In conjunction with Representative Dave Camp’s rollout of the draft legislation of the Tax Reform Act of 2014, the House Ways and Means Committee has prepared a section-by-section summary that discusses the current law, what this legislation would change, what considerations were taken into account when proposing the changes.
In order to discuss the legislation, I’ll have to set out the broad formula for how income tax is calculated:
- (Income) minus (deductions and exemptions) equals (taxable income)
- (Tax due) equals (taxable income) multiplied by (the tax rate), minus (credits against tax)
Deductions and exemptions are reductions in income, the tax effect of which is measured by multiplying the change in deduction by the tax imposed on that income. A decrease in a deduction will, all other facts remaining the same, will increase federal taxable income and federal income tax.
Example 1: Joe, filing as a single taxpayer, has taxable income of $90,000 in Year 1. In Year 2, with all other facts being the same, a legislative change limits a deduction by $1,000, increasing Joe’s taxable income to $91,000. Under federal law, all taxable income earned between $90,000 and $91,000 is taxed at 28 percent. Joe’s income tax has increased by $280 ($1,000 times 28 percent).
But this is only part of the package of changes. In conjunction with these changes to deductions, the tax rates would be reduced:
Example 2: Same facts as Example 1, except that the income earned between $90,000 and $91,000 is taxed at 25 percent. Joe’s income tax has increased by $250.
A credit is a dollar-for-dollar reduction of the income tax, so if the legislation also increases a credit Joe claims from $1,200 to $1,600, the net effect on Joe’s tax liability is a net reduction in tax of $150.
Not every taxpayer would have all three changes to their bottom-line tax due, but the major changes (tax rates, the standard deduction, child tax credit, for example) are a) would apply to the largest group of taxpayers, and b) for most taxpayers, this would be net reduction in their income tax.
The primary purpose of the TRA is twofold: simplify the Internal Revenue Code by eliminating some of these boutique deductions and credits, and to reduce the tax liability for most taxpayers. Importantly, the TRA also proposes reforms to the IRS following its politicized treatment of certain social welfare (“501(c)(4)” groups).
The legislation is designed to be revenue-neutral, meaning that the changes will increase revenue by an equal amount that they will decrease revenue. The Joint Committee on Taxation has put out a paper that analyzes the revenue impact piece by piece. I’ll incorporate their analysis into the conversation.