Trending in D.C.: Is Federal Tax Reform Dead Before it Began?

For several years many people in Washington have been preparing for the time when Congress could take on the issue of federal tax reform.  

The U.S. tax code has become outdated and inefficient, reflecting years of neglect and manipulation by special interests. 

With Republicans taking control of Congress, the prospect of tax reform has once again emerged as a possibility.  Republicans have focused on corporate tax reforms they believe will spur continued economic growth and promote innovation, entrepreneurship, savings and investment. They want any tax reform to be revenue-neutral, meaning that if a proposal raises taxes in one area it must be offset by cuts in another area, and they have long said the complicated tax code needs to be simplified.

Democrats have focused more on individual tax reforms they believe will help those in the middle class to be more successful.  In his State of the Union address, President Obama laid out a plan for tax reform that is much different than the Republicans had in mind.

Dubbed “Middle Class Economics,” the President used his annual address to describe his plan to use the tax code to promote more equity in American society, when he said, “…Let's close the loopholes that lead to inequality by allowing the top one percent to avoid paying taxes on their accumulated wealth. We can use that money to help more families pay for childcare and send their kids to college. We need a tax code that truly helps working Americans trying to get a leg up in the new economy, and we can achieve that together.”

President Obama proposed a tax increase on households earning over $500,000 per year, taxing 529 College Savings Plans, taxing capital gains on inheritances, and raising the overall capital gains tax rate.  According to a Wall Street Journal analysis, the White House proposal would raise taxes by $320 billion over 10 years on high-income Americans to fund initiatives to benefit those at lower income levels.

President Obama’s plans include tax credits aimed at the lower-middle-class, including a $500 “second earner” credit to help cover the additional costs faced by families in which both spouses work, benefiting 24 million couples. He proposed a streamlined child-care tax incentive that will give middle-class families a tax cut of up to $3,000 per child. This proposal would complement major new investments in the President’s budget to improve child-care quality, access and affordability. The president also proposed simplifying education tax incentives, increasing the Pell Grant program, and making community college education free for most students.

The President has already abandoned one part of his plan when he dropped the proposal to tax 529 plans.  He not only received significant pushback from Republicans, but from several prominent Democrats, including Minority Leader Nancy Pelosi and Rep Chris Van Hollen, the ranking member of the House Budget Committee.  His proposal would have effectively ended the popular savings plans and replaced them with increased federal subsidies for students attending college. 

The goal of eliminating 529 plans was to remove a tax break for wealthier families, since the majority of participants in the plans have annual incomes over $150,000, and shift the benefit to lower income households.  However, White House officials failed to clearly justify ending the program and subjected themselves to increased scrutiny and criticism.  This is proof that even relatively minor changes in policy, with little chance of actually passing through Congress, can garner intense debate.

Interestingly, the day after the State of the Union, Treasury Secretary Jack Lew and Representative Paul Ryan (R-WI), the chairman of House Ways and Means Committee, both said they saw a path to victory on corporate tax reform.  Lew said there is bipartisan support to reduce the corporate tax rate from 35 percent to 28 percent, while using some tax revenue to pay for infrastructure spending. Congressman Ryan stated that, just like the last round of tax reform in 1986, it will require a bipartisan approach.  Also, there is no consensus on how to deal with Corporate Inversions, which is the process being pursued by companies like Burger King to re-incorporate in a different country to avoid high corporate tax rates in the United States.

With the Republican and President’s tax plans differing so greatly, the prospect of meaningful reform has become much more difficult after the State of the Union address.  The example of the quick and dramatic failure of the plan to end 529 college savings plans is an indicator that each proposal or idea will engender extreme levels of scrutiny and debate.  This creates an environment in which any substantive changes to the US tax code could be a tough lift in the current political environment.