It is tax time
again. As we organize for and prepare,
or have prepared, our federal income tax returns we often think about the need
for tax reform.
If we really want
to simplify the current complicated and convoluted federal Tax Code, we should
look at a tax system based, with some modifications, on the Pennsylvania state
income tax.
The Pennsylvania
state income tax is truly unique. The tax
returns of most states with an income tax follow the federal return and, for
the most part, federal tax law – starting with federal AGI or taxable income
and making state adjustments to this number.
PA had to be different. Its state
tax system was created from scratch, with very little similarity to federal tax
law.
PA taxes gross
income at a flat rate. There are no
exemptions for dependents and no filing status differences. The only deductions allowed are unreimbursed
employee business expenses, deducted directly against wages, and contributions
to a Medical Savings Account, Health Savings Account, Section 529 qualified
Tuition Program account, and Pennsylvania ABLE account. Retirement income – distributions from IRAs,
401(k)s, 403(b)s, Social Security and Railroad Retirement, and other pension or
retirement plans – is not taxed, and contributions to retirement accounts are
not deductible or considered “pre-tax”.
Net gambling winnings, after directly deducting losses to the extent of
winnings, are taxed.
Losses in one
category are not allowed to reduce income in other categories. Capital losses can reduce capital gains, but
a net capital loss or a rental loss cannot be deducted from wages or interest
and dividend income, as can be done, within some limitations, on the federal
return.
The only credits
allowed that are not related to a business activity are a special refundable
“Tax Forgiveness” credit, sort of like the Earned Income Credit (unlike the
EIC, based on earned income, eligibility for Tax Forgiveness is based on
eligibility income, which differs from state taxable income, that includes a
variety of sources) and a credit for taxes paid to another jurisdiction (like
the federal Foreign Tax Credit).
I would make three
modifications to the PA system for the federal return –
(1) Make the
equivalent of PA’s “Tax Forgiveness” credit nonrefundable, and adjust
“eligibility income” to include otherwise non-taxable retirement income,
including Social Security and Railroad Retirement benefits.
(2) Allow losses
in one or more categories to be deducted against income from other categories
to create a “net” total taxable income.
(3) In calculating
the net earnings from self-employment activities like sole proprietorships and partnerships
I would allow direct additional deduction on the Schedule C and Schedule K-1 for
self-employed health insurance premiums (also allowed for sub-S
owner-employees) to make the federal treatment of these activities similar to
the treatment for a “C” corporation.
Like the PA state
return the new federal return would allow a deduction for certain unreimbursed
business expenses of employees directly against wages. Also like PA, all pension and retirement
account distributions would be exempt from tax (except for a transitional
amount) and net gambling winnings, after a direct deduction of losses, would be
the amount included in total income.
Gross wages would be taxed, with nothing treated as “pre-tax”.
The “transitional”
amount of pension and retirement account distributions that would be taxed
would be the remaining amount of applicable employee contributions that were
treated as “pre-tax” or deductible on a prior Form 1040. Going forward all pension and retirement
accounts would be “ROTH-like” – no deduction or pre-tax treatment going in and
no tax coming out.
There would be no
“adjustments to income” other than the current self-employment tax deduction (the
self-employed health insurance deduction would already be applied directly on
Schedules C or E) and perhaps contributions to the same non-retirement savings
accounts allowed on the PA return, no itemized deductions, and no tax credits,
except for perhaps the Foreign Tax Credit.
The tax rate, currently 3.07% on the PA state return, would be perhaps
12% or more of the net total federal taxable income.
It would be an
almost pure “flat tax”.
TAFN
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