Barriers to Tax Reform

The New York Times ran an article yesterday titled “The Real Barrier to Tax Reform” written by Bruce Bartlett. I have no issue with Mr. Bartlett, although I rarely read The New York Times. Nonetheless, what caught my eye is the following table of “tax expenditures”:

These “expenditures” make it difficult to raise enough “revenues” to cover whatever the government’s spending binge of the moment is.

I can see how reasonable people may debate the tenth – accelerated depreciation – as an expenditure. Instead look at categories such as the 401(k), medical insurance and employer-provided pension plans.

 A couple of observations on this:

(1)   Since when are monies taken from us as taxes to be called “revenues?”

(2)   Since when are monies we keep to be called “expenditures?”

There is an odor of bad fish with the vocabulary. Apple has revenues, as they have something I want and am willing to pay for. The government - not so much. This damage to the language is itself a barrier to tax reform.

Oh, you may be wondering about “exclusion of net imputed rental income.” Here is the concept: if you rented out your home rather than lived in it, someone would pay you rent. The government would then tax you on your rent. So, by living in your home rather than renting it out, you are costing the government money.

You, dear homeowner-living-in-your-home, are an “expenditure.”

Bruce Bartlett "The Real Barrier to Tax Reform"

Thinking About The New Medicare Taxes

You may recall that Obamacare incorporated certain tax increases, albeit delayed in some cases. I have been revisiting the payroll tax changes that will kick-in in 2013. 

The High-Earnings Medicare Tax

Beginning in 2013 the employee Medicare tax will increase if the employee is high-earning, defined as $200,000 for singles and $250,000 for marrieds. One’s tax rate will go from 1.45% to 2.35%.  Remember that there is no income limit on the Medicare tax.

Note that the employee and employer will be paying different tax rates.

There are peculiar things about this tax increase. For one thing, one’s Medicare tax rate will be affected by a spouse’s income.

EXAMPLE: Al makes $175,000 and his wife makes $100,000. In 2013 their combined income is $275,000 and subjects them to the increased 0.9% Medicare tax. The tax increase is levied on the excess earnings over $250,000, which is $25,000 ((175,000 + 100,000)-250,000).

Here is the problem: how will Al’s employer (or his wife’s) know this? They won’t. The IRS has said that an employer is required to withhold only on the employee’s wages and disregard the earnings of the spouse. Therefore, as long as a married employee is below $250,000, the employer does not have to withhold the higher tax.

Here is my problem: I am going to be as popular as bedbugs when I come in at year-end and point-out the tax due to Al and his wife.

Also, since when is one’s Medicare tax affected by a spouse’s income? This is a first, to the best of my knowledge.

The Investment Income Tax

Let’s start off with the easy part: the same $200,000 and $250,000 income limits apply.

If one’s income exceeds the limit ($200,000 or $250,000), then one will have a tax hike of 3.8% on one’s net investment income. Net investment income includes interest and dividends (the classics), but it also includes net capital gains, rents (unless it is from a trade or business), royalties and some annuities. It does not include distributions from qualified retirement plans, including distributions in the form of annuities from such plans.

Let’s go with an example.

EXAMPLE: Let’s say that Jeff and Candy have combined salaries of $235,000 and combined interest and dividends of $ 32,000. Their AGI is $267,000. They have exceeded $250,000, so they are in trouble. How much is subject to the new tax? It would be the lesser of the net investment income ($32,000) or the excess over $250,000 ($17,000). Their brand-new tax for 2013 will be $646 ($17,000 times 3.8%).

Some things about this make me uncomfortable. Say that Jeff and Candy earned $213,000 instead, with the same $32,000 in interest and dividends. Their AGI is $245,000 – below $250,000 and thus avoiding the new investment income tax. However, say that they break a 401(k) to pay family medical bills or higher education expenses. Say they break $40,000. This would put their AGI at $285,000. What just happened?

Here is what happened: we have just subjected Jeff and Candy to the new tax. They will owe tax on the lesser of (1) their net investment income ($32,000) or (2) the excess of their AGI over $250,000 ($35,000). The 401(k) break just cost them $1,216 ($32,000 times 3.8%). If Jeff and Candy are under 59 ½, remember that it also cost them the 10% penalty. And income taxes on the break itself.

Again, since when have we paid Medicare tax on unearned income?

Anyway, if you are in these income ranges, you may want to start thinking about the year after next. I can immediately see the appeal of Roths and municipal bonds under this tax regime, as they will not increase one’s AGI. On a darker side, I wonder if we will see higher-income singles less willing to marry – or alternatively higher-income marrieds more willing to divorce – for tax reasons.  Taxes encourage changes in behavior. We just don’t know yet what changes these will encourage.