The ‘Winners’ and ‘Losers’: An Analysis of the Bush Tax Advisory Panel’s Proposals

By the NYSSCPA's Tax Policy Subcommittee

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Upon the release of the Panel’s report, the NYSSCPA’s Tax Policy Subcommittee of the Tax Division Oversight Committee decided to study the proposals in detail and prepare an analysis of how taxpayers would be affected. An immediate reaction to the Panel’s proposals can be found in “Reflections on Reform,” a panel discussion featuring the opinions of several of these subcommittee members that was published in the February 2006 CPA Journal. The NYSSCPA’s own proposal for tax reform, the “SET” Tax, was also presented as a white paper in the February 2006 issue.

The current article compares the treatment of taxpayers in different kinds of financial situations under the current federal income tax system to the tax implications under the two proposals made by the Panel: the Simplified Income Tax Plan (SITP) and the Growth and Investment Tax Plan (GITP).

Goals for Reform

When President Bush created the Panel in January 2005, his stated purpose was the development of recommendations and options for fundamental tax reform. A tax subcommittee of the NYSSCPA decided to examine the Panel’s substantive proposals to provide useful information to decision makers and the public. The need for reform is obvious, even if the politically acceptable solution has so far proven elusive. This analysis is policy neutral and is designed to explain how the Panel’s proposals would affect individual taxpayers in different circumstances.

The President’s Panel claimed that current tax provisions provide targeted tax benefits to a limited number of taxpayers while creating complexity, imposing large compliance costs, and using resources inefficiently. The Panel favored using a broad tax base while allowing certain popular deductions and credits, thereby retaining the progressive nature of the current tax system.

The need for greater transparency and simplicity is commonly found in the vocabulary of tax reform. Many share the view that, under current tax law, individuals and businesses cannot easily understand their own tax obligations or be confident that others are paying their fair share. These conditions have led to diminishing public support for the current tax system.

The Executive Order establishing the President’s Panel included the following directives:

• Make the tax code simpler, fairer, and more conducive to economic growth.
• Recognize the importance of home ownership and philanthropy in American society.
• Maintain “revenue neutrality.” This means that reform proposals must collect the same amount of estimated revenue as projected under existing law. Thus, if some taxpayers would pay less, others would have to pay comparably more.
• Permanently retain the 2001 and 2003 tax cuts that included reductions in the tax rates (to a maximum of 15%) on dividend income and long-term capital gains. The current tax rates on dividends are scheduled to expire at the end of 2008.
• Assume that the increase in the aternative minium tax (AMT) exemptions for the years 2003 through 2005 would lapse at the end of 2005. (Congress has since extended these increased exemptions to 2007.) This assumption increased the amount of tax revenue needed if the Panel’s proposal was to repeal the alternative minimum tax (AMT) while remaining “revenue neutral.”
• Maintain the same tax burden on the various income “strata” of taxpayers as exists under current law. This means that taxpayers in specific income groups should not pay more or less income taxes, as a group, than they do now.

Summary of the Tax Panel’s Proposals for Individual Taxpayers

The Panel devised two plans to meet the President’s goals: the Simplified Income Tax Plan (SITP) and the Growth and Investment Tax Plan (GITP). The two plans differ primarily in the taxation of businesses and capital income. The plans developed by the Panel attempt to achieve the President’s goals in a number of ways:

• Reduce complexity by allowing every taxpayer to use a simple tax form that is less than half the length of the current Form 1040;
• Combine 15 different tax provisions for at-work saving, health saving, education saving, and retirement saving into three simple savings plans;
• Eliminate a complicated set of phase-outs that left taxpayers wondering if they are eligible to benefit from numerous provisions;
• Replace a confusing, full-page worksheet for seniors reporting Social Security income with a simple computation that is no more than six lines; and
• Replace the complicated rules for small businesses with a system that is based on records that business owners already maintain.

The major features of the plans include the following items aimed at simplifying the entire tax system and streamlining tax filing for both families and businesses:

• Lower the tax rates on families and businesses while retaining the progressive nature of our current tax system.
• Extend important tax benefits for home ownership and charitable giving to all taxpayers (not just the 35% who itemize).
• Extend the tax deduction for health insurance premiums to all taxpayers (not just those who receive insurance from their employers).
• Remove impediments to saving and investment by maintaining the 15% maximum tax rates on dividends, lowering long-term capital gains tax rates, and simplifying retirement savings provisions.
• Eliminate the AMT (projected to affect more than 21 million taxpayers in 2006 and 52 million taxpayers by 2015).

