Monday, February 4, 2019

INCOME TAXES – PENNSYLVANIA HAD THE RIGHT IDEA



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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