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It’s going to be a busy day in the tax world, as President Obama will be unveiling  his long-awaited  proposal for corporate tax reform in a few hours. Expected to be included among the proposals are the following:

  • A reduction in the corporate tax rate from 35% to 28%;
  • A modification to Section 199 to ensure that U.S. manufacturers pay no more than a 25% effective tax rate;
  • Elimination of up to a dozen tax deductions currently available;
  • Renewal of the R&D credit under Section 41; and
  • The addition of a “worldwide minimum tax” to ensure that U.S. corporations that move operations offshore pay tax on its overseas profits.

It’s important to note, while the 7% reduction in the corporate tax rate may look universally appetizing, for those corporations that currently take advantage of many of the tax preferences on the chopping block, they may actually see their effective tax rate increase as a result of the lost deductions. Those corporations — typically in the technology and pharmaceutical fields — likely will not be on board with the proposed changes.

In general, however, corporate tax reform is one of the few areas where Republicans and Democrats may be able to find some common ground, as it is widely recognized that the current corporate tax regime is putting the U.S. at a competitive disadvantage with other nations.

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[Ed note: WS+B State and Local expert John Daly stops by to provide his take on a topic of growing relevancy: is a state better off with no income tax?]

Oklahoma, if it ain’t broke, why fix it?

A question that has always weighed heavily on the minds of state legislators and politicians across the country is, “how can I make my state a more attractive place to be?”  Naturally, any elected official wants a thriving economy and a happy or satisfied electorate.  There is no better recipe for reelection.  So how do you strike a healthy  balance  between meeting the needs of the state’s business community and its individual residents?  Certainly one of the most effective tools government officials have at their disposal is the tax code.

 The Wall Street Journal (WSJ) published an article last week titled, “The Heartland Tax Rebellion.”  The article delves into the changing tax landscape in many states and tries to address the question of, which tax scheme works best?  At the center of the article is Oklahoma. The governor of that state, Mary Fallin, had managed to reduce her state’s individual income tax rate last year by a quarter point, but now she is proposing a much more dramatic reduction in 2013.  The governor wants to eliminate the income tax completely for those making less than $15,000 a year. That will certainly garner her a few votes come election time. She also plans to reduce the current seven bracket income tax system to three brackets, and cut the top individual rate by almost two percentage points.  Ultimately, the plan is to phase out the income tax completely.

The WSJ article points out that the states bordering Oklahoma either have no income tax (e.g. Texas) or are planning to eventually eliminate their income tax (e.g. Missouri and Kansas).  South Carolina also plans to abolish its income tax and a host of other states are looking to dramatically reduce their tax rates as well.  The question for Oklahoma (or any state for that matter) is, does it really matter what type of tax structure a state has?  An even bigger question given today’s global debt crisis might be, how do you make up for the loss of revenue once the income tax is reduced or removed? 

On the surface, Texas appears to have answered these questions.  They have neither an individual income tax nor a corporate income tax and the Texas economy has grown at a faster rate than the rest of the country, for years.  Granted, they are geographically blessed with abundant energy producing resources and a unique climate.  The state leaders do, however, deserve some credit for putting in a tax structure that is quite unlike any other tax system in the country, yet appears to be serving the state’s immediate needs.

How can you gauge Texas’ success?  One way might be by looking at its healthy population growth.  According to the 2010 United States Census, the state has increased its population between 2000 through 2010 by over 4 million.  That growth yields an impressive percentage increase of over 20%. Something besides the promise of heat and humidity has attracted this migration.  In 2011, the Texas economy grew to become the country’s second largest behind only the huge state of California.

What are the most positive attributes of the tax structure in Texas?  For individuals of course, there is no income tax.  For the small business, the state does not tax an entity’s earnings until annual revenue exceeds $1,000,000.  That is very “attractive” to any entrepreneur looking to create something.  Once that minimum revenue threshold is surpassed the tax rates are slightly higher than average, but nowhere near the country’s higher tax states.  Sounds pretty good.

Oklahoma has much of the same resources as its neighbor to the south.  If Fallin is intent on eliminating her state’s income tax, perhaps she might consider adopting the Texas method of “gently” taxing success, while encouraging risk taking and hard work by allowing small business people earning less than $1 million in revenue to keep more of their income.

