In an election season like no other, the occasional glimpse of a normal race peeks through. For example: a candidate promising he will raise taxes, but not for you.
Joe Biden has said more than once that he plans to raise taxes only for taxpayers earning more than $400,000 a year. There is nothing inherently wrong with this threshold – it is higher than the line in the sand President Barack Obama drew at $250,000, and it is hard to argue anyone making more than $400,000 isn’t comfortably well-off. The Penn Wharton Budget Model notes that only 1.8% of American households fall above this threshold, The Wall Street Journal reported. But Biden is missing the chance to push for something bigger, and potentially fairer.
Beyond headlines and campaign promises, the tax code is complex and continues to get more so. This is, in part, because every recent administration has layered its changes over the existing framework. Over time, we have created a patchwork system that no sane person would ever design from scratch.
To understand how we ended up with a tax code that is roughly 2,700 pages long, consider some of the ways that recent administrations have continued to add on. The 3.8% Net Investment Income tax imposed under the Obama administration applies to single taxpayers with income over $200,000, and to married couples with income over $250,000. The George W. Bush-era tax cuts reduced taxes on long-term capital gains for most taxpayers from 20% to 15%. But for single taxpayers with income over $441,451 or married taxpayers with income over $496,601, these gains are still taxed at 20%. President Donald Trump’s 2017 tax reform package created a new deduction for qualified business income, but phased it out in many cases for single taxpayers with income over $213,300 and married taxpayers with income over $426,600. The entire alternative minimum tax system is built on dividing taxpayers into groups and subjecting some of them to different rules. While most taxpayers qualify for an “AMT exemption,” this exemption isn’t available to single taxpayers with income over $500,000 and married taxpayers with income over $1 million. In short, the tax code is what my kids would call a “hot mess dumpster fire.”
Since the federal income tax began in 1913, many politicians have pledged to simplify the tax code. Those promises have been fulfilled only partially, if at all. Many candidates use reducing the number of income tax brackets as shorthand for simplifying the system. But the brackets aren’t the problem. As William Gale, co-director of the Urban-Brookings Tax Policy Center at the Brookings Institution, told NPR, “The real complication in the system is in the tax base, not in the rate structure. Figuring out how you calculate capital gains or figuring out whether you’re eligible for the [earned income tax credit], given the child rules — once you've got that, then you just plug in the rates.”
Even when reform packages do simplify the process for some taxpayers, they inevitably introduce more complexity elsewhere. The 2017 Tax Cuts and Jobs Act raised the standard deduction to streamline the process for many individual taxpayers. (The Urban-Brookings Tax Policy Center estimates that 90% of U.S. taxpayers now take the standard deduction.) It also introduced the concept of QBI, leaving business owners and tax preparers scrambling to interpret the complicated new rules. Policy objectives can add complexity too. Lawmakers want to support certain groups of Americans or encourage particular behavior, and the result is often narrower, more complex tax rules. When economists, rather than politicians, argue for a simpler tax system, they generally mean it “should be easy to understand, transparent and hard to game,” as Harvard’s Matthew Weinzierl put it.
Part of the problem is that getting rid of credits and deductions is unpopular with the people accustomed to taking them. It is politically much easier to add a benefit than to take one away. But the tax system’s complexity involves real costs. Roughly 80 million Americans paid a professional to do their taxes in the 2019 filing season. Of those who self-prepared, millions paid for software; in 2019, 40 million used Intuit’s TurboTax, and most of them paid to do so. Americans spend an estimated 2 billion hours collectively preparing and filing income tax returns each year. Beyond these costs in time and money, many taxpayers worry that their honest attempts to pay what they owe are somehow wrong. And even when lawmakers hope to encourage or discourage certain behavior, they may not be able to do so efficiently if people are not aware of credits or deductions they could claim. For example, an estimated 20% of taxpayers eligible for the earned-income tax credit don’t claim it.