The Exhibit lists the major provisions of the SITP and the GITP that apply to individuals. Case studies of representative individual taxpayers are presented to provide a comparison between the current tax system and the proposed SITP and GITP. Tables 5.1, 6.3, and 7.3 of the Panel’s report are summarized in the Exhibit’s presentation of reform options for individuals.

Case Studies of the Effects of the SITP and the GITP

The Panel’s two alternative plans for changes to our current individual tax system can be applied to sample cases to illustrate their effect on American taxpayers. The data in the cases described below have been applied to the current (2006) tax provisions and to the proposed SITP and GITP.

Readers should keep in mind the directives and constraints under which the Panel operated in order to appreciate how the directives apply to the different cases. The cases are accompanied by an explanation of the reasons for the different results between current tax law (2006) and the proposed SITP and GITP. The case studies show the likely “winners” (those who would pay less tax under the proposals) and the likely “losers” (those who would pay more).

Case 1: Lower-Middle-Income Taxpayers

Case 1 is an example of a lower-middle-income married couple filing jointly (MFJ) who have four children, two of whom are over age 16. Their income is derived from $37,400 of wages, $2,720 of self-employment income, and $2,010 of gains from the sale of machinery and equipment related to the self-employment business.

Their itemized deductions under the current tax system are only $2,530 in state and local income taxes and $50 in tax preparation fees, so they would take the standard deduction of $10,300 instead of itemizing. With six exemptions, they can deduct another $19,800 ($3,300 x 6), resulting in a taxable income of $11,838. Their income tax, before credits, under the current system is $1,184.

Under both the SITP and the GITP, the income tax before credits is $6,291 because the standard deduction and the deduction for personal and dependency exemptions have been replaced by a Family Credit.

Under all three tax systems, however, the couple’s income tax is completely eliminated by tax credits.

Under the current tax system, the Child Tax Credit of $2,000 (allowed only on the two children under age 16, even though they all qualify as dependents) exceeds the income tax liability. Full utilization of the allowable Child Credit would cover the income tax on an additional $6,527 of taxable income. The couple’s income is too high for the Earned Income Tax Credit.

Under the SITP and the GITP, the Family Credit of $9,300 ($3,300 credit for the married couple, and an additional $1,500 for each dependent) also exceeds the income tax due. The taxpayers receive the benefit of a Family Credit for each of the four children, because they all qualify as dependents. In these cases, the excess Family Credit covers the income tax on an additional $20,060 of taxable income. (At this income level, the marginal tax rates of the SITP and the GITP are both 15%.) The couple’s income is too high for the proposed Work Credit.

Under either the current tax system or the proposed SITP/GITP, the taxpayers will still pay $384 in self-employment tax on the $2,720 of self-employment income. Nevertheless, the SITP and the GITP are more beneficial to taxpayers with ordinary income up to $60,000, as the proposed Family Credit covers the income tax on a greater amount of taxable income than the Child Tax Credit, and is available on all dependent children, without an age cap. Thanks to the Family Credit, low- to middle-income MFJ taxpayers are winners under either SITP or GITP. The simplified Work Credit should allow more of the lowest-income families to not only reduce their income tax liabilities, but also qualify for refundable tax credits.

Cases 2 and 3: Comparison of Middle-Income Taxpayers Renting Versus Owning Their Home

Case 2 and Case 3 illustrate the different results that occur with MFJ taxpayers who either rent their residence or own their own home. In both cases, the couples have no children and have income in excess of $100,000, mostly from wages. In Case 2, the renting taxpayers take the standard deduction, while in Case 3, the homeowning taxpayers take itemized deductions of $28,820.

In Case 2, in the current, SITP, and GITP scenarios the net income tax after credits is almost the same. In the SITP and GITP calculations, the additional income tax incurred by the loss of the standard deduction and personal exemptions is almost offset by the Family Credit of $3,300. Case 2 illustrates that middle-income taxpayers using the standard deduction can expect comparable income tax results under either SITP or GITP.

