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Biden-Harris’s High Hopes for a Fairer Tax Code

Posted on Sep. 14, 2020
Jed Bodger
Jed Bodger
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@taxanalysts.org) is a contributing editor with TaxNotes. He formerly worked in the mergers and acquisitions and international tax groups at PwC and with the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP. Jed Bodger (jed.bodger@gmail.com) is the vice president of taxation at Sierra Nevada Corp. The views expressed here are their own.

In this article, the third in a series, Willis and Bodger explore whether the evolving Biden-Harris tax plan will create a fairer tax code by applying tax principles of fairness to proposals to increase capital gains tax rates and permit indexing for inflation, repeal the state and local tax deduction cap, and eliminate the carried interest loophole.

In our previous two articles, we covered how tax rate disparities on business income affect choice-of-entity determinations, as well as potential changes to net operating losses and estate and gift tax proposals that focus on eliminating the section 1014 basis step-up.1

It is extraordinarily difficult to determine how tax rate changes affect taxpayers because it involves determining who ultimately bears the burden of rate increases and factoring in the code provisions altered by rate changes. So let’s fill in the picture by elaborating on the topics discussed in our previous article and by addressing fairness in tax and whether the law should be used to pick winners and losers.

Guiding Principles of Fairness

In the foreword to a 2014 Senate Finance Committee report on tax reform,2 then-Sen. Orrin G. Hatch explained that “the key is to understand the complexities and wade through them to engineer a tax system that enhances efficiency, fairness, and simplicity.” He went on to state that the costs of compliance alone are staggering, and that “those costs are nothing compared to the economic distortions created by a tax system that, far too often, picks winners and losers.”

Despite Republican leaders making such statements, the Tax Cuts and Jobs Act was passed three years later. The TCJA mostly picked winners and losers, dividing not only the country but also the world. America’s economy is service-based, and intangible property is the lifeline for scientists, engineers, and technologically innovative companies that drive the success of America’s companies. But the TCJA created a minimum tax on intangible income under section 951A, an export subsidy under section 250, a 20 percent deduction under section 199A for qualifying business income of only some passthrough businesses, which benefits real estate moguls while excluding medical professionals and consultants, again, a large portion of America’s evolving economy. Even worse, the policies for the TCJA’s choices in picking winners and losers is questionable at best.

The 2014 report included a passage from The Wealth of Nations by Adam Smith, “the father of capitalism” and the “the father of economics”:

The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state. The expense of government to the individuals of a great nation is like the expense of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate. In the observation or neglect of this maxim consists what is called the equality or inequality of taxation.3

Horizontal equity is the fundamental principle that taxpayers who have the same amount of income should pay the same amount of taxes. Some believe the U.S. Constitution supports this view based on its requirement for equal protection. Specifically, the 14th Amendment, adopted on July 9, 1868, as a reconstruction amendment following the American Civil War, provides:

No State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws.

In fact, the Supreme Court held that a corporation was entitled to equal protection against unfair taxes under the 14th Amendment.4 Similarly, former House Ways and Means Committee Chair David Camp once stated in a letter to former Attorney General Eric Holder in 2014 regarding unfair bias in tax that groups should not be denied “equal protection under the law.” Both Hatch and Camp agreed in 2014, amidst their efforts as leaders to bring forth bipartisan tax reform, that tax should encourage equity and not pick winners and losers.

Equal protection from deprivation of life, liberty, or property based on horizontal equity aligns with a fundamental principle discussed in our last article: ability to pay. The ability-to-pay principle also provides that those with the same amount of income should pay the same amount of taxes generally. As Franklin D. Roosevelt stated, “For many years the country has accepted without question the principle of taxation in accordance with ability to pay. This principle applies to all forms of additional wealth accruing to individuals.”5 As the Supreme Court explained in its 1966 decision in Virginia Board of Elections to strike down a poll tax, “the state law violated the Equal Protection Clause of the Fourteenth Amendment because it put an unequal burden on different groups of people according to their age, sex, and ability to pay.”6

While some believe that both wealthy investors and poor workers should pay the same amount of tax regardless of their income or ability to pay, such views regarding fairness in taxation are atypical.