This brings me back to Biden’s opportunity. Should he get elected – and should Democrats secure control of the Senate – he could think bigger than just adjusting rates or tacking on additional taxes. Real reform would involve streamlining. It would mean taking things away, not adding them. And the combination of low interest rates and a high standard deduction creates a new opportunity for this sort of thinking.
Arguably the two most popular income tax deductions are those for mortgage interest and property taxes. The high standard deduction means that most people aren’t itemizing deductions at all, so they will not be sensitive to any changes to the deduction rules. With all-time low interest rates, taxpayers who do claim the mortgage interest deduction are gaining much less from it than they used to. In addition, lawmakers recently cut the amount of interest that is deductible from $1 million of mortgage principal to $750,000. As for the property tax deduction, the Tax Cuts and Jobs Act made it useless for many taxpayers by imposing a $10,000 cap on deductions for state and local taxes. The real estate industry has pushed hard to keep or expand these deductions. But as the mortgage interest and property tax deductions have become less valuable, the demand for real estate has suffered little, if at all. Based on this, I suspect that if Congress chose to eliminate these deductions entirely, demand for real estate wouldn’t change much.
Yes, getting rid of existing deductions would create winners and losers compared to the current system. But Congress now has an unusually favorable window to strip off layers of compromises and half-measures, and start fresh. Lawmakers should figure out how much revenue they need or want to raise, and design a simplified tax code that would allow them to raise it.
This may sound far-fetched, but many states have tax codes that are quite simple. Yes, the federal government must balance factors that states don’t have to worry about. That does not mean a more straightforward and transparent system is impossible. A new system would involve tough decisions, and questions where well-intentioned people can disagree. Should we tax capital gains and wages the same way? Should charitable contributions be deductible? Reaching a consensus will not be easy, but the costs of continuing to tack rules on to the existing system are real, too. A rational system should balance fairness, transparency and effectiveness while raising the necessary revenue.
Simplifying the federal tax system would involve trade-offs. But there may never be a better time to try for a saner, clearer way forward.
Posted by Paul Jacobs, CFP®, EA
photo by John Morgan, licensed under CC BY
In an election season like no other, the occasional glimpse of a normal race peeks through. For example: a candidate promising he will raise taxes, but not for you.
Joe Biden has said more than once that he plans to raise taxes only for taxpayers earning more than $400,000 a year. There is nothing inherently wrong with this threshold – it is higher than the line in the sand President Barack Obama drew at $250,000, and it is hard to argue anyone making more than $400,000 isn’t comfortably well-off. The Penn Wharton Budget Model notes that only 1.8% of American households fall above this threshold, The Wall Street Journal reported. But Biden is missing the chance to push for something bigger, and potentially fairer.
Beyond headlines and campaign promises, the tax code is complex and continues to get more so. This is, in part, because every recent administration has layered its changes over the existing framework. Over time, we have created a patchwork system that no sane person would ever design from scratch.
To understand how we ended up with a tax code that is roughly 2,700 pages long, consider some of the ways that recent administrations have continued to add on. The 3.8% Net Investment Income tax imposed under the Obama administration applies to single taxpayers with income over $200,000, and to married couples with income over $250,000. The George W. Bush-era tax cuts reduced taxes on long-term capital gains for most taxpayers from 20% to 15%. But for single taxpayers with income over $441,451 or married taxpayers with income over $496,601, these gains are still taxed at 20%. President Donald Trump’s 2017 tax reform package created a new deduction for qualified business income, but phased it out in many cases for single taxpayers with income over $213,300 and married taxpayers with income over $426,600. The entire alternative minimum tax system is built on dividing taxpayers into groups and subjecting some of them to different rules. While most taxpayers qualify for an “AMT exemption,” this exemption isn’t available to single taxpayers with income over $500,000 and married taxpayers with income over $1 million. In short, the tax code is what my kids would call a “hot mess dumpster fire.”
