US Politics: A Beginner's Guide to Tax Rate Reform

I noted on Tuesday that it appears US legislators may actually get serious about dealing with the Federal Government's debt. And so it is time for an introduction to the report of the President's Deficit Reduction Commission, "The Moment of Truth",with the plan for reforming the tax code.

To tackle the deficit, the government must sharply curtail the $1.1 trillion it currently "spends" annually on exemptions and deductions in the tax code. To give that number some perspective: it roughly equals what America spends each year on discretionary programs --- including defense --- and is about 2/3 of the yearly deficit. If these “backdoor spending grants” for special interests are eliminated, the commission contends, marginal tax rates can be lowered to broaden and simplify the tax base while increasing government revenue. Controversially, much of this increased revenue would not be used to finance government spending, but would be dedicated solely to paying off America's debt.

US Politics: Getting Serious on the Federal Debt?

By getting rid off every single tax break, known as "zero-base budgeting", tax rates could be reduced to 8% for the bottom rate, 14% for the middle rate, and 23% for the top rate, with a corporate tax rate of 26%. These figures of the zero-base can then be used as the foundation for re-introducing, and reasserting the rationale for, deductions for taxpayers. The commission, bringing back some deductions, recommends a plan with income tax rates of 12, 22, and 28%.

The major changes:

The Alternative Minimum Tax, designed back in 1969 to stop the rich from avoiding paying tax but increasingly hitting middle-class Americans, would be repealed along with the Personal Exemption Phase-out and Pease, the itemised deduction phase-out.

The Earned Income Tax Credit, and the Child Tax Credit would be retained. Standard deductions, the level at which you begin to pay tax, and personal and dependent exemptions would remain the same, but with the important proviso that itemised deductions would be eliminated.

To ensure that Americans continue to assign a portion of incomes to charitable giving, which currently can be listed as a deduction by itemised tax reporters, the Bowles-Simpson plan includes a 12% non-refundable tax credit available to all taxpayers. This idea raises some serious questions about the ability of so-called charities to continue raising large sums of tax-deductible funds from a limited number of individuals for the purpose of influencing elections, or the political process in general.

Itemised deduction of mortgage interest payments would also be eliminated, and again a 12% non-refundable tax credit would be available to all tax payers. But the changes for homeowners do not stop there: The mortgage figure eligible for interest relief on a principal residence would be reduced to $500,000 from the present $1 million, and would be eliminated altogether for second homes.

Changes to tax rules for employer-provided health insurance would also be aimed at raising revenue from higher-income earners, at least in the short-term, thus replacing the money lost by eliminating the Alernative Minimum Tax. Currently, this health insurance is not counted as individual income for the purpose of tax returns, but there is a 40% excise tax on the most expensive plans due to be introduced in 2018. The Moment of Truth suggests that the exclusion should be limited to the lower 75% of premium levels from 2014, meaning that the top 25% would pay income tax on health plans paid for by their employers. The excise tax would remain, but would be reduced to 12%, meaning that very high earners would not be doubly penalised. They would pay 28% in income tax, and 12% in excise tax, equalling the 40% excise tax under current projected law.

The Bowles-Simpson plan stresses that it adheres to the principle of progressive taxation, i.e, that the wealthier pay more in taxes, and this is most apparent in changes to tax rates for capital gains and dividends. Under their proposal all income from capital gains and dividends would be taxed as ordinary income. This means a lower-income tax payer would pay 12% on their dividend from a certain stock, while higher earners would pay 28% on the same dividend. This particular recommendation includes the footnote, ”An alternative could be to exclude a portion of capital gains and dividends from income (e.g. 20%), reducing the effective top rate on investment income. To offset this while maintaining progressivity in the code, the top rate on ordinary income would need to be increased.”

On business tax reforms, there are three general recommendations. Firstly, the various corporate tax rates would be eliminated and replaced with a single band no lower than 23% and no higher than 29%. Secondly, this reduction would be achieved by eliminating more than 75 subsidies for special interests.

And thirdly, to make American multinational businesses more competitive internationally, the United States would adopt a territorial tax system. When an American company earns profits abroad, it would only pay taxes in that country. It would not, as now under the Worldwide tax system, pay taxes in America for profits earned in,say, Mexico.

The Bowles-Simpson recommendations for tax reform detailed here are only a template for further discussions. Other deductions, for instance, reinstating the second home deduction for mortgage interest relief, could be added, but only by paying for it by raising marginal tax rates. The only hard and fast rules are that taxes should aim to raise 21% of GDP in revenues by 2022, at which point the rates would be capped. Along the way to that goal,$80 billion of increased tax revenue will be dedicated by 2015 to reducing the deficit, with that number rising to $180 billion in 2020.