We all know how Warren Buffett feels about how much he pays in income tax, but the majority of Americans do not believe that they underpay. In fact, according to a 2014 Gallup poll, 52% of Americans believe the amount they pay in federal income taxes is too high, compared with 42% who feel the amount is “about right.” That more than half of Americans believe they are overtaxed may, at first glance, seem striking. However, over the nearly 60 years Gallup has been asking this question, we are currently close to a historic low in that sentiment.
Factors driving declining dissatisfaction likely include decreases, over the same period, in the top marginal rates on income and the overall number of tax brackets. In the late 1950s, for example, the top marginal rate on ordinary income was 91% on income over $400,000 (more than $3.4 million in today’s dollars). That rate has steadily fallen – to 70% in the 1960s and 1970s, 50% in the 1980s, 35% during the George W. Bush administration, and now in 2015 to 39.6% on income over $413,200 for single filers and $464,850 for married joint filers. Likewise, the number of brackets and rates in the tax code significantly decreased during the last major overhaul of the tax code in 1986, when the number of brackets declined from 15 to five.
It may be surprising then, given the historically low unpopularity of the amount of taxes people pay, that tax reform is a key component of many of the 2016 presidential candidates’ platforms. Perhaps some of the attention on tax reform is a result of the discontent individuals feel not toward how much they pay in their own taxes, but how much everyone else pays. Rising discussions of income inequality and comments like Buffett’s over his secretary’s effective tax rate being higher than his own have likely fueled the public’s discontent in this regard. This may also be why the candidates’ proposals focus primarily on restructuring the already streamlined bracket and rate structure, rather than streamlining the tax code and accompanying regulations, which have swelled from fewer than 30,000 pages in 1986 to more than 70,000 pages today.1 I would not be the first author to point out that simplicity in brackets and rates does not automatically translate into simplicity in the tax code. Simpler or not, the tax reform proposed by the current candidates would have a meaningful impact on most, if not all, of our clients’ overall wealth. The remainder of this article showcases the current candidates’ proposals in detail.
Ordinary Income Taxes
The most detailed proposals the candidates have made are in regard to the rates and brackets for ordinary income, which includes income earned on interest, wages, rents and royalties. These rates are also applied to investment income for investments held for one year or less – that is, short-term capital gains. The proposals mainly address the rates at which different amounts of income – the so-called income “brackets” – will be taxed.
Of the five candidates, only Hillary Clinton has left the brackets and rates unchanged. However, she has proposed a 4% surtax on income over $5 million, which effectively creates an additional bracket and rate of 43.6%. In addition, Clinton would institute the so-called “Buffett Rule,” which would subject individuals earning more than $1 million to a mandatory alternative minimum tax of 30%. Sens. Ted Cruz and Bernie Sanders have proposed the most aggressive plans. Cruz has proposed abolishing the progressive rates in favor of a flat tax of 10% on ordinary income; in addition, he would eliminate all itemized deductions except for the charitable and mortgage interest deductions. In stark contrast, Sanders would introduce four additional brackets and rates in an attempt to make the rates more progressive, particularly for higher-earning families.
Finally, all candidates except Clinton would eliminate the alternative minimum tax, and each of the Republican candidates would abolish the distinctions between single filers and couples filing jointly by simply doubling the bracket amounts for married couples. This would eliminate the so-called “marriage penalty,” where some couples, particularly dual earners, pay a heftier tax after marriage than if both individuals had filed as single filers.
Capital Gains Taxes
Under current law, dividend income and income earned from an investment asset held longer than one year receive a favorable capital gain rate. The current rate for single filers on long-term capital gain income is 20%. However, for taxpayers with a certain calculated income of more than $200,000, or $250,000 for married couples filing jointly, an additional 3.8% net investment income tax is assessed, making the effective capital gain rate 23.8%.