There are some things however, that Governor Fallin might want to consider before she makes any wholesale changes to her state’s tax scheme.  Oklahoma currently has a budget surplus.  It also has a very low unemployment level, so the citizenry of the state presumably must be content.  Further, according to US Government statistics, Oklahoma is ranked sixth in the nation in terms of its Gross State Product to Debt ratio.  This fact should be viewed as extremely positive given the debt problems that currently plague the rest of the world.

Nowhere in the WSJ article is the word, “debt” mentioned, but a state’s borrowing  needs must be taken into consideration prior to reducing or eliminating its income tax.  While Texas has experienced the aforementioned growth, its state debt has increased at a faster rate in the last ten years than even that of the federal debt. The percentage increase is over 281%.  Another fact worth noting is that some studies show that Texas has unfunded pension liabilities in the neighborhood of $150 billion. Like any other state or country, having a lot of debt is ok as long as you can service that debt.

If I were to offer my advice to Governor Fallin, I would ask her to continue to guide her state on a healthy course.  Exploit your state’s natural resources and develop industry.  Reduce state expenditures. Continue to earn a surplus and pay down your existing debt when possible.  Don’t be distracted by the political gimmickry of your peers who think that slashing tax rates is the answer.  It is not, and evidence of this fact can be seen everywhere.

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The awesomeness of the internet cannot be overstated. It’s not just a place for admiring vintage pornography and slandering people anonymously, it’s also a place where we can go to engage in wild speculation about topics on which we have little to no information. It’s a beautiful thing: we can make baseless predictions on whether Peyton Manning will retire,  pontificate on whether Sarah Palin’s had some work done, or devote a poll to questioning Daniel Tosh’s sexuality, and do it all without fear of reprisal.  

Such is the foundation for this Wall Street Journal article, which attempts to take the sting out of the political firestorm surrounding Mitt Romney’s much-publicized 13.9% effective tax rate for 2010 by using Romney’s 2010 tax return to “back into” an estimated effective rate for 2009 of 19%; a rate that would likely be more palatable to the American voter.

In fairness, the analysis in the article is well thought-out, and probably pretty darn accurate. Unfortunately, that doesn’t make the task of guessing someone’s effective tax rate any less an exercise in futility.

Their theory goes like this:

  • On their 2010 return, the Romney’s made estimated payments totaling only $1,369,000 before $3,250,000 was paid with extension. Since no underpayment of estimated tax penalty was assessed under I.R.C. § 6654 upon the filing of the return, the estimated payments were enough to “safe harbor” the Romney’s 2010 estimated tax based on 110% of their 2009 tax. This would put their 2009 tax liability at $1,240,000.
  • In 2010, the Romney’s $17,000,000 of capital gains were partially offset by a $5,000,000 capital loss carryforward. This would mean that the Romney’s had no net capital gain in 2009, but rather a $3,000 capital loss, the maximum allowable under I.R.C. §  1211.
  • Removing the capital gain from the Romney’s 2010 return and assuming items like interest, dividends, and speaking fees remained relatively constant from 2009 to 2010,  the article puts their 2009 AGI at approximately $6,500,000.
  • Dividing the federal tax bill of $1,2400,000 by the assumed AGI of $6,500,000, the article concludes that the Romney’s effective rate in 2009 was 19%, a much more reasonable number for a man of such prodigious wealth.

The shortcoming of the article is not in its methodology, but rather in the meaningfulness of its conclusion. What is to be accomplished by pegging Romney’s tax rate at 19%? Truth be told, Romney’s widely reported 2010 effective rate of 13.9% isn’t even particularly meaningful – since it fails to take into consideration the corporate level tax paid by many of Romney’s investments, making his real effective rate likely considerably higher — so why go through the exercise of guessing at Romney’s 2009 rate?

To illustrate, what if Romney’s 2009 AGI was $8,000,000 or $5,000,000 rather than the $6,400,000 posited in the article, a totally reasonable margin for error. This would put Romney’s effective rate at 15.5% or 23% rather than 19%. Would it matter? It’s hard to imagine a  4% reduction in a tax someone paid three years ago costing them votes, just as its equally unlikely that a 4% increase in the same tax rate would calm concerns of financial inequity. 

From my perspective, investing this much guesswork in Romney’s 2009 tax picture can only reinforce two things we should have already known: 

1. Romney’s effective tax rate — like most Americans — varies from year to year.

2.  The stock market really, really tanked in 2008 and 2009 for a private equity kingpin like Mitt Romney to have a net capital loss.  

