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Business Title: Reviewing The Rubio-Lee Proposal For Tax Reform Hey, I’ve got a neat idea…why don’t we take a break from futilely attempting to understand the existing tax law and devote some time to futilely attempting to understand proposed tax law that will, in all likelihood, never become a reality? Sound good? Great. Last week, Republican Senators Marco Rubio (Fla) and Mike Lee (Utah) released a fairly detailed plan to overhaul the existing Code. The creatively-coined “Rubio-Lee” plan has garnered a lot of attention, and considering Republicans currently control both the House and Senate, it should certainly be taken seriously. Let’s take a look at the plan’s most interesting talking points: Individual Tax Rates on Ordinary Income Current Law Under current law, there are a whopping seven rates on ordinary income — 10%, 15%, 25%, 28%, 33% 35% and 39.6%. It is a cruelly inefficient structure, and quite honestly, a laughable one when considering the fact that for single taxpayers, the 35% bracket is all of $1,800 wide. Rubio-Lee The Rubio-Lee plan would follow in the footsteps of earlier plans posited by Bowles-Simpson and Mitt Romney by consolidated the seven brackets into only two: all income below $75,000 (if single, $150,000 if married filing jointly) would be taxed at 15%, while every dollar in excess of those thresholds would be taxed at 35%. Commentary A revised 15%/35% structure would likely leave everyone unhappy: Those who are currently taxed at the top rate of 39.6% (taxable income in excess of $413,200 if single, 464,850 if married jointly) will not be thrilled at their rate dropping a mere 4.6%, particularly when previous plans by Bowles-Simpson and Romney had proposed a top rate ranging from 25-28%. On the other end of the spectrum, you’ll have a large range of taxpayers whose marginal rate will increase as a result of the proposed change. Under current law, the 35% tax bracket doesn’t kick in until income exceeds $411,500; under the Rubio-Lee proposal, it would take effect at only $75,000 for single taxpayers and $150,000 for married filing jointly. This means that middle-class taxpayers currently paying tax at a top rate of 25%, 28% or 33% will see their marginal rate rise. Of course, other changes to the proposal may well mitigate this rate increase; but people are rarely interested in the details of tax reform. In all likelihood, the headline-maker of this Republican plan will be the decrease in the top rate for the richest 1% and the increase to the middle class, and that may make the plan a tough sell. Individual Tax Rates on Interest, Capital Gains, and Dividend Income Current Law Under current law, interest income is taxed at ordinary income tax rates as laid out above. Long-term capital gains and qualified dividends, however, are subject to preferential rates, though one shouldn’t confuse “preferential” with “simpler.” There are five possible rates on LTCGs and dividends – 0%, 15%, 18.8%, 20%, and 23.8%. Determining the appropriate rate requires navigating a complex set of rules and thresholds. Rubio-Lee The Rubio-Lee plan would take the bold step of exempting all interest, dividends, and capital gains from income tax, regardless of level of income. Commentary The “regardless of level of income” portion of this tax reform is largely a meaningless gesture, because of all the interest, capital gains, and dividend income earned by American taxpayers, 85% of that income is earned by the richest 2% (those with taxable income in excess of $400,000). This means that under the Rubio-Lee plan, the rich undoubtedly get richer. Whether that’s a good or bad thing, however, likely depends on your political leanings and your viewpoint on economics. President Obama and leading Democrats have spent the past six years declaring that the wealthy need to pay their “fair share.” The President has taken steps in that direction by increasing the top rate on ordinary income from 35% to 39.6% and on long-term capital gains and dividends from 15% to 23.8%. But the President is clearly not satisfied with those changes; in his FY 2016 budget, he proposed a further increase in the top rate on capital gains and dividends to 28%, while also seeking to institute a minimum tax of 30% on all taxpayers with income in excess of $1,000,000 (the so-called “Buffett Rule,”) which would ensure that wealthy taxpayers can’t benefit too much from preferential rates by generating millions of dollars of income but paying tax at an effective rate in the teens. And oh, do they benefit. Over the next next four years, the top rate of 23.8% on capital gains and dividends is expected to save taxpayers $540 billion dollars, and as mentioned, 85% of that benefit will inure to the wealthiest 2%. The savings generated by adopting a 0% rate stand to be astronomical, and beg the question: how do Rubio and Lee intend to pay for this plan? The answer, at least at this point, is that they don’t, at least in the traditional manner that tax proposals are scored. Rubio and Lee don’t