What defines good tax law? As a taxpayer, I bet you have your thoughts on this. As a tax professional, I certainly have my own opinions. For researched and broad-reaching direction on this, we can look to a few sources, including the American Institute of CPA’s guidance. The AICPA describes an effective tax system as one that is (1) fair/equitable, (2) neutral, (3) simple/certain, and (4) economically efficient.
- Fair/Equitable. Compare the tax returns of two taxpayers with the same income. Would they show the same tax liability? From a fairness standpoint, one could argue they should. If one taxpayer’s income is higher than another’s, does that taxpayer pay more taxes? Again, if the tax rules in place are equitable, one would expect so.
- Neutral. Ideally, taxes should be neutral, meaning they distort behavior as little as possible. Are tax laws influencing your decision to donate to charity or buy a new home? Are you moving to a new state for tax reasons? If so, these tax laws aren’t neutral.
- Simple/Certain. For most people, the US tax code is a foreign language. The concepts of simplicity and certainty assert that taxpayers should be able to easily understand tax rules and apply them consistently. Taxpayers should have a clear idea of how and when a tax is paid. They should have confidence that a tax has been calculated correctly. The more complicated and vague tax laws are, the less certainty taxpayers have that their tax liabilities are accurate.
- Economically efficient. Effective taxing regimes don’t obstruct economic growth. This concept can be harder than the others to pin down. Whether a tax law is fair, neutral, or simple is fairly easy to measure. Just ask your tax advisor! However, whether a new tax law will allow for the economy to “do its thing” must be modeled and, well, guessed. Furthermore, because nothing happens in a vacuum, the historic impact of a particular tax policy may not always be clear either.
This article looks at a few key components of President Donald Trump and former Vice President Joe Biden’s tax positions from the perspective of whether their ideas meet the “good tax law” tests of being fair, neutral, simple, and economically efficient. (The Libertarians and the Green Party also have their take on taxes, but, well, I had to stop somewhere.)
Individual Tax Rates
Currently, the top tax rate for ordinary income, such as wages, is 37%. Biden would like to increase that back to the pre-2018 rate of 39.6% and have this rate apply for individuals with taxable income over $400,000. Trump would like to keep the 37% rate and has hinted at lowering the 22% rate for middle-income taxpayers to 15% or restructuring tax brackets so more taxpayers fall into the lower brackets.
Biden’s plan prioritizes fairness. It justifies a rate hike for high income earners based on their ability to pay. This can distort behavior, however, as those in the top tax bracket look for other ways to lower their tax bill. As we don’t have much detail for Trump’s ideas on this, moving more taxpayers into lower brackets may or may not demonstrate fairness depending on how “middle-income” is defined.
Under current law, certain dividends and long-term capital gains from investments held for more than one year are taxed at lower rates than ordinary income. The top tax rate for long-term capital gains is 23.8% when including the net investment income tax. Trump has expressed interest in lowering the top rate to 15% or indexing the rate for inflation. Biden, on the other hand, wants to tax long-term capital gains at ordinary income rates for those with taxable income greater than $1 million.
For many, Trump’s ideas seem unfair because they can result in situations in which a taxpayer with higher investment-related income is paying less federal taxes than a taxpayer with lower non-investment income, such as wages. Biden’s plan tries to address this, at least with high income earners, touching on the good tax law components of neutrality and simplicity. However, it’s important to note the original intention of taxing this type of income at lower levels, dividends at least, is because this income has already been taxed at the corporate level before it makes its way to shareholders. In other words, the lower rate helps minimize overall double taxation – a potential impediment to economic efficiency.
The Tax Cuts and Jobs Act of 2017 (TCJA) significantly increased the standard deduction while limiting certain itemized deductions. These changes are currently scheduled to expire at the end of 2025. If re-elected, Trump would like to make them permanent. Under Biden’s tax plan, the value of itemized deductions would be capped at 28% for taxpayers with incomes over $400,000.