All Republican candidates want to dispose of the net investment income tax surcharge. Cruz and Gov. John Kasich would reduce the capital gain rate to 10% and 15%, respectively, while Donald Trump wants to leave the rate at its current 20%. Meanwhile, the Democratic candidates seek to significantly overhaul the capital gain rates. Clinton’s plan provides for the favorable 20% capital gain rate only on investments held for more than six years; those held for fewer than two years would be taxed at ordinary income rates. She would introduce a new “medium-term capital gain” that would provide a somewhat favorable rate – varying between 27.8% and 29.8% (including the net investment income surcharge) – for investments held longer than two years but fewer than six years. Finally, Sanders wants to eliminate the favorable treatment capital gains receive altogether for households with incomes over $250,000, taxing those taxpayers’ capital gains at rates as high as his proposed 54.2% on income above $10 million. In addition, Sanders would introduce a new financial transactions tax that would tax the value of all stocks, bonds, derivatives and other financial assets traded by U.S. persons at a rate varying from 0.005% to 0.5%, depending on the asset type.
Corporate Income Taxes
It is no secret that at 35%, the United States has a very high corporate tax rate. To put this in perspective, consider that the average top corporate income tax rate in the EU is 18.7%. In fact, the United States has the third-highest corporate tax rate worldwide, exceeded only by Chad and the United Arab Emirates. Additionally, the U.S. taxes American corporations’ income no matter where in the world they earn it – a relatively uncommon practice. Most developed nations use a so-called “territorial system,” in which corporations pay taxes only on the profits earned domestically. The United States’ high corporate tax rate and worldwide tax regime puts American corporations at a competitive disadvantage, the result being that many relocate to foreign countries with territorial systems and significantly lower income tax rates.
It comes as no surprise, then, that many of the candidates have proposed a move toward a territorial tax regime with lower corporate income tax rates. For example, Kasich and Trump want to lower the top corporate tax rate to 25% and 15%, respectively, while Cruz and Kasich have advocated ending the worldwide tax regime and shifting to a territorial tax system. Most notably, Cruz has proposed replacing the corporate income tax altogether with a 16% “business transfer tax,” levied on business profits after subtracting capital investments. As of this writing, the Democratic candidates have not released specific proposals regarding corporate tax rates.
Currently, the top federal estate tax rate is 40%; estates receive an exemption from the estate tax when valued at or under $5.45 million, assuming the decedent did not use this exemption to make taxable gifts during his or her lifetime. All three of the current Republican candidates wish to fully eliminate the estate tax. It remains to be seen whether they will also propose corresponding changes to the gift tax laws and the rules that allow a step-up in basis to the fair market value in the decedent’s assets at death.
Both of the Democratic candidates want to continue the estate tax regime and would lower the exemption amount from its current $5.45 million to $3.5 million. Furthermore, Clinton and Sanders each propose increasing the estate tax rate from its current 40% to 45% and 65%, respectively.
The foregoing discussion does not present a comprehensive list of all the candidates’ platforms. For example, Clinton, Sanders and Trump propose taxing carried interest at ordinary income rates. In addition, Cruz and Trump would phase out all deductions, except for the charitable and mortgage interest deductions, while Clinton and Sanders propose capping the benefit of itemized deductions at specific levels. Some candidates propose expanding certain tax credits, such as the child tax credit.2
None of the candidates are proposing a comprehensive reform of the Internal Revenue Code; however, their plans would significantly alter – for better or worse – the code’s bracket and rate sections. Of course, tax reform, even adjustments in brackets and rates, requires an act of Congress, so whether any of the aforementioned proposals will be codified into the code depends entirely on the alignment between Congress and the president elected on November 8, 2016.
Currently, in addition to all 435 seats of the House of Representatives, there are 34 Senate seats in contention, 24 of which are held by Republicans. In order to flip control of the Republican-controlled Congress, the Democrats would need to pick up 30 seats in the House and five in the Senate – not a straightforward task. Thus, despite the shared demand across the two parties’ candidates for tax reform, without alignment among the executive and legislative branches in the next Congress, tax reform is likely to stall.
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1 Source: Tax Foundation.
2 A complete review of the candidates’ tax proposals can be found on their respective websites.