pretend that any increased tax revenue created by their plan would offset the decreases, which is why, according to a preliminary look by the Tax Policy Center, the proposed changes would add trillions to the deficit over the next decade. So how can the plan work? It can only work if you put faith in the concept of “dynamic scoring,” which aside from being one of my preferred alternate titles for a tax-themed porno (first choice: “Hot Assets”), is also many Republicans desired method for measuring the cost of tax reform. In short, dynamic scoring requires that you evaluate a plan not just in terms of static increases and decreases to tax revenue resulting from proposed changes, but by also considering the impact the changes will have on the behavior of taxpayers. Think of it this way…President Obama has long publicized his belief that the rich getting richer is a bad thing for America. But what if it’s not? What if by cutting taxes on the wealthy you spur them to expand their businesses, hire more employees, and raise salaries, providing a boost to the economy and the working class? Of course, eliminating the tax on capital gains and dividends also has a tremendous impact on the current state of corporate taxation. Let’s take a look… Corporate and Flow-Through Taxation Current Law C corporations are famously subject to “double taxation.” Income earned by a C corporation is first taxed at the corporate level, and then a second time when either 1) distributed to the shareholders as a dividend, or 2) the shareholders sell the stock of the corporation, resulting in capital gain. The entity-level tax tops out at 35%, a rate that is currently the highest in the industrialized world. Tack on the top rate of 23.8% on dividends and capital gains, and an individual who operates a business as a C corporation will pay over 50% in taxes before the income gets from the C corporation to the shareholder’s pocket. S corporations and partnerships, however, are subject to only a single level of taxation. This is because they are “flow-through entities,” meaning that unlike C corporations, income earned by an S corporation or partnership is generally not taxed at the entity level. Instead, the income “flows through” to the individual owners, who pay the tax on their share of the entity’s income on their individual tax return. As discussed above, the top rate on ordinary income is currently 39.6%; as a result, the income of S corporations and partnerships is sometimes taxed at a higher rate than a C corporation (before considering the second level of tax upon distribution/sale of stock). Rubio-Lee The Rubio-Lee plan would reduce the corporate rate to a flat 25%, a move that has been embraced by both parties in hopes of making the U.S. more competitive in the global marketplace. Perhaps more importantly, however, because the plan would eliminate any tax on capital gains and dividends, the “double taxation” that has been the hallmark of the C corporation structure since 1986 would be no more; instead, corporate income would be taxed only once, when earned. Rubio and Lee would then marry the taxation of S corporation and partnership income to that of C corporations, at least in part. These business types would continue to pay no tax at the entity level; however, to avoid situations where shareholders or partners are paying tax on their share of the income at the proposed top individual rate of 35% (putting them at a disadvantage to their C corporation counterparts, who would pay only 25%), Rubio and Lee would tax the flow-through income on the shareholder or partner’s return at a top rate of 25%. Commentary The Rubio-Lee plan would largely homogenize the treatment of C corporations, S corporations, and partnerships, and that’s a good thing. One of the many faults of our current system is that similarly situated businesses are often taxed in a drastically different manner depending on their choice of entity. In a perfect tax world, business owners would choose their desired entity structure based on their business goals rather than tax goals. The proposals set forth by Rubio and Lee would be a giant step in that direction. Other Business Tax Changes: Inventory, Depreciation, and Interest Expense Current Law Under current law, businesses are not permitted to take a current deduction for purchases that will benefit the business in some future period. For example, the cost of inventory — whether purchased for resale or produced — must be capitalized and cannot be deducted until sold. In addition, if a business purchases assets — i.e., machinery, equipment, furniture and fixtures or buildings –to be used in its business, the cost of the assets must be capitalized and depreciated over the period of time the business stands to benefit from the use of the asset. Interest expense on business debt is fully deductible, subject to fairly narrow limitations. Rubio-Lee The Rubio-Lee plan would take a flamethrower to Section 263(a) of the Code. It would permit an immediate deduction for the full cost of inventory, whether purchased or