The increased standard deduction was a step toward a simpler tax system. It eliminated the need for many taxpayers to calculate various itemized deductions. On the other hand, many individuals with large mortgages and significant charitable giving continue to benefit from itemizing their deductions. In other words, with the standard deduction so much higher, continuing to keep itemized deductions in the tax code disproportionately benefits those who have higher levels of deductions to itemize. Between pre-TCJA law and TCJA, the percentage of individuals itemizing their deductions dropped from 31% to 14%, with nearly all higher earners continuing to itemize while many middle earners stopped. This situation runs contrary to the effective tax principles of equity and, to some extent, neutrality. Biden’s plan seems to recognize this by capping the value of itemized deductions at 28% for higher earners.
Child Tax Credit
Under current federal tax law, a $2,000 child tax credit for children under age 17, plus a $500 credit for certain other dependents, are available for many taxpayers. Biden supports the expansion of the child tax credit as outlined in the original version of the HEROES Act, recently revised, that passed the House earlier this year. This would increase the child tax credit to $3,000 per child for children ages 6 to 17 and $3,600 for children under age 6. Biden also would like to make the credit fully refundable.1 Trump hasn’t proposed any major changes to the current child tax credit rules.
Some argue that the child tax credit is unfair since it treats taxpayers with children differently than those without children. From that perspective, Biden’s plan would be lower on the fairness scale. However, note that this credit is a significant benefit for lower income families, whose ability to pay taxes is disproportionately reduced by the expense of raising children as compared to higher income families. In other words, the child tax credit could instead be viewed as a way to remove some of the costs associated with child rearing from the equation and put families on more of an equal ground for tax purposes than taxpayers without young children. Whether this credit and its expansion are seen as fair will depend on your perspective.
Deduction for Pass-through Income
If you own a pass-through business such as a partnership or S corporation, you may benefit from the 20% qualified business income (QBI) deduction that was part of the TCJA. This deduction is set to expire at the end of 2025 along with other components of the TCJA. Trump’s plans regarding the deduction aren’t clear at this time. Biden would like to phase out the deduction for those with income greater than $400,000. Based on the mechanics of the deduction, an income threshold applies to many passthrough business owners already.
The qualified business income deduction is one of the more complicated provisions of US tax law, and its various limitations make it challenging for taxpayers to predict what their deduction will be. For the most part, it does not meet the good tax policy component of certainty/simplicity. Also, it does not treat businesses in different industries equally and treats business owners differently from employees in the same line of work. For these and other reasons, the QBI deduction is neither fair nor neutral. Although Biden’s plan of phasing out the deduction for certain high earners could possibly increase fairness, doing so would add yet another component to calculating an already confusing deduction.
In an August 2020 Presidential Memorandum, Trump directed the US Treasury to defer Social Security tax obligations of certain American workers for September – December 2020. If re-elected, Trump would like to eliminate these deferred taxes by providing a temporary payroll tax holiday. Biden would like to expand the Social Security tax by applying it to wages greater than $400,000. Currently this tax is capped at wages of around $137,000, meaning once a worker makes over this amount at any point in a calendar year, Social Security taxes no longer apply to further earnings for the remainder of that year.
Because of this wage cap, Social Security taxes are regressive. In the tax world, regressive means that the more money you make or have, the less percentage of your income or wealth is spent on the tax. To illustrate, someone who is under the Social Security wage threshold earning $30,000/year will pay about $1,900 of Social Security tax while someone over the Social Security wage who makes $300,000 will pay about $8,500 of Social Security tax. The first person pays a little over 6% of their earnings in Social Security taxes while the second person pays a little less than 3% of their earnings in Social Security taxes. We see a similar situation with some consumption-based taxes, such as sales taxes. Compare a low-earning family to a high-earning family of the same size and their grocery bills are likely to be about the same. However, the percentage of sales tax the low-earning family pays relative to their earnings will be higher than the high-earning family.
