falls far short of telling the real story of how challenging this provision will be for many business owners.
In 1998, Congress enacted the IRS Restructuring and Reform Act that, in part, required the staff of the Joint Committee on Taxation, in consultation with the Internal Revenue Service and the Treasury Department, to provide a tax complexity analysis “for all legislation reported by the Senate Committee on Finance, the House Committee on Ways and Means, or any committee of conference.” The analysis is supposed to specify any added costs or additional recordkeeping for individuals and small businesses, as well as any need for regulatory guidance.
As required, JCT did produce such an analysis just before the House passed the TCJA and again just before Congress adopted a final bill. But because Congress produced the TCJA in less than two months, it appears that JCT, IRS, and Treasury were overwhelmed with other work and simply did not complete a proper complexity analysis. The pass-through provisions are the most striking example of this shortcoming.
Some provisions of the new law attempt to deter employees from converting themselves into a business or independent contractor to benefit from this tax break. Others attempt to separate “owners” from “employees” even when both make the same amount of money from the same partnership. Limits are placed on the deduction for income from “personal service” companies. Other limits are based on taxable income or wages paid. Meanwhile, because Congress established a corporate income tax rate that is significantly lower than the individual income tax rate, businesses must decide whether to organize specific business activities as pass-through entities or as a taxable corporation.
Here is JCT’s full analysis:
It is estimated that the provision will affect over ten percent of small business tax returns.
It is not anticipated that individuals will need to keep additional records due to the provision. It should not result in an increase in disputes with the IRS, nor will regulatory guidance be necessary to implement this provision. It may, however, increase the number of questions that taxpayers ask the IRS, such as how to calculate qualified business income and how to apply the phaseins of the W–2 wage (or W–2 wage and capital) limit and of the exclusion of service business income in the case of taxpayers with taxable income exceeding the threshold amount of $157,500 (twice that amount or $315,000 in the case of a joint return), indexed. This increased volume of questions could have an adverse impact on other elements of IRS’s operation, such as the levels of taxpayer service. The provision should not increase the tax preparation costs for most individuals. The IRS will need to add to the individual income tax forms package a new worksheet so that taxpayers can calculate their qualified business income, as well as the phaseins. This worksheet will require a series of calculations.
The analysis says the provision will affect “over ten percent of small business tax returns.” But a number between 10 percent and 100 percent is not very informative, and in any event, there are millions of small businesses.
The analysis asserts that “[i]t is not anticipated that individuals will need to keep additional records” and “[i]t should not result in an increase in disputes with the IRS nor will regulatory guidance be necessary.” This seems implausible at best given the obvious potential for gaming this provision.
The analysis’s claim that “[t]he provision should not increase the tax preparation costs for most individuals” is downright misleading. Since most individuals are not business owners, it is self-evident that their costs won’t increase due to this provision. But the real question, which the analysis does not answer, is what about those individuals who are business owners—or employees who can convert to being business owners as independent contractors? Almost surely, the increased record-keeping alone should increase costs.
Perhaps most importantly, the analysis is silent on the required planning “costs to taxpayers” that nearly always exceed those associated with filing tax returns.
As a former Treasury official, I greatly respect those nonpartisan offices that serve the public so well, such as the JCT and the Treasury’s Office of Tax Policy. I once dedicated a book to IRS personnel, who do the thankless task of reducing the share of the taxes borne by honest taxpayers. So, I do not make this criticism of their work product lightly.
In the case of the complexity analysis of the TCJA, these agencies have more work to do to fulfill the spirit of the law, not just its letter. More important, Congress needs to legislate in a way that allows staff to fulfill the 1998 statutory mandate.
Thanks to Robert Pear of The New York Times, who first asked me about the House bill’s complexity analysis.