produced, as well as any business assets. It would also shift the current debt preference to equity by disallowing any deduction for business interest. Commentary: Goodbye, Section 471. It’s been real, Section 263A. See you in hell, repair regulations. If these changes were to come to fruition, thousands of pages of the current statute would instantly become obsolete. Aside from the aforementioned provisions governing the general rules, there would no longer be any need for the various exceptions to capitalization found in Sections 179, 179D and 168(k), among others. More importantly, business owners would be encouraged to expand their operations, secure in the knowledge that they would receive an immediate return on their investment in the form of a full tax deduction. Even better, there would be no more need for a good portion of the “extender provisions” that fill each year-end with uncertainty. This all sounds great, right? Right. But, good God the cost. After eliminating the tax on dividends and capital gains and dropping the top rates on C corporation, S corporation and partnership income, Rubio and Lee want to provide an immediate deduction for every item of inventory and asset purchased? Sure, the disallowance of business interest will provide a partial offset, as will their stated, yet vague, intention to eliminate ”industry-specific preferences and deductions,” but to what extent can these small increases possibly offset the huge loss in tax revenue? And, of course, we’ll have to see what the powerful banks have to say about removing the tax incentive of borrowing. International Tax Reform Current Law Currently, the income of foreign subsidiaries of U.S. corporations is taxed under what is commonly referred to as a “deferral” system. This means that the income earned by the foreign subsidiary is generally not subject to U.S. tax until it is repatriated to the U.S. in the form of a dividend. As you might guess, this deferral system provides tremendous incentive for U.S. companies to move foreign operations offshore – where they often pay a tax rate well below 35% — and then leave it there, beyond the reach of the 35% U.S. tax rate. This deprives the U.S. government of much-needed cash and U.S. taxpayers of much-needed jobs. At present, it is anticipated that as much as $2 trillion of profits are currently housed offshore in foreign subsidiaries of U.S. corporations, with Microsoft MSFT -1.84% reported to have nearly $93 billion stashed overseas. To illustrate, let’s take a simple fact pattern: X Co. is a U.S. corporation. X Co. owns 100% of Foreign Co., a foreign corporation that generates no revenue from U.S. sources. Foreign Co. has, however, generated $100 million in taxable income in Ireland, where it has paid tax at a 12.5% tax rate. Under the current system, there is generally no U.S. tax imposed upon the earnings of Foreign Co. until the earnings are repatriated to the U.S through a distribution to X Co. At that point, X Co. will pay U.S. tax on the dividend received from Foreign Co. at a rate as high as 35% — or $35 million in tax — subject to any treaty between X Co. and Ireland. Upon receiving the dividend, X Co. is permitted to utilize a foreign tax credit to reduce the U.S. tax applied to the dividend, preventing the same income from being taxed twice: once when earned by Foreign Co. and a second time when distributed to X Co. Because Foreign Co. paid tax at 12.5% in Ireland – or $12.5 million – when the $100 million is repatriated to the U.S., X Co. will only pay corporate level tax of $22.5 million ($35 million of U.S. tax less a credit for the $12.5 million of corporate tax paid in Ireland). Rubio-Lee The Rubio-Lee proposal would move to a full territorial systems; leaving income earned by foreign subsidiaries of U.S. corporation to be taxed only by the jurisdiction in which it is earned, with no second U.S. tax imposed when the foreign income is repatriated to the U.S. Of course, we can’t let the $2 trillion of income currently housed overseas to escape taxation entirely, so Rubio-and Lee propose a one-time tax of 6% on the $2 trillion of foreign earnings, to be paid over a 10-year period. Commentary There is no tax issue on which Democrats and Republicans hold more diametrically opposed positions that the proper international taxation regime. The Rubio-Lee plan represents a move to a “territorial system;” the one favored by most of America’s trading partners. Democrats, however, embrace a “worldwide system,” where U.S. corporations would be required to pay an immediate minimum tax on income earned anywhere in the world, whether by a U.S. corporation or its foreign subsidiary. Such a system has been dismissed as outdated, and accused of putting U.S. corporations at a competitive disadvantage in the international marketplace. Rubio-Lee clearly share that sentiment, and their proposal to move to a territorial system is sure to excite many multinational U.S. businesses. Estate Tax Provisions Current Law At the end of 2012, the estate tax exemption – set at $5.12 million in 