Okay, lets talk about taxes. Not the kind we have all been paying, but new and improved taxes. Taxes that are simple and painless. The kind we dream about. The kind that don't cost anything, but pay all of the government's bills. The kind that let us believe "Hi, I'm from the Federal Government and I'm here to help you." The kind that let us believe that things that are simple can be fair; and that things that are fair can be simple.
Time to wake up now and return to reality
In this article, I will discuss the eight main new tax reform proposals that are being considered, or that the proposers would like to have considered.
Before we start, please keep in mind that, despite what Congress seems to think, money does not grow on trees. If they keep spending money, it has to come from somewhere. Since we have an annual deficit (and an annual closing of the federal government), we all know that the current system is not raising enough money to cover today's spending. Any proposal that indicates taking in less tax money than the current system has to be viewed with skepticism, particularly, if there is no rational explanation of how Congress will reduce spending. This leaves proposals that are going to take the same amount of tax revenue, but only changes who it takes it from. Since all of these proposals are attempting to "shift" taxation between taxpayers, you need to pay attention as to who taxes are being shifted from and who they are being shifted to before you choose which proposals you like.
The idea of making a major change to the tax system structure we have all learned to live with, and make decisions based upon, comes with a danger. Congress has been wanting to turn a nation of "spenders" into "savers" for some time. They have also wanted to make taxes fair and simple. The problem comes because, for a long time, tax laws have been used to encourage certain desired behavior. Congress wanted people to own homes, so they created a deduction for mortgage interest. They wanted people to have families, so they created exemptions. They didn't want taxpayers to know how much their taxes were, so they created wage withholding.
In 1986, as part of Congress' desire to change "spenders" into "savers," they decided to phase out the deduction for interest. The premise was that people who borrowed money in order to make purchases were rewarded by the tax laws. By doing away with the deduction, Congress could get these people to spend less. It seems that no one remembered that when consumers spend less, merchants sell less. When sales drop, lay-offs occur, and recessions start.
At the same time Congress wanted to close tax shelters, so they changed the law regarding placing limits on passive activities. These tax shelters, that people no longer wanted to own, were heavily invested in real estate. As were the savings & loans. When the tax shelters lost value, so did the thing they were invested in - real estate. When that market crashed, so did most of the S&Ls that were tied to it.
I bring these two examples up because no one ever intended those results. Those two law changes were based on good intentions, the same kind that the road to Hell is paved with. As for the new tax proposals, no one has ever tried to throw out the old system and replace it with a whole new way of doing things. Beware, no one has traveled this way before. Things that will happen that we cannot see now.
Nearly all of the proposals either cut or eliminate the taxes on savings and/or investment income. Municipal bonds are currently tax-exempt and their market value is determined partly by the effect the tax savings has on the income. If interest is no longer taxed, what will that do to the market value of municipal bonds? What would that do to investors heavily invested in tax-exempt bonds? How about cities and local governments that need to raise money.
If the tax laws reward people for saving, and not spending, will that cause a bigger recession than the one caused by the law change that eliminated deductions for interest did in the late 80s and early 90s?
One of the goals of a consumption tax is to "catch" members of the "underground economy;" those who are self-employed and who pay little or no taxes. If a consumption tax is adopted, it is assumed that these people will pay their taxes when they spend money. As "underground" business people, will they pay the taxes they collect from their customers to the government? Will anything change really?
Some of the proposals involve eliminating deductions for businesses, such as for fringe benefits. If an employer can no longer deduct these benefits and decides to reclassify tax-free fringe benefits, such as health insurance, to fully taxable wages, how will this affect your taxes? What if you cannot obtain health insurance at all?
If a consumption tax is adopted, the tax will be added to the cost of purchases of items such as cars and homes, which would drive up the price. What would this do to the sales of homes and cars? What would that do to people who currently have jobs in those areas? What effect would their lost jobs (and reduced spending) have on our economy? Tax collections? At least one proposal would also add the tax to the mortgage interest (which is a financial service). What effect would that have?
As Bette Davis once said, "Fasten your seatbelts. It's going to be a bumpy night."
Before you can understand the proposals, you must understand the principles they operate on. There are two types of proposals, ones based on taxing income and ones based on taxing spending.
The proposals that are based on income generally will change our current system by redefining income (ie, not taxing interest or capital gains), reducing the tax rates, or changing exemptions and/or deductions. Advantages of an income based system include fairness-taxpayers who make more money, (generally) pay more tax. It also encourages spending since many expenditures are deductible. Perhaps most importantly, it is a system that we know. Disadvantages are that it punishes people for making money (sounds un-American, doesn't it?) and is complicated. Many also believe that others are not paying their fair share, either through loopholes, or outright fraud.
