Testimony: Temporary Policy in the Federal Tax Code

by r Hampton | Mar 13, 2019 | Tax News

Tax Policy – Testimony: Temporary Policy in the Federal Tax Code

Written Testimony for the House Ways and Means Committee

Today, I want to discuss the important tax policy principle of stability. Taxpayers deserve consistency and predictability in their tax code, and as such, governments should avoid enacting temporary or retroactive tax laws. Stability is also important for the success of any tax policy. A policy that may otherwise produce economic growth or other positive benefits may fail if the policy is temporary or is seen as temporary by taxpayers.

For more than a decade, a collection of temporary, narrowly targeted tax provisions for individuals and businesses have routinely expired and then been temporarily reauthorized, earning the nickname of “tax extenders.” Extending these provisions, especially retroactively, would not contribute to economic growth and would simply be a windfall to taxpayers. The best course of action for the majority of these narrow, temporary tax policies would be for Congress to allow them to expire permanently.

Besides extenders, there are major portions of the Internal Revenue Code that are set to change or expire over the next decade. This is due to the temporary nature of much of the Tax Cuts and Jobs Act. These temporary provisions frontload some of the anticipated economic growth, but because they expire, they do not contribute to the long-run economy.

While it was not ideal to make significant portions of the TCJA temporary, there is now an opportunity for lawmakers to evaluate different aspects of the TCJA and make those that improve the tax code permanent. Permanently dealing with all provisions of the TCJA will increase taxpayer certainty and can contribute positively to the economy. However, making all or part of the TCJA permanent will require lawmakers to address important trade-offs due to the fiscal costs.

How Tax Policy Affects the Economy

Taxes play a role in the decisions to work, save, and invest by impacting the returns on those activities. Workers decide how many hours to work, and even whether to work based on their after-tax wage. A change in marginal tax rates can impact the incentive to work by changing the after-tax wage earned by a taxpayer. Likewise, businesses make decisions on whether to invest based on the after-tax return on a given investment.

For example, the speed at which companies can deduct investments they make against taxable income is an important determinant of the cost of capital, which affects how much people are willing to invest in new capital. Research by Giorgia Maffini, Jing Xing, and Michael Devereaux found that expensing provisions in the United Kingdom encouraged firms to increase their rate of investment by between 2.1 and 2.6 percent compared to firms that didn’t qualify for expensing.[1]

The amount individuals and businesses work, save, and invest has an impact on economic output. If individuals supply more work, or if businesses supply investments in new equipment or factories, this leads to more individuals working more hours and more productive capital in the economy. Higher quantities of capital and labor mean that America earns more income and produces more goods and services. Importantly, capital and labor in the economy are complements. Additional labor increases the returns to capital, leading to additional investment; similarly, additional capital increases the productivity of labor, leading to higher wages for workers.

The decision to work, save, and invest is a forward-looking activity. A business with a potential investment project will look several years into the future at the revenues of the project and any associated expenses, including any taxes assessed on the investment. As a result, tax policies today and those anticipated in the future can impact investment decisions today.

Tax policy doesn’t permanently change the rate of growth in the economy, but it does impact the level. When tax policy increases the incentive to work, save, and invest, this results in a new desired level of labor and capital in the economy. The economy may take a few years to get to that new level, which means slightly accelerated growth for a while, but eventually growth will return to its original rate. However, the economy will be at a higher level than it otherwise would have been, assuming tax policy is permanent.

Lastly, tax policy does not necessarily have an immediate effect on output. Changes in tax revenue can impact total economic activity in the short run. However, it can take time for taxpayers to adjust their behavior to new incentives in the tax code. Under a new tax regime, two new factories may be profitable for a company, but it can take years to plan the projects, get the permits to build, and finally get the projects running. It may take an economy several years or even decades to adjust to a new tax code, depending on the magnitude of the change.

Temporary and Retroactive Tax Policy is Ineffective

In general, temporary tax policies should not be expected to have a permanent impact on the economy. Some temporary tax policies may reduce incentives for business to invest. Other policies may simply encourage taxpayers to shift activity from one year to another. Retroactive tax policy, in which a policy increases or decreases tax liability on a past activity, shouldn’t have any impact on economic activity. Temporary and retroactive tax policies can cause uncertainty for businesses and individuals, which reduces the effectiveness of such policies to work as incentives.

Compared to permanent changes in tax policy, temporary tax policy has limited economic effects, especially temporary cuts for businesses. [2] This is because investment is a forward-looking behavior. The possibility of a tax increase in the future makes productive activity under a lower rate less enticing, especially for activities where the payoff comes years later.

Take, for example, a temporary cut in the business tax rate. Under this policy, businesses would be reluctant to invest in long-lived assets like structures that generate revenue years or decades after the investment is put in place. If the revenue is not going to come until after the tax cuts expire, the tax cuts are of no use to the investor and do not positively impact the decision to invest.

In 2016, we estimated and compared the economic effects of a permanent and temporary corporate tax cut to 15 percent.[3] Both a permanent and temporary corporate rate cut would result in increased economic growth for a while. However, a temporary corporate tax cut would produce less growth. A permanent reduction would raise growth by 0.39 percentage points in the first year. A temporary corporate tax cut would raise it by 0.28 percentage points.

The economic growth effects of a permanent corporate rate cut would continue through the entire decade. The growth from a temporary tax cut, however, would not. By the middle of the decade, we estimated that growth would start declining and eventually be nearly half a percentage point below what it otherwise would have been if the tax were not cut at all. This is because companies would start to anticipate the expiration of the rate cut and begin cutting back on investment.[4]

Other temporary tax policies may shift the timing of some investments. A good example of this is a one-year policy of expensing. Companies know that they would only be able to qualify for expensing for a single year. As a result, they would have an incentive to shift investments that they may have otherwise put in service the following year into the current year. This makes investment seem higher the year in which expensing is in effect. However, much of that gain is taken back once expensing expires and investment in year two is lower than it otherwise would have been.

Similarly, retroactive tax policies have little long-run economic benefit. If a retroactive tax cut occurs, businesses cannot go back in time and choose to invest more, nor can individuals go back in time and choose to work more. Instead, retroactive tax cuts result in after-the-fact transfers that do not boost long-run growth nor improve incentives.

Tax Extenders

For more than a decade, a collection of temporary, narrowly targeted tax provisions for individuals and businesses have routinely expired and then been temporarily reauthorized, earning the nickname of “tax extenders.”

Many of these provisions were originally designed to phase out, often because they were part of temporary bills like the stimulus package.[5] But rather than letting the provisions phase out as designed, or making them permanent features of the tax code, Congress has instead reauthorized these provisions on a temporary basis, most often at the last minute or retroactively.

Currently, 26 tax breaks that expired at the end of 2017 are under review for retroactive reauthorization. These 26 remaining provisions broadly fall into two categories: those that provide cost recovery benefits for certain investments and those that are tax credits for specific economic activities.[6]

Cost Recovery Extenders

Many extenders improve cost recovery treatment of certain investments. These extenders include accelerated depreciation for racehorses, motorsports entertainment complexes, and mine safety equipment. Generally, these provisions reduce the user cost of capital and move towards proper treatment of investment in the tax code. However, Congress should avoid providing special tax treatment to certain industries, businesses, and business forms.

To the extent that the property covered by these extenders is also covered by 100 percent bonus depreciation from the Tax Cuts and Jobs Act, these extenders are not needed as such property is already eligible for proper cost recovery treatment. However, if the property is considered nonresidential real property, residential real property, water utility property, or railroad grading and tunnel bores (railroad improvements), then it would not qualify for more favorable depreciation schedules under the TCJA.

Tax Credits for Specific Activity

More than half of the remaining provisions are tax credits that subsidize specific economic activities.[7] These extenders include provisions such as tax credits for two-wheeled plug-in electric vehicles, new energy-efficient homes, and qualified fuel cell motor vehicles. These tax preferences reduce the neutrality and efficiency of the tax system by altering relative returns of different investments. This can lead to otherwise inefficient allocation of resources and favor certain privileged businesses and industries over others.

Most Extenders Should be Left Expired

Most current extenders are not must-pass policies, but rather provide narrowly targeted preferences for specific economic interests, which distorts economic activity and creates uncertainty. The best course of action for the majority of these narrow, temporary tax policies would be for Congress to leave them permanently expired. In addition, most of the cost recovery provisions are duplicative with the 100 percent bonus depreciation provision passed as part of the TCJA.

At this point, these 26 provisions have been expired for well over a year; the tax year that they would be authorized for, tax year 2018, is completely over, and the filing season is well underway. Extending these provisions cannot change the economic activity that occurred in 2018; further, to the extent that tax revenue is a concern, retroactive extension makes little sense as it would constitute a transfer of tax revenue without promoting economic growth.

Leaving aside whether any specific extender is a worthwhile policy, these provisions result in an after-the-fact transfer to narrow groups without incentivizing the intended activity. Businesses and individuals cannot go back in time and make different decisions, and the uncertainty surrounding these incentives renders them ineffective going forward. If lawmakers do think a specific extender is worthwhile, it should be extended permanently.