Perhaps this comment left on the Wall Street Journal website reacting to the article said it best, and using much more modern vernacular to boot:

“OMG, who cares…..”

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Ed note: If you received an email earlier today, please disregard. I had a case of premature publication. It’s embarassing, but it happens, and I’m not ashamed to admit it.

In response to increased scrutiny regarding the effective tax rate paid on his substantial income, Republican Presidential candidate Mitt Romney released his tax returns late last night. Yours truly was given an opportunity to review the returns immediately upon their release for Bloomberg and provide comment. You can read that article here, but in the interest of keeping this blog self-contained, the most revealing items included in Romney’s 2010 individual tax return are discussed below:

  •  His real name is Willard? I’d go with Mitt, too.
  • Romney paid $3,000,000 of federal tax on $21,600,000 of gross income, for an effective rate of 13.9%. While this is sure to draw ire from the 99-percenters, it is 100% legal, and is largely attributable to two things:
  1. Romney’s $18,000,000 of alternative minimum taxable income (he paid a small amount of AMT)  consisted of $15,500,000 of income eligible for the preferential tax rate of 15%. In specific, $3.3M of Romney’s $4.7M of dividend income was eligible to be taxed at this lower rate, a break that was added to the Code with the Bush tax cuts. In the absence of the Bush legislation, Romney’s entire $4.7M of dividends would have been taxed at the maximum ordinary income rate, currently 35%. In addition, Romney’s also recognized $12.2M of long-term capital gains, which similarly benefitted from the Bush cuts. The gains are currently taxed at 15% rather than the 25 or 28 percent rates that existed previously.
  2. As expected, Romney benefits greatly from the current treatment of “carried interest” as provided for under administrative rulings issued by the IRS. In short, a carried interest is a partnership interest granted to a partner — typically a money manager in a private equity firm — in only the future profits of the partnership in exchange for managing the money of the private equity firm, choosing its investments, divestitures, etc… Under Rev. Procs. 93-27 and 2001-43, the granting of a pure profits interest is not a taxable event; thus, when Romney receives a profits interest in a private equity firm, it is not taxed as compensation (or capital gain), and the future income of the private equity partnership that is allocated to him — typically long-term capital gains — is eligible for the preferential 15% rates.

The reason carried interests have come under attack — particularly from the Obama administration — is obvious. On the surface, the amounts allocated to the managing partner certainly appear to be compensation for services; thus, according to critics, they should be taxed at ordinary income rates rather than capital gain. While this law may change in the future, it is important to note that Romney is completely correct in treating the amount of income allocated to him from his carried interests — $7,000,000 of the total $12,200,000 of capital gain according to his campaign — as LTCG rather than compensation.

  • Of Romney’s $3,000,000 of charitable contributions, half were made in cash to the Church of Latter Day Saints (which would appear to be part of Romney’s tithing requirement), and half made in stock to Romney’s private foundation, the Tyler Foundation.
  • How bad were things in 2009 if even Mitt Romney had a $4,000,000 capital loss carryforward to 2010?

All in all, there as nothing shocking about Romney’s tax returns. Yes he paid only 13.7% of his income to the IRS in federal tax, but such is life under the current tax regime when the overwhelming majority of your income is earned in the form of long-term capital gains and qualified dividends. Critics, however, are sure to focus on four things:

  1. The effective rate. Again, for right or wrong, Romney paid only 13.7% of his income in tax, but he did so legally and in total compliance with the current rules.
  2. The pure size of the numbers. Even for a Presidential candidate, $20M of AGI is a lof to income, which may not be particularly well received in this time of the Occupy Wall Street movement, cries of economic inequality, and other opening salvos of class warfare.
  3. Romney received a $1.6M tax refund in 2010. Now you and I know that tax refunds are purely a function of your tax liability compared to the estimated payments you’ve made, but the public is likely to find it hard to swallow that someone with $20M of income received a refund exponentially larger than most people’s income for the year. Again, it’s not the right reaction, but it’s likely to occur.
  4. Prior to the release of his returns, Romney admitted to a 15% effective rate, stating that he did generate some ordinary income from speaking fees, but “not much.” It turns out “not much” was in excess of $500,000, a sum most would be more than happy to accept for a few hours of speaking. This could position Romney as “out of touch” with the average American, an angle many of his critics and opponents may embrace.

Additional coverage:

The Washington Post

The NY Times

CBS News

Wall Street Journal

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