10 December 2010

Simplifying Taxes For Individuals

The President is considering a call for an income tax overhaul next year. One of the objectives is tax simplification. This is possible, without significantly changing overall tax revenues, without greatly rearranging the distribution of taxes due for low income taxpayers, and with a far more rational marginal tax rate structure for working class taxpayers than the current regime.

In this post, I'll lay out thirty key elements of a core tax simplification package, without much background or detailed proofs that these results are achieved.

End all net federal income and FICA taxes on the first $20,000 of income per married couple and $10,000 of income per single person.

1. Increase the standard deduction to $20,000 to married couples filing jointly, and $10,000 for married couples filing separately and single taxpayers.

2. End the special standard deductions for the elderly and the blind. End the phase out of itemized deductions.

3. Create a income tax credit for individuals equal to the amount of FICA taxes owed on the first $20,000 of wages (and to the extent not fully used for wages, of self-employment taxes owed on self-employment income) earned by a married couple filing jointly, and the first $10,000 of wages (and to the extent not fully used of self-employment income) of married copules filing separately and single taxpayers. Allow the FICA tax credit as a credit against both ordinary income tax and alternative minimum tax liabilities. Do not phase this out

Pay stubs and W-2s would reflect the FICA tax paid and the FICA tax income tax credit applied against it, and withholding tables would be adjusted to reflect cases where a married couple filing jointly has only one employed individual or a worker has multiple jobs.

4. The only penalty for failure to report income that would not have been subject to income or FICA taxes or self-employment taxes after the standard deduction and this tax credit would be a failure to receive credit for those earnings in the calculation of Social Security benefits.

5. Employers would get an income tax credit equal to the amount of employer FICA taxes paid on the first $10,000 of wages per employee per year, with withholding tax tables adjusted accordingly. All this credit against both ordinary income tax and alternative minimum tax liabilities. Do not phase this out.

Replace the benefits related to having children in head of household filing status, the per child tax credit, personal exemptions and the earned income tax credit, with a single, simpler per child tax credit.

6. Establish a fully refundable $3,000 per child tax credit.

In the case of married couples filing separately, or children with two parents who are not married to each other, each parent would get a $1,500 per child tax credit unless otherwise agreed in writing or otherwise allocated in a court order. Allow this per child tax credit against both ordinary income tax and alternative minimum tax liabilities. Do not phase this out. Do not require proof of financial support or parenting activities; any parent with parental rights is eligible for it until a written agreement or a state court order allocates it otherwise.

7. End the head of household filing status, personal exemptions, the phase out of personal exemptions, the existing per child tax credit, and the existing earned income tax credit.

Adjust marginal tax rates to produce similar revenues from individuals with similar income to the current regime

8. Replace the 10% and 15% marginal income tax rates with a 20% income tax rate up to the point where the 25% marginal income tax rate starts.

Simplify selected itemized deductions

9. End the percentage of AGI cap on medical expenses including health insurance expenses, and allow the medical expense deduction against self-employment taxes as well as income taxes. This result can already be achieved under current law in a variety of ways with various forms of tax planning.

10. End the deduction for state sales taxes.

11. End the second home mortgage interest deduction.

12. Limit the mortgage interest deduction loan amount for new loans to the greater of the existiing amount of mortgage interest deduction loan eligible debt, or the purchase price of the residence plus the amount of any capital improvements financed with a construction loan, rather than the fair market value of the residence. This would make it impossible to take out home equity loans borrow against paper increases in housing values, an incentive that contributed significantly to the financial crisis.

13. Make the private mortgage insurance deduction permanent.

Simplify the taxation of Social Security benefits

14. Include half of Social Security benefits received in income in lieu of existing formulas. This reflects the fact that half of Social Security taxes were collected before tax and half were collected after tax, paralleling the tax treatment of other retirement benefits. Existing means tested social security benefit inclusion would be repealed.

Simplify retirement contribution taxation

15. Limit the income that can be considered for all employer based, qualified defined contribution and defined benefit retirement plans (such as 401(k) plans, defined benefit pension plans, cash balance plans, profit sharing plans, SEP and Simple IRAs) to the Social Security wage base and impose a uniform cap on contributions for all plans of an employer to 15% of FICA wages paid.

16. Cap IRA, Roth IRA and Keogh plan contributions at 15% of wages earned from employers without a retirement plan of any kind plus 15% of self-employment income.

17. End the retirement savings contributions credit.

Simplify selected business expense deductions.

18. Disallow a deduction for any business meals for employers or clients, and for business entertainment for employers or clients. But, do not include these meals and entertainment in the income of the person receiving them.

Food and entertainment are personal benefits to whoever receive them that in a transaction cost free world would be taxed as compensation income to the person who benefits. Disallowing a deduction for these expenses instead imposes a tax in lieu of a tax on the person who benefits on the person who pays for them, a rough justice solution that results in similar levels of taxation. This expense item invariably eats up a disproportionate share of IRS audit resources and compliance costs for taxpayers.

19. Allow self-employed individuals who have no other office, own or rent a home, and have a permanent designated office in their home, a standard deduction of $5,000 or the amount of their business profit, for the year, whichever is less, for a home office. Someone who takes a home office deduction may not deduct expenses for rent, mortgage interest, utilities, or a landline phone that is not dedicated exclusive to the business. Home office expenses can be itemized in lieu of the home office deduction under existing rules.

20. Make simplified business use of a cell phone tax deduction rules permanent.

21. Replace the child and dependent care expense credit with an above the line deduction covering a comparable amount of such expenses.

22. Consolidate the educator expense deduction, the deduction for business expenses of reservists, performing artis and fee based government officials, the moving expense deduction, the student loan interest deduction, and the itemized deduction for employee business expenses into a single above the line deduction for employee business expenses in excess of $200 per year on a return for a single person or married filing separately return, and in excess of $400 per year on a return for a married couple filing jointly. Allow expenses required to maintain a license as a lawyer, doctor, engineer or other profession on this line for employed individuals and as a business expense for self-employed individuals.

23. End the deduction for tuition and fees, instead using education tax credits as the way to provide tax incentives for tuition and fee payments.

24. End the domestic production activities deduction (Section 199).

Equity Based Compensation

25. Compensation in the form of an ownership interests in a company in exchange for services, including carried interests in private equity funds, should have a zero basis and be taxed only when sold, without regard to its marketability, and then treated as ordinary earned income subject to self-employment taxation when sold. In publicly held companies, individuals owning stock received in exchange for services may elect to make a deemed sale of the stock and repurchase of the shares for the cash earned at any time.

26. Compensation in the form of stock options in a company in exchange for services should be not be taxed when the option is exercised. At that point the stock should be treated as compensation in the form of an ownership interest in the company in exchange for services, except that it would have a basis equal to the exercise price of the option, rather than zero. Incentive stock option rules under current law and the AMT would be repealed for options issued after the effective date.

27. End the penalty tax on straight compensation in excess of $1,000,000 per year.

Adjust The Self-Employment Income Tax Base

28. Include tips earned in self-employment income rather than in wage and salary income. Thus, employers would not be required to withhold taxes for, or account for tips, other than to issue 1099s to employees for tips paid to the employer and then paid in turn to employees, rather than paid directly to employees.

29. Include K-1 income from all S corporations and partnerships in which the taxpayer is active in the business as self-employment income (except to the extent that it is unearned income).

30. Include royalties from creative works that one has authored in self-employment income.

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