Temporary Policies in the Tax Cuts and Jobs Act

Another source of temporary policy in the Internal Revenue Code emerges from the passage of the Tax Cuts and Jobs Act, which made some important reforms to the federal tax code. But many business provisions and nearly all the individual provisions are set to either change or expire over the next decade. In fact, by the end of the decade, most of the remaining changes to the tax code will be those made for corporations. Since many parts of the TCJA are temporary, the growth effects of the law will be somewhat muted, especially in the long run.

The TCJA and its Effects

The TCJA reduced statutory tax rates for most taxpayers, reformed family benefits, and broadened the individual income tax base by eliminating and scaling back several itemized deductions.[8] The TCJA also established a 20 percent deduction of qualified business income from certain pass-through businesses. The Alternative Minimum Tax was retained but was scaled back significantly. Lastly, tax parameters will now be adjusted based on chained CPI-U instead of CPI-U. The TCJA also greatly scaled back the estate tax.

The TCJA cut the corporate income tax rate from 35 percent to 21 percent and eliminated the corporate alternative minimum tax. The TCJA also expanded expensing for all businesses (corporations and pass-through businesses) by increasing bonus depreciation from 50 percent to 100 percent for five years. At the same time, the TCJA changed the treatment of the foreign profits of multinational corporations. It also broadened the corporate tax base by limiting the deductibility of net interest expense, eliminating net operating loss carrybacks, and limiting carryforwards to 80 percent of taxable income.

On net, the TCJA is a tax cut over the next decade. Our most recent estimate shows that the TCJA will reduce revenue by $1.8 trillion on a conventional basis between 2018 and 2027.[9] Some $1.1 trillion in the revenue loss would be due to a reduction in individual income taxes, $647 billion from the corporate income tax, and the remaining $72 billion from the estate and gift tax.[10]

The Tax Foundation model also projects that the TCJA would boost the size of the economy over the next decade. In the first few years, the economic impact will be modest as companies begin to invest more, building the capital stock. In 2018, we project the economy to be 0.3 percent over baseline; but by 2020, it will be 1.4 percent over baseline. On average, GDP will be about 2 percent above baseline between 2018 and 2027. By the end of the decade, however, the economy will begin to slow relative to how the economy would have performed without the TCJA.[11]

We estimate that in the long-run, the economy will be about 1.7 percent larger than it otherwise would have been in the absence of the TCJA.[12] This is due almost entirely to the permanent reduction in the corporate income tax rate from 35 percent to 21 percent. Without that provision, the TCJA would likely have produced no long-run benefits for the economy.

We project that the additional economic growth over the next decade would produce about $900 billion in additional federal revenues, mostly through the payroll and individual income tax. As a result, we estimate the net reduction in revenue to be around $900 billion between 2018-2027.

The TCJA will result in a reduction in tax liability for taxpayers in all income groups for most of the decade. However, the distribution of the tax burden would be less progressive than it used to be. The increase in after-tax income is largest in the first few years of the decade. Over time, however, as major provisions of the TCJA begin to phase out and base broadeners begin to phase in, the size of the tax cut will decline, and taxpayers will see smaller increases in after-tax income relative to the baseline. By 2026 and 2027, when the individual provisions have expired, taxpayers in most income groups will see tax increases relative to prior law.

Many Aspects of the TCJA Will Phase Out or Expire over the Next Decade

For lawmakers to satisfy Senate budget rules, while still providing a net tax cut during the decade, major portions of the TCJA were set to phase out or expire.[13] From 2018 until 2021, all business and individual provisions will be in effect. At the end of 2021, two business base broadeners will be phased in. First, businesses will no longer be able to expense research and development costs. Instead, they will need to amortize those costs over five years. Second, the limitation on interest expense will tighten from 30 percent of earnings before interest, tax, depreciation, and amortization (EBITDA) to 30 percent of earnings before interest and tax (EBIT), a narrower definition of corporate income.

At the end of the following year (2022), 100 percent bonus depreciation will begin to phase out, further increasing tax collections from businesses. Its phaseout runs from 2023 to 2027, when the depreciation system will revert to MACRS.

At the end of 2025, a significant number of policy changes are scheduled to occur. All three of the new international provisions (GILTI, FDII, and BEAT)[14] will change. All three are scheduled to change, which will raise the tax burden on U.S. multinational corporations. The estate tax exemption will revert to pre-TCJA levels. Most significantly, however, is that nearly all the individual income tax cuts will expire. The new statutory tax rates and brackets, the standard deduction, the personal exemption, the Child Tax Credit, and the Alternative Minimum Tax will all revert to pre-TCJA rates and levels. The only significant individual income tax change that will remain is the use of chained CPI to adjust tax parameters for inflation.

The Effect of Temporary Policy in the TCJA

While making parts of the TCJA temporary allowed lawmakers to satisfy Senate budget rules, it created uncertainty for taxpayers. The TCJA may have improved the incentive to invest and will boost economic output and income over the next decade, but not as much as it could have if the law were permanent.

One major goal of the TCJA was to boost domestic investment by lowering the cost of capital. This was done in the TCJA chiefly by enacting 100 percent bonus depreciation. The new 100 percent bonus depreciation provision allows businesses to immediately deduct the full cost of eligible investments, as they would with any other business expense, rather than stretching deductions over many years. This removes the tax code’s bias against these specific capital investments.

The provision is scheduled to be in effect for five years before it begins gradually phasing out at the end of 2022. Beginning in 2023, the provision would be reduced by 20 percentage points each year, for example, dropping to 80 percent in 2023, 60 percent in 2024, and so on until it expires entirely at the end of 2026.

The temporary nature of the provision will incentivize businesses to make their investments sooner, while they can deduct the full cost, rather than later, when they must take depreciation deductions over longer periods. Thus, the provision will pull some investments forward, leading to faster growth in earlier years that slows back down as the provision expires in later years. 

The TCJA also greatly increased the incentive for individuals to work, through reductions in individual income tax rates. However, most of the individual income tax changes are scheduled to expire after 2025. As a result, these incentives will go away. This is a primary reason why we expect the TCJA to produce less economic growth near the end of the decade than the beginning.[15]

There are also businesses that earn their income through the individual tax code. These “pass-through” businesses make up the majority of businesses in the United States and earn about half of all business profits.[16] Since their profits are taxed through the individual income tax, these businesses face a great deal of uncertainty over how investments they are making today will be taxed in the future. This uncertainty will reduce these businesses’ willingness to invest.

The effect of the TCJA’s temporary policies goes beyond their impact on the incentives to work and invest. The TCJA also enacted policies that were meant to encourage certain behaviors by taxpayers. For example, the new FDII provision, paired with the tax on GILTI, is meant to encourage companies to shift their intellectual property (IP) back to the United States and reduce the incentive to shift profits out of the United States.[17]

However, both of these provisions are scheduled to change after 2025. As a result, the tax benefit on FDII will go down and the tax rate on GILTI will go up. This may change the calculus for these companies thinking about bringing their intellectual property back home. For one company, the current tax rates under FDII and GILTI provide sufficient incentive to bring IP back to the United States. However, the change may reverse that incentive, so companies may opt to not bring their IP back to the U.S. at all.

Making Temporary Policies in the TCJA Permanent

Making portions of the TCJA temporary reduced its effectiveness. Lawmakers could improve the federal tax code’s long-run treatment of work, saving, and investment by making major portions of the law permanent. For example, if 100 percent bonus depreciation were permanent, it would have been the most pro-growth provision in the bill. We estimate that making the 100 percent bonus depreciation provision in the TCJA permanent would increase the size of the capital stock by 2.2 percent and long-run GDP by 0.9 percent; the larger economy would result in a 0.8 percent increase in wages and 172,300 full-time equivalent jobs.[18]

Lawmakers may also want to make the individual income tax cut permanent. According to the Tax Foundation Taxes and Growth model, making these provisions permanent would have a small, positive impact on the economy during the 2019 to 2028 budget window. The growth impact of expansion is limited, due to the extension’s timing. The provisions are currently in effect through 2025, meaning that only three years of extension are being captured in the budget window.

The economic benefits from making these provisions permanent are found in the long run, as the impacts of tax reform take several years to be fully realized. In the long run, making all individual tax provisions permanent will lead to 2.2 percent higher long-run GDP, 0.9 percent higher wages, and 1.5 million more full-time equivalent jobs.[19]

Making all or part of the TCJA permanent would have a positive impact on the economy, but it would also decrease revenue in both the short term and the long term. Making 100 percent bonus depreciation permanent would reduce federal revenue by $141 billion between 2023 and 2028. Extending all of the individual provisions would increase the budget deficit each year after 2025 by about $200 billion a year.

Given the revenue implications of making all or part of the TCJA permanent, it is important to bear in mind that some provisions are more cost-effective than others, and not all tax policies deserve a permanent place in the tax code.

For example, permanence for 100 percent bonus depreciation as well as the individual provisions would grow the economy, boost wages, and increase jobs. However, making bonus depreciation permanent does so at a lower cost. In the long run, permanent 100 percent bonus depreciation produces about 4.5 times more GDP growth per dollar of forgone revenue than making individual TCJA provisions permanent.[20]

While growth considerations like these are important to factor into permanence discussions, so too are broader tax policy considerations. Often Congress extends most or all policies that are set to change or expire, but it is not advisable to enact blanket extensions, nor permanence, for any policy. Some aspects of the TCJA are important improvements over previous law and should be made permanent. Other aspects of the TCJA should be revisited and improved upon.

