12 October 2005

A Tax Reform Rant

I noted the early conclusions of the President's Tax Reform Advisory Panel yesterday. Today, I'd like to note a dozen ways that the Internal Revenue Code can be tweaked to raise more revenue, in a manner that is not economically damaging, not distributionally harmful to the poor and middle class, which in many cases will promote greater simplicity in the tax system. These revenue raisers can then be used to fund tax cuts in other parts of the Code, increase spending (e.g. for Katrina and Iraq related expenditures), or deficit reduction.

(1) Establish a rule that Section 1031 can not be used for like kind exchanges of real estate because all real estate in unique.

Section 1031 currently is used to allow almost all investment real estate to be sold tax free, regardless of how much profit is made on the sale, to the extent that the proceeds are reinvested in investment real estate within a time period established by statute and regulation, on the theory that it is an exchange of "like kind" property.

(2) Require inherited retirement accounts and IRAs to be rolled over by a surviving spouse or distributed within two years of the date of the owner's death.

When distributions are made from retirement accounts and traditional IRAs, an ordinary income tax must be paid on the distribution by the person receiving it, whether the recipient is the original owner or an inheritor of the account. A surviving spouse can roll a decedent's accounts over into the surviving spouse's own IRA, deferring taxation until the spouse needs to make a distribution. Alternately, any account beneficiary can take a distributions up to five years after the date of death, or over the beneficiary's life expectency. This allows the funds in the accounts to grow on a tax deferred basis for many decades beyond the life of the original owner, providing a tax benefit roughly equivalent to allowing all returns after the date of death to be tax free. As the inherited funds were not saved with the intent of providing for the heir's retirement, there is no compelling tax policy reason to allow this and the tax cost of doing so is often very great. A limitation on this option would close a tax loophole that is the subject of a great deal of active efforts to engage in elaborate tax reduction planning that provides little or no economic benefit aside from tax reduction.

(3) End the mortgage interest deduction for new second homes and home equity loans.

Current law allows an individual to deduct mortgage interest on a principal residence and a second home, for a total loan of up to $1,000,000, and home equity loan interest for a loan of up to $100,000. Encouraging home ownership is not an unreasonable policy. But, there is no sound policy behind encouraging mortgage financed purchases of second homes or home equity loans. These kinds of loans leave our economy more highly leveraged and reduce the security of a homeowner's investment in a home by encouraging its use as collateral for purposes like education borrowing, car loans and vacation loans. Existing loans should be able to retain their tax deductability, however, as the purchases those loans represent were made in reliance on the belief that a tax deduction would be available for the interest.

(4) Eliminate preferrential tax rates for capital gains and qualified dividends.

The effective tax rate of capital gains is still lower than a tax on an interest bearing investment with the same total return, because the capital gains tax defers taxation until a gain is realized. No further incentive is needed, especially in this day and age when ordinary income tax rates are already low.

One could argue that low capital gains tax rates encourage investments in capital equipment that increases productivity. But, the argument doesn't work. Corporations get no such break, and productive equipment usually generates ordinary income which is offset by depreciation deductions. It does not appreciate in value. There is no compelling reason to favor investments in real estate or in corporate shares over other investments, like investments in human capital to generate greater profits. But, the current law has the effect of favoring purchases of physical assets over investments in the people whose ideas and skills drive corporate profitability. Dividends likewise, look just like interest on a bond to a taxpayer when received, yet are taxed at a far lower rate.

One can also justify reduced tax rates on capital gains and qualified dividends as a partial way of mitigating the effect of double taxation of corporate profits at both the corporate level and the shareholder level. But, the current system does so in a way that distorts economic decision making, does so imperfectly, and distorts the impact of graduated tax rates. There is a solid justification for integrating individual and corporate taxes, but favorable tax rates on capital gains and qualified dividends is a poor way to achieve this end. Treating the corporate level tax as a dividend withholding tax, or allowing corporations to deduct dividends paid to shareholdes like interest payments to bondholders, would achieve this end in a much more economically sound way (and with relatively little disruption to corporate operations as most corporations do not make substantial dividend distributions).

A number of minor rate adjustment, for example, the preference for the sale of certain small business stock, should also be eliminated.

(5) End graduated tax rates for corporations, trusts and estates.

It makes sense to tax high income individual human beings at higher tax rates than those with lower incomes. Money has decreasing marginal utility. A marginal $100 of additional taxes hurts someone who is making $1,000,000 a year less than it does someone who is making $10,000 a year. The same reasoning does not apply to corporations, trusts and estates which all also have graduated tax rates. The amount of profit made by a corporation tells you nothing about the amount of income of its owner. The same applies with even more force in the cases of trusts and estates. The tax system would be simplified, complex planning of entity level distribution amounts would no longer be necessary, and a modest amount of revenue would be raised, if these entities were taxed as a single flat rate equal to the maximum income tax rate which an individual would pay on comparable income. The change would also make complex aggregation rules for owners of multiple entities unnecessary.