As you can see, regressive taxes such as Social Security taxes impact lower-earning taxpayers more than higher-earning taxpayers, and thus run counter to the sound tax policy principle of fairness. In theory, Trump’s payroll tax deferral was a way to temporarily make the payroll tax somewhat less regressive, as the deferral only applied to individuals earning around less than $100,000/year. To be effective, however, the deferral would need to become permanent which would take Congressional approval. Without such agreement, workers deferring their taxes now will pay back the deferred taxes in 2021, which not only brings back the regressive nature of the tax but puts such individuals in a tough cash flow position. Further, if this move was meant to provide greater economic momentum by putting more cash into workers’ wallets, it doesn’t address those without jobs. The US unemployment rate was around 8% as of September 2020 as compared to 3.5% the same time last year. With this provision’s ultimate impact up in the air, many employers, including the US House of Representatives, have so far declined to participate.
Biden’s proposal takes a different, more permanent, approach to making payroll taxes less regressive and more equitable. His stance improves the certainty aspect of payroll tax adjustments from a temporary deferral but could generate other issues as higher-earning workers and business owners adjust for a potentially significant hit to their earned income. In addition to the tax side of this, we must also consider how adjustments to Social Security tax withholdings impact the solvency of the Social Security system itself.
Currently, C corporations are taxed at a flat rate of 21%. Before the Tax Cuts and Jobs Act of 2017, C Corporation tax rates ranged from 15% to 35%. Trump has stated that he prefers a 20% rate, but a formal proposal hasn’t been released. Biden would like to see the corporate tax rate at 28%. He has also proposed a 15% minimum tax on “book” income, presumably making it more difficult for large companies to report little to no income for tax purposes.
Biden’s proposal is primarily motivated by fairness. Many US taxpayers are concerned that large corporations aren’t paying their “fair share.” While understandable, this position ignores the belief among many tax and economic policy experts that a significant portion of corporate taxes are ultimately paid by workers, shareholders, and consumers as opposed to companies themselves. For example, the Council of Economic Advisors – the agency within the Executive Branch that advises the President on economic policy – published a study in October 2017 indicating that lower corporate tax rates would both increase real wages to workers and increase GDP, speaking to the sound tax policy components of being fair and economically efficient.2 Further, changes to how C Corporations are taxed can impact a business’ choice of tax entity; new or existing businesses may be able to adjust their tax structure to either move to – or away from – C Corporation taxing regimes, depending on which is more favorable at the time. Lastly, with countless estimates and convoluted calculations involved in many larger companies’ financial statements, an income tax imposed on a business’ book income would not be simple or neutral.
There you have it, the Republican and Democratic candidates’ ideas on several key tax issues. So, who makes the grade? While I’ll leave it up to you to make that call for yourself, here are some general observations:
- Neither candidate has put forth a detailed, formal tax plan. As a tax professional, I would certainly appreciate that.
- Understanding the impact of changes to tax law can be challenging and potentially impossible. As I’ve said earlier, nothing happens in a vacuum.
- Overall, Biden’s ideas concentrate on being fair/equitable, while Trump’s plans are more focused on encouraging economic growth – hardly surprising given their party allegiances. As a tax advisor who’s helped clients navigate numerous convoluted and vague changes to tax law over the years, I would like to see tax platforms that focus on neutrality and simplicity.
Although tax policy won’t be the only thing on your mind as you cast your ballot, it probably will play an important role. If you have any questions about the candidates’ tax positions, please don’t hesitate to reach out.
1 “Refundable” means that you can be refunded the amount even if it is greater than your tax liability. For example, your tax liability is $2,500, while your refundable credit is $4,000. You will be entitled to a refund of the $1,500 difference. Using the same numbers, if a credit is non-refundable, you would eliminate the $2,500 liability, but would not receive a refund.
2 But have we seen this with the Tax Cuts and Jobs Act passed effective for 2018? Among other notable provisions, this act lowered effective federal income tax rates for many C Corporations and other businesses for which the owners are taxed directly on business profits such as Partnerships and S Corporations. Did this legislation increase jobs and fuel the US economy? Same say yes, some say no, some say the jury’s still out.