Taxing Decisions About the Tax Code

This week, Gail breaks down proposed changes to the tax code and how they will affect homeowners, small businesses and consumers.

"If the money spent every year on tax preparation and compliance was collected — about $140 billion each year or over $1,000 per family — it could fund a substantial part of the federal government, including the Department of Homeland Security (search), the Department of State, NASA, the Departments of Housing and Urban Development, the Environmental Protection Agency, the Department of Transportation, the United States Congress, our federal courts, and all of the federal government’s foreign aid."

Report of the President’s Panel on Federal Tax Reform

Dear Friends,

I have yet to meet the individual who doesn’t resent the time and money — and frustration!#$@& — required each year to fill out his or her income tax return. On top of that, when you’re finished you’re never [really] sure that it’s correct and you sweat getting audited.

When you finally stick it in the mailbox, you have this gnawing sense that you were a sucker because you probably missed some deductions you could have taken, but you couldn’t understand the rules about whether they applied to you or not and as a result, you’re paying more than you should.

The tax code has grown so complex since it was “simplified” in 1986 that 60 percent of American taxpayers paid someone else to prepare their returns for them in 2003. Another 25 percent used a computer and a software program they had to buy.

Another cost are the thousands of federal employees who work at the IRS (search), sifting, sorting, sniffing to uncover any mistakes or deliberate fraud in our returns.

The point is, our tax code is a monstrosity that is devouring an increasing amount of resources — time, energy, money and talent — that could otherwise be spent increasing this country’s productivity, improving our ability to compete globally and raising our collective standard of living.

This is why President Bush appointed a blue-ribbon panel of politicians, academics and economists to come up with a proposal to fix the system. Instead, the panel produced two proposals, with one making more radical changes in the way business and investment income is taxed.

You can read the full 270-plus-page report at

I strongly recommend it. Really. Unlike the tax code, it is written in straightforward language that doesn’t require an advanced degree to comprehend. It even has cartoons! You’ll also find refreshingly candid remarks such as: “If you were to start from scratch, the current tax code would provide a guide on what to avoid in designing an income tax system.”

The guidelines set for the panel were that its recommended changes had to lead to: (1) a simplified tax system that (2) encouraged economic growth and (3) was revenue-neutral, meaning it generated the same amount of income to the federal government that the current system does.

Even if you disagree with some of the recommendations, the background information is eye-opening. Consider this tidbit about the Alternative Minimum Tax (AMT):

“The Treasury Department (search) projects that in 2006, in spite of the AMT, over 6,000 taxpayers with income greater than $200,000 and over 1,300 taxpayers with income over $700,000 will pay no tax through various combinations of legitimate tax avoidance.”

I promise you will not like everything in these plans. But at least the pain and the benefits seem to be evenly distributed. Further, don’t think for a second that either plan is going to be adopted as proposed. The panel members themselves admit this is just a starting point for discussion. In fact, you can already imagine the lobbying groups gearing up to protect their own special interests. “Take away someone else’s tax deduction, not mine!”

Here’s a sample of what’s on the table for individual taxpayers:

Repeal the Alternative Minimum Tax

Amen to that. But this means the government has to come up with some other way to collect the increasing amount of money the AMT has been raising every year.

Simplify Exemptions

Replace the different personal exemptions (married, filing separately, head of household, etc.), standard deductions and overly complex child tax credit with a “Family Credit," a dollar-for-dollar reduction of your tax bill for which everyone would qualify. The size of the credit would depend on your filing status and the number of children you have.

New Account to Encourage Saving

Every household is entitled to a “Save for Family Account” into which they could put as much as $10,000 a year. All growth would be tax-free. Use the money for education, home improvements, medical expenses or that Harley you’ve had your eye on for your 55th birthday.

If you need to save for a child’s college education, this is the account in which to do it — 529 plans and Coverdell Education Savings Accounts would be eliminated. So would the Hope and Lifetime Learning tax credits. As the panel points out, the rules governing these credits are so confusing “more than one-fourth of taxpayers eligible to claim one of these benefits failed to do so.”

Change the Tax Breaks for Homeowners

This one’s guaranteed to raise a ruckus, especially with all those folks who “traded up” in recent years and bought a big, mega-house with an over-stuffed mortgage because interest rates were low and, after all, you get to deduct the annual interest you pay as long as the mortgage isn’t more than a million dollars.

If the panel’s recommendation is adopted (and you can hear the realtors screaming now) there would be a cap on the amount of mortgage interest you could deduct. Instead of a nationwide dollar amount, which would hurt folks in expensive states such as California, the limit would be based on the average price of housing in your region and range from approximately $227,000 to $412,000.