The TCJA also creates equity problems on an international scale. The base erosion and antiabuse tax under section 59A and section 250’s foreign-derived intangible income deduction discourage outbound flows and encourage inbound flows of money, which has devastated trade relations, invited retaliation from other countries, and likely violated WTO principles. This all comes at a time when the OECD is trying to inspire multilateral action to eliminate winners and losers by fostering fairness among the world’s taxing jurisdictions.

In a future article we’ll discuss proposals from Democratic presidential nominee Joe Biden and his running mate, Sen. Kamala Harris, D-Calif., regarding international tax provisions, largely involving changes in the global intangible low-taxed income regime, and offer recommendations to foster global agreement as opposed to conflict. Here, we’ll continue to focus on domestic priorities.

Capital Gains

Capital gains were initially taxed at ordinary rates, but the rates quickly increased during World War I, and beginning in 1921 capital gains on assets held for at least two years were taxed at a reduced rate of 12.5 percent because indexing for inflation was initially beyond the tax laws.7 In 1934, 20, 40, 60, and 70 percent of gains were excluded on assets held for one, two, five, and 10 years, respectively.8 The legislative history indicates that the capital gains provisions were enacted to mitigate the taxpayer’s burden of paying in a single year at the progressive rates applicable to that year a tax on gain from property that had increased in value over several years.9 Many believe this concern can be addressed by indexing basis for inflation. Until 1976 a pattern of decreases and increases followed for various reasons, but the main concern was generating revenue to decrease deficits.

From 1913 to 1921, the top capital gains rate was 7 percent; in 1977 the top rate was 49.88 percent.10 While the rate soon dropped again, the Tax Reform Act of 1986 repealed the exclusion of long-term gains, raising the maximum rate to 33 percent for some taxpayers. While long-term capital gains now face a maximum rate of 20 percent, it has been said that lower rates can be justified because of the lack of indexing for inflation over the long periods that many capital assets — including stock and homes — are owed. The indexing of the adjusted basis of long-term capital assets could indeed justify the increase of the rates to match that of ordinary income. The income tax rates, standard deduction, and dozens of other provisions are adjusted for inflation so that economic income is more accurately taxed.11 This would bring fairness to the code and eliminate rate disparities that were originally created because indexing for inflation wasn’t done in 1921.

As is frequently the case in tax, past is prelude. All the changes during the 1900s reflected a relatively common and consistent treatment of capital gains, with rate fluctuation as the primary differentiator. Now we are in a similar place, looking toward rate differentiation once again with the idea of aligning the top capital gains rate with the top marginal ordinary income tax rate in line with Biden-Harris proposals. As we previously discussed, increasing capital gains rates to ordinary rates for incomes exceeding $1 million, or perhaps $400,000, could stimulate revenue generation and prevent the ultra-rich from being able to use capital gains to avoid larger federal tax payments.12

Pieces of the proposal that would further demonstrate the Biden-Harris commitment to fairness in the tax code include limiting itemized deductions to 28 percent of their total value; increasing tax rates on capital gains, which would effectively eliminate the benefits that fund managers received from carried interests; making section 1061 as implemented under the TCJA unnecessary; and creating a better mechanism for taxing what is ultimately income from services rendered.

28 Percent Limitation to Replace SALT Cap

Limiting the tax benefit of deductions to 28 percent of their total value would reduce the incentives created by the existing system for taxpayers in rate brackets above 28 percent, who would see their subsidy rate fall from as high as 39.6 percent to 28 percent.13 Those taxpayers would continue to receive a tax benefit for each additional dollar they spent on tax-preferred items, but the amount of that benefit would be less than under current law. Coupling this with the elimination of the $10,000 SALT deduction limitation seems fair.

