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THIRD COUSIN, ONCE REMOVED, OF TAX REFORMS

October 26, 2007

The Chairman of the House Ways and Means Committee issued his much-touted "mother of all tax reforms" yesterday. While the plan may be a distant relative of tax reform, there's no way that it's tax reform's momma.

There are two building blocks for real tax reform: broadening the tax base and lowering the rates. The 1986 Tax Reform Act was the last tax bill that did that. The dozens of changes to the code since then have been dedicated to carving new loopholes and targeted tax breaks that narrow the base, increase complexity, and shift the burden to those not favored by Congress.

The Rangel plan goes both ways. For individuals, it is the opposite of tax reform. It increases individual rates while adding to the list of loopholes. For corporations, it actually has some elements of tax reform, lowering the top corporate rate while eliminating tax breaks. The list of tax breaks is a mixed bag. Some make sense, like the repeal of the misbegotten Section 199 domestic production deduction. Others, like the extensions of the goodwill deduction to 20 years, or the repeal of lower-of-cost-or market accounting, look like pure revenue grabs. So while the Rangel may have some DNA of tax reform, we need to keep looking for the mother, or the grandaddy, for that matter.

INDIVIDUAL TAX

The main elements of the Rangel plan for individuals are:

- An increase in the top marginal rate to 39.6%;
- A repeal of the alternative minimum tax.

So to get rid of the AMT, the Rangel plan raises the regular tax rates.

The Rangel plan also embraces an awful idea that had been slated for repeal: the phase-out of deductions for higher-rate taxpayers. This is a sneaky way to increase the top tax rate by a bit over 1%.

The bill also creates or extends a whole raft of special interest tax deductions, from the Indian Employment Credit to the Research credit. Any serious tax reform would eliminate these, not preserve them.

CORPORATE TAXES

The bill would lower the top corporate tax rate to 30.5%, while eliminating the domestic production deduction, LIFO inventory accounting, and the lower-of-cost-or-market method for non-lifo taxpayers. This actually looks like tax reform, and getting rid of the complex and economically illiterate production deduction in exchange for lower rates is a good deal.

GOING TWO DIRECTIONS

Raising individual rates while lowering corporation rates is itself nonsensical if you believe tax reform involves simplification and treating taxpayers alike. If you get the top rates of different taxpayers out of whack, you create incentives to game the system through multiple entities. Taxpayers would have more motivation than ever to shift income to lower-taxed corporations.

The Rangel plan also punishes the post-1986 move of many businesses to "pass-through" status - S corporations and partnerships. The 39.6% top rate will hit closely-held S corporations hard, for no good policy reason other than to stick it to "the rich."

LIST OF REVENUE RAISERS

The likely lasting impact of the Rangel plan is that it includes a catalogue of potential revenue raisers for the loophole writers to use to pay for their own pet projects. These will keep coming up. In addition to the inventory changes, these include:

- Making S corporation shareholders of service businesses (like me) subject to self-employment tax on all of our K-1 income - eliminating the "John Edwards Shelter."

- Requiring brokers to report the basis of stock sold by brokerage customers

- Taxation of carried interests (profits interests) of investment partnerships as ordinary income.

The Rangel plan is a big disappointment. Its recognition of the problem of high corporation rates is welcome, but the drastic increase in individual rates and its failure to broaden the base - in fact, it narrows the base further - keep it from doing much to advance tax reform.

Links:

The Tax Prof, with many links to official documents and big media articles.

The Tax Policy Blog

Scrappleface

TaxGuru.net

Text of Bill

Ways and Means Summary

Tags: Rangel.tax policy.tax reform.TRA 1986.