On the other hand, the proposals that are based on spending will change the basic premise of how taxes are figured, from being based on money coming in to money going out. People who save money will pay less tax and people who spend money will pay more tax, regardless of where it came from (including savings you have today). The advantages of a consumption tax is that it encourages saving and also investment in new businesses. In addition, it is easy to figure and easier to enforce than our current system. The disadvantages are that the cost of goods & services will increase by the amount of the tax and that it will hit people with less money and those who must spend all they have to get by much harder than those who are more fortunate.
A VAT, or Value Added Tax, has similarities to a sales tax, but is not the same. Each time something is produced and sold, the VAT is added to the sales price, like a sales tax. However, a sales tax is only added when the final consumer acquires it (unless the Department of Revenue wants to audit you). With a VAT, the tax is added every time it changes hands. The only saving grace is that all purchasers except the final consumer are allowed a deduction for VAT paid. In theory, the total value is eventually taxed and, in theory, it is taxed only once.
Keep in mind that even the best proposal is meaningless if it cannot made into law. The proposals by Armey and Domenici are considered to be the most serious because they are considered to have the best chance of passing. On the other hand, since Steve Forbes is not a lawmaker, his proposal has little chance of becoming law. None of the spending based proposals are considered to have a good chance of passing.
Modified Flat Tax
Sen Arlen Spector (R-Penn)
Proposes to amend the Internal Revenue Code to impose a flat tax on the earned income of individuals and business income of corporations. Individuals would be taxed 20% of all income earned from wages, pensions, and salaries. They would not be taxed on capital gains, interest on savings, or dividends. The only deductions allowed would be home mortgage interest up to $100,000 and charitable deductions up to $2,500. Personal exemptions would be allowed, $9,500 for a single taxpayer, $16,500 for a married couple, and $4,500 per child or dependent. The taxes would be paid through withholding. The tax return would be a 10-line postcard. Businesses would be taxed 20% of revenues less wages, direct expenses (not defined), and purchases. Businesses would also be allowed to expense 100% of the cost of capital formation (not defined) in the year in which the investments are made. The three anticipated advantages are: 1) it will dramatically simplify the payment of taxes, 2) it will remove much of the IRS regulatory morass now imposed on taxpayers, & 3) because it will reward savings and investment, it will spur economic growth.
Freedom and Fairness Restoration Act (Flat Tax)
Rep Dick Armey (R-Texas)
Proposes to tax wages, salaries, and pensions at 17%. Personal exemptions of $13,100 for single person, $26,200 for a married couple, and $5,300 for each dependent would be allowed. Earnings from savings would not be taxed. Owners of businesses would be taxed 17% on the difference between revenue and expenses, defined as - gross revenue less purchases of goods & services, capital equipment, structures, land, and wages paid to employees. No deductions would be permitted for fringe benefits, interest, or payments to owners. Subject to this tax would be corporations, partnerships, professional farms, and rental profits and royalties. Under this proposal, the rates are actually set at 20% for the first year, but because federal spending will fall and the deficit will be lowered (look, I'm only writing what the proposal says here), the taxes will be correspondingly lowered. On a non-tax note, the proposal would set rigid spending caps and would force Congress to determine the cost, benefits, and risks of all new regulations before imposing them. Interestingly, the proposal would do away with tax withholding in an attempt to remind taxpayers just how much their tax bills really are. It makes you wonder if Armey has forgotten why they instituted withholding in the first place.
Tax Simplification Plan
Rep Richard Gephardt (D-Mo)
Return would be a small postcard for those who have to file and majority would not have to file at all. The standard deductions would be $5,000 for a single person and $8,350 for a married couple and the personal exemption would be $2,750. Virtually all deductions, except mortgage interest, would be eliminated. After subtracting standard deduction, personal allowances and mortgage interest from gross income, married couples making up to $60,000 and singles making up to $32,000 would be taxed at 10%. Other rates would be 20%, 26%, 32%, & 34%. Capital gains and interest would continue to be taxable.
Unlimited Savings Allowance Tax
Sen Sam Nunn (D-Ga) & Sen Pete Domenici (R-NM)
The proposal would tax income that is neither saved nor invested. The idea is to only tax income that is spent. If the amount invested in savings or a standard type investment, such as stocks or bonds, increases, the taxpayer would get a deduction; if it decreases, the taxpayer would have additional income to claim. The information I had did not address what would happen if the taxpayer spends money that was saved prior to this law taking effect. Tax brackets would be 8%, 19%, & 40%. New deductions would include a college-tuition deduction up to $2,000 per person and a tax credit for FICA payroll taxes. Each household would get a tax free family living allowance up to $17,600 for a family of four. The allowance would be different if your family is the wrong size. Deductions for mortgage interest and charitable contributions would continue.
