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It's About Time We Simplified the Tax Code
Many individuals end up asking themselves each year, "Did I pay too much, did I pay too little, who will notice?"
Twenty years after the last major tax overhaul (and nearly 15,000 tax law changes since) Washington, D.C.,and local areas are abuzz with reaction to the possibilities of major changes in our tax lives.
The federal government is attempting to eliminate the tax gap and simultaneously simplify the tax filing and enforcement process. The tax gap is the difference between the total tax that should be paid each year and what taxpayers actually pay. This gap accounts for an estimated nearly $300 billion of lost tax revenue annually. The following is an assessment of how the changes could affect you.
A three-year study by the National Research Program has confirmed that "the vast majority of Americans pay their taxes honestly and accurately," according to IRS Commissioner Mark Everson. But "the government is (still) being shortchanged by over a quarter-trillion dollars by those who pay less than their fair share."
When it comes to individual filings (as opposed to corporate filings) the majority of that "shortchange" comes from underreported income by self-employed individuals. The complexity in the tax code is a big part of the problem.
According to Mr. Everson, "Those who try to follow the law but cannot understand their tax obligations may make inadvertent errors or ultimately throw up their hands and say 'why bother.' Meanwhile, individuals who seek to pay less than what they owe often hide behind the tax code's complexity in order to escape detection by the IRS."
Many locals would prefer tax reform sooner rather than later to simplify their already-busy lives, but there is little consensus on the details. And many worry that some of the proposed changes -- such as a reduction in the mortgage interest deduction -- could cost them considerably over time. Popular sentiment favors a plan that would succeed in making the federal tax code much simpler and fairer, but most proposals have already drawn criticism from Congress. Our intangible stock and bond investments as well as tangible real estate values will likely be affected before we turn another decade on the calendar.
The bipartisan, handpicked presidential advisory panel delivered its 272-page report of possible changes to Treasury Secretary John Snow after 10 months of debate. The panel actually endorsed two alternative plans -- the "Growth and Investment Tax Plan" and the "Simplified Income Tax Plan" -- in trying to keep their recommendations "revenue-neutral," as President Bush had required. The goal is not to increase or decrease taxes -- it is only to collect in a timely manner more of what's due. After some review, Mr. Snow will promote a simplification that can deliver "long-term economic growth and job creation."
Let the special interest lobbying begin.
Some of the major proposals common to both plans include:
Abolishing the alternative minimum tax: Few will weep for this virus if it gets eliminated. Originally seen as a way to nab the wealthy whose deductions put them just out of the IRS' grasp, this elimination will likely be welcomed by a majority of the projected 79 percent of taxpayers who earn between $75,000 and $100,000 per year who would be affected.
Reducing the mortgage interest deduction: This cutback will definitely face an uphill battle. However, we need to be aware that California is in the minority when it comes to the negative impact of this measure on American taxpayers. In our neck of the woods, the currently qualifying $1.1 million loan maximum could be reduced by more than 50 percent. The amount would phase in over five years and theoretically vary each year after that.
Does that approach sound simple enough? While the government estimates that 85 percent to 90 percent of 2004 mortgages nationally would have been unaffected by this proposed change, Gerald Howard, chief executive of the National Association of Home Builders, criticized the measures as "the biggest tax hike for homeowners ever considered."
Enacting the proposal could cause the value of residential property to "decline 15 percent or more" according to the National Association of Realtors.
Also proposed under the home credit measure: the total elimination of interest deductions on home equity loans plus the increase of the home sale exclusion (capital gains tax exclusion) from two out of five to three out of five owner-occupied years. To keep this in perspective, the U.S. home ownership rate is comparable to the United Kingdom, Canada and Australia -- all of which do not provide home mortgage incentives.
Reducing the charitable donation deduction: This is probably one of the least contested ideas in both plans with the greatest effect on not-for-profit organizations. If you currently itemize your deductions, this change will cut the value of your deduction by 1 percent of your adjusted gross income. If you're a giver who opted for the standard deduction, you stand to gain. If you're a charity, get ready for higher scrutiny of your tax-exempt status if this part of the plan passes.
Limitation of untaxed employer-paid health benefits: This element is likely to be included in the final plan. All taxpayers -- employed and self-employed -- would be able to purchase health insurance with pretax dollars. The deductible amount for tax-free health insurance premiums for families would be limited to $11,500 per year.
This change may encourage individual responsibility in judicious use of the medical care system -- part of a trend -- and cause some workers to reduce the amount of health insurance they buy, leading to higher co-pays and deductibles. It would also reduce the number of uninsured Americans by a projected 1 million to 2 million. Have you seen the reporting on Wal-Mart and other large companies' efforts to rationalize health care expenses? Anybody have a better idea to try to put a limit on soaring health care costs? The U.S. has the highest per capita health care spending in the world -- $1.5 trillion in 2002 (the latest year reported).
Elimination of state and local tax deduction: This move is very unpopular politically. Our representatives will not often campaign on a tax increase platform of thousands of dollars per household.
Reduction of marginal tax rates and revised savings and investment accounts: This piece of the proposal is likely to be included in an effort to "simplify" our annual filings. Both plans offer a different reduced number of tax brackets and both bolster incentives for saving and investing. This is where the largest and most numerous tax reform change may occur. As the plans are debated, we will hear various iterations of the tradeoffs between lower tax rates and eliminating deductions for both individuals and businesses. Experts are expected to heatedly defend the push to eliminate taxes on foreign profits and other controversial ideas.
A few other noteworthy elements of both proposed plans: Marriage penalties would be reduced; capital investments would be immediately expensed (land and buildings are excepted under the Simplified Income Tax Plan); the tax treatment of Social Security would be simplified; and line items for the standard deduction, personal exemption and child tax credits would be eliminated, leaving only two tax credits -- a Family Credit and a Work Credit.
Remember the Social Security reform opportunity that seems to have slipped by? Will we glance back on the tax reform issue of 2006 the same way? These are indeed bold measures and may reduce our tax form line items by more than half. But implementing any major changes will be difficult in the current political environment and will possibly be postponed until after the presidential election of 2008.
Could the issue end up slipping by altogether? Not likely.
The productive capacity of the American economy depends on everyone doing his or her part. Right now the problem continues to be one where tax nonfilers, underreporters and nonpayers shift the burden of responsibility for the cost of government to the people who do pay properly and on time, with the greatest portion of the "tax gap" attributable to those who underreport their income. Many think it would be easier to have a flat tax, but that still wouldn't solve the tax gap problem. Numerous European nations with a flat tax still experience people who underreport their income or don't report at all.
America's income tax process is complicated. Many individuals end up asking themselves each year, "Did I pay too much, did I pay too little, who will notice?" If we were to start from scratch as a society, the current tax code would probably be a good guide on what to avoid in designing an income tax system. And so the government will continue to look for ways to refine what will never be a perfect system.
So while we want to confront tax code complexity and whip it once and for all, it looks like we can't throw out our 1040 guidebooks just yet. Nor, unfortunately, will tackling these code recommendations adjust the federal budget deficit. We are not likely to enter the next decade with more combined police officers and firefighters than paid tax preparers (1.2 million), but maybe we'll create a soft landing for our housing market by then.
David A. Uhler is a partner in the accounting firm of Bartlett, Pringle, & Wolf. Wayne Cassriel is the director of client relations at Mission Wealth Management This article was origionally written for the Santa Barbara Pressx | 