Since the federal income tax began in 1913, many politicians have pledged to simplify the tax code. Those promises have been fulfilled only partially, if at all. Many candidates use reducing the number of income tax brackets as shorthand for simplifying the system. But the brackets aren’t the problem. As William Gale, co-director of the Urban-Brookings Tax Policy Center at the Brookings Institution, told NPR, “The real complication in the system is in the tax base, not in the rate structure. Figuring out how you calculate capital gains or figuring out whether you’re eligible for the [earned income tax credit], given the child rules — once you've got that, then you just plug in the rates.”
Even when reform packages do simplify the process for some taxpayers, they inevitably introduce more complexity elsewhere. The 2017 Tax Cuts and Jobs Act raised the standard deduction to streamline the process for many individual taxpayers. (The Urban-Brookings Tax Policy Center estimates that 90% of U.S. taxpayers now take the standard deduction.) It also introduced the concept of QBI, leaving business owners and tax preparers scrambling to interpret the complicated new rules. Policy objectives can add complexity too. Lawmakers want to support certain groups of Americans or encourage particular behavior, and the result is often narrower, more complex tax rules. When economists, rather than politicians, argue for a simpler tax system, they generally mean it “should be easy to understand, transparent and hard to game,” as Harvard’s Matthew Weinzierl put it.
Part of the problem is that getting rid of credits and deductions is unpopular with the people accustomed to taking them. It is politically much easier to add a benefit than to take one away. But the tax system’s complexity involves real costs. Roughly 80 million Americans paid a professional to do their taxes in the 2019 filing season. Of those who self-prepared, millions paid for software; in 2019, 40 million used Intuit’s TurboTax, and most of them paid to do so. Americans spend an estimated 2 billion hours collectively preparing and filing income tax returns each year. Beyond these costs in time and money, many taxpayers worry that their honest attempts to pay what they owe are somehow wrong. And even when lawmakers hope to encourage or discourage certain behavior, they may not be able to do so efficiently if people are not aware of credits or deductions they could claim. For example, an estimated 20% of taxpayers eligible for the earned-income tax credit don’t claim it.
This brings me back to Biden’s opportunity. Should he get elected – and should Democrats secure control of the Senate – he could think bigger than just adjusting rates or tacking on additional taxes. Real reform would involve streamlining. It would mean taking things away, not adding them. And the combination of low interest rates and a high standard deduction creates a new opportunity for this sort of thinking.
Arguably the two most popular income tax deductions are those for mortgage interest and property taxes. The high standard deduction means that most people aren’t itemizing deductions at all, so they will not be sensitive to any changes to the deduction rules. With all-time low interest rates, taxpayers who do claim the mortgage interest deduction are gaining much less from it than they used to. In addition, lawmakers recently cut the amount of interest that is deductible from $1 million of mortgage principal to $750,000. As for the property tax deduction, the Tax Cuts and Jobs Act made it useless for many taxpayers by imposing a $10,000 cap on deductions for state and local taxes. The real estate industry has pushed hard to keep or expand these deductions. But as the mortgage interest and property tax deductions have become less valuable, the demand for real estate has suffered little, if at all. Based on this, I suspect that if Congress chose to eliminate these deductions entirely, demand for real estate wouldn’t change much.
Yes, getting rid of existing deductions would create winners and losers compared to the current system. But Congress now has an unusually favorable window to strip off layers of compromises and half-measures, and start fresh. Lawmakers should figure out how much revenue they need or want to raise, and design a simplified tax code that would allow them to raise it.
This may sound far-fetched, but many states have tax codes that are quite simple. Yes, the federal government must balance factors that states don’t have to worry about. That does not mean a more straightforward and transparent system is impossible. A new system would involve tough decisions, and questions where well-intentioned people can disagree. Should we tax capital gains and wages the same way? Should charitable contributions be deductible? Reaching a consensus will not be easy, but the costs of continuing to tack rules on to the existing system are real, too. A rational system should balance fairness, transparency and effectiveness while raising the necessary revenue.
Simplifying the federal tax system would involve trade-offs. But there may never be a better time to try for a saner, clearer way forward.
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