In Case 3, all of the couple’s itemized deductions and personal exemptions are lost under SITP and GITP and replaced by a $3,300 Family Credit and a $1,703 Home Credit (15% of the mortgage interest). The resultant net income tax is approximately $3,100 higher than under the current tax law. This represents a 22% increase. Case 3 illustrates that middle-income families who own their own home and have substantial mortgage payments, property taxes, and state income taxes can expect to pay significantly more in federal income taxes under either SITP or GITP. Middle-income itemizers look to be major losers.

Even the addition of two children would not change the comparison between the current system and the proposed SITP or GITP. Under the current system, the exemptions for two children would reduce the income tax by $1,650 and, assuming that the children are 16 or younger, would allow a child credit of $2,000, for a total reduction in income tax of $3,650. Under SITP or GTIP, the addition of two children would increase the Family Credit and reduce income taxes by only $3,000.

Case 4: Retired Middle-Income Couple Using the Standard Deduction

Case 4 illustrates the effects of the different treatment of interest income under SITP and GITP. In this case, the taxpayers are a retired couple, MFJ, without dependents. They have $16,910 in interest income, a $3,000 capital loss, and pension and Social Security income of $129,630. These taxpayers would take the standard deduction in 2006.

The income taxes under the current tax system and under SITP would be almost the same because the Family Credit offsets the higher initial income tax under SITP. The big difference in this case is between SITP and GITP. While SITP taxes interest income at the regular tax rates, GITP taxes interest income at a maximum 15% rate. Thus, the $16,910 of interest income would result in income taxes about $2,000 less under GITP than under either SITP or the current tax system. Because interest and dividend income is taxed equally at a maximum rate of 15% under GITP, the advantage of receiving dividends (as opposed to interest income) under the current tax system and SITP would be eliminated. Under GITP, there is an incentive to own more stable debt instruments. Because many retired people have moved more of their retirement assets into debt instruments, they would be major winners under GITP.

Case 5: Upper-Middle-Income Family Owning Their Home with No Mortgage

Case 5 illustrates the effects of the elimination of the alternative minimum tax (AMT) under SITP and GITP. In this case, the MFJ taxpayers have two children and own their home outright (i.e., they do not take a deduction for mortgage interest payments). Under current law, these taxpayers will pay $5,347 in additional AMT due to the loss of their deductions for property and state income taxes and some of their AMT exemptions, based upon the level of their adjusted gross income (AGI).

Compared to the current tax system, the taxpayers would see a decrease in net income tax of $484 under SITP and $2,451 under GITP. The loss of the itemized and personal exemption deductions under the proposed plans would increase the initial income tax under both SITP and GITP to more than under the current law, even with the AMT. However, this increase would be more than offset by the new $6,300 Family Credit in both proposed plans. This upper-middle-income family would be a small winner under the proposals because of the effect of the Family Credit and the fact that they had no mortgage interest deduction.

As will be seen in Case 7, a large mortgage-interest deduction is more beneficial under the current tax law than the corresponding Home Credit would be under SITP or GITP because this group of taxpayers is in a higher than 15% tax bracket. The Family Credit would appear to be a powerful tool that would offset the fact that certain current deductions and exemptions would be eliminated under SITP/GITP.

The SITP tax due would be $1,967 greater than the GITP tax due because of the different tax rates in the new plans: SITP has four brackets (with the highest, 33%, beginning at $200,000 for MFJ taxpayers), while GITP has three brackets (with the highest, 30%, beginning at $140,000 for MFJ taxpayers). Also, as noted above, GITP would tax interest at 15%; SITP would tax interest at regular rates.

Case 6: Taxation of Capital Gains and Dividends

Case 6 highlights a major difference between the SITP and GITP, as well as demonstrating once more the effect of repealing the AMT. Case 6 presents an example of a single retired taxpayer, with no dependents, and $300 in interest income, $38,200 in dividends ($37,940 of which are qualified), $296,660 of net long-term capital gains from the sale of U.S. corporate stock, and Social Security income of $12,680.

Under current law, the taxpayer is subject to AMT because he has a deduction of $45,540 for state and local taxes on Schedule A and $2,980 of net miscellaneous deductions, both of which must be added back for AMT purposes. In this case, the income tax under the current system is $50,002, including an AMT adjustment of $8,634.

Under SITP, the income tax before credits would be reduced to $17,605. Most of this change would be due to the fact that, under SITP, 75% ($225,458) of his long-term capital gains are excluded from taxable income. In addition, SITP would exclude dividends from U.S. corporations from taxable income. This would result in taxable income of $84,183 under SITP. The SITP income tax before credits would be only 5% of AGI as computed under the current tax system.