- that presidents, Cabinet members, legislators, and other elected officials would be held to the same ethical standards and penalties for wrong-doing as entry-level civil servants;
- that Congress would attack sycophancy directly by slashing the number of political appointees and the larger number of would-be appointees who view it as the route to power;
- that the media would examine how its pursuit of stories with sensationalism and conflict has been exploited by terrorists and unethical politicians alike to garner attention and power;
- that news shows would recognize that interviewing paired Democrat and Republican spokespeople leaves out the plurality of people whose expertise, not political leanings, drives what they say;
- that more voters would stop equating so much of their personal identity with some political party banner so they would find it easier to object strongly to the wrongful actions of those for whom they voted;
- that laws would be written to penalize more the individuals who are ultimately responsible for corporate misbehavior and less the consumers and workers who often bear the costs;
- that churches claiming to prioritize the poor would come to recognize the symbolism of keeping the poor box at the back of the church and passing a collection plate for the poor only after passing one for themselves;
- that athletes signing lucrative contracts would start negotiating over money for community and public purposes rather than just themselves;
- that charities would unify around promoting the good and addressing the bad in their midst; and
- that everyone of goodwill would take heart by recognizing how important you are for bringing order out of disorder, peace amid conflict, and, for me, a continuing sense of thankfulness and hope.
This post originally appeared on TaxVox.
Bismarck is credited with the warning: “If you like laws and sausages, you should never watch either one being made.” It is never truer than with tax legislation, and Tax Cuts and Jobs Act (TCJA) is no exception.
Even the Tax Reform Act of 1986, held by many as a model of reform, resulted in its fair share of deform and complexity. The reason then was the same as it is today: Accommodating the demands of lawmakers requires special interest give-backs (reversing or modifying proposed reforms) that are, in turn, paid for with badly-designed and gimmicky revenue-raisers.
Here are just a few examples of how either the House or Senate Finance Committee versions of the TCJA would move backward from stated goals of reform: While their aim is to lower tax rates, they’d create backdoor individual income tax rate increases. They’d delay the effective dates of some provisions and make others temporary, decrying the use of such gimmicks in current law, then almost bragging that “a lot of this is a gimmick” in defining their own efforts. They’d raise taxes for many families with children in the name of reducing taxes to help them meet their living expenses, and they’d make some business taxes more complex while purporting to simplify them.
“Bracket creep” that raises average tax rates. As peoples’ incomes rise over time due both to real wage increases and inflation, they move into higher income tax brackets. Current law protects them in part by indexing the tax code for inflation using the Consumer Price Index. But the House and Senate Finance bills would use a less generous inflation index so tax rates rose more quickly as people moved into higher tax brackets faster and indexed tax credits would grow more slowly. The effect is relatively modest to start but it compounds decade over decade.
A new bubble tax rate. Copying one gimmick from the ’86 Act, the House bill would require people with moderately high incomes to pay a 6-percentage point surtax. My colleague, Bill Gale describes how this and other provisions would create a hidden combined top marginal tax rate of 49.4 percent. But the House bill adds yet another gimmick that would raise marginal tax rates even faster on more people.
The added glitch in creating a bubble top rate. Though the 1986 law, too, imposed a surtax on some taxable income, it was made transparent in a new tax rate table that showed rates of 15, 28, 33, then 28 percent. The 33 percent rate wiped out benefits of the lower income tax rates. The new bill requires a new more complicated calculation because the surtax is imposed on adjusted gross income, not taxable income. As a result, more people pay the surtax and adjustments to income that reduce taxable income, such as charitable deductions, are disallowed for purposes of the surtax.
Exchanging a higher standard deduction and an indexed child credit for removal of personal exemptions. This combination of tax policies was not based on any theory of taxation of the family. Elsewhere I have explained how it arose in response to simplistic proposals to double the standard deduction. And my colleague Elaine Maag gives examples of some of the losers. One tradeoff: Displacing a personal exemption indexed for inflation while adding a child credit that for most households would not be indexed for inflation would gradually increase taxes on families with children in a bill that is touted to be pro-family. And, oh, the standard deduction isn’t being fully doubled.
The new partnership and flow-through business rules. My colleague Steve Rosenthal details some of the problems with the new proposals for taxing “pass-through” businesses such as sole proprietorships, S-Corporations, and partnerships. These ideas would be extremely complicated for taxpayers. They’d also violate a key principle of the ’86 Act—that top income tax rates would not be greatly different for different types of income, whether earned by workers or owners, corporations or partnerships. Noncorporate tax law, in turn, has long recognized the near-impossibility of trying to distinguish returns for labor from those for capital. The traditional solution: set similar top rates for all types of income and all types of owners.
But the House and Senate bills turn this on its head by trying to lower taxes for corporations and some other business owners, but not for workers or working owners of some firms. The big winners are the lawyers and accountants already making millions of dollars finding ways to save their clients billions of dollars by changing ownership arrangements in new, creative, ways.