Conclusion

Tax policy can increase the size of the economy by having a positive impact on the incentives to work and invest. However, when tax policy is temporary or retroactive, these positive effects are muted, and policies do not effectively incentivize the intended activity.

When considering which policies deserve a permanent place in the tax code, factors such as cost-effectiveness, efficiency, and neutrality should play a central role. Not every tax policy deserves permanence; appropriate care should be taken to ensure that permanence is only given to those policies which are economically efficient and conform to principles of sound tax policy.

Notes

[1] Giorgia Maffini, Jing Xing, and Michael P. Devereux, “The Impact of Investment Incentives: Evidence from UK Corporation Tax Returns,” Oxford University Centre for Business Taxation, Working Paper 16/01.

[2] Alan Cole, “Why Temporary Corporate Income Tax Cuts Won’t Generate Much Growth,” Tax Foundation, June 12, 2017, https://taxfoundation.org/temporary-tax-cuts-corporate/.

[3] Ibid.

[4] Ibid

[5] Alan Cole, “Extenders and the Opportunity for Tax Reform,” Tax Foundation, Nov. 19, 2014, https://taxfoundation.org/extenders-and-opportunity-tax-reform/.

[6] Erica York, “Recommendations to Congress on the 2018 Tax Extenders,” Tax Foundation, April 17, 2018. https://taxfoundation.org/2018-tax-extenders/.

[7] Ibid.

[8] Huaqun Li and Kyle Pomerleau, “The Distributional Impact of the Tax Cuts and Jobs Act over the Next Decade,” Tax Foundation, June 28, 2018, https://taxfoundation.org/the-distributional-impact-of-the-tax-cuts-and-jobs-act-over-the-next-decade/.

[9] This estimate is $300 billion higher than the Tax Foundation’s original score of the TCJA. This is due to an update to the CBO baseline, which estimated that pre-TCJA revenues would be higher than previously thought.

[10] Ibid.

[11] Ibid.

[12] Tax Foundation Staff, “Preliminary Details and Analysis of the Tax Cuts and Jobs Act,” Tax Foundation, December 18, 2017. https://taxfoundation.org/final-tax-cuts-and-jobs-act-details-analysis/

[13] Huaqun Li and Kyle Pomerleau, “The Distributional Impact of the Tax Cuts and Jobs Act over the Next Decade,” Tax Foundation, June 28, 2018, https://taxfoundation.org/the-distributional-impact-of-the-tax-cuts-and-jobs-act-over-the-next-decade/.

[14] GILTI: Global Intangible Low-Tax Income; FDII: Foreign Derived Intangible Income; BEAT: Base Erosion and Anti-Abuse Tax.

[15] Ibid.

[16] Scott Greenberg, “Pass-Through Businesses: Data and Policy,” Tax Foundation, Jan. 17, 2017, https://taxfoundation.org/pass-through-businesses-data-and-policy/.

[17] Kyle Pomerleau, “A Hybrid Approach: The Treatment of Foreign Profits under the Tax Cuts and Jobs Act,” Tax Foundation, May 3, 2018, https://taxfoundation.org/treatment-foreign-profits-tax-cuts-jobs-act/.

[18] Erica York and Alex Muresianu, “The TCJA’s Expensing Provision Alleviates the Tax Code’s Bias Against Certain Investments,” Tax Foundation, Sept. 5, 2018, https://taxfoundation.org/tcja-expensing-provision-benefits/.

[19] Nicole Kaeding, Kyle Pomerleau, and Alex Muresianu, “Making the Tax Cuts and Jobs Act Individual Income Tax Provisions Permanent,” Tax Foundation, July 10, 2018, https://taxfoundation.org/making-the-tax-cuts-and-jobs-act-individual-income-tax-provisions-permanent/.

[20] Erica York, “Permanence for 100 Percent Bonus Depreciation Provides More Cost-Effective Growth than Permanence for Individual Provisions,” Tax Foundation, Sept. 5, 2018, https://taxfoundation.org/100-percent-bonus-depreciation-permanence-offers-more-bang-for-the-buck/.

Source: Tax Policy – Testimony: Temporary Policy in the Federal Tax Code

The Trade-offs of Repealing Step-Up in Basis

by r Hampton | Mar 13, 2019 | Tax News

Tax Policy – The Trade-offs of Repealing Step-Up in Basis

Key Findings

• The cost basis of property transferred at death receives a “step-up” in basis to its fair market value. This eliminates an heir’s capital gains tax liability on appreciation in the property’s value that occurred during the decedent’s lifetime.
• Property transferred before death receives “carryover basis,” which means the donor’s original cost basis is carried over to the recipient. This requires recipients to pay capital gains taxes on appreciation in the property’s value that occurred during the donor’s lifetime when they sell the property.
• Step-up in basis discourages people from realizing capital gains. Eliminating the policy would encourage capital gains realization, increase federal revenue, and remove a tax expenditure that allows taxpayers to entirely exclude returns on saving from taxation.
• Step-up in basis can reduce compliance costs for heirs because tracking cost basis of long-held assets, especially from decedents, can be difficult. Step-up in basis could also shield heirs from paying both estate and capital gains taxes on the same asset.
• Repealing step-up in basis would make the tax code more neutral and eliminate a tax expenditure. But eliminating the policy without changing the estate tax could increase the tax burden on capital and increase compliance burdens for taxpayers.

Introduction

When a person leaves property to an heir, the cost basis of the bequeathed asset receives a “step-up” in basis to its fair market value at the time of the original owner’s death. Step-up in basis reduces capital gains tax liability on property passed to an heir by excluding any appreciation in the property’s value that occurred during the decedent’s lifetime from taxation.[1]

This policy has been critiqued for its “lock-in effect,” that it discourages taxpayers from realizing capital gains by allowing a deceased person’s returns from saving, in the form of capital gains, to be passed on to heirs without tax. This reduces federal revenue and benefits mainly high-income taxpayers.^[2]

Yet, step-up in basis could also keep heirs from paying both the estate tax and capital gains tax on the same asset. In other words, step-up in basis protects capital from double taxation.[3] The policy also reduces compliance costs for taxpayers, largely because proving the original cost basis of a deceased person’s asset can be difficult.[4]

This analysis explains how step-up in basis works, focusing particularly on how the provision interacts with the estate tax. It discusses the considerations before policymakers when evaluating this possible policy change. In deciding whether to repeal step-up in basis, policymakers must confront several trade-offs. Eliminating step-up in basis would make the tax code more neutral and remove a tax expenditure that primarily benefits wealthy taxpayers. But eliminating step-up in basis without changing the estate tax would increase the tax burden on capital and compliance burdens for taxpayers.

Background on the Estate Tax and Step-Up in Basis

The Estate Tax

Each year, the estate tax impacts a small subset of taxpayers that transfer wealth to heirs at death[5] and generates little revenue compared to other taxes. In 2017, the number of taxable estate tax returns filed was 5,185,[6] compared to the more than 153 million individual income tax returns.[7] Estate and gift taxes combined—which tax financial and physical assets such as real estate, securities, and cash[8]—accounted for less than 0.7 percent of federal revenue in 2017, compared to almost 48 percent for individual income taxes.[9]  

Taxpayers can reduce the amount of their taxable estate with several deductions, such as donations made to charitable organizations as well as funeral expenses. Taxpayers can also use a large exemption (known as the “unified credit”) to exclude a portion, or oftentimes all, of their taxable estate from the estate tax.[10] In 2019, the first $11.18 million of an individual’s estate is exempt from taxation ($22.36 million for married filers).[11] Any taxable value beyond deductions and the exemption is taxed at a rate of 40 percent, meaning the estate tax takes $0.40 of every dollar of taxable value beyond the exemption.^[12]

Step-Up in Basis

Currently, whenever any property is transferred from a decedent to an heir at the time of death, the basis of capital gains for that piece of property is stepped up to current fair market value. Step-up in basis reduces capital gains tax liability on property passed to an heir by excluding any appreciation in the property’s value that occurred during the decedent’s lifetime from taxation. If the heir decides to sell this property immediately upon transfer, no capital gains tax would be owed. If the heir decides to hold on to the property and sell in the future, any capital gain would be measured against the heir’s new stepped-up basis, and the gain would be taxed at the heir’s applicable capital gains tax rate. Importantly, the heir doesn’t have to realize the capital gain at all. Instead, the heir could keep the property until death and give the property to a new heir, at which time the property would take another step-up in basis to its fair market value, and the process would begin again.[13]

Step-up in basis differs from the treatment of cost basis applied to transfers of property before death. Property transferred before death receives “carryover basis,” and the donor’s original cost basis in any property is transferred to the recipient of the property.^[14] Like step-up in basis, the recipient is liable for capital gains taxes only when the property is sold, but upon sale, the capital gain will most likely be larger, resulting in a higher capital gains tax liability. This is because, under carryover basis, any appreciation in the property’s value from the time the donor acquired the property to the time the donor transferred the property to the recipient is taxable. Recipients of gifts transferred before death can also defer capital gains until their own death, in which case the capital gains would receive step-up in basis when transferred to an heir in an estate.^[15]

The Impact of Step-up in Basis

To see the potential difference in tax liability between step-up in basis and carryover basis, assume that a person owns a single asset with a value of $6 million in 2019, and that the original cost basis of this asset was $2.5 million.

