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Annette Nellen

Strategy for Major Tax Reform

Tax bills enacted since the Tax Reform Act of 1986 (TRA ’86) have never measured up to its reforms. Here’s a strategy for major reform that compares H.R. 3970 to TRA ’86.

November 8, 2007
by Annette Nellen, CPA/Esq.

On October 25, 2007, House Ways and Means Committee Chair Charles Rangel introduced H.R. 3970 (text, summary (PDF)), the Tax Reduction and Reform Act of 2007, a bill he informally calls the “mother of all tax reforms.” Based on what we have learned from the last major reform effort — the Tax Reform Act of 1986, are we likely to see H.R. 3970 enacted?

Strategy

Briefly described below are actions and techniques that can improve the chances of a major income tax reform proposal becoming law. These features are also compared with TRA ’86 and H.R. 3970 to gauge the likelihood of H.R. 3970 becoming an enacted reform.

Studies: There must be thorough studies of how the tax law currently operates, its strengths and weaknesses and analysis of possible reforms that would remedy the problem areas.

Cooperation: Both the administrative and legislative branches must agree that existing tax law problems can only be remedied through major reform that will likely affect many parts of the existing tax law and most taxpayers. Both branches must be willing to work together to craft and support reform.

Purpose: In order to convince policymakers and taxpayers that reform is the right direction, the purpose of the effort must be clear. Leaders of the effort should be able to articulate the reasons why change is needed. Knowing the purpose enables legislators to identify appropriate changes and to verify if they address the problems. The purpose for making major changes must be perceived as meaningful to taxpayers. Legislators and taxpayers will not want to endure the change process and the results if they are not convinced it is all for a good cause.

Thoroughness: A thorough review of existing law should underlie the reform efforts in order for it to be major and justifiable.

Resoluteness: Every tax preference has a group that supports it. Thus, every change will have opposition. But, if the change is appropriate given the purpose of reform, legislators must be resolute in pursuing the change; otherwise, the goals for reform will not be achieved.

Policy: The principles of good tax policy (PDF) — equity, transparency, simplicity, economic efficiency and others should be followed.

Transition: Taxpayers have made long-term decisions based on existing tax rules. The pain of new rules that alter past plans can be eased by transitioning in new rules if feasible.

Make everyone a winner: Taxpayers are more likely to accept the loss of favorable provisions if they see that there are also benefits for them, such as lower tax rates.

TRA ’86 vs. H.R. 3970 

           

Strategy

 

TRA ’86

 

H.R. 3970

 

Studies

 

Several including Treasury’s Tax Reform for Fairness, Simplicity, and Economic Growth (PDF) (11/84).

 

Several from the Joint Committee on Taxation, GAO, and others, particularly on AMT, the tax gap, and international taxation.

 

Cooperation

 

The President and the tax-writing committees were in favor of reform.

 

The President created his own Panel on Federal Tax Reform that produced broad proposals but little discussion in Congress. AMT reform is a major goal for both the President and Congress.

 

Purpose

 

Improve fairness and efficiency and reduce complexity.

 

Primarily to repeal individual AMT, but also has a mix of other items, some of which are not reforms, such as one-year extensions of at least 30 temporary provisions.

 

Thoroughness

 

Per the General Explanation of the Tax Reform Act of 1986 (PDF) (5/4/87): “After extensive review of virtually the entire prior tax statute, Congress concluded that only a thorough reform could assure a fairer, more efficient, and simpler tax system.”
Arguably, Congress was not thorough in all changes and subsequent changes were made, such as to long-term contract accounting and home mortgage interest.

 

While thorough studies of the Code have been made in recent years (such as the 2001 Joint Committee on Taxation’s simplicity study (PDF)), H.R. 3970 does not seem to be tied directly to any particular study. In addition, it extends many temporary provisions even though many have had no study performed as to their effectiveness. In addition, while at least one proposal — basis reporting by stock brokers, has been mentioned in tax gap reports, other tax gap remedies are omitted.

 

Resoluteness

 

Arguably, yes, given the number of favorable provisions eliminated and new limitations added.

 

Remains to be seen.

 

Policy

 

Arguably equity was achieved through passive activity loss rules, interest limitation rules and others. It is questionable whether simplicity was achieved due to the complexity of some of the new rules.

 

Repeal of AMT and §199 manufacturing deduction helps achieve simplicity and transparency, although offset somewhat by limitation on itemized deductions, phase-out of personal exemptions, and surtax on modified AGI. Tax gap partially addressed by basis reporting for stockbrokers. Economic growth and efficiency hurt by extension of life of §197 intangibles to 20 years, although helped by permanence of current §179 expensing deduction.

 

Transition

 

Many were included such as the phase-in of passive activity loss limitation and phase-out of the personal interest deduction.

 

Not apparent.

 

Winners

 

Individual tax rates were reduced and brought down to only two rates. This was likely perceived as a “win” by many despite the loss of some favored deductions, such as personal interest.

 

There are several “wins” such as repeal of the individual AMT and increase in the standard deduction. The new surtax for individuals with $200,000 of income will only affect a minority of taxpayers, but legislators will need to be able to show individuals that the bill is unlikely to increase their tax liability.

 

Conclusion

Change is never easy. Major tax law change is further burdened by the inherent complexity in the law and most taxpayers’ weak understanding of the tax law and related policies. Also, past efforts to do many things with the tax law besides raise revenue, as evidenced by the inclusion in H.R. 3970 of one-year extensions of 32 temporary tax preferences, adds to the challenge of tax reform. That is, the more preferential provisions there are, the harder it is to reach reform by broadening the base and lowering rates as was done by TRA ’86.

Congressman Rangel’s bill will be discussed in Congress. It includes proposals in several areas where studies have shown that reforms are needed, such as to reduce the tax gap and modernize international tax rules. However, H.R. 3970 does not completely address what is needed in these areas.

Along with the myriad tax reform proposals of presidential candidates, H.R. 3970 presents a good opportunity for evaluating reform strategy, particularly identifying the purpose for major reform.

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Annette Nellen, CPA/ Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.