As Bismarck knew, the price of any “reform” is often the deal-making necessary to round up votes. If the net result is better law, these changes may be the cost of doing political business. If not, it is just worse tax law.
This post originally appeared on Forbes.
Saying that one is for tax reform doesn’t provide much information about what is being sought or how to do it. Potential options extend almost infinitely, as do amendments to any set of options. So how does one both focus and ensure that reform, proposed or enacted, serves the public in a meaningful way? Here I identify eight lessons that were vital to the organization of the Treasury study (“Treasury I”) that led to the Tax Reform Act of 1986, the only comprehensive base-broadening tax reform in the hundred-plus history of the income tax
- Know the unique requirements and opportunities of the time. No past reform is repeatable. Today is not yesterday. Society today has new needs, different things to fix, novel opportunities, and changing leadership. The 1986 reform was made possible by many factors, including growing tax shelters that everyone agreed were unfair and inefficient, a President who cared about tax rates more than just about anything else, high levels of productivity as baby boomers moved into their peak earning years, Congressional leaders like Senators Bill Bradley and Jack Kemp who had been promoting tax reform, and budget acts in 1982 and 1984, along with Social Security reform in 1983, that left room for at least a reform that didn’t have to raise revenues.
- Don’t try to build up reform out of a stack of wants. The more politicians try to organize reform by supporting a bunch of giveaways, as opposed to allowing tax experts to give them viable options for fixing different parts of the system, the more that they are likely to suggest provisions that don’t add up, are inconsistent, fail to meet stated objectives, can’t be administered, and cause other unintended consequences.
- Use principles, not symbols, to drive choices. I’m not so naive as to believe that symbols aren’t important. That’s why every tax bill, no matter how much it deforms, tends to get the label of “reform.” But principles should guide where one is going, and create borders to deter consideration of items that don’t meet any principle well. Tax policy principles center on: equal justice or equal treatment of equals or “horizontal equity;” efficiency; progressivity (though the degree is open to dispute, the principle is not, since, among other reasons, those with no income can’t pay tax); limits on the disincentives to work, save, or invest that are inherent in any tax; and “administrability,” or avoiding both high enforcement costs and the corruption that rises when cheating can’t be controlled.
- Build a baseby focusing on those particular principles, like equal justice, accepted by conservatives, liberals, and independents alike. The main fight between political parties over many decades has been between two principles: progressivity and avoidance of the distortions that higher tax rates create. That still leaves huge amounts of the tax system to be reformed on the basis of concerns that are widely shared. When the roof leaks, families can work together to fix it even if they still are in conflict over whether to spend money on a new bed or sofa.
- Always keep in mind the balance sheet within both the tax system and the broader budget. Nothing deters a reform process more than trying to give away money without immediately calculating who will pay the bill—whether through tax increases to offset the tax cuts, spending decreases, or rising debt and interest costs to be paid by future generations.
- Engage those health, housing, charity, pension, and other policies that are woven into the tax code. With about one quarter of all federal subsidies lying within the tax rather than expenditure system, these issues are hard to dodge even in modest reforms and impossible to avoid in comprehensive reform. Whether it’s the hundreds of billions of dollars spent on the tax subsidy for employer-provided insurance, or housing tax subsidies that cost more than the budget of the Department of Housing and Urban Development (HUD), tax reform almost inevitably will affect those policies. To the extent that tax subsidies are maintained, they should still be reformed to be more effective in, say, increasing charitable giving or promoting adequate retirement saving.
- Gather evidence continually, rather than waiting to provide ex post apologetics for a final proposal. Among the many reasons for success in 1986, Treasury and IRS got very busy gathering evidence on growing problems such as the tax shelters of those days, on who benefited from various provisions, and on what the academic literature said. Some efforts require long-term investments, such as in individual and corporate tax models, and even then one often has to change traditional ways of doing things. Before 1984, tax changes were distributed by adjusted gross income (AGI), which meant that the fictitious negative partnership income of tax shelters was subtracted from AGI in a way that made many rich look poor and tax shelter reform look like an attack on the poor. This had to be amended. Many of these efforts take months or years to develop.
