Monday, December 11, 2017

Double taxation, non-taxation, and regulatory clean-up under the House and Senate tax bills

I've often commented, in the realm of international taxation, that focusing on "double taxation" can be a suboptimal way of understanding the tax burdens being imposed. E.g., I'd rather be taxed twice on the same income at 5% each time, than once at 35%.

But "double taxation" rhetoric can sometimes identify settings where the overall marginal rate might seem, upon closer examination, to be unduly high.

Now, in the Republican tax bills, we get "double taxation" via the disallowance of state and local income tax deductions. Again, that alone just means one should look more closely, rather than showing that it inherently must be bad. But it is surprising that the "double taxation" framework has been so little mentioned, given the common practice of decrying estate taxes as potentially leading to "double taxation" of income that was taxed when earned and then might be taxed again when it's transferred at death (albeit, of course, that the estate tax runs off value, not gain from a prior value).

So if one is "double-taxing" income via denial of the state and local income tax deduction, one should take extra care that combined tax rates don't go too high. But if there is anything at all that the Congressional Republicans are not doing as they rush these tax bills through, it's take care.

Now Richard Rubin has a nice article showing that the phaseout of passthrough benefits for certain professionals, plus taxes in a state like New Jersey can yield marginal rates, for certain taxpayers and in certain ranges, in excess of 100%. In other words, earn more and you end up with less.

Meanwhile, allowing complete non-taxation - zero ever (at least federal) on potentially unlimited amounts of income that one earns - appears to be a bedrock principle of both bills, despite its being rather hard to justify.

To my knowledge, a 2015 House bill offered the first instance in the history of the U.S. federal income tax in which a proposal to eliminate the estate tax was not accompanied by proposing curtailment of section 1014, the tax-free step-up in asset basis at death. But that was just a for-show exercise, given that President Obama would be certain to veto the legislation anyway. Now, in 2017, they've done it again, and apparently for real.

In 2001, by contrast, deferred repeal of the estate tax WAS accompanied by rule changes to make sure that people who had untaxed appreciation, and who now wouldn't be facing the estate tax, would at least not get the basis increase as well, and hence would not be able to eliminate permanently the prospect of any federal tax on huge gains.

Say I bought a Renoir painting for $1M, and due to the run-up in the art market its value has gone up to $100M. Under the House bill, the accretion and the value will never face any federal income or estate tax liability if my kids sell it after elimination of the estate tax. Under existing law, the same thing happens under the income tax, but at least the estate tax offers a kind of back-up (and anti-"double taxation" arguments have been deployed in support of the income tax result).

Some people thought that getting rid of the estate tax without addressing basis step-up, being so unprecedented and hard to justify, must just be an accidental glitch. But then the Senate bill substantially scaled back the estate tax without doing anything about it either. This despite their scrambling for revenue at the end, so they could purport to make the overall target. This suggests that it must have been deliberate. (And it's not hard to see why if one thinks in terms of what the donors would like.)

In sum, as the bills now stand, in certain very standard situations, there can be marginal tax rates in excess of 100% for some people, and of 0% for others.

One last bit about allowing the tax-free basis step-up at death is that it hugely increases the attractiveness of using corporations as a tax shelter through which one can pay just a 20% rate on both one's labor income and one's investment income. If the second level of tax is merely being deferred, the gambit may become significantly less appealing. But with a lower tax rate today, plus no tax in the future if you play your cards right, it's another way of having tax rates decline as one moves up the income scale (since the wealthy can more easily arrange this). And again, after what we've seen from both houses, I can only presume that this is an intended effect.

Will the Treasury attempt to address some of the worst tax planning gambits in the tax legislation, in cases where it can be argued that a given gambit must have been unintended? It's hard to say. What was intended will certainly be up for grabs here. Plus, if the IRS and Treasury leadership address enforcement in the same spirit that, say, the EPA reportedly does, you could have a setting where aggressive tax planning gambits, yielding untoward results, that arguably could be addressed through regulatory provisions and/or auditing, will deliberately be left alone, by policymaking fiat from up high.


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