If this property is transferred to an heir after death via an estate, step-up in basis would apply and the cost basis of the capital gain would be increased to its fair market value. If this property were sold immediately by the heir upon transfer, step-up in basis would eliminate capital gains tax liability (see Table 1). The heir could also decide to hold on to the property. If the heir sells the property in the future, the basis of the capital gain would be $6 million, instead of the decedent’s original cost basis of $2.5 million. The heir could also hold on until death and transfer the property in her estate with step-up in basis.

If the property was transferred before death, carryover basis would apply, and the recipient’s cost basis would be the same as the transferor’s original cost basis. If the recipient sold the property immediately upon receipt, at $6 million, the recipient would pay capital gains tax on the $3.5 million capital gain. This capital gains income would be subject to a 23.8 percent tax rate (the top, 20 percent rate for capital gains income, and the 3.8 percent net investment income tax).[16] This means the recipient would owe $833,000 in capital gains taxes. If the recipient does not sell immediately, any capital gain in the future would be measured from the donor’s original cost basis. In other words, the $3.5 million appreciation that occurred between the donor’s acquisition of the property and transfer to the recipient, as well as any appreciation that occurs after that transfer of the capital gain to the recipient, would be taxed at the recipient’s applicable capital gains tax rate (in this case, 23.8 percent).

Overall, Tables 1 and 2 demonstrate the potentially significant difference in capital gains tax liability between step-up in basis and carryover basis. This difference provides an incentive to pass on property at death through an estate, instead of passing along property before death.

Step-up in Basis is a Nonneutral Tax Expenditure that Discourages Capital Gain Realizations

A tax expenditure is a deviation from the “normal” tax code that lessens a taxpayer’s tax burden. Currently, when defining whether a policy is a tax expenditure, the federal tax code relies heavily on the Haig-Simons definition of income, which defines income as equal to the sum of your consumption plus your change in net worth.[17] Under the current system, both step-up in basis and carryover basis are defined by the Joint Committee on Taxation (JCT) as tax expenditures, reducing federal revenue between fiscal years 2018 and 2022 by an estimated $204.4 billion and $9.7 billion, respectively.[18]

Defining a tax base matters when thinking about a tax expenditure. The federal government’s current tax base is less than ideal because it taxes delayed consumption, or saving, more heavily than immediate consumption, which reduces after-tax returns on saving and investment.[19] On the other hand, a consumption tax base, which taxes an individual’s income but allows an individual’s net saving to be deducted from their taxable income,[20] taxes each dollar once, regardless of whether it is consumed immediately or saved for future consumption. When a dollar is taxed more than once, neutrality is violated. But neutrality is also violated when income escapes taxation entirely, as is the case with employer-provided health insurance.[21]

Step-up in basis would be a tax expenditure under a consumption tax base. This is because step-up in basis would allow the returns from a decedent’s saving to escape tax completely, so long as the asset is passed to an heir. Carryover basis would not be a tax expenditure under a consumption tax base. While it’s possible for a gift recipient to defer capital gains under carryover basis, these returns to saving will eventually be taxed when the recipient of the gift realizes the capital gain. This recipient would be able to avoid capital gains tax by transferring to an heir at his own death, but in this case, step-up in basis would take effect.   

This lock-in effect reduces federal revenue and primarily benefits wealthier taxpayers. Wealthier taxpayers are generally in a better position to pass property on at death than less wealthy taxpayers, who must spend down resources in retirement.[22] Step-up in basis has also been criticized on the grounds that its lock-in effect deters taxpayers from reinvesting capital gains earnings in other areas of the economy.[23] The importance of eliminating step-up in basis as a way to spur U.S. investment is overstated. The U.S. is an open economy with access to a large amount of global saving and doesn’t need to rely solely on U.S. saving to fund investment opportunities.[24] In fact, eliminating step-up in basis would likely reduce the incentive to save as it would increase the marginal effective tax rate on saving in the U.S.

Repealing Step-up in Basis Without Changes to the Estate Tax Could Increase Taxes on Capital and Compliance Burdens

Although step-up in basis deserves skepticism as a nonneutral tax expenditure that reduces revenue and primarily benefits wealthy taxpayers, it also mitigates the double taxation of investment income and the economic harm produced by the estate tax. Step-up in basis also makes life simpler for taxpayers that receive property in an estate.

While the estate tax raises little revenue it is harmful from an economic point of view because it discourages saving.[25] This is because the estate tax’s 40 percent tax rate allows taxpayers to keep just 60 cents of every dollar above the exemption.^[26] Moreover, the estate tax is a third, or even fourth, layer of tax on a given dollar of income, after individual income taxes, corporate income taxes, and other types of taxes paid over a person’s lifetime.^[27]

Step-up in basis removes one layer of tax on transferred property for heirs by eliminating taxation on any appreciation that occurred during the decedent’s life. This makes sure property transferred to heirs is not subject to an estate tax on the total value of an estate’s property, as well as capital gains taxes on any appreciation within the property’s assets. In a sense, step-up in basis mitigates what would otherwise be a significant effective tax rate on saving.

It’s worth noting that estates that currently fall below the estate tax’s exemption are spared from the estate tax and the heirs who receive this property are spared from capital gains tax by step-up in basis. In this case, the revenue foregone from step-up in basis doesn’t mitigate the effect of the estate tax on investment—it provides an additional tax preference for capital gains income for taxpayers with estates that are not hit by the estate tax.[28]

There is also an administrative argument for step-up in basis. If the policy were eliminated, taxpayers would have to verify the original cost basis of every capital gain to ensure they are compliant. This is often difficult when a donor is living but could be next to impossible for an heir if a decedent did not leave proper documentation of an asset’s original cost basis. Eliminating step-up in basis could increase compliance costs for taxpayers.^[29]

Conclusion

Repealing step-up in basis for capital gains—which increases the basis of any capital gain transferred to an heir after death to its fair market value—is a difficult call for policymakers. On the one hand, eliminating step-up in basis removes a nonneutral tax expenditure that reduces federal revenue and primarily benefits wealthy taxpayers. But on the other hand, eliminating step-up in basis without changing the estate tax would increase the tax burden on investment and could reduce the size of the economy. Eliminating step-up in basis would also increase the compliance burden for heirs, who would have to verify the original cost basis of property upon a decedent’s death. Policymakers should consider these trade-offs when they think about repealing step-up in basis.

[1] 26 USC § 1014.  See also “Income tax basis in property received,” in “Part VI: Increase in Estate and Gift Tax Exemption,” in Joint Committee on Taxation, “General Explanation of Public Law 115-97,” Dec. 20, 2018, https://www.jct.gov/publications.html?func=startdown&id=5152.

[2] See “Exclusion of Capital Gains at Death; Carryover Basis of Capital Gains on Gifts,” in Committee on the Budget, United States Senate, “Tax Expenditures: Compendium of Background Material on Individual Provisions,” Congressional Research Service, December 2012, https://www.govinfo.gov/content/pkg/CPRT-112SPRT77698/pdf/CPRT-112SPRT77698.pdf, as well as Option 74: “End stepped-up basis of capital gains at death,” in Options for Reforming America’s Tax Code (Washington, D.C.: Tax Foundation, 2016), https://files.taxfoundation.org/20170130145208/TF_Options_for_Reforming_Americas_Tax_Code.pdf.

[3] Stephen J. Entin, “The President Proposes a Second Tax on Estates,” Tax Foundation, Jan. 23, 2015, https://taxfoundation.org/president-proposes-second-tax-estates/. 

[4] Option 74: “End stepped-up basis of capital gains at death,” in Options for Reforming America’s Tax Code.

[5] 26 USC § 2001-2210. For information on the declining number of taxpayers subject to the estate tax, see “Table 2. – Number of Taxable Estate Tax returns Filed as a Percentage of Deaths, Selected Years, 1935-2013,” in Joint Committee on Taxation’s “History, Present Law, and Analysis of the Federal Wealth Transfer Tax System,” March 16, 2015, https://www.jct.gov/publications.html?func=startdown&id=4744.

[6] Internal Revenue Service, “SOI Tax Stats – Estate Tax Statistics Filing Year Table 1,” 2017 data, https://www.irs.gov/statistics/soi-tax-stats-estate-tax-statistics-filing-year-table-1.

[7] Internal Revenue Service, SOI Tax Stats – Individual Income Tax Returns, Preliminary Data, “Table 1—Individual Income Tax Returns:  Selected Income and Tax Items,” 2017 data, https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-returns#prelim.

[8] Internal Revenue Service, “Estate Tax,” https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax. See also Alan Cole, “Modeling the Estate Tax Proposals of 2016,” Tax Foundation, June 14, 2016, https://taxfoundation.org/modeling-estate-tax-proposals-2016.

[9] Scott Eastman, “New IRS Data Reiterates Shortcomings of the Estate Tax,” Tax Foundation, Oct. 18, 2018, https://taxfoundation.org/new-irs-data-reiterates-shortcomings-estate-tax/.

[10] The estate tax’s exemption is called the unified credit because it is shared with the gift tax. The credit is unified because amounts used to offset the gift tax cannot be used to offset estate tax liability at death. The estate and gift taxes also share the same rate schedule and other features. See “Section III. B—Common Features of the Estate, Gift and Generation Skipping Transfer Taxes,” in Joint Committee on Taxation’s “History, Present Law, and Analysis of the Federal Wealth Transfer Tax System.” 