(6) End the deduction for business meals and entertainment, and greatly narrow the deduction for business owned executive jets.

Meals are a prototypical personal expense. There is nothing wrong with a business providing meals large or small for their employees. But, if the employee isn't paying tax on that personal benefit, then the business needs to do so in lieu of the employee.

There is nothing wrong with business entertainment. But, true business entertainment should be income to the customer or vendor, and to the employees of a business, who are entertained. It is impractical to send them 1099s or W-2s for this kind of benefit, however. By denying a deduction for these expenses, the business, in effect, pays tax on this benefit on behalf of the true beneficiary in a more efficient manner. There is no need to allow the 50% deduction allowed under current law for these expense account lifestyle items, indeed, allowing them encourages a culture of corruption in corporate America.

Likewise, while business people may genuinely need to engage in business travel, the benefit that comes from having a private jet rather than using a commercial airline is largely a luxury. Passengers usually avoid having income attributed to them by reimbursing the company at first class airline ticket prices when used for their personal use. But, this hardly covers the actual cost of this luxury. Instead, the deduction for air travel should be limited to the cost of first class commercial airline tickets for actual business trips, the executives should be able to enjoy this fringe without paperwork, and the business should not be able to deduct any further costs as it is paying taxes, in effect, on behalf of the executives of the company who receive the excess personal benefits involved.

(7) Treat transfers of appreciated property in gifts and upon death to a non-spouse as deemed sales for fair market value on the date of the gift or death respectively, subject to a limited exclusion of gain at death.

Under current law, a transfer of, for example, appreciated shares of stock to a child in a gift does not trigger capital gains taxation. The receipient of the gift steps into the shoes of the donor and will have to pay tax on the gain when the property is eventually sold. Any appreciation in property owned at death is not taxed at all. These rules allow capital gains taxes to be indefinitely deferred (sometimes with the property used to secured credit to obtain cash anyway) until they are eventually forgiven at death, and thus form a key element of many tax avoidance plans. These rules also allow gains to be shifted from high income taxpayers to low income taxpayers (a benefit particularly important if favorable capital gains tax rates are repealed). There is no good reason why the tax code should permit someone to shift income taxes to a donee and postpone taxation in this manner. It also requires the donor and receipient to exchange tax information about the basis of the property for tax purposes (often involving very old records), something that is rarely, in fact, done. And, there is no good reason for the tax code to favor transfer in kind, which are hard to tax accurately, over transfers in cash, which are easily to regulate with the tax code.

The Canadian rule, which treats a gift or the death of the owner as a deemed sale for fair market value, solves these problems. Gain is taxed to the person who earned it at their rates. Gain is taxed to someone who already had a duty to keep the necessary tax records to determine a gain. A donor may accurately estimate fair market value on the date of the gift without assistance from the donor if necessary for his or her own tax purposes. Gain cannot be deferred. There is no incentive to transfer what are often marketable appreciated assets in kind. No reporting for income tax purposes would be necessary for ordinary birthday and Christmas type gifts of personal property as they usually either depreciate once purchased or are newly purchased and have not changed in value. An exclusion of up to $1,000 of appreciation on gifts in kind per year could be added as a safe harbor top eliminate the need for paperwork in the case of modest gifts of heirloom property that has appreciated somewhat.

It may still be useful to have a generous safe harbor for gains on appreciated property at death, to ease administration and eliminate the need to search for often lost records in modest estates, perhaps an ability to treat the residence as a tax free sale with up to a $250,000 of gain for an individual, that the decedent would have received during life, and an additional $250,000 of gain in other property. But, there is no reason that someone with a millions of dollars of appreciated property should be able to ultimately avoid taxation on that gain which would otherwise have been subject to capital gains taxes.

(8) Eliminate the exclusion from self-employment taxes for S corporation profits.

In a partnership or an entity taxed like a partnership, such as a limited liability company, profits of an owner actively engaged in carrying on the business of the entity are subject to self-employment taxes in lieu of FICA taxes. This is not true in an S corporation, and, as a result, many businesses choose S corporation status in order to reduce their self-employment tax burden, deliberately underpaying the principals' salaries so that this burden can be reduces by compensating the owner-operators in the form of profits. There is no justifable reason for the distinction and it should be abolished.

(9) Eliminate the tax exclusion for interest on newly issued state and local bonds.