The Biden-Harris proposal would limit the value of itemized deductions and other income tax breaks to 28 percent for higher-income households: we expect those earning more than $400,000. For example, $100,000 in deductions would be worth up to $39,600 for a very-high-income household under the Biden-Harris proposals. This is because the top individual tax rate would be 39.6 percent. However, the Biden-Harris proposal would limit those deductions to $28,000.14

That proposal, which originated in the Obama administration and received substantial support,15 has ties to section 55’s alternative minimum tax, which caps benefits at 28 percent. Biden and Harris believe this would provide more fairness than the TCJA’s SALT cap. What New York Gov. Andrew Cuomo (D) said in his annual State of the State message on January 3, 2018, is telling: “You’re now robbing the blue states to pay for the red states. It is crass, it is ugly, it is divisive, it is partisan legislating, it is an economic civil war . . . our federal government is furthering the divisions. They govern by dividing. It’s winners versus losers, it’s rich versus middle class versus poor.”16

Reinstating the itemized deductions for individual taxpayers, with a 28 percent cap on every dollar will cover the vast majority of the American taxpaying population, demonstrates the reintroduction of fairness into the tax code that the Biden-Harris plan is attempting to achieve.17 Ultimately, it appears that under a Biden-Harris plan, six of seven marginal tax rate brackets will remain the same, with the first four of those at or below the 28 percent deduction threshold.18 Thus, most Americans will be able to use the full value of their deductible items, which more fairly and accurately measures economic income.

The individuals who are limited will be those in the highest marginal tax brackets. Capping the value of itemized deductions at 28 percent for those in higher marginal tax brackets and restoring the Pease limitation on itemized deductions for those with taxable income above $400,000 is in line with the Biden-Harris ideals of placing a higher tax burden on the wealthy. This is another attempt of the Biden-Harris plan to tax those with greater ability to pay, further bringing progressiveness and fairness to a tax code that has been shifting away from those ideals.

Section 1061 Carried Interests

Arguably, the carried interest debate could have been resolved by Treasury authority under section 707(a)(2)(A). The regulations could have provided any allocation of income to a service partner will be treated as compensation for services to a non-partner.19 That section leaves a lot up to Treasury when it comes to determining whether one is “acting other than in his capacity as a member of the partnership.” Such an interpretation by Treasury seems even more reasonable in light of section 707’s treatment of guaranteed payments, which Treasury recently decided could be treated as interest when it sees fit, as we recently discussed.20

Treasury cleared the path for carried interest allocations to receive capital gains treatment with Rev. Proc. 93-27, 1993-2 C.B. 343, treating the grant of a pure profits interest as a closed transaction in which services are provided in exchange for property (the profits interest) with a zero value, based on liquidation value, for tax purposes. Partnership tax often deals with valuation questions by using liquidation value because other valuation methods can sometimes open up even worse opportunities for gamesmanship. And while one can quibble about value since, as we’ve discussed, anything can be valued, the private equity fund manager provides services and should be taxed as such. The three-year holding period of section 1061 does little to change this. The carried interest loophole is alive and well.

In fact, the biggest change to level the playing field between carried interest for fund managers and income earned by the average American would be to implement the change in capital gains rates for gains in excess of $400,000.21 When capital gains rates and ordinary income tax rates are equalized, the opportunity for gamesmanship and the ability to reduce effective tax rates for income received is mitigated because there is no rate differential to arbitrage, putting aside taxes such as FICA and SECA, which many limited partners argue they are not subject to. Without a rate differential, the holding period of section 1061, the section 83(b) election, and all the other fund manager benefits associated with carried interests are eliminated. The classification of that carried interest as capital or ordinary in nature is a distinction without a difference. If section 1061 is eliminated and a $1 million dollar limitation is used, perhaps Congress or Treasury will explore the use of section 707, which is in part designed to distinguish service providers from partners and often bifurcates transactions, as would occur if a service provider also contributed capital.

Conclusion

So, where does that leave us? Well, as we have seen throughout this series, an efficient and effective tax code requires fairness and simplicity (to the extent practical). The TCJA has altered corporate tax rates in a manner that has eliminated the progressivity to which American taxpayers have become accustomed over the past century. That has lightened the burden on those taxpayers who can best bear the higher tax. This seemingly flies in the face of that fairness principle.

Some of the Biden-Harris proposal attempts to shift that result through changes in the taxation of capital gains and the limitations on deductions against income. Coupled with the increase in capital gains rates to ordinary income tax rates, fairness is expanded into the tax code because those who are taking the most advantage of rate disparities would be on equal footing with those who are unable to arbitrage the rates on their own. Reducing the increased capital gains rates below the $1 million mark would increase fairness; particularly if indexed for inflation. After all, gains resulting from inflation aren’t true accessions to wealth, and historic basis should not create artificial income. The policies underlying indexing tax rate brackets and deductions apply equally to basis. These are steps toward both horizontal and vertical equity within the tax code. Such fairness should be applauded, and the tax community should continue to remember the guiding principles of a fair and just tax code.