A major point to emphasize is that this SITP benefit is achieved only if the long-term capital gain comes from the sale of stock in a U.S. corporation. Any other long-term capital gain, such as the sale of real estate or fixed or intangible assets in a flow-through entity, does not qualify for the 75% exclusion and is taxed at ordinary rates. In this case, if all the long-term capital gain was from these other sources, the SITP tax due would be $91,529: $76,140 higher than if the gain were from the sale of U.S. stock, and $26,138 higher than under the current tax system.

Under GITP, both capital gains and dividends would be taxed at 15%, the same as the current tax system. This would result in an income tax after credits comparable to the current 2006 tax after the AMT adjustment and credits. Under AMT provisions, almost all of the AMT taxable income would be taxed at 15% due to the large long-term capital gains.

Case 6 illustrates that SITP makes investors in U.S. corporations big winners, while owners of flow-through business entities; real estate investors; and small business owners would be big losers under the proposal.

Case 7: High-Income Family with a Large Mortgage

Case 7 illustrates high-income taxpayers earning most of their income through wages and large itemized deductions because they have a highly mortgaged house and a high property and income tax locality, like New York, New Jersey, or California. The MFJ taxpayers have two children.

It is surprising to note that, in this case, the net income tax after credits under current tax law would be more than the income tax under SITP, approximately $2,500 more, and approximately $20,000 more than under GITP. One would expect that the loss of all those itemized deductions under SITP/GITP would cause the tax to be greater than under the current tax laws. The loss of deductions under SITP/GITP does not have much effect in this case because most of those deductions are already lost under current law due to the AMT.

Case 7 illustrates many of the differences between each of the three tax systems discussed. Under the current tax system, the AMT eliminates much of the tax benefit from the major itemized deductions, with the exception of mortgage interest and charitable contributions. In addition, at income levels this high, the full AMT exemption is lost. The resulting AMT income, excluding the long-term capital gain (taxed at 15%), is taxed at 28%.

Even though the maximum SITP rate is 33%, the net income tax in this case is $2,500 lower than under current law. The SITP taxable income of $743,144 is much less than the AMT income of $857,070, thus offsetting the higher SITP rates. The primary difference between the two net taxable incomes is the exclusion from SITP taxable income of dividends and 75% of long-term capital gains on the sale of U.S. corporate stock. A further reduction of the SITP tax is realized by using the Family Credit and Home Credit, which are not phased out at higher income levels.

The trade-off between the mortgage- interest deduction under the current system and the Home Credit under the SITP/GITP proposals should also be considered. First, the Home Credit is limited to an average regional housing price (in this case, the $412,000 maximum).

Additionally, the 15% credit is lower than the tax benefit of 28% under the AMT. Unless a taxpayer is in the 10% or 15% tax bracket, or uses the standard deduction, the Home Credit does not compensate for the lost mortgage-interest deduction.

The GITP income tax due in Case 7 is also lower than under current law, because of three factors. First, the GITP taxable income of $821,387 is less than the AMT income of $857,070. Second, the GITP’s lower tax brackets help offset its higher maximum rate of 30%, yielding an effective tax rate of 25%, lower than the AMT flat rate of 28%. Third, the Family Credit and Home Credit are not phased out at higher incomes.

The charitable deduction is less under SITP and GITP than under the current system because only contributions exceeding 1% of gross income are deductible for SITP and GITP.

In Case 7, the high-income family is a big winner. This would also be true even if it did have long-term capital gains. In that scenario, the current tax would be approximately $195,000, compared to the SITP tax of $182,000 and the GITP tax of $173,000. If the long-term capital gains came from sources other than the sale of U.S. corporate stock, the tax due under SITP would increase by $33,395. Under GITP, the tax due would increase by $20,240, because the income would be taxed at the top marginal rate of 30% instead of a 15% capital gains rate.

Winners and Losers

Case 1 illustrates that for lower-income taxpayers, the proposed tax credits under the SITP and the GITP would offset the additional income tax caused by the loss of current deductions. As income levels increase, the effect of the SITP and the GITP would become more dependent upon whether the taxpayer is a homeowner or pays substantial state and local income taxes. Case 2 demonstrates that middle-income taxpayers who claim the standard deduction would pay about the same amount of federal income tax under the current or proposed tax systems. Middle-income taxpayers who lose the benefit of current itemized deductions would likely pay more under the SITP and the GITP, as illustrated in Case 3.