[11] For tax years 2018 through 2025, the TCJA doubled the estate and gift tax exemptions. These provisions are also indexed for inflation occurring after 2011. See “Explanation of Provision,” in Joint Committee on Taxation, “General Explanation of Public Law 115-97,” 89.

[12] The estate tax has a progressive rate schedule, with the lowest rate beginning at 18 percent for estates valued between 0 and $10,000, going up to a top marginal rate of 40 percent for estates valued at more than $1 million. But due to the size of the unified credit, estates face a functionally flat tax rate of 40 percent for every dollar beyond the exemption. For the rate schedule, see 26 USC § 2001 (C). For Basic Exclusion Amount, see 26 USC § 2010 (C) (3).

[13]26 USC § 1014. See also “Exclusion of Capital Gains at Death; Carryover Basis of Capital Gains on Gifts,” in Committee on the Budget, United States Senate, “Tax Expenditures: Compendium of Background Material on Individual Provisions.”

[14] 26 USC § 1015. 

[15] See “Exclusion of Capital Gains at Death; Carryover Basis of Capital Gains on Gifts,” in Committee on the Budget, United States Senate, “Tax Expenditures: Compendium of Background Material on Individual Provisions.”

[16] In 2019, capital gains for individual taxpayers will be taxed at 0 percent if an individual’s income is below $39,375; 15 percent if an individual’s income is between $39,375 and $434,550; and 20 percent if an individual’s income is above $434,550. See Amir El-Sibaie, “2019 Tax Brackets,” Tax Foundation, Nov. 28, 2018, https://taxfoundation.org/2019-tax-brackets/. Individuals with income above $200,000 ($250,000 for married filers) are subject to an additional 3.8 percent tax on their net investment income. See Internal Revenue Service, “Questions and Answers on the Net Investment Income Tax,” June 18, 2018, https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax.

[17] Robert Bellafiore, “Tax Expenditures Before and After the Tax Cuts and Jobs Act,” Tax Foundation, Dec. 18, 2018, https://taxfoundation.org/tax-expenditures-pre-post-tcja/.

[18] Joint Committee on Taxation, “Estimates of Federal Tax Expenditures for Fiscal Years 2018-2022,” Oct. 4, 2018, https://www.jct.gov/publications.html?id=5148&func=startdown.

[19]Ibid. See section “What is the Normal Tax Code?”

[20] Robert Carroll, David Joulfaian, and James Mackie, “Income Versus Consumption Tax Baselines for Tax Expenditures,” National Tax Journal 64, no. 2, Part 2 (June 2011), 491-510, http://www.ntanet.org/NTJ/64/2/ntj-v64n02p491-510-income-versus-consumption-tax.pdf?v=%CE%B1.

[21] For instance, the tax treatment of savings vehicles like the 401(k) or the Roth Individual Retirement Account (IRA) are both neutral. In a 401(k), taxation is deferred until savings are withdrawn, and all returns are taxed, whereas after-tax income is invested in Roth IRAs and any returns are withdrawn tax-free. See Erica York, “The Complicated Taxation of America’s Retirement Accounts,” Tax Foundation, May 22, 2018, https://taxfoundation.org/retirement-accounts-taxation/.

[22] See “Exclusion of Capital Gains at Death; Carryover Basis of Capital Gains on Gifts,” in Committee on the Budget, United States Senate, “Tax Expenditures: Compendium of Background Material on Individual Provisions.”

[23] Ibid.

[24] Kyle Pomerleau, “Economic and Budgetary Impact of Indexing Capital Gains to Inflation,” Tax Foundation, Sep. 4, 2018, https://taxfoundation.org/economic-budget-impact-indexing-capital-gains-inflation/.

[25] See “Chapter 3: Estate and Gift Taxes,” in Options for Reforming America’s Tax Code.

[26] For context, the top marginal income tax rate for individuals is 37 percent for those earning more than $510,300 in 2019. See Amir El-Sibaie, “2019 Tax Brackets,” Tax Foundation.

[27] See Alan Cole, “Modeling the Estate Tax Proposals of 2016,” Tax Foundation.

[28] Steve Entin, “The President Proposes a Second Tax on Estates,” Tax Foundation.

[29] Option 74, “End stepped-up basis of capital gains at death,” in Options for Reforming America’s Tax Code.

Source: Tax Policy – The Trade-offs of Repealing Step-Up in Basis

Who Wants to Tax a Millionaire? The State of New Jersey

by r Hampton | Mar 11, 2019 | Tax News

Tax Policy – Who Wants to Tax a Millionaire? The State of New Jersey

In his recent budget address, as reported by CBS Philly, New Jersey Gov. Phil Murphy (D) presented a budget of $38.6 billion, 3 percent higher than the previous budget—a difference of about $1 billion. Reportedly, he plans to partially fund this increase through a “millionaire’s tax.”

New Jersey currently taxes earnings above $500,000 and $5 million at rates of 8.97 and 10.75 percent, respectively. The millionaire’s tax would expand the top bracket to include everything over $1 million. While the current $5 million bracket includes roughly 6,700 New Jerseyans, the new plan would include about 18,000. This accounts for the highest-earning 0.4 percent of the 4.7 million filers in New Jersey.

The governor also pushed for a four-year surtax on corporations as part of the plan. Companies with more than 50 employees who use Medicaid as their health care would pay a “corporate responsibility fee” of $50 per worker.

The plan is far from top-tier. An ideal tax structure is levied on a broad base with low rates, and is simple, stable, transparent, and neutral. The millionaire’s tax violates principles of stability and neutrality, while doing nothing to solve the state’s current problems with complexity and lack of transparency. It makes the state budget even more reliant on high earners, creating a more volatile source of revenue. The tax also has a nonneutral effect on economic growth by distorting incentives for higher earners and inducing even more outmigration.

New Jersey has seven income tax brackets with high top rates, a complex system that ranks worst in the nation on our 2019 State Business Tax Climate Index. At best, this new plan retains the status quo of complexity while increasing tax uncertainty. After all, the state would be changing a bracket that was only created in July of 2018.

The surtax also fails to be neutral, as it is levied upon certain corporations and excludes others. The surtax hits corporations that have employees on Medicaid, in effect taxing them for not providing their employees with a health-care alternative to Medicaid. However, one reason that some of these corporations might not provide a health-care plan is that they might have low profit margins, meaning that the surtax might hit the corporations least able to pay. Penalizing corporations through the tax code is a distortive and ill-guided way to achieve a policy goal like company-provided health-care.

Under the millionaire’s tax, the uncompetitive Garden State would fall even further behind its neighbors. Overburdened New Jerseyans could look to Pennsylvania with its flat rate of 3.07 percent. Or to others nearby: Rhode Island and Connecticut have top rates of 5.99 and 6.99 percent, respectively. New Jersey is already seeing large outflows of income-earning power to states like Florida, Pennsylvania, North Carolina, and Texas.

In 2018, the Garden State saw the most outmigration of any of the 48 contiguous states. New Jersey would benefit from a way to attract residents, and a better tax system would be a good place to start. It should look toward creating a simpler, more neutral tax code instead of pushing changes like the millionaire’s tax that lead to greater revenue instability and stronger incentives for high earners to relocate to a lower-tax jurisdiction.

New Jersey’s tax code ranks last in our Index. This fact matters because a state’s tax system can make a difference in where a business chooses to locate. After all, corporations tend to put down roots where they have the greatest competitive advantage. This, in turn, can affect a state’s economic growth and job creation. As New Jersey’s tax code is already uncompetitive with other states, it seems misguided to accept a proposal that will make things even worse.

Source: Tax Policy – Who Wants to Tax a Millionaire? The State of New Jersey

Rhode Island Entity-Level Tax Proposal Raises Legal and Practical Concerns

by r Hampton | Mar 11, 2019 | Tax News

Tax Policy – Rhode Island Entity-Level Tax Proposal Raises Legal and Practical Concerns

Since enactment of the Tax Cuts and Jobs Act (TCJA), states have employed strategies to work around the federal cap of $10,000 when deducting state and local income taxes (SALT) from one’s federal tax return. In addition to workarounds involving state charitable deductions and payroll taxes, several states have enacted a tax on pass-through businesses (such as S corporations and partnerships) to avoid the SALT deduction cap. Under recently-introduced legislation, Rhode Island looks to join their ranks.

State income tax codes typically allocate business income from pass-through firms on to the owners’ individual income tax returns. An entity-level tax assesses a liability directly on the firm before the income passes to the owners, much like a corporate income tax. States provide a credit for some or all of the entity-level tax paid for owners’ individual income tax liability. Because the TCJA only capped the deduction for SALT on individuals, not businesses, owners can only fully deduct SALT from their tax liability at the business level. 

Under H. 5576, Rhode Island pass-through businesses would have the option to pay an entity-level tax at the flat rate of 5.99 percent, with a state tax credit in that amount available to the owners on a pro rata basis. Because 5.99 percent is the top rate on Rhode Island’s individual income tax, with lower rates on income below $145,600, the appeal of this provision for taxpayers will vary based on the amount of business income they have, as well as how much taxable income they may earn from other sources.

