January 04, 2018
Anniversaries, particularly meaningful ones such as Eide Bailly’s centennial, give us the opportunity to step back for a moment and reflect on the past as we look forward to the future. That makes it seem almost fitting that there has been a lot of conversational buzz about tax reform this year.
Tax reform sounds good, and it seems everyone is in favor of tax reform—as long as it doesn’t make them pay more tax.
But a look through tax history shows us that tax reform does indeed happen, and even with the best intentions, it should be considered carefully because of lasting unintended effects.
Why Do I Have to Pay Tax?
Outside of tax practitioners who read the very fine print of an actual Internal Revenue Code, most people, if asked, don’t know why they are required to pay federal income tax. They might say “because it’s the law,” which is true, but how and why did the law requiring payment of federal income tax come about in the first place?
Before the federal income tax came into existence, revenue was gathered by the government in the form of tariffs. This included the British government before the formation of the United States. In large part, it was the British government’s imposition of the Tea Tax, an import tariff, that lead to the American Revolution and the creation of the United States.
Tariffs, essentially fees collected for things imported or produced, were the main revenue source of the new U.S. government until the introduction of the 16th Amendment to the U.S. Constitution and ratification in 1913.
The 16th Amendment was necessary to get past some specific apportionment language in Article I of the Constitution which limited the ability to impose a direct tax on the U.S. population, as well as to deal with a 1895 U.S. Supreme Court case ruling in Pollock v. Farmer’s Loan & Trust Co. prohibiting a federal tax on income from property.
The simple language of the 16th Amendment states:
“The Congress shall have power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”
Origins of the Current System
In October 1913, the Revenue Act of 1913 was enacted by Congress. This was not actually the first income tax imposed on personal income. That was done in 1861 to finance the Civil War. The Revenue Act of 1861 and 1862 imposed a 3 percent tax on all incomes over $800. The tax rates and levels of income required were adjusted over the years until the tax was repealed in 1872. A new income tax law was enacted in 1894, but the 1895 Pollock case brought the apportionment requirement into focus, which lead to the 16th Amendment fix.
The income tax law created by the Revenue Act of 1913, the beginning of our current taxing system, became effective on March 1, 1913. It imposed a 1 percent tax on net personal income above $3,000. In 2016 dollars, that would be roughly equivalent to $73,000. There was also a 6 percent surtax on incomes above $500,000.
It didn’t take long for the accounting professionals of that time to understand the future importance of this new tax law. And as world events began to unfold into the World War I, the rather insignificant 1 percent tax rate would increase by 1918 to a tax rate of 77 percent on income above $1 million. The increase was required to finance the war efforts and the reconstruction period. This up and down pattern of volatility in the tax rates was experienced throughout the years following World War II, when the top marginal tax rates would finally top out to be near or above 90 percent. It wasn’t until 1964 when a downward movement in top marginal tax rates started.
But from the beginning, the effect on business and the importance of training for the new 1913 tax law was evident. An announcement for a 1917-18 special course of six lectures to be given at Northwestern University School of Commerce said:
“American business will be called upon to pay unusually heavy taxes during the period of reconstruction, and therefore, a thorough knowledge of the laws and Treasury Department regulations is essential to those who are charged with the responsibility of preparing returns for individuals, partnerships, corporations and estates.”
Undoubtedly, dealing with the new tax laws provided an extra financial benefit to the first developmental years of Eide Bailly.
Into the Modern Era
According to the Tax Policy Center, there have been 80 pieces of major enhanced tax legislation enacted between 1940 and 2012. While there have been tax law changes since 2012, there have been only two that could be considered major. And, while titling of tax legislation bills doesn’t always represent what is actually in the bill, there have been only three that have carried the title of “tax reform”—the Tax Reform Acts of 1969, 1976 and 1986. No legislation rising to the level of tax reform has been passed since 1986.
To most, the difference between designated tax reform legislation and the tax law changes made by the various tax laws passed over the years is probably insignificant. But, when more closely examined, tax reform legislation changes the direction of tax laws because it deals with tax policy changes, not the adjustment of currently established policy to better fit the social or economic environment of the time.
Tax Reform Act of 1969
In the years leading up to 1969, there was a concern that a group of very high-wealth individuals and large corporations were able to escape paying income tax because they had high capital gains income or various specialized deductions available to them that were not available to most taxpayers.
To address this, the Tax Reform Act of 1969 created a new system of taxation, the Alternative Minimum Tax (AMT), which was designed to force a 10 percent tax payment even though the regular tax calculation would produce a no tax due result. However, this tax change became a prime example of why tax reform efforts should not be rushed, and all ramifications of any tax reform proposal should be addressed at its start. Here’s why.
The AMT was designed to specifically address a group of 154 individuals with adjusted gross incomes of $200,000 a year or more whose taxes were reduced dramatically by the defined specialized deductions. However, a problem developed. The legislation did not provide for indexing the level of gross income at which the AMT would become applicable. Therefore, as inflation began to rise in the years following passage, the number of people subjected to the AMT also began to rise from the original targeted 154 to an estimated 2.4 million in 2003 and 4.3 million in 2011.
The AMT was finally indexed for inflation beginning in 2013, 44 years after it was created. The unintended tax revenue windfall became difficult for Congress to fix.
Tax Reform Acts of 1976 and 1986
The Tax Reform Act of 1976 was less ambitious. It established the first tax incentives to encourage the preservation of historical structures and created the unified estate and gift tax rate schedule. There was also a provision included to allow a tax-exempt organization to participate in legislative lobbying up to certain financial limits, among other items.
But, the Tax Reform Act of 1986 was an aggressive piece of tax legislation designed to simplify the Internal Revenue Code, expand the tax base of payers and eliminate tax shelters. To accomplish those objectives, and remain revenue neutral to prevent veto by President Reagan, the new legislation moved many standard individual tax costs over to corporations and specialized individual taxpayers.
By expanding the benefit of the standard deduction, personal exemption and earned income tax credit, more than 6 million taxpayers were removed from the tax rolls and a tax decrease was achieved for most individual taxpayers. However, those who were the focus of the new revenue sources created to keep the legislation revenue neutral weren’t celebrating.
Some of the changes that caused concern were:
Non-deductibility of consumer loan interest, such as credit card debt
Phase out of rental housing investment incentives
New depreciation asset lives based on economic theory
IRA deductions availability restrictions
Probably the most lasting and sometimes still confusing area of change in the Tax Reform Act of 1986 was the limitation placed on the deduction of passive activity losses and the use of passive credits, which was designed to eliminate tax shelters, particularly in the real estate industry. In practice, many more business operations would be affected than just tax shelters. Business investments began to dry up, and without capital to invest, projects failed or were never started. It took some time before the affect of this legislation would be absorbed.
What To Expect From Current Tax Reform Efforts?
It is still unclear the path and timing that current tax reform will take. But, when you consider that from 1969 to 2014 the number of pages in the U.S. Federal Tax Code has increased almost 400 percent to more than 76,000 pages according to data from Wolters Kluwer, the sheer size, complexity and interweaving of current tax provisions would suggest that tax reform is needed.
Tax reform can change business economics. The globalization of business and the mobility of people since the last tax reform was completed in 1986 also suggests a new tax focus is needed to enhance economic development in this age of globalized activities.
No doubt there will be winners and losers in the tax reform effort—there always are. The underlying question still remaining to be answered is: Will those responsible for tax reform change be up to the challenge to make it happen sooner, rather than later, for the benefit of everyone in the long run?