2012 – was slated to revert to $1,000,000 in 2013 in the absence of Congressional action, while the estate tax rate would jump from 35% to 55%. While President Obama went into the negotiations hoping to split the difference with an exemption of $3.5 million and a 45% tax rate, he ultimately conceded a $5.25 million exemption amount and 40% tax rate for 2013 and beyond. He made those amounts permanent, with the exemption indexed for inflation. As a result, the exemption is $5.43 million in 2015. Rubio-Lee The Rubio-Lee plan would abolish the estate tax entirely. Commentary Considering President Obama recently proposed eliminating the tax-free basis step-up currently enjoyed at death, thereby subjecting a decedent’s appreciated property to two levels of tax — the idea of completely doing away with the estate tax must sound extremely enticing to the nation’s wealthy. Of course, the issue once again will be, how do you pay for it? Other Individual Changes Current Law Approximately 30% of individual taxpayers “itemize” their deductions because the total of those deductions — things like mortgage interest, state and local income taxes, charitable contributions, and real estate taxes – exceeds the “standard deduction” available to every taxpayer of $6,300 (if single, $12,600 if married filing jointly). In addition, among the many needless complexities in the tax law is the requirement for individual taxpayers to compute their tax liability under a separate, parallel system to determine their “alternative minimum tax (AMT).” If the AMT exceeds the taxpayer’s regular tax liability, the taxpayer must pay the AMT. Lastly, there are currently several incentives in the law for raising children, including the child tax credit and the dependent care credit. The current child tax credit tops out at $1,000, and is subject to phase out at moderate income levels. Rubio-Lee Under the Rubio-Lee plan, the “either-or” of the current itemized deduction – standard deduction decision would disappear. Taxpayers would receive a credit — rather than a deduction — of $2,000 (if single, $4,000 if married filing jointly). In addition to the credit, taxpayers would be entitled to a modified mortgage interest deduction and a charitable contribution deduction. All other itemized deductions will be eliminated. The plan also enhances the child tax credit to a maximum of $2,500 per child with no phase out. Commentary: A $4,000 tax credit equates to $26,666 of deductions for someone in the 15% tax bracket. This should compensate those taxpayers who earn less than $75,000 (if single, $150,000 if married filing jointly) for the loss of the standard deduction, itemized deductions, and personal exemptions, as well as the loss of the 10% tax bracket that currently applies to the first dollars of income. Those taxpayers in the 35% bracket may feel a bit shortchanged by being required to take a credit in lieu of what may have been substantial itemized deductions, but any complaints should be largely muted by the continued ability to benefit from the mortgage interest deduction – albeit in modified and presumably limited for – and charitable contribution deductions. And of course, replacing itemized deductions with a credit (plus mortgage interest and charitable contributions) will provide sorely-needed simplicity. The enhanced child tax credit may prove to be a challenging point for Rubio and Lee to defend to their party-mates, as conservative Republicans have already derided the change as a needless handout. Summary By greatly reducing the tax on business income and eliminating the tax on savings (capital gains, dividends, and interest), the Rubio-Lee plan appears to be a subtle move towards a consumption tax, which is favored by many economists. The real question with the plan, I would think, is whether scored statically or dynamically, what will be the impact on tax revenue? And will the revenue generated be enough to balance the budget over the next decade, lest the U.S. become the largest province in the Chinese empire? As stated in the introduction, when Senators with the pedigree of Rubio and Lee put forth a plan, it warrants serious consideration, particularly when the authors’ party controls both the House and Senate. If you are asking for my opinion — and if you are, I strongly encourage you to reconsider your tax resource hierarchy — I would suggest that in a time when the divide between the nation’s richest 1% and the rest of the population — whether real or imagined — has never been wider, a plan that lowers rates on the rich, eliminates the tax on capital gains and dividends, which overwhelmingly benefit the rich, and raises tax rates on the middle-class, may prove tough to sell to a distrusting public.
Poster Comment: The rich get richer and the poor get poorer.
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#1. To: Willie Green (#0)
No. Waste of time.
Obamanomics: the rich get richer, the poor get poorer humanevents.com/2014/09/0...rich-get-richer-the-poor- get-poorer/
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