Major “winners” under the SITP would be owners of common stock in U.S. corporations. Under the SITP, their dividend income and 75% of their long-term capital gains would be excluded from taxable income. This effect should more than offset their loss of certain itemized deductions. In assessing the potential impact of the proposal by the President’s Panel, it is important to remember that under SITP, other long-term capital gains—such as the sale of real estate or partnership interests—would be taxed as ordinary income at rates up to 33%. Under GITP, bond owners are also winners because interest income, as well as dividend and long-term capital gains on the sale of U.S. corporate stock, is taxed at a maximum 15% rate.

Other winners are low- to middle-income taxpayers who can fully utilize the Family and Home Credits (which do not phase out with income) to offset their income tax liabilities.

Under the Panel’s proposals, the major “losers” would be middle-income taxpayers with fact patterns similar to those in Case 3. These are homeowners with large mortgages, high property taxes, and who live in high-income-tax states. This is a large and broad group. Whereas higher-income taxpayers have already lost most of these deductions under current law due to the AMT, this group of homeowners loses the benefit of these deductions under SITP and GITP, and the gap is not sufficiently made up by the Family and Home Credits.

Other losers would be real estate owners and business owners, who will see the income taxes due on the sale of their property and businesses increase substantially.

While the President required the Panel’s proposals to be revenue neutral, these cases illustrate that reaching the goal of revenue neutrality means that some will pay less and others will pay more. To the individual taxpayer, no tax law change is neutral.

Impact on State Taxation

While the effects of the Panel’s proposals on the federal income tax system are the center of this discussion, the proposed changes would affect individuals’ state income taxes directly and, possibly, substantially. Many states base their income tax calculations on federal law, and would be affected immediately if either SITP or GITP were adopted.

Taxpayers in states that compute taxable income based on federal tax return income and deductions would find that several deductions disappear. In the case of SITP, dividend income and 75% of long-term capital gains would no longer be included as taxable income. Large decreases or increases would occur in a taxpayer’s state income tax.

An excellent example of the changes is illustrated in Case 6. If a state uses federal taxable income as its starting point, the unadjusted taxable income for the calculation of state taxes could vary from $347,840 under the GITP to $84,183 under the SITP, whereas under current federal law it would be $296,747.

Unless state legislative actions to address the consequences that would arise at the state level were taken prior to the enactment of either of the Panel’s proposals, certain taxpayers could see a substantial change in their state income taxes. Likewise, state governments would see income tax collections change substantially with the resultant effects on budgeting and financial planning. Taxpayers in states that base their income tax on a percentage of the federal income tax would also see their state tax increase or decrease correspondingly. Thus, the adoption of either the SITP or the GITP would likely spur immediate action by many states to revise their own tax laws.

There are some easy-to-implement measures that states could take to reverse the consequences of changes in the federal tax system. For example, dividends received from U.S. companies out of domestic earnings that are excluded from the computation of gross income under the SITP could be added back for state tax purposes. In addition, the 75% of the capital gain on the sale of U.S. company stock that would be excluded under the SITP could be added back to the computation of gross income. Such actions would be similar to states’ disallowance of the 30% and 50% special depreciation deductions in the 2001 and 2003 federal tax law changes.

If the Panel’s proposals are adopted, some deductions would be eliminated unless appropriate state legislation was enacted to continue to allow them for state income tax purposes. This applies particularly to the mortgage-interest deductions that would become a home credit on the proposed federal tax return. It is hard to know what the states would do with the charitable-contribution deduction floor of 1% of AGI. While the loss of the federal deduction for state and local income taxes would not affect state income tax filings, it could renew concerns about individual state income tax burdens and their interplay with the federal income tax burden.

Simple, Fair, and Pro-Growth?

The analysis above is intended to offer CPA Journal readers an informed perspective on the potential effects of the SITP and the GITP on a cross-section of hypothetical taxpayers, so they can make their own judgments as to whether the President’s Panel’s proposals are truly “simple, fair, and pro-growth,” as the title of the report title claims. As with any major tax reform, even if the aggregate results are revenue neutrality and income progressivity, there will inevitably be “winners” and “losers” based upon individual circumstances. To properly understand an individual’s tax situation under each of the Panel’s Proposals, taxpayers should consult their own tax advisors to make a case-by-case comparison in the manner shown here.