Annette Nellen
Annette Nellen
Tax Considerations in Deficit Reform

What should be considered in evaluating tax proposals from President Obama's Fiscal Commission?

December 9, 2010
by Annette Nellen, CPA, Esq.

In February 2010, President Obama established the National Commission on Fiscal Responsibility and Reform, often referred to as the Bipartisan Fiscal Commission. The 18-member commission was to come up with plans to address the growing deficit and put the federal budget on a more sustainable path. The Commission's report released on December 1, 2010 describes the problem as follows:

"Since the last time our budget was balanced in 2001, the federal debt has increased dramatically, rising from 33 percent of GDP to 62 percent of GDP in 2010. The escalation was driven in large part by two wars and a slew of fiscally irresponsible policies, along with a deep economic downturn." (Final Report (PDF), page 10)

This article offers some considerations in evaluating the tax proposals in the report released on December 1 as well as ones issued by commissioners (and others) wanting to offer alternatives.

The Report

The Commission's report, titled "The Moment of Truth," was released at a meeting on December 1, 2010. Commissioners had until December 3 to vote on the report. At least 14 must vote favorably to reach consensus. The preamble to the report indicates agreement on the following: "Together, we have reached these unavoidable conclusions: The problem is real. The solution will be painful. There is no easy way out. Everything must be on the table. And Washington must lead."

The preamble further notes that the proposals in the report are intended as a "starting point for a serious national conversation in which every citizen has an interest and all should have a say." In addition, it is noted that none of the commissioners agree with all parts of the report; the proposals instead represent some compromise in order to produce a plan.

The release of a report prior to an official vote is an interesting tactic. Whether the report receives the requisite 14 votes or not, the 65-page report exists and is available for discussion. In addition, this approach — release of a report prior to voting, likely puts pressure on anyone who votes "no", to offer an alternative. Thus, there will be plenty of ideas available for Congress, President Obama, and others to discuss.

Considerations in Evaluating the Tax Proposals

The tax changes suggested in the Commission’s report, such as eliminating most tax expenditures, repealing the AMT, lowering tax rates, and moving to a territorial system, are significant. Suggestions for evaluating the proposals follow.

1. Use Principles of Good Tax Policy as a Guide: Principles of good tax policy can help guide discussion, identify strengths and weaknesses in existing rules and proposals, and shape proposals to meet principles of good tax policy. Consideration of principles can help ensure, for example, that a proposal designed primarily to simplify the law does not cause distortions in the economy or increase the tax gap.

The AICPA and others have various formulations of the "principles of good tax policy." The AICPA suggests use of these ten principles:

  • Equity and Fairness
  • Certainty
  • Convenience of Payment
  • Economy of Collection
  • Simplicity
  • Neutrality
  • Economic Growth and Efficiency
  • Transparency and Visibility
  • Minimum Tax Gap
  • Appropriate Government Revenues

For information on various formulations of principles of good tax policy, see Policy Approach to Analyzing Tax Systems (PDF), by Nellen.

2. Don't Overlook Key Aspects of the Tax System: Income tax reform tends to focus on income, deductions and credits all key aspects of reform. But there are more pieces to any tax system, such as administration, that should also be considered in reform. Some of these areas that should not be overlooked are listed below.

  • Tax Administration: There are over 100 civil penalties in the federal tax law which add  complexity while not necessarily improving compliance. Lower rates and fewer deductions and credits may warrant elimination of some penalties and restructuring of others. In addition, some examination and collection practices may not be effective at meeting their goals. The National Taxpayer Advocate's 2010 mid-year report to Congress highlighted that funding for taxpayer service programs was declining and some collection practices were harming a taxpayer's ability to pay (IR-2010-83, 7/7/10).
  • Worker Classification: Congress has left this topic open since 1978. It becomes even more important when employers are required to provide certain health care coverage, and changes are made to fringe benefits and worker expenses.
  • Corporate Integration: A longstanding weakness with the federal income tax is that corporate income is taxed twice. There are various methods to integrate the corporate and individual tax systems.
  • Form of Entity: The majority of businesses in the U.S. operate as sole proprietorships or passthrough entities. However, a lot of business tax reform is aimed at C corporations. Consideration should be given to whether certain reforms should apply more broadly than only to C corporations.
  • Modernization: Changes in how people live and do business as well as in technology should be considered in evaluating all parts of a tax system. For example, just-in-time inventory practices challenge current rules such as UNICAP, producing temporary book-tax differences.

3. Strategy: Obviously, the key purpose for the Commission's tax proposals is to rein in deficits and the growing national debt. While a noble and important goal, additional questions should be addressed as to how tax system design can support (rather than hinder) the economic, social and environmental goals for the country.

4. Transition: Businesses and individuals have made long-term decisions based on existing tax rules. For example, form of operations, international business strategy, retirement plans, lease versus purchase decisions, and financing decisions likely were shaped by existing tax rules. An overnight change in the tax laws may cause significant disruption to all taxpayers. To minimize such disruptions, removal of some rules should be done over a period of years, such as was done with some of the Tax Reform Act of 1986 changes which, for example, phased in the application of the §469 passive activity loss limitation rules.

5. Impact to Subnational Governments: Most states with an income tax base it on the federal tax rules. Also, state and local governments are indirect beneficiaries of various federal tax rules such as the exemption for state and municipal bond interest and low-income housing credits. Congress and President Obama should be sure that ideas and concerns of state and local governments are included in the federal tax reform discussions.

6. Tax Reform Library: Federal tax reform reports from the government, think tanks, academics and others date back to at least the 1970s and include information still relevant today. Anyone who will be directly or indirectly involved in the tax reform discussions should become familiar with the key ones, such as those from the Joint Committee on Taxation, Government Accountability Office (GAO), and Treasury. It is unlikely that additional study is needed because a wealth of information already exists on problems, possible solutions and their pros and cons. Any call for further study may really be a ruse to delay taking action on difficult budget problems. A comprehensive catalog of the "library" has been compiled by Bruce Bartlett in a post at Capital Gains and Games Blog (entry of 11/24/09).

Looking Forward

The Commission's report suggests that one of Congress' next steps is to enact fundamental tax reform by 2012. If Congress agrees that acting sooner rather than later is the best approach for the economy and federal budget problems, 2011 will be a very active year. Tax professionals should not sit on the sidelines. Their expert knowledge of the tax laws and their impact on individuals and businesses can benefit lawmakers and help taxpayers understand proposals. It should be an interesting year!

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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.