Bush Tax Cuts Post Mortem

The Bush Tax Cuts were originally passed in 2001 and policies took effect from 2001 to 2003. The most dramatic effects took place in 2001, notably cutting the top income tax bracket from 39.6% to 35%. Some of these provisions have expired while some have been extended.

Much controversy remains as to whether the Bush Tax Cuts improved the economy. In this case, hindsight is not 20/20. Simply put, can can’t hit reset and replay history as if the tax cuts were never put into effect. To add complexity, the real estate bubble that lasted through 2007 made the economy appear better than it really was.

The real estate bubble caused a great wealth deception in which people generally felt secure about their financial situation. This caused people to spend more money. Since GDP’s biggest component by far is consumer spending, it rose considerably after the 2001 recession. In fact, there was a period of time in which household savings rates went negative.

Since there was considerable GDP growth between 2001 and 2007, government received more revenue from taxes. Although tax rates were lower, GDP growth more than made up the difference. In fact, tax revenue as a percentage of GDP was higher in 2007 than in 2001.

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In order to give the Bush Tax Cuts a fair evaluation, one must consider what the pace of GDP growth would have been if asset prices rose at the same rate as inflation. This is impossible to do with any precision because asset bubble change consumer behavior. When people feel secure financially, they continue investing in risky assets and spend money on luxuries. When the opposite is true, no asset price seems too low when fear is prevalent.

Generally speaking, tax cuts are positive for economic growth. Since private individuals and businesses are better allocators of capital than governments, low taxes are beneficial. That being said, if a government continues to overspend when less tax revenue is coming in, problems are inevitable. This causes weakening of the dollar and the debt will need to be repaid at some point. Because of the increases in spending do to the wars in Afghanistan and Iraq, the dollar depreciated during this period while government deficits increased.

Extension of the Bush Tax Cuts and the Fiscal Cliff

If the Bush Tax Cuts were made permanent, the Congressional Budget Office (CBO) projects that an additional $3.3 trillion would be added to the national debt. Although it’s obvious, the debt would be higher, projections like this lack accuracy. This is because of the indirect effect tax policy has on human behavior. In addition, one change causes other variables to change such as future income and GDP. As a result, we can only take these projections with a grain of salt.

The effectiveness of the Bush Tax Cuts is questionable at best. This is a outcome that will be debated for many years to come.

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How the Tax Preparation Business Has Changed

At the current time of writing, it has become more difficult to be a tax professional. Our biggest competitor is the D-I-Y tax software industry. People can do their income taxes online and e-file with ease.

This has done a couple of things. For starters, a higher portion of our work consists of handling complex and difficult problems. People filing 1040-EZ’s simply do it themselves. Those who own businesses, rental properties, etc. are more likely to seek the assistance of a tax professional.

I can recall the early days of electronic filing where there was a lot of low hanging fruit for tax professionals. They could simply offer Refund Anticipation Loans and make a lot of easy money. The alternative for most of these filers was to fill out everything by hand and mail in the return. Boy, how things have changed.

Now, each household each has multiple computing devices. There is no longer a need to download and install software. There are many tax preparation apps hosted in the cloud. And, for individual taxpayers with reasonably simple returns, this is a viable solution. On the other hand, filers with complicated returns get frustrated with this software and are better off hiring a tax consultant.

Because of this, good tax preparers should have plenty of job security for the foreseeable future. This is because, as more things get added to the tax code, the complexity requires more knowledge and experience than what was required in the past. Indeed, a portion of the market will consist of people who refuse to use a tax professional even when it makes sense to do so. But, this is something that occurs within the target market of every service industry. For example, in the auto repair industry, there are the stubborn folks will attempt to repair their own car. And they’ll never see the logic of why it makes no sense spend the time and energy to do something just one time. Now, with that rant out of the way, I will briefly cover how income taxes have become more complex and why it’s beneficial for tax accountants.

To put how income taxes have changed into perspective, we need to start from the beginning. Way back, in 1913, Congress passed the income tax law. Couples making over $4,000 were required to pay a tiny 1% tax.

History suggests that more things keep getting added to the tax code rather than getting removed. There was one notable exception, the Taxpayer Reform Act of 1986. But those exceptions are very rare.

The Bush Tax Cuts, implemented in 2001, included some big changes and attracted a lot of attention to income taxes. Some of the provisions have expired while others still exist or have since evolved. Most notably, the top income tax had been reduced to 35% