Tony Nitti, a contributor for Forbes.com, wrote a fabulous piece on the Rubio-Lee Proposal For Tax Reform. It is entitled, “Reviewing The Rubio-Lee Proposal For Tax Reform.” Mr. Nitti covers not only the individual income tax reform aspects of the Rubio-Lee proposal but also the corporate tax reform aspects, as only he can. I’ve posted snippets from the article below, but you are depriving yourself of Mr. Nitti’s deep insight into the proposal if you don’t read the entire article.
As many of you are aware, I have been very vocal on the topic of U.S. corporate tax reform, having written an article that appeared in CCH’s Global Tax Weekly on December 11, 2014. For those of you who are interested in my views, you can find a copy of my article entitled, “Onward and Upward Towards Corporate Tax Reform” here. It begins on page 17. As always, I’d love to get your feedback.
Below are some excerpts from Mr. Nitti’s article:
Hey, I’ve got a neat idea…why don’t we take a break from futilely attempting to understand the existing tax law and devote some time to futilely attempting to understand proposed tax law that will, in all likelihood, never become a reality? Sound good?
Last week, Republican Senators Marco Rubio (Fla) and Mike Lee (Utah) released a fairly detailed plan to overhaul the existing Code. The creatively-coined “Rubio-Lee” plan has garnered a lot of attention, and considering Republicans currently control both the House and Senate, it should certainly be taken seriously. Let’s take a look at the plan’s most interesting talking points:
Individual Tax Rates on Ordinary Income
Under current law, there are a whopping seven rates on ordinary income — 10%, 15%, 25%, 28%, 33% 35% and 39.6%. It is a cruelly inefficient structure, and quite honestly, a laughable one when considering the fact that for single taxpayers, the 35% bracket is all of $1,800 wide.
The Rubio-Lee plan would follow in the footsteps of earlier plans posited by Bowles-Simpson and Mitt Romney by consolidated the seven brackets into only two: all income below $75,000 (if single, $150,000 if married filing jointly) would be taxed at 15%, while every dollar in excess of those thresholds would be taxed at 35%.
A revised 15%/35% structure would likely leave everyone unhappy: Those who are currently taxed at the top rate of 39.6% (taxable income in excess of $413,200 if single, 464,850 if married jointly) will not be thrilled at their rate dropping a mere 4.6%, particularly when previous plans by Bowles-Simpson and Romney had proposed a top rate ranging from 25-28%.
On the other end of the spectrum, you’ll have a large range of taxpayers whose marginal rate will increase as a result of the proposed change. Under current law, the 35% tax bracket doesn’t kick in until income exceeds $411,500; under the Rubio-Lee proposal, it would take effect at only $75,000 for single taxpayers and $150,000 for married filing jointly. This means that middle-class taxpayers currently paying tax at a top rate of 25%, 28% or 33% will see their marginal rate rise. Of course, other changes to the proposal may well mitigate this rate increase; but people are rarely interested in the details of tax reform. In all likelihood, the headline-maker of this Republican plan will be the decrease in the top rate for the richest 1% and the increase to the middle class, and that may make the plan a tough sell.
Individual Tax Rates on Interest, Capital Gains, and Dividend Income
Under current law, interest income is taxed at ordinary income tax rates as laid out above. Long-term capital gains and qualified dividends, however, are subject to preferential rates, though one shouldn’t confuse “preferential” with “simpler.”
There are five possible rates on LTCGs and dividends – 0%, 15%, 18.8%, 20%, and 23.8%. Determining the appropriate rate requires navigating a complex set of rules and thresholds.
The Rubio-Lee plan would take the bold step of exempting all interest, dividends, and capital gains from income tax, regardless of level of income.
The “regardless of level of income” portion of this tax reform is largely a meaningless gesture, because of all the interest, capital gains, and dividend income earned by American taxpayers, 85% of that income is earned by the richest 2% (those with taxable income in excess of $400,000). This means that under the Rubio-Lee plan, the rich undoubtedly get richer.
Whether that’s a good or bad thing, however, likely depends on your political leanings and your viewpoint on economics.
President Obama and leading Democrats have spent the past six years declaring that the wealthy need to pay their “fair share.” The President has taken steps in that direction by increasing the top rate on ordinary income from 35% to 39.6% and on long-term capital gains and dividends from 15% to 23.8%. But the President is clearly not satisfied with those changes; in his FY 2016 budget, he proposed a further increase in the top rate on capital gains and dividends to 28%, while also seeking to institute a minimum tax of 30% on all taxpayers with income in excess of $1,000,000 (the so-called “Buffett Rule,”) which would ensure that wealthy taxpayers can’t benefit too much from preferential rates by generating millions of dollars of income but paying tax at an effective rate in the teens.
And oh, do they benefit. Over the next four years, the top rate of 23.8% on capital gains and dividends is expected to save taxpayers $540 billion dollars, and as mentioned, 85% of that benefit will inure to the wealthiest 2%. The savings generated by adopting a 0% rate stand to be astronomical, and beg the question: how do Rubio and Lee intend to pay for this plan?
The answer, at least at this point, is that they don’t, at least in the traditional manner that tax proposals are scored. Rubio and Lee don’t pretend that any increased tax revenue created by their plan would offset the decreases, which is why, according to a preliminary look by the Tax Policy Center, the proposed changes would add trillions to the deficit over the next decade. So how can the plan work?
It can only work if you put faith in the concept of “dynamic scoring,” which aside from being one of my preferred alternate titles for a tax-themed porno (first choice: “Hot Assets”), is also many Republicans desired method for measuring the cost of tax reform. In short, dynamic scoring requires that you evaluate a plan not just in terms of static increases and decreases to tax revenue resulting from proposed changes, but by also considering the impact the changes will have on the behavior of taxpayers.
Think of it this way…President Obama has long publicized his belief that the rich getting richer is a bad thing for America. But what if it’s not? What if by cutting taxes on the wealthy you spur them to expand their businesses, hire more employees, and raise salaries, providing a boost to the economy and the working class?
Of course, eliminating the tax on capital gains and dividends also has a tremendous impact on the current state of corporate taxation. Let’s take a look…
Corporate and Flow-Through Taxation
C corporations are famously subject to “double taxation.” Income earned by a C corporation is first taxed at the corporate level, and then a second time when either 1) distributed to the shareholders as a dividend, or 2) the shareholders sell the stock of the corporation, resulting in capital gain. The entity-level tax tops out at 35%, a rate that is currently the highest in the industrialized world. Tack on the top rate of 23.8% on dividends and capital gains, and an individual who operates a business as a C corporation will pay over 50% in taxes before the income gets from the C corporation to the shareholder’s pocket.
S corporations and partnerships, however, are subject to only a single level of taxation. This is because they are “flow-through entities,” meaning that unlike C corporations, income earned by an S corporation or partnership is generally not taxed at the entity level. Instead, the income “flows through” to the individual owners, who pay the tax on their share of the entity’s income on their individual tax return. As discussed above, the top rate on ordinary income is currently 39.6%; as a result, the income of S corporations and partnerships is sometimes taxed at a higher rate than a C corporation (before considering the second level of tax upon distribution/sale of stock).
The Rubio-Lee plan would reduce the corporate rate to a flat 25%, a move that has been embraced by both parties in hopes of making the U.S. more competitive in the global marketplace. Perhaps more importantly, however, because the plan would eliminate any tax on capital gains and dividends, the “double taxation” that has been the hallmark of the C corporation structure since 1986 would be no more; instead, corporate income would be taxed only once, when earned.
Rubio and Lee would then marry the taxation of S corporation and partnership income to that of C corporations, at least in part. These business types would continue to pay no tax at the entity level; however, to avoid situations where shareholders or partners are paying tax on their share of the income at the proposed top individual rate of 35% (putting them at a disadvantage to their C corporation counterparts, who would pay only 25%), Rubio and Lee would tax the flow-through income on the shareholder or partner’s return at a top rate of 25%.
The Rubio-Lee plan would largely homogenize the treatment of C corporations, S corporations, and partnerships, and that’s a good thing. One of the many faults of our current system is that similarly situated businesses are often taxed in a drastically different manner depending on their choice of entity. In a perfect tax world, business owners would choose their desired entity structure based on their business goals rather than tax goals. The proposals set forth by Rubio and Lee would be a giant step in that direction.