How much income should be rendered unto Caesar
The recent weeks have been quite interesting from a tax policy standpoint. The release of tax returns from candidates running for president and the president’s State of the Union address included many general tax proposals.
The tax rate paid by top income earners has become an increasingly hot topic among politicians. “Paying one’s fair share” is becoming a more common theme. Taxes are a centuries-old issue. We only need to recall the first portion of the statement Jesus is quoted as making: “Render unto Caesar what is Caesar’s.” What portion of one’s earnings should be rendered is definitely an issue in the 2012 political campaign.
Looking back a year, who would have thought that the rate of tax Warren Buffet’s secretary pays would become such a hot topic. The discussion on tax rates is an age-old item of debate and it will likely continue to be debated in years to come.
I recently took a few minutes to look at the candidate tax returns made public, and one only needs to look at the sheer size (pages, not income) of the tax returns. The hundreds of pages of tax reporting demonstrate the current complexity of the Internal Revenue Code. The U.S. has created a very complex compliance environment for many taxpayers.
As I digested the returns and filtered the various media reports of the call for instituting the so called “Buffet Rule,” it became apparent we may have been down this path before. Call it déjà vu, but I recall early in my career the reports of some millionaires paying no federal income tax and the outcry in Washington to change the tax code.
Congress heard and responded to this issue first in 1969 and then again with more significant changes in 1986. The fix was the alternative minimum tax. As part of a more comprehensive tax reform in 1986, the AMT was reformatted with the intent to capture certain high-income taxpayers who may have otherwise avoided paying a certain level of federal income tax through the use of large itemized deductions of other tax preferences.
This repackaged AMT generally provided for a 28 percent rate imposed on a modified tax base. Some of the hallmarks of the tax calculation were one started with taxable income and made modifications to that amount by adding back certain deductions and reducing other deductions. For example, depreciation expense on business assets is recalculated for AMT purposes, the deduction for state income and property taxes are added back and a list of other adjustments in order to determine a taxpayer’s income subject to the AMT.
If we fast forward 25 years or so, the result of the AMT is that it actually hits many middle- and upper-middle income taxpayers. Also, if not for the AMT patch that is up for renewal every year or two, many more middle- and lower-income taxpayers would also be hit by the AMT. So many taxpayers are now hit by the AMT, for several reasons. One reason is that state income and real estate taxes are a significant itemized deduction item. The fact that state and local taxes are not deductible for AMT tax purposes results in many families in higher-taxed states falling into the AMT net.
In addition, many tax credits are only available as a credit against regular tax liability and not the AMT. Thus, many taxpayers with tax credits have their regular tax liability reduced below their AMT liability, and thus have an AMT tax to make up the difference between the two. So, in many cases, tax credits are not useable. Then, the AMT rate of tax is relatively high: 28 percent. Like a perfect storm, the above factors all contribute to a large number of middle- and upper-middle income taxpayers being subject to the AMT.
The impact of AMT results in a situation where a tax aimed at high-end taxpayers actually affects a class of taxpayers never intended to be subject to the tax. Will the Buffest Rule follow a similar course? The stated intent to have a minimum rate of tax is understandable. Tax changes can morph over time and sometimes catch unintended victims.
Legislation has actually been introduced to place a new minimum tax or Buffet Rule in the Internal Revenue Code. The rate would be phased in for incomes over $1M and be fully phased in at $2M. Charitable deductions appear to be the one deduction that will be allowable to reduce income under the proposal. This is good news for charities.
The proposal is interesting, but I did some back-of-the-envelope calculations. Granted, they may be simplistic, but here is what I came up with. The Buffet Rule can be effectively enacted without needing to actually do anything in 2013. The Bush tax cuts will expire again starting Jan. 1, 2013, so the capital gains tax rate will revert back to 20 percent (from 15), and the ordinary income tax rate will revert to 39.6 percent, and that rate will also apply on qualified dividends. In fact, the Medicare tax on passive investment income will add another 3.8 percent for high-income earners.
Thus, the marginal federal income tax rates in 2013 for individuals will be 23.8 percent on long-term gains and 43.4 percent on ordinary income (including dividends). So, if a taxpayer in the top marginal tax brackets earned $1,000 of long-term gains and $1,000 of qualified dividends, the federal income tax on that income in 2012 is $300 (15 percent). In 2013, (if the Bush-era tax rate reductions are not extended), the federal income tax liability on that same amount of income is $672 ($434 on dividends plus $238 on the gains) or an effective rate of 33.6 percent. This result is actually in excess of the proposed Buffet Rule rate of 30 percent. As I stated earlier, the example is perhaps simplistic, but it does illustrate what happens to tax rates if certain provisions of the Bush-era tax cuts are not extended.
The Buffet Rule discussion and the debate about candidate’s tax rates may provide an opportunity to overhaul the AMT and make other tax reforms for individual and corporate taxes. A more global and comprehensive tax policy may allow for more certainty and less complexity with taxpayers.
Unfortunately, there will be some winners and losers no matter what reforms or changes are enacted. The trade-off for less complexity and more certainty may result in additional taxes in some situations. We may grow tired of the rhetoric and debate, but perhaps it will lead to real comprehensive tax reform.
Bill Roth is a tax partner with the local office of BDO USA LLC. The views expressed above are those of the author and are not necessarily those of BDO. The comments are general in nature and not to be considered as specific tax or accounting advice. Readers are advised to consult with their professional advisers before acting on any items discussed herein.