What exactly is tax simplification? Well, it's complicated...
Much of the talk about taxes these days focuses on “tax simplification.” But terms like tax simplification and tax reform mean different things to different people. They often get used interchangeably to describe a wide variety of proposed changes to federal tax law. Perhaps the easiest way to understand tax simplification is to answer a series of questions about it.
Is it rate reduction?
Not so much. Reducing the income tax rates and the number of brackets that individuals and businesses use to calculate how much tax they owe may be tax relief, but it would be only an illusory form of simplification. Most of the complexity in the system is driven by the calculation of the income on which tax is owed and various phase-outs and thresholds applicable to exclusions, deductions, and credits. Having fewer brackets may make it easier to remember marginal tax rates but wouldn’t generally make a tax computation any simpler.
Will I lose deductions or credits if taxes are simplified?
One way to reduce complexity is to eliminate deductions and credits or change the way they’re calculated.
For example, President Trump has proposed eliminating all deductions for individuals except those for mortgage interest and charitable contributions. That would certainly eliminate some complexity and reduce the number of receipts that individuals would have to gather at tax time, but it could also result in higher taxable income for some taxpayers. Therefore, the calculation of taxable income would be simpler, but the amount of tax owed could increase depending on what tax rate is applied to that income.
Somebody has to pay for any reduction in tax revenue, either in cash or in foregone government services.
For businesses, much of the complexity results from credits and incentives that Congress added to the tax code to encourage certain behaviors or support specific industries. A broad attempt at simplification might eliminate many of these tax breaks. For instance, the House Republican proposal calls for eliminating the domestic production activities deduction. This deduction was meant to be an effective 3 percent tax rate reduction for producers. If eliminated, it could drastically reduce complexity but would also reduce the incentive for taxpayers to produce goods. Whether this is good or bad depends on your point of view.
Will tax simplification mean I pay less in taxes?
Not necessarily. In fact, the most likely legislative process for tax simplification would require that the proposal be revenue neutral unless it sunsets after 10 years. That would mean that, for every decrease in taxes, there would need to be an equal offset that either increases government revenue or decreases government expenditures. Even if it’s not revenue neutral, somebody has to pay for reduction in tax revenue, either in cash or in foregone government services.
Would federal tax simplification also simplify state income taxes?
Most states use federal taxable income as a starting point for calculating state taxable income. So the short answer is that if federal tax simplification results in higher taxable income but with lower tax rates, state taxes might increase dramatically if there are no other state tax law changes. However, states don’t exist in a vacuum. If simplification at the federal level causes a significant change in state revenues, they’ll react; this could be as simple as reducing tax rates to apply to a larger state taxable income or as complex as completely redefining taxable income solely for state tax purposes. A sweeping simplification at the federal level could result in 50+ different state reactions that might make the overall tax calculation even more complex.
Is tax simplification likely to happen in 2017?
It’s still too early to say for sure. But, as Yogi Berra once said, “It’s getting late early.” Congress will adjourn shortly for the week of Memorial Day with no significant progress toward a tax simplification bill. As we discussed in a previous article, the ideal timeline for a successful tax simplification bill requires a vote on a final package before the August recess, and there are only 31 days on the legislative calendar between now and then. Given those time constraints, it’s looking more likely that tax simplification legislation will be postponed until the fall, or maybe even later. This will pose a whole different set of issues, including how close legislative efforts are to the 2018 elections and what the effective date of legislation may be.
If you have additional questions about tax simplification as the process unfolds, please give us a call.