Similarly, in 2018, Connecticut lawmakers established the pass-through entity tax (PET), which is assessed on partnerships and S corporations. This establishes a 6.99 percent tax on the pass-through firms at the entity level. On the individual’s income tax return, the PET provides credit for 93.01 percent of the pass-through entity tax paid. This tax works in a similar way to a proposed entity-level tax in New York, and a pass-through tax has been enacted in Wisconsin.

Rhode Island’s entity-level tax is voluntary, meaning that businesses for which it is a nuisance or would yield a tax increase need not adopt it. For some, it could mean a substantial reduction in tax liability. For others, it may not be so simple. While states tend to offer credits for taxes paid to other states (to avoid double taxation), the credits are tied to income taxes and are unlikely to apply to taxes recharacterized as entity-level payments.

If one or more of the business partners reside out-of-state, the lack of a credit for taxes paid to other states is only the beginning of their concerns. Those partners may have little or no income tax liability in Rhode Island itself, and their own state won’t offer them a tax credit for entity-level taxes paid. There is no mechanism for the entity-level tax to only be paid on the pro rata amount associated with in-state partners, or only distributed to them.

The American Institute of Certified Public Accountants has also highlighted another challenge to this arrangement: the Internal Revenue Service (IRS) may argue that any reliance on a state tax provision enacted to avoid the SALT limitation is a “listed transaction,” which requires taxpayers to disclose the transactions on federal income tax returns. Listed transactions are determined by the IRS to be methods to legally avoid tax. While this would not change the legality of the tax, it could be a source of complexity for taxpayers.

In September, the Treasury Department and IRS provided guidance on business expense deduction, clarifying that businesses can still deduct business-related taxes in full as a business expense on their federal income tax returns. This may bolster the case that entity-level taxes on pass-through firms comply with the TCJA and IRS rules.

But significant concerns remain. Professor Daniel Hemel of the University of Chicago Law School, who has defended the viability of New York’s other SALT cap workarounds (conclusions with which we have disagreed), has questioned whether the entity-level tax approach would succeed. Certainly, business taxes are fully deductible, but the Internal Revenue Code regards all income from pass-through businesses to be subject to the individual income tax and imposes the $10,000 cap on all “state and local, and foreign, income, war profits, and excess profits taxes,” among other taxes.

Professor Hemel maintains that the entity-level tax is still an income tax, and that the deduction flows through Schedule K-1 (for the business) to the individual owner’s 1040 and is claimed there. This means that a pass-through business does not have the ability to deduct the tax at the entity level because the federal code does not countenance entity-level taxation of such businesses. For federal purposes, it’s all individual income. If this interpretation is correct, it would defeat the entire purpose of such workarounds—in Rhode Island, Connecticut, Wisconsin, or anywhere else.

The IRS could also challenge entity-level pass-through taxes on quid pro quo grounds or argue that they differ from payment of individual income taxes in form only. Indeed, Scott Dinwiddie of the IRS’s Income Tax and Accounting Division recently said that regulations on the matter were “likely,” adding, “From the IRS perspective, the workarounds certainly have not gone unnoticed.”

Whether entity-level pass-through taxes pass legal muster, the benefit they provide to states and their highly-compensated taxpayers is not worth the added complexity and administrative costs, nor is there much equity in a provision which reduces taxes on the income of business owners but not their employees. States would be better off using their creative energy to refom their tax codes and alleviate the overall burden on taxpayers.

Source: Tax Policy – Rhode Island Entity-Level Tax Proposal Raises Legal and Practical Concerns

Twelve Things to Know About the “Fair Tax for Illinois”

by r Hampton | Mar 11, 2019 | Tax News

Tax Policy – Twelve Things to Know About the “Fair Tax for Illinois”

Key Findings

• New Illinois Gov. J.B. Pritzker (D) has proposed sweeping changes to Illinois’ tax code, advocating a constitutional amendment to permit a graduated-rate income tax and proposing a new rate and bracket structure.
• Under the proposal, corporate income would be taxed at 10.45 percent, the third-highest rate in the nation, while pass-through business income would be taxed at a top rate of 9.45 percent, the fourth highest such rate nationwide.
• The proposal diverges sharply from ideal—or even typical—income tax structure. It omits inflation indexing (resulting in “bracket creep”), creates a marriage penalty, and includes a recapture provision which subjects the entirety of a taxpayer’s income to the top marginal rate once they reach that bracket.
• The neighboring states of Indiana, Iowa, Kentucky, and Missouri have all cut income taxes in recent years, while Illinois may be headed in the opposite direction.
• The governor’s proposed tax rates are merely notional; should voters permit a graduated-rate income tax, there are compelling reasons to believe that rates may climb even higher, and that more taxpayers would be subjected to higher rates.
• Were the proposal implemented, Illinois is projected to decline from 36th to 48th on the State Business Tax Climate Index, which measures tax structure.

Introduction

The new governor of Illinois, J.B. Pritzker (D), has one campaign behind him, but an even bigger one lies ahead: convincing the legislature—and Illinois voters—to scrap a key constitutional feature of Illinois’ system of taxation.

A provision in the state constitution which prohibits a graduated-rate income tax has long been a source of controversy.[1] In a state where taxes tend to be high, it has also been crucial to keeping one tax (the individual income tax) highly competitive, because there are practical and political limits on just how high a rate can go when it is applied uniformly.

The constitutional amendment Gov. Pritzker is championing would change all that, and under the rates and brackets he has proposed,[2] would give Illinois some of country’s highest income taxes (individual and corporate), particularly on businesses. That’s of particular concern in a state that has struggled to stem the tide of business departures, as the governor noted in remarks this week, but it’s only one of many issues raised by the proposal.

All told, the governor’s “Fair Tax for Illinois” proposal would result in a 10.45 percent combined rate on corporate income, and a 9.45 percent rate on about half the state’s pass-through income, including the “personal property replacement taxes” the state tacks onto rates (discussed later).

It is important to note that the governor’s proposed rates and brackets will likely be separate from the actual constitutional amendment on which the legislature and, ultimately, the people, will vote. They are notional—a sense of where he is headed. Although an amendment could, theoretically, enshrine a set of rates and brackets in the constitution, or cap the top rate, it is more likely that an amendment will simply lift the prohibition on a graduated-rate income tax, leaving this and subsequent legislatures to adopt rates of their choosing. (A joint resolution proposing a constitutional amendment has already been introduced, but it does not appear to be entirely consistent with Pritzker’s plan.)

Under Gov. Pritzker’s proposal, however, the current 4.95 percent flat individual income tax would be transformed into a six-rate tax, with rates ranging from 4.75 to 7.95 percent. A recapture provision means that filers with income in the top bracket will have their entire income, not just their marginal income, subject to the top rate of 7.95 percent. Meanwhile, the base corporate rate would increase from 7 to 7.95 percent (10.45 percent counting the personal property replacement tax), in a misguided—and miscalculated—effort to match the new top rate on individual income.

The plan also includes an increase in the value of the property tax credit, from 5 to 6 percent of the taxes paid on one’s primary residence, and a new $100 per child tax credit, which phases out beginning at $40,000 in income ($60,000 for two-income families). The following table shows the proposed rates and brackets.

Many things could be said about this proposal, but here are twelve points that should be part of any consideration.

1. The proposal would create some of the highest rates in the country.

When Illinois lawmakers repealed the state’s taxes on tangible personal property forty years ago, they paid for the repeal by creating a second set of taxes on both pass-through and corporate income, confusingly termed “personal property replacement taxes” (PPRTs).[3] The name references the tax they replaced rather than the nature of the taxes themselves, which are nothing more than additional income tax levies of 2.5 percent on corporate income and 1.5 percent on the income of pass-through businesses, with revenue devoted to local government. The income of pass-through businesses (S Corps, partnerships, LLCs, and sole proprietorships) “passes through” to their owners’ individual income tax returns (hence the name). Including these taxes, the top rate on pass-through businesses would be 9.45 percent and the new rate on corporate income would be 10.45 percent.

This would represent the third-highest corporate rate in the country, after Iowa (12 percent) and New Jersey (11.5 percent), and Iowa is scheduled to reduce its top corporate rate to 9.8 percent in a few years. It also represents the fourth-highest rate on pass-through income nationwide, after California (13.3 percent), Oregon (9.9 percent), and Minnesota (9.85 percent). The 7.95 percent rate on non-business income would be the eighth-highest state rate in the country.

2. Illinois’ neighbors are making their tax rates more competitive, not less.

If Illinois were to raise its rates, it would be moving in the opposite direction of its neighbors. Indiana has reduced its top corporate income tax rate from 8 to 5.75 percent and is on track to bring it down to 4.9 percent in a few years, while its individual income tax rate has gone from a flat 3.4 percent to 3.23 percent over five years. Policymakers in Indiana have consciously positioned themselves as a more competitive alternative to Illinois, and they aren’t alone.[4]

In Missouri, a set of bills in 2018 reduced the top income tax rate from 5.9 to 5.5 percent, with a further phasedown to 5.1 percent in the works, while the corporate rate is set to fall from 6.5 to 4 percent in 2020.[5] Meanwhile in Iowa, a package of reforms adopted last year will ultimately bring the top individual income tax rate to 6.5 percent (from 8.98 percent) and the corporate rate to 9.8 percent (from 12 percent),[6] and Kentucky just replaced its graduated-rate individual and corporate income taxes with single-rate taxes of 5 percent.[7] Even in Minnesota, legislators are contemplating tax cuts to offset additional revenue from tax conformity. In short, Illinois would be raisings its tax rates at a time when its neighbors are headed in the opposite direction.

