Comprehensive Tax Reform

The first salvo in the battle for federal tax reform has been launched by the release of a draft from the President’s Deficit Commission. The draft includes tax reform as a key component in plans for overall deficit reduction.

The draft provides three different scenarios for tax reform:

  • The Zero Plan. This plan has three individual rates, one corporate, and no alternative minimum tax (AMT). What those three individual rates would be depend on which tax breaks are retained. If all deductions and tax credits are eliminated, the rates would be 8%, 14%, and 23%, with a 26% corporate tax rate. Scaling upward, if the deduction for mortgage interest, the child tax credit, earned income credit, and certain other breaks are retained, then the rates would rise to 13%, 21%, and 28%, with a 28% corporate tax rate.
  • Wyden-Gregg Style Reform Plan. This would also set three individual tax rates of 15%, 25%, and 25%, with a standard deduction of $15,000 for individuals and $30,000 for married couples. The mortgage interest deduction would be limited to a primary residence, and charitable deductions would have a 2%-of-adjusted-gross-income floor. The corporate rate would be set at 26%, with a permanent research credit.
  • Tax Reform Trigger Plan. This plan would be created by the end of 2012 and would include a so-called “haircut” to trim itemized deductions, the exclusion for employer-provided health care, and business credits of tax reform is not enacted.

Impact on small business

Since most small businesses are pass-through entities (such as S corporations and limited liability companies), where owners pay income taxes on their share of business income on their personal returns, lower rates generally are a good thing. However, looking only at the overview does not provide any meaningful way to assess the benefit of the plans in the draft.

It’s the details that count when it comes to tax reform. Will write-offs be retained for buying equipment? Paying for health insurance? Funding retirement plans?

More importantly, what assurances will be given to taxpayers that initially low tax rates won’t be raised in the future? It’s helpful to remember that the Reagan tax cuts in 1986 brought the individual tax rates down to 15% and 28% (with a 33% rate to eliminate the benefit of the low bracket for high income taxpayers) starting in 1988. These low rates lasted only three years. In 1991, a new 31% rate was added, and two years later (in 1993) the 36% and 39.6% brackets came into effect.

Like babies, everyone loves the idea of tax reform. But be prepared to take the bad with the good; don’t forget those smelly diapers.

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