FOOTNOTES

1 Benjamin M. Willis and Jed Bodger, “Biden-Harris’s High Hopes for Mitigating Tax Rate Disparities,” Tax Notes Federal, Aug. 24, 2020, p. 1473; and Willis and Bodger, “Biden-Harris’s High Hopes for Taxing Wealth Transfers,” Tax Notes Federal, Sept. 7, 2020, p. 1831.

2 Finance Committee Republican staff, “Comprehensive Tax Reform for 2015 and Beyond” (Dec. 2014).

3 Adam Smith, “An Inquiry Into the Nature and Causes of the Wealth of Nations” (1776).

4 Santa Clara County v. Southern Pacific Railroad Co., 118 U.S. 394 (1886).

5 Roosevelt letters to House Ways and Means Committee Chair Robert L. Doughton and Senate Finance Committee Chair Pat Harrison (Apr. 13, 1938); for a broader discussion of this quote and different views, see Willis and Bodger, “Taxing Wealth Transfers,” supra note 1.

6 Harper v. Virginia Board of Elections, 383 U.S. 663 (1966) (the dissent summarized the view of the majority well, stating that: “While the ‘Virginia poll tax was born of a desire to disenfranchise the Negro’ (Harman v. Forssenius, 380 U.S. 528, 380 U.S. 543), we do not stop to determine whether on this record the Virginia tax in its modern setting serves the same end.”).

7 Act of 1921, section 206(a)(6), 42 Stat. 233 (1921).

8 Revenue Act of 1934, section 117(a), 48 Stat. 714; see also Gerald Auten, “Capital Gains Taxation,” Urban Institute (Oct. 1, 1999).

9 H.R. Rep. No. 67-350, at 10-11 (1921); H.R. Rep. No. 67-1388, at 1-2 (1923).

10 Rich DiPentima, “The Greatest Generation Put Common Good First,” Seacoastonline.com (May 10, 2011) (providing for 2011 that “the tax rate on long-term capital gains, the major source of income for the wealthy, is only 15 percent. It was 49.88 percent in 1977. Amazingly, the period of America’s greatest prosperity, growth, economic power and world dominance, was when our tax rates were the highest in history. The Greatest Generation realized that greatness required sacrifice from everyone, not just the few. They understood that contributing to the common good was just as important as individual success.”); Auten, supra note 8.

11 See Rev. Proc. 2019-44, 2019-47 IRB 1093.

12 Willis and Bodger, “Mitigating Tax Rate Disparities,” supra note 1.

13 Steve Wamhoff and Carl Davis, “A Fair Way to Limit Tax Deductions,” Institute on Taxation and Economic Policy (Nov. 14, 2018). This also assumes that the Biden-Harris proposals would be implemented to include a return to a 39.6 tax rate on individuals; see also James R. Horney and Jason Levitis, “Limiting Itemized Deductions for Upper-Income Taxpayers Would Have Little Effect on Small Business, Charities, Housing,” Center on Budget and Policy Priorities (Mar. 12, 2009).

14 John D. McKinnon and Siobhan Hughes, “Plan to Cap Tax Breaks Is Gaining Steam,” The Wall Street Journal, Apr. 4, 2013.

17 The TCJA increased the standard deduction from $6,500 to $12,000 for individual filers, from $13,000 to $24,000 for joint filers, and from $9,550 to $18,000 for heads of household in 2018 while eliminating or restricting many itemized deductions in 2018 through 2025.

18 See, e.g., Rev. Proc. 2019-44, 2019-47 IRB 1093.

19 Victor Fleischer, “Two and Twenty Revisited: Taxing Carried Interest as Ordinary Income Through Executive Action Instead of Legislation,” SSRN 2661623 (Sept. 18, 2015). Note that this article was issued before section 1061 was enacted as part of the TCJA.

20 Willis, “TCJA International Regulations: Deference for Expertise and Interest,” Tax Notes Federal, Aug. 3, 2020, p. 863.

21 Willis and Bodger, “Mitigating Tax Rate Disparities,” supra note 1.

END FOOTNOTES

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