Your qualified mortgage interest would then be multiplied by 15 percent to come up with a “Home Credit” (instead of the current “deduction”) that directly reduces your tax bill.

The panel would also entirely eliminate the deduction for the interest paid on home equity loans. In addition to the tax justification for this, the report says this would “reduce the incentive to take on more debt.”

To see how this might play out, I asked Mark Luscomb, the principal federal tax analyst at CCH, to look at a hypothetical married couple with two kids and adjusted gross income of $85,000 this year, which puts them in the 25 percent tax bracket.

We assume they paid $6,500 in interest on their $130,000 mortgage and $1,400 on a $20,000 home equity loan that they’re using to cover their older son’s college tuition.

Under the current tax system, this year the deduction for their housing-related debt reduces their federal income tax bill by $1,975.

The reform proposal would give them a “Home Credit,” which would cut their federal tax bill by just $975.

The $1,000 difference results from losing the full deduction of the mortgage interest and all of the interest on the home equity loan.

In fairness, because the panel’s recommendations reduce some taxes and raise others, you can’t make an accurate assessment by looking at the different sections in isolation. However, in general, Luscomb says if this proposal were adopted, people “in higher tax brackets would lose out a little because even though a credit is better than a deduction, you wouldn’t get the full amount.”

Before you jump up and down, consider the alternative: According to the report, “between 77 and 94 percent of taxpayers with income over $100,000” would pay less income tax under this approach than they would under the AMT, which both proposals would eliminate.

It also helps to know that the American tax system is unusually generous on this issue compared to other developed countries. If you lived in Great Britain, Canada or Australia you wouldn’t get any tax break for home mortgage interest.

Moroever, under the current system most of the tax benefit for the home mortgage deduction flows to taxpayers with incomes in excess of $200,000. “Over 70 percent of tax filers did not receive any benefits from the home mortgage interest deduction in 2002,” presumably because they didn’t itemize.

The panel’s report states that giving people a credit instead of a deduction “would encourage home ownership, not big homes, … while the current subsidy for luxury and vacation homes would be curtailed.”

Eliminate Deduction for State and Local Taxes

This recommendation is already raising the hackles of folks who live in high-tax states. But as the report explains, allowing taxpayers in states with high income and property taxes to deduct these amounts reduces the tax they pay to the federal government and amounts to a federal subsidy. In other words, the big tax deductions residents of places such as New York and California currently get mean federal taxes for the rest of us are higher than they have to be.

Hey, if you can’t enjoy the beach, why should you have to help pay the cost to maintain it?

While it’s likely this makes a lot of sense to someone living in Indiana, South Carolina or Oklahoma, if you inhabit the politically charged environs of Washington, D.C., this idea probably doesn’t have a snowball’s chance. As Luscomb points out, “If you have different impacts depending on the state you’re in, it’s going to make it tough to get through Congress.”

Tax Overly Generous Health Insurance

In case you haven’t noticed, you don’t pay any income tax on the health insurance provided by your employer. In addition, your employer gets a tax deduction for paying the premiums. And that’s just one of numerous tax “preferences” health care gets. What’s worse, this drives up medical costs for everyone, even those who don’t have company-paid health insurance. (There’s an excellent explanation in the report.)

The panel notes that “as with housing-related tax subsidies, tax benefits related to health care tend to benefit higher-income households more than lower-income households.” It would limit the amount of tax-free health insurance your employer can provide: If it’s over $11,500 for families or $5,000 for a single person, that amount will be included in your taxable income.

Other Recommendations

Other changes in the panel’s two proposals include:

— Lower the top individual income tax rate to either 30 percent or 33 percent

— Consolidate employer-sponsored retirement plans such as 401(k), 403(b) and 457 plans into a single, simple “Save at Work” plan

— Replace IRAs with a “Save for Retirement” account where everyone could invest $10,000 per year

— Reduce the tax on dividends and capital gains to encourage instead of discourage investment

— Charitable contributions would only be deductible once the total exceeds 1 percent of your income

— Simplify the calculation to determine if your Social Security income is taxable and index the threshold amount to inflation.

— Allow small businesses to deduct 100 percent of expenses in the year they occur, except for land and buildings

So now what? Despite the massive amount of work that went into these proposals, what are the chances that members of Congress are going to say, “Let’s set our differences aside and consider these or some other plan to significantly simplify the federal tax system for the good of all Americans?” Or is it more likely that representatives and senators will make loud declarations about protecting their constituents, slam their fists and — as they have with Social Security reform — accomplish nothing?

As Tom Anfinson, president of the grassroots group Capitol Watch, says, “I’m afraid if we look back in five years, not a thing will be done.”

Unless each of us demands our representatives in Washington fix the status quo.

Get vocal.