The future of tax reform:

What does the election mean for the United States tax system?

Read the article in the Cayman Financial Review Magazine 

On 6 November, 2012, after approximately $6 billion was spent by candidates and political groups, United States voters decided to keep the status quo. Barack Obama won re-election and will serve as president for another four years.  

The Democrats kept control of the United States Senate, although they will remain short of a filibuster proof majority, and the Republicans kept control of the House of Representatives. 

The question is what do the election results mean for the possibility of major or even minor tax reform in the United States? The usual answer to that question is “not much”. However, this time really might be different; and there may be major changes in the next year or so. One reason for this is the approaching “fiscal cliff”. In 2011, President Obama and the Republican house enacted a compromise over the dispute on raising the public debt ceiling.

This agreement extended the Bush tax cuts enacted in 2001 and 2003 until the end of 2012 and also imposed mandatory cuts in spending if no agreement is reached. Thus, unless another agreement is reached, the 2013 income tax rates will return to Clinton era levels and spending cuts on many federal programmes will be imposed (a few federal programmes, such as Social Security and Medicaid, are exempted from the cuts).

Ideally, this situation would lead to a grand compromise between the two parties, perhaps something similar to the Tax Reform Act of 1986 where Republican president Ronald Reagan worked with the House of Representatives (controlled by Democrats) to broaden the tax base by eliminating many deductions in exchange for a major reduction in the marginal tax rates.

Such a grand bargain appears unlikely to occur in the current climate. First, the United States has a major debt problem; and, at some point, the growing deficit must be addressed. President Obama views increased taxes as the primary solution to deal with the enormous deficit. Second, President Obama campaigned on a promise to raise tax rates on the “wealthy” while insulating everyone else so he has no incentive to agree to an across-the-board tax cut. He views his election as proof that most voters favour a rate increase for high-income earners.

The two sides do agree on one thing – tax rates should not go up for married taxpayers earning less than $250,000 ($200,000 for singles). Where they disagree is what should happen to those taxpayers earning more than those amounts. Republicans would like to keep the current ordinary tax rates (thus a maximum marginal rate of 35 per cent) whereas President Obama would allow the tax rates for that group to return to the Clinton era rates (maximum rate of 39.6 per cent).

Republicans would also keep the capital gains rate (15 per cent) unchanged for all taxpayers and allow qualified dividends to continue to qualify for that beneficial rate. President Obama favours raising the capital gains rate for the wealthy to 20 per cent and would tax dividends at ordinary rates rather than the preferential capital gains rate. While preferring to leave tax rates the same as 2012, Republicans have offered to increase revenue collection by eliminating or limiting the use of certain deductions.

It now appears that both sides favour a cap on some deductions. Reducing deductions is just one way to raise the effective tax rate albeit the increase will be apportioned differently than would an increase in nominal rates. A cap on some deductions will cause a much more significant increase in some taxpayers effective tax rate then would any of the proposed increases of nominal rates.

So what will happen? If I knew the answer to that question, I would be significantly wealthier than I am. Instead, I will provide my best guess and then also provide what I hope will happen (which means, of course, that it will not).

As I noted above, the chances of a 1986 type grand bargain on tax reform are slim to none. There is no question that taxes will go up, the only issue is by how much and whether the increase will be accomplished through increased marginal rates, elimination of deductions or both. Based on the current fiscal cliff negotiations, it seems likely that it will be both.

However, tax reform may still be part of a larger compromise. It is likely that the Republican House of Representatives would be willing to accept the return of the Clinton era rates for the wealthy, and perhaps also some elimination of deductions or exemptions, in return for entitlement reform.

Republicans view the current spending of the federal government, especially on large entitlement programs such as Medicare and Social Security, as a major problem in attempting to deal with the deficit crisis. Republicans might be willing to accept a deal whereby for every dollar of tax increase, there is some corresponding cut to spending.

Although this type of compromise could be beneficial for the United States as it attempts to rein in its debt and the increasing cost of entitlement programmes, I am far from optimistic that it would truly do any good.

Usually, these bargains involve immediate tax increases in exchange for future promises of spending cuts. The problem is the future never arrives. Politicians have a very difficult time cutting spending programmes and instead the can is merely kicked further down the road. It would be disappointing, but not surprising, if this scenario plays out.