3. These higher taxes would have a significant impact on Illinois businesses.

While $1 million is undoubtedly a lot of money, over half of all pass-through business income is reported on returns with more than $1 million in business income alone (to say nothing of other income sources), and almost 72 percent comes from returns of $500,000 or higher. Under the Pritzker proposal, taxes would be higher on all income above $250,000—which accounts for the overwhelming majority of net business income from pass-throughs in Illinois. While the Internal Revenue Service does not maintain data using a $250,000 inflection point, we know that more than 93 percent of all pass-through income is on returns claiming more than $200,000 in pass-through income.[8] (See table below.)

In other words, while those paying these higher taxes may be well-to-do, the proposal represents a significant new tax on Illinois employers. While not all pass-through businesses are small businesses, it’s worth noting that small businesses are responsible for 46.4 percent of Illinois employment.[9] In a state already suffering from an outmigration of businesses and high earners, a tax increase of this size could do real damage.

Illinois ranked 46th in the nation in private sector job growth in 2018.[10] Policymakers should be exceedingly careful about adopting policies that make it harder to do business in the state.

4. The cost of high rates has never been higher.

With the new $10,000 cap on the state and local tax (SALT) deduction, high earners in high tax states no longer receive a generous federal tax subsidy to offset their state and local tax liability. Under the old law where state income taxes were deductible on federal returns, a rate of 9.45 percent (on pass-through business income) or 7.95 percent (on other income) would reduce federal tax liability to the point that net amount paid on the marginal dollar of income was really 5.71 or 4.80 percent respectively. Under the new law, high earners no longer have the dubious luxury of enjoying the benefits of a high service state while exporting a significant share of their tax burden to non-itemizers or taxpayers in other states. That represents good policy, but it also means that all Illinois taxpayers will feel the brunt of any substantial rate increase, with all that entails. Such high rates could accelerate migration out of Illinois, which is already a major concern.

It’s a concern, in fact, that the governor acknowledged in his press conference, albeit in an effort to dispute it. “Now, there are those who want to scare people by claiming that this proposal will cause residents and businesses to flee Illinois,” said Pritzker. “They couldn’t be more wrong. They ignore the fact that people and businesses are fleeing our state now under our current regressive tax system, yet states with fair tax systems on average grow faster and create more jobs than Illinois.”[11]

This is a curious statement. Individuals and businesses are already fleeing Illinois. Higher taxes aren’t going to turn things around, especially if the tax increase does nothing to address Illinois’ unpaid bills, pension debt, or other fiscal challenges.

5. Business rate parity makes little sense.

There is no real reason why corporate and individual income tax rates should be aligned absent a much broader, structural integration of business entity types, since they are not meaningfully comparable. While many small businesses pay through the individual income tax because they are organized as pass-through entities, traditional C corporations are double-taxed, paying taxes at both the entity level and again at the ownership level, so an attempt to keep the corporate rate aligned with the top individual rate only exacerbates an existing disparity. The PPRT on corporate income, moreover, is one percentage point higher than the PPRT on pass-through income, leading to a higher combined rate on corporate (10.45 percent) than pass-through (9.45 percent) income. Furthermore, documents issued by the Pritzker administration indicate that the corporate rate would remain flat—albeit at a much higher rate—so this does not, in fact, represent a true attempt to align the rates.

6. The new rates include a highly unusual “recapture” provision.

Tax rates are typically marginal, which is to say that they are imposed on marginal income. For instance, under the governor’s proposal, the first $10,000 in taxable income would be taxed at a rate of 4.7 percent, and someone earning $11,000 would only pay the higher rate of 4.9 percent on the additional $1,000, not the whole $11,000. According to handouts outlining Gov. Pritzker’s proposal, however, “[o]nce income reaches $1.0 million, entire income is taxed at 7.95 [percent] rate” (emphasis in original).[12] In other words, the entire benefit of the lower rates on income below $1 million (worth $8,565) disappears for filers with income above that threshold, and their top marginal rate is converted into a flat rate of 7.95 percent.

This is highly unusual. Similar rate recapture provisions exist in only three other states: Connecticut, Nebraska, and New York. Additionally, Arkansas has different tax schedules for different income classes, such that people with higher incomes still face a graduated rate schedule, but a different schedule than one that a middle- or low-income filer would face. Under the federal income tax, and the income tax rate schedules as they exist in all other states, rates are imposed on marginal income, with no recapture provision.

This creates a significant tax cliff, where a person making $1,000,000 pays $70,935 in taxes, while someone earning one dollar more pays $79,500, a difference of $8,565 on a single dollar of income.

Pritzker himself has not endorsed any particular language for a constitutional amendment. The joint resolution that has been introduced thus far has several elements that may be in tension or even at odds with his proposals, including a requirement that there be “one tax” on both individual and corporate income, which would seem to require that the corporate income tax include the entire rate schedule, and not maintain its current single-rate form. It is also not entirely clear that the proposed constitutional amendment even permits a recapture provision, though it does not expressly disallow it. The state constitution currently requires that “[a] tax on or measured by income shall be at a non-graduated rate.”[13] Under SJRCA 1, the tax “may be a fair tax where lower rates apply to lower income levels and higher rates apply to higher income levels”[14]—a description that is not wholly aligned with how a recapture provision would work. It is entirely possible, however, that the language of the joint resolution will be amended to match Pritzker’s proposal.

7. The proposal creates a significant marriage penalty.

A marriage penalty exists whenever two earners owe more tax filing jointly than they would if they filed separately. The penalty can emerge when any part of the tax code—brackets, deductions, or exemptions—do not increase for joint filers, but bracket widths under a graduated-rate income tax are particularly important. Many states double their bracket widths for married couples to avoid the penalty, but the Illinois proposal envisions the same brackets for single and joint filers.

Imagine a two-earner household where both partners make $100,000 in taxable income. If taxed separately under the proposed rates, they would both owe $4,885, for a combined tax bill of $9,770—each having their first $10,000 taxed at 4.75 percent and their next $90,000 at 4.9 percent. But as a married couple filing jointly, the first dollar of the second earner’s income is taxed at 4.95 percent (the rate for income above $100,000). They would face a marriage penalty, small in their case, but much larger as earners get into higher brackets.

One might be tempted to say that we need not be concerned about a modest marriage penalty on dual-income professionals, or a higher penalty on wealthier taxpayers, but bad policy like this is not easily reversed, and there is no guarantee that the rate structure will remain the same forever. If a marriage penalty is accepted from the outset, it may hit far more families down the road, the next time Illinois faces a revenue shortfall.

8. Tax burdens will rise due to “bracket creep.”

Within a graduated rate structure, inflation can impose a hidden tax, increasing the taxpayer’s liability as a greater share of their income is taxed even if that income has not increased in real terms, since bracket kick-in thresholds are fixed. To avoid this “bracket creep,” most states with graduated-rate structures index bracket widths and other features of the income tax to inflation. Pritzker’s proposal gives no indication of this, meaning that over time, taxpayers will pay an increasing amount of taxes as a percentage of income—even if their income has not increased in real terms.

9. There is no guarantee that rates will not rise in the future.

Pritzker’s rate proposal is just that—a proposal. If the legislature and voters grant approval for a graduated-rate income tax, nothing prevents the legislature from adopting higher taxes than those proposed now, or a future legislature from raising rates. Even under a single-rate tax, rates have risen twice in the past eight years (from 3 percent to the current 4.95 percent rate), and a graduated-rate income tax would make future rate increases much easier. The governor implicitly acknowledged this when he dismissed the alternative of a 5.95 percent flat tax.[15] When most or all taxpayers share in a tax increase, there is substantial political pressure to balance revenue needs with tax competitiveness. The ability to single out select taxpayers for higher rates—which will also fall on many small businesses—would make future tax increases easier in a state where lawmakers have already demonstrated a willingness to countenance unusually high rates.

Even higher taxes (as high as 11.25 percent on small businesses) have been contemplated in Illinois in recent years, as part of prior graduated-rate income tax proposals. Such rates would be unthinkable in a single-rate system but could easily reemerge if the single-rate requirement were repealed.

10. The numbers do not add up.

This proposal is estimated to increase revenues by $3.4 billion—but not immediately. The $3.4 billion figure appears to be the projection for 2021, the first possible year in which these new taxes could be in place. It’s also closely aligned with the current structural deficit as estimated by the governor’s office. Gov. Pritzker says that the alternative to these tax increases is significant cuts to discretionary spending, which he seeks to avoid, but there is no way that the state can start collecting new revenue under this proposal until the 2021 tax year. Illinois has a tradition of not paying its bills, but this proposal will not help in the short-term, so there is every reason to believe that the structural deficit could exceed $3.4 billion by the time it might conceivably help. The mountain of unpaid bills would presumably be higher, too.[16]

That is not an argument for doing nothing, but it does mean that other steps would have to be taken as well, and it also means that all of the new revenue—and then some—would presumably pay for existing government programs. The governor campaigned on increasing school funding, improving infrastructure, expanding social services, and reducing pension debt, and none of those things would be covered by the proposed tax increases. That may be a compelling reason to believe that these rates, as high as they are, will not be the last increases should voters approve a graduated-rate income tax. If that is the case, however, eventually rates will have to rise on middle class families, as there is only so much additional revenue at the top. The governor’s nonbinding rate schedule avoids a tax increase for most of these filers, but how long will that last?