It isn't widely known, but the courts have clearly held that the federal government has the right to tax interest on state and local bonds in a non-discriminatory manner. This is the easiest way and one of the most common ways for wealthy individual to avoid all federal taxation, and to furthermore, not even be pushed into a higher tax bracket as a result. While there is a reliance argument in preserving the benefits associated with already issued bonds, there is no good reason to provide this preference which we do not even provide to bonds issued by the federal government and non-profits. If the federal government is going to subsidize municipal government projects, which is what it does by allowing them to borrow at favorable rates made possible by their federal tax free status, it should do so on a case by case basis related to the merits of federal involvement in a particular project. This again, greatly simplifies both the costly municipal bond underwriting process designed primarily to preserve this tax benefit, and reduces usefulness of the many planning schemes that currently involve this form of legitimate tax free income which is unlimited in amount.

Some lower and middle income people do invest in tax free municipal bonds, but they shouldn't because the bonds provide lower returns than the after tax returns of comparably risky corporate bonds.

(10) Revise the taxation of employee stock options and stock for service grants.

Stock options are the dominant form of executive compensation today, largely because they are tax favored. Stock options turn ordinary compensation into capital gains. They also have complicated and sometimes unfair alternative minimum tax impliciations. And, they have largely failed in their purpose of creating good incentives for executives, because the exercise prices can be easily manipulated.

Incentive stock options, governed by a special provision of the Internal Revenue Code, are taxable not when granted or exercised, but when the stock gained in the exercise is sold at a gain, at which point it is a capital gain (but early recognition may be required on occassion for AMT purposes). They are also subject to limitations on how soon they can be exercised.

Crudely speaking, other stock options are generally taxable when the vest and have a eadily ascertainable value (e.g. in a publicly held company), at the time of grant (or as soon thereafter as the vest). Stock options in privately held companies typically do not have a readily ascertainable value when granted, and are taxed when the stock is purchased pursuant to the option.

Stock option profits are not subject to FICA taxation.

Stock purchased for property is usually a non-taxable transaction, but stock received for services is usually income equal to the fair market value of the stock on the date received (often hard to determine in a small company).

A better rule would simply assign stock received for services or purchased by an employee pursuant to a stock option a basis (i.e. deemed purchase price) equal to only what the employee paid for it, but many any sale of the stock ordinary income subject to FICA like any other employment income. Special alternative minium tax rules could be removed. The granting of the stock or stock option, and the exercise of the stock option would not be taxable events. Employees of publicly held companies could make a "deemed sale" at fair market value at any time after the stock was acquired, paying any applicable taxes on the accrued profits and converting subsequent gains into capital gains (under my proposal taxed at ordinary rates) not subject to employment taxation rules.

The simplified rule could apply equally to publicly held corporations and privately held one, and would create a built in incentive to trigger taxation with a sale or deemed sale as soon as practicable. The simpler rules would also make it much easier to provide employees of small entities with stock as a benefit with few tax consequences.

(11) Eliminate the minister's housing allowance.

This provision is small revenue wise, but there is no reason that the tax code should contain a provision that expressly conditions a substantial tax benefit (tax free housing) on a taxpayer's expressly religious practices.

(12) Require property to be depreciated over realistic useful lives.

When equipment and buildings are used in a business, the purchase price can be taken as an expense that is spread out over a number of years. The number of years is governed by Internal Revenue Code statutes and related regulations. The depreciation period is systemmically shorter than the useful life of the property, in an effort to create an artificial incentive to buy equipment rather than devoting business funds to other functions.

For example, property with a useful life of at least ten years is depreciated over seven years, property with a useful life of at least sixteen years is depreciated over ten years, property with a useful life of at least twenty years is depreciated over fifteen years, and property with a useful life of twenty-five years or more is depreciated over twenty years. In some cases, purchases which are substantial for a small business can be immediately expensed (i.e. depreciated in a single years rather than the many years which would ordinarily applied). While there is room for some de minimus exceptions and rough justice, the current system encourages purchases of plant and equipment even when it would make more economic sense to make other investments.

Resorting realistic deprecation periods (for example, depreciating property with a useful life of ten to fifteen years over ten years rather than seven) would bring more realistic decision making to corporate America and would also raise tax revenues substantially.

Conclusion

For those of you who aren't tax specialists, the list above may have been difficult to follow or sleep inducing. But, the point of the list is to make clear that it is possible to raise substantial revenues by closing often obscure (and hence less politically painful) tax loopholes that no longer have (or never had) any legitimate justification in sound tax policy. This is good to keep in mind when a politician argues that a more treasured tax benefit for average people must be eliminated in order to pay for other tax cuts, for other spending, or to reduce the deficit.

1 comment:

Kyle said...

On top of raising a little revenue, #1 and #3 might help to reduce the real estate bubble and deep consumer debt.

I really liked this list. With a couple of exceptions that I don't think I'm qualified to pass judgement on, they all seemed fair and well thought out - not just good policy, but the right thing to do.