The idealist in me would prefer to utilise this crisis as an opportunity to enact major tax reform. If I were in charge (and did not have to compromise), I would reduce tax rates and simplify the tax law by eliminating costly deductions and preferences, including the preferential rate for capital gains.

Broadening the base could be structured to keep the changes revenue neutral on a static basis but the expected growth in the economy from such a plan would actually increase significantly the amount of revenue that the federal government collects. The United States economy would also be more efficient as federal tax laws would have less influence on the behaviour of individuals and businesses. These proposed changes are applicable to both the personal income tax and the corporate income tax.

In the international area, a move to a territorial system of taxation would align the United States with world consensus on the taxation of foreign income. Finally, the estate tax and the alternative minimum tax should be eliminated completely.

With President Obama’s re-election, none of these proposals are likely to occur. For “wealthy” individuals, the effective tax rate will rise, likely through a combination of increased marginal tax rates and a reduction of tax deductions and exemptions.

The extent to which this will have a significant negative impact on an already depressed economy remains to be seen. In the corporate tax area, President Obama proposed, in early 2012, reducing the corporate tax rate to 28 per cent (it is currently 35 per cent) in exchange for the elimination of certain corporate income tax preferences. There has been little discussion of this proposal since and it does not appear to be a part of the current negotiations between the White House and Congress.

In the international tax area, President Obama has not proposed any major reform and seemingly opposes a move to a territorial system. To the contrary, President Obama has favoured imposing a minimum tax on United State multinational corporations that are operating in low-tax jurisdictions.

For the estate tax, President Obama has proposed returning the tax rate and exemption amount to the same levels they were in 2009 – thus, a maximum tax rate of 45 per cent and an exemption amount of $3.5 million (the 2012 maximum tax rate is 35 per cent and the 2012 exemption amount is $5.12 million). Finally, while President Obama has proposed eliminating the alternative minimum tax, he would replace it with the so-called Buffet rule, a measure that attempts to ensure that taxpayers who earn over a specified amount ($1 or $2 million) pay a minimum effective tax rate of 30 per cent.

While many parts of the future tax reform are unclear, the election did eliminate one uncertainty. The re-election of President Obama means that his major health reform, Obamacare, will not be repealed. This means that the many tax items that are a part of Obamacare, including the individual mandate provision that Supreme Court Justice Roberts ruled was a tax provision, will take effect in 2013 and beyond. For example, the health reform provisions include a 3.8 per cent Medicare contribution tax on “net investment income”.

There is also an increase in the regular Medicare tax of 0.9 per cent for high-income earners. Other examples include a new contribution limit for health flexible spending accounts and an increased floor for itemised medical expenses. All of these provisions will likely remain a permanent part of the tax system as Obamacare becomes more and more entrenched.

Herbert Stein said “If something cannot go on forever, it will stop”. The United States currently spends like a social European democracy but does not impose the same tax burden on its citizens.

The deficit for the last four years has been at least $1 trillion and is projected to be close to the same in 2013. This obviously cannot continue. Taxes likely would have gone up no matter who was elected president, but the re-election of President Obama ensures it.

The two important questions that we don’t know the answer to yet are by how much and whether the economy will handle it. 


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Jeffrey Kahn

Professor Kahn has a J.D., University of Michigan Law School, 1997 and a B.A., Duke University, 1994. His scholarship focuses on the federal tax area. He is the author of several treatises including Federal Income Tax (6th ed., Foundation Press 2011) (with Douglas Kahn) and Principles of Corporate Income Taxation (Thomson/West 2010) (with Douglas Kahn and Terrence Perris). He also has published numerous articles in both general law reviews and tax journals. Professor Kahn teaches primarily in the area of federal taxation, including personal income tax, corporate tax, partnership tax and international tax courses. He has also taught a seminar on tax policy. Outside of the tax area, he teaches torts and business organizations.
Kahn worked for three years as a tax associate in the Chicago office of McDermott, Will & Emery. He has served on the faculties at Washington & Lee School of Law, Pennsylvania State University Dickinson School of Law and Santa Clara University School of Law. He has also been a visiting professor at Vanderbilt University Law School, Stanford Law School, University of California Hastings College of Law and University of North Carolina at Chapel Hill School of Law.

Jeffrey Kahn
Larson Professor of Law
Florida State University
College of Law
United States

T: +1 (850) 644 7474            
E: [email protected]            


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Florida State University
College of Law
United States

T: +1 (850) 644 7474            
E: [email protected]