11. The proposal eliminates the best feature of Illinois’ tax code.

The state’s relatively low single-rate individual income tax has historically been one of the few saving graces in a state with otherwise high and economically inefficient taxes. High taxes on income are generally among the least desirable taxes because they discourage wealth creation. A comprehensive review of international econometric tax studies found that individual income taxes are among the most detrimental to economic growth, outstripped only by corporate income taxes. The literature on graduated-rate income taxes is particularly unfavorable, with substantial evidence that higher marginal tax rates reduce gross state product growth even after adjusting for overall state tax burdens.[17]

Plenty of states with graduated-rate income taxes have better tax codes than Illinois overall, but Illinois policymakers have shown little ability to keep taxes or spending in check, and tax burdens are high throughout the rest of the system. Illinois has the 11th highest state and local tax collections per capita, at $5,654,[18] despite a relatively competitive, flat income tax. Absent the existing constitutional constraints, Illinoisans have every reason to fear that their income tax burdens will continue to rise. A child tax credit, or an expansion of the property tax credit that provides less than $50 in tax relief for the median homeowner, may come to seem like a very small inducement for the income tax burdens to come.

12. Illinois’ business competitiveness will decline.

Every year, the Tax Foundation publishes a new edition of the State Business Tax Climate Index, a measure of state tax structure. Illinois currently ranks 36th overall, with its competitive income tax balancing out poor tax structure elsewhere.[19] If, however, the state were to adopt the graduated rate structure Pritzker proposes, with top rates of 9.45 percent on pass-through income and 10.45 percent on corporate income, while creating a marriage penalty and forgoing inflation indexing, the state’s overall rank would plummet from 36th to 48th, ahead of only California and New Jersey.

States should care about their Index ranking because it is measuring something real and economically meaningful—the competitiveness, or lack thereof, of the state’s overall tax structure. Were Pritzker’s proposal adopted, Illinois would trail its peers in just about every aspect of its tax code. If businesses and individuals are leaving the state now, these policies can only make the problem worse.

[1] Ill. Const. art. ix, § 3, cl. a.

[2] Office of the Governor of Illinois, “Fair Tax for Illinois,” presentation, March 7, 2019, https://drive.google.com/file/d/14cV8N3i8krcYnspkpoybbf1xgvat4GEA/view.

[3] Illinois Department of Revenue, “What Are Replacement Taxes?,” https://www2.illinois.gov/rev/localgovernments/Pages/replacement.aspx.

[4] Nicole Kaeding and Jeremy Horpedahl, “Help from Our Friends: What States Can Learn from Tax Reform Experiences Across the Country,” Tax Foundation, May 15, 2018, https://taxfoundation.org/state-tax-reform-lessons-2018/.

[5] Jared Walczak, “Missouri Governor Set to Sign Income Tax Cuts,” Tax Foundation, July 11, 2018, https://taxfoundation.org/missouri-governor-set-sign-income-tax-cuts/.

[6] Jared Walczak, “What’s in the Iowa Tax Reform Package,” May 9, 2018, https://taxfoundation.org/whats-iowa-tax-reform-package/.

[7] Morgan Scarboro, “Kentucky Legislature Overrides Governor’s Veto to Pass Tax Reform Package,” Tax Foundation, April 16, 2018, https://taxfoundation.org/kentucky-tax-reform-package/.

[8] Internal Revenue Service, “Individual Income and Tax Data, by State and Size of Adjusted Gross Income,” Statistics of Income, Tax Year 2016, https://www.irs.gov/statistics/soi-tax-stats-historic-table-2.

[9] U.S. Small Business Association, “2018 Small Business Profile: Illinois,” 2018, https://www.sba.gov/sites/default/files/advocacy/2018-Small-Business-Profiles-IL.pdf.

[10] Orphe Divounguy and Bryce Hill, “Illinois Ranks 46 out of 50 States in Private Sector Jobs Growth,” Illinois Policy Institute, Jan. 23, 2019, https://www.illinoispolicy.org/illinois-ranks-46-out-of-50-states-in-private-sector-jobs-growth/.

[11] Office of the Governor of Illinois, “Gov. Pritzker Unveils Fair Tax Plan with 97 Percent of Taxpayers Getting Tax Relief,” March 7, 2019, https://www2.illinois.gov/Pages/news-item.aspx?ReleaseID=19772. 

[12] Office of the Governor of Illinois, “Fair Tax for Illinois.”

[13] Ill. Const. art. ix, § 3, cl. a.

[14] 2019 Ill. S.J.R.C.A. 1.

[15] Office of the Governor of Illinois, “Gov. Pritzker Unveils Fair Tax Plan with 97 Percent of Taxpayers Getting Tax Relief.”

[16] State of Illinois Comptroller, “Bill Backlog,” https://illinoiscomptroller.gov/financial-data/fiscal-focus-blog/bill-backlog/.

[17] William McBride, “What is the Evidence on Taxes and Growth?,” Tax Foundation, Dec. 18, 2012, https://taxfoundation.org/what-evidence-taxes-and-growth/.

[18] U.S. Census Bureau, “Annual Survey of State and Local Government Finances,” 2016 Tables, https://www.census.gov/programs-surveys/gov-finances.html; Tax Foundation calculations.

[19] Jared Walczak, Scott Drenkard, and Joseph Bishop-Henchman, “2019 State Business Tax Climate Index,” Sept. 26, 2018, https://taxfoundation.org/publications/state-business-tax-climate-index/.

Source: Tax Policy – Twelve Things to Know About the “Fair Tax for Illinois”

Michigan Governor Proposes Gas Tax Increase, Entity-Level Business Tax

by r Hampton | Mar 8, 2019 | Tax News

Tax Policy – Michigan Governor Proposes Gas Tax Increase, Entity-Level Business Tax

Michigan Governor Gretchen Whitmer (D) this week released her fiscal year (FY) 2020 budget bill, central to which is a 45-cent gas tax increase and a new entity-level tax on unincorporated businesses.

Currently, Michigan’s fuel excise tax is 26.3 cents per gallon (cpg). Under the governor’s proposal, a 45-cent increase would occur in three 15-cent increments over a one-year period: the excise tax would reach 41.3 cpg in October 2019, 56.3 cpg in April 2020, and 71.3 cpg in October 2020.

While the proposed excise tax increase alone would make Michigan’s gas tax the highest in the nation, it’s important to keep in mind that per-gallon excise taxes are not the only taxes states collect on gasoline. In fact, Michigan is among the few states that applies its sales tax to purchases of fuel, bringing the total state tax on a gallon of gas to an average of 44.13 cpg, the sixth-highest in the nation. As such, a 45-cent increase would bring Michigan’s total average gas tax to 89.13 cpg, by far the highest in the nation, and over 30 cents higher than in Pennsylvania, which currently has the highest gas tax (58.7 cpg). The result: Michiganders would be paying double the state taxes they currently pay at the pump.

To offset the gas tax increase for lower-income residents, this proposal would incrementally double the Earned Income Tax Credit (EITC) from 6 percent to 12 percent of the federal credit amount, starting with a 4 percent increase in FY 2020 and an additional 2 percent increase in FY 2021.

In addition, the governor’s budget would create a new entity-level tax on pass-through businesses, including sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations. Currently, the income of unincorporated businesses is taxed at Michigan’s flat 4.25 percent individual income tax rate. That’s because, with limited exceptions, pass-through businesses are taxed under federal and state individual income tax codes. It’s in their very name: business income passes through to owners’ individual income tax returns.

However, under the governor’s proposal, pass-throughs would be subject to an entity-level tax at a higher rate of 6 percent. Business income would still technically flow through to owners’ individual income tax returns, but owners would receive an offsetting credit so only non-business income would be taxed at the lower 4.25 percent rate.

The governor’s proposal cites “tax parity” as the justification for the tax increase on pass-through businesses, since traditional C corporations are subject to a 6 percent income tax. It’s important to keep in mind, though, that parity of rate does not equate to parity of tax burden. Strict comparisons cannot be made between corporate income tax rates and individual income tax rates, in part because corporations are taxed at the entity level and again when profits are distributed, and because differences exist between individual and corporate income tax bases. If parity truly becomes an issue that prevents businesses from incorporating when they otherwise would, there are better solutions than raising tax rates on small businesses and forcing them to pay taxes at the entity level.

Another reason for the tax increase on pass-throughs is as an offset to “pay for” the creation of a new income tax exemption for pension income. Currently, Michigan properly treats most retirement income, including pension income, like other forms of income for tax purposes, but the governor’s proposal would carve pension income out of the income tax base. The governor’s proposal characterizes this move as a repeal of the “pension tax,” but that term is misleading because pension income is not subject to a special tax; it is treated like other forms of income and taxed at the state’s 4.25 percent rate. Exempting pension income would in fact create a disparity in the tax treatment of retirement income. A more neutral approach is simply to tax all income, whether personal income, pass-through business income, or retirement income, at the state’s competitive, flat rate.

Source: Tax Policy – Michigan Governor Proposes Gas Tax Increase, Entity-Level Business Tax