- Empower well the plumbers, architects, and engineers—your crew in the Treasury’s Office of Tax Policy and the Congressional Joint Committee on Taxation—if you want a structure that will stand. They often know what pipes can or need to be welded together, but they only do what they are empowered to do in a world where a lot of people make crazy claims. For some reason, smart doctors, lawyers, and entrepreneurs when elected or appointed to political positions think that they have miraculously garnered the talent to weld together the pipes through which explosive gas flows.
Want to predict the probability of reform? Simply go through the list and ask yourself the extent to which those in charge at any stage understand and have a plan for dealing with these types of issues.
This post originally appeared on TaxVox.
Q: Since the modern federal income tax was created in 1913, how often has Congress enacted a revenue-neutral income tax reform that significantly expanded the tax base and lowered rates??
A: One. In 1986.
It is no wonder that the Trump administration—like others before it—is struggling with broad and systemic tax reform. To better understand why, think of tax legislation in three distinct flavors: tax cuts, tax increases, and revenue-neutral changes.
Most income tax bills cut taxes. The reason is obvious. Elected officials like to give something to voters rather than take something away from them.
Since the large tax increases required to finance World War II, most revenue bills reduced taxes, particularly in the period up through 1981. Significant reductions in defense spending as a share of the economy, along with inflationary increases in incomes that pushed people to pay higher individual income tax rates, made legislated tax cuts possible during what I call the Era of Easy Finance.
In a few cases, Congress did raise income taxes. Tax historians Joseph Thorndike and Elliott Brownlee have shown that almost all major income tax increases came about as a result of war. Others, generally raising annual revenues by well less than 1 percent of GDP, have been enacted, for instance, as part of several deficit reduction agreements between 1982 and 1997.
Broad-based and systemic income tax reform that keeps revenues roughly the same as current law requires a tremendous amount of work, largely because it means broadening the tax base by identifying which popular tax subsidies, now costing more than $1 trillion annually, should be targeted for elimination.
Less broad-based but still systemic reforms are also possible. Outstanding modern examples are the codification effort of 1954 and the 1969 reform best known for addressing tax issues surrounding foundations and charities.
As economic coordinator of the Treasury’s 1984 study that led to the Tax Reform Act of 1986, I remember how difficult it was for Treasury and Joint Committee on Taxation staffs to draft legislation and to estimate cost and distributional effects for those proposals. Increasing taxes on some to pay for tax cuts for others requires tax writers to agree on principles to guide and justify their actions. The political aspects of tax reform, building a political coalition to push to see these principles enacted, are even more difficult than the technical concerns.
Tax reform of the revenue-neutral variety is much harder than merely cutting taxes. To cut taxes, lawmakers simply tally a set of wants, perhaps pare them down to fit within a specified amount, and leave the financing bill for current tax cuts to future generations of unidentified taxpayers.
Finally, the design of any systemic reform must acknowledge the economic and political environment of its time. The 1986 Act, for instance, took advantage of bipartisan concerns over tax shelters, President Reagan’s focus on high tax rates, Democrats’ objections to the rising income taxation of the poor, and social conservatives’ efforts to reverse the rising burden being placed on families with children. Deficits were perceived to be a problem, though a smaller one than today in part because Congress had raised taxes and cut spending in the 1982 and 1984 budget agreements and in the Social Security Act of 1983.
President Trump and his team have promised to cut tax rates for all businesses and for the middle class, while not increasing the deficit. They can’t get there by taxing the poor. Even if they assume greater economic growth, it’s not going to be enough to pay for the historically large tax cut provisions. So what’s left?
Some seem to want simply to throw in the towel on revenue neutral tax reform and just cut taxes instead. But $1.3 trillion in additional spending is already built in for 2026 (largely due to rising interest costs and increased spending on Social Security, Medicare, and Medicaid). This is far more than the $850 billion in additional taxes projected to be collected for that year due to a growing economy. How will Congress and the president cover that existing shortfall, even before they think of more tax cuts?
That’s the box the Administration is in. And it is why tax reform is no easier than health care reform. Avoiding big new revenue losses requires systemic reform, such as increasing taxes on individuals to offset business tax cuts. Or engaging in true budget reform that includes scaling back on popular programs. Those are the requirements of our time, like them or not, and while briefly they might be ignored politically, over the longer run they can’t be dodged as a matter of either economics or arithmetic.