As a candidate for the Presidency, Steve Forbes proposes to exempt investment income, capital gains, and Social Security benefits, and to tax wages at 17%. No deductions would be allowed, except for a $13,000 personal allowance and $5,000 exemption for each child.
National Retail Sales Tax
Sen Richard Lugar (R-Ind)
Proposal would abolish the federal income tax (individual and corporate), capital gains taxes, gift taxes, and inheritance taxes, to be replaced by a 17% national retail sales tax. All of the IRS apparatus would also be abolished, to be replaced by a smaller office or agency to administer the national sales tax and the FICA (payroll) tax which would be actually collected by individual states. Certain categories, such as food and medicine, would be exempt from the tax. Problems facing low-income citizens would be factored into the law. Supporters believe that without an income tax to add to the price of products, most goods & services would be cheaper, and that, with savings and investments no longer taxed, we would have a capital formation boom resulting in strongly increased productivity, higher paying jobs, and investment from around the world attracted by a policy of no income taxes.
Sen Bill Archer (R-Texas)
Proposes to completely destroy our current system and replace it with a new system, essentially a hybrid of a national sales tax and a value added tax. The four main goals are to: 1) achieve simplicity and remove the IRS from taxpayers' lives, as much as possible, 2) tax the underground economy, 3) allow for maximum savings, & 4) advance our competition overseas. This proposal would tax consumer and business spending at 16%, with exemptions for medical and certain housing expenses.
Rep Sam Gibbons (D-Fla)
Proposal would eliminate FICA taxes and corporate income taxes. All businesses, including government businesses and non-profit organizations (which would make them "taxpayers"), would be subject to the tax, set at 11% in the proposal. Businesses would be required to collect the tax, file the periodic returns, and remit the tax. The taxable amount for each business would be its economic "value- added," which equals the excess of its receipts from sales of goods and services over its payments for purchases of goods and services from other business (wages are not mentioned). Sales of all goods and services, except exports, would be subject, including professional services, financial services, food & beverages, medical services and products, new houses, and rental housing. Imported goods & services would also be included. No businesses would be exempted from the system.
Simplicity - I saw samples of forms for four of these proposals. Of the three that would allow deductions for dependents, only one (Gephardt's) had a place for names and social security numbers of dependents, and it only had room for two dependents. The current 1040 package instructions have nearly 1 and a half pages discussing exemptions, the five tests (relationship, marital status, citizenship, income, and support) for dependents, and situations involving divorce and multiple support. Having been in this business for nearly 20 years, it strikes me as awfully simplistic and naive to believe that this can be reduced to a postcard with no names listed. Congress has been requiring social security numbers for dependents for years for good reason, people sometimes claim deductions they are not entitled to. Sometimes not by accident. And this is a matter that doesn't even involve a calculation.
Fairness - Is it fair to hit the middle class, both wage earners and the retired living on fixed incomes, hard and let millionaires like Steve Forbes off with paying little, if any, tax? Will we, as a society, be better off?
These proposals remind me of a cartoon I once saw in which the IRS agent said, "Mr Jones, you have to actually file a return. Phoning in a pledge is not good enough."
Unless Congress is willing to accept whatever taxpayers wish to pay, instead of what they are required to pay, tax collecting will never be painless or easy. The bottom line is that most Americans don't really want to revamp our tax system. They simply want a break. Only the proposals that do that will be popular. Discussing anything else is a waste of time.
On a personal note, for those who asked with concern (or was it glee?), what would I do for a living if Congress simplified taxes, I can pass on what a fellow tax practitioner stated, "If the end of my career depends on Congress simplifying something, then my job is safe. Besides, the transition rules will be in effect for the rest of my life."
"Life is what happens while you're making plans."
Gary J Wood, P C, CPA has been solving tax and accounting problems for individuals and owners of closely-held businesses in the Valley area for more than a decade. Information contained in this article is general by its nature and should not be construed to be tax or legal advice.
If you would like specific advice for your situation,
please call (602) 956-1774 and arrange an appointment.
A copy of his newsletter, Schedule FYI, is available on the Internet at / or by sending a SASE to
P O Box 32815, Phoenix, AZ 85064.
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