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Financial Planning > Tax Planning > Tax Reform

Andy Friedman: Why tax reform’s not happening soon

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According to political analyst Andy Friedman of The Washington Update, tax reform, however much favored and seen as necessary by policy advocates and ordinary Americans, remains far from inevitable.

In his most recent report, Friedman cites his namesake in his analysis of the current tax reform proposal by House Ways and Means Committee chairman David Camp, R-Mich., and explains why Camp’s fellow Republicans and Democrats alike are backing off the effort to lower rates and close loopholes.

Friedman explains the high political hurdles for comprehensive tax reform — last undertaken in 1986 under President Reagan — in terms of the principles and objectives or the tax code changes envisioned.

He explains that Democrats generally approve of tax reform that raises revenue, while Republicans adhere to a philosophy that tax-code reforms be revenue neutral.

Both Reagan’s and Camp’s proposal are in the revenue-neutrality camp, which necessitates that resultant tax-code changes not favor the wealthy in order to be politically viable. Writes Friedman:

“Because wealthy taxpayers typically have the most taxable income, they save the most in taxes when tax rates are reduced. If the wealthy save taxes and the overall reform plan is to be revenue neutral, then middle- and lower-income taxpayers must pay more taxes to make up the difference.”

If the wealthy are not to come out ahead from tax-rate reductions, then the closing of loopholes and elimination or curtailing of deductions become practical necessities.

That means changes to politically sacrosanct items such as the mortgage interest deduction or tax-free municipal bonds that have vocal and powerful defenders in Washington.

Camp’s proposal adheres to these principles and therefore faces these political hurdles. The plan would reduce the top tax rate from near 45%, including the Obamacare surtax, to 25%, and adding a 10% surtax on household income above $450,000 would render the top rate effectively 35%.

(The surtax would, controversially, apply not just to wages but to muni bond interest and employer-provided health insurance, and would preserve the new Obamacare 3.8% surtax on investment income, Friedman adds.)

The combined lower rates and surcharges on the wealthy address the tax reform imperative of ensuring the wealthy don’t come out ahead at the expense of the middle class.

But further changes, needed to achieve revenue neutrality, include reducing the threshold of the mortgage interest on a primary resident that can be sheltered from taxation from $1 million to $500,000; the elimination of state and local tax deductions; limiting charitable tax deductions to amounts in excess of 2% of adjusted gross income; and treating half of 401(k) contributions like a Roth IRA, meaning those contributions are taxed but their eventual distribution is tax-free. The alternative minimum tax would be repealed, and current estate and gift tax rules would remain unchanged. Camp also addresses corporate tax reform in his proposal, seeking to lower what is currently the world’s highest corporate tax rate of 35% to 25%, while recovering lost revenue by repealing accelerated depreciation (thus triggering the opposition of manufacturing interests); ending last-in-first-out accounting (thus invoking the wrath of retailers); imposing new asset-based taxes (upsetting to the financial sector); and a number of other measures, some of which are designed to encourage the repatriation of profits earned overseas.

Because many of these changes have a negative economic impact on interest groups with the resources to vigorously oppose them on Capitol Hill, Friedman says that reaction to Camp’s proposed reforms has been bipartisan and negative:

“Most Hill Republicans have distanced themselves from Camp’s plan. Democrats also have criticized the plan as failing to raise additional revenue and unduly favoring wealthy taxpayers,” he writes.

What’s more, timing further erodes the plan’s viability: approaching midterm elections ensure it won’t be taken up this year, and because Camp is retiring this year, needed tax reforms await a new champion next year. Friedman says that Camp’s likely successor, Paul Ryan, R-Wis., and on the Senate side, Ron Wyden, D-Ore., and Orin Hatch, R-Utah, “have expressed interest in tax reform.”

Even still, the high political hurdles involving changes to the deductibility of muni bond interest or charitable contributions may require not only the interest of Capitol Hill but also leadership from the White House, which was key to passage of tax reform under Reagan. “Past inaction by the Obama administration suggests that is unlikely,” Friedman observes.

The political analyst is more hopeful about the achievement of corporate tax reform in the coming years, citing Apple’s use of overseas operations to reduce taxes and Pfizer’s attempt to lower its taxes through its failed takeover of AstraZeneca as catalysts to eventual change. 

But as to a broader reform impacting individual taxpayers, Friedman says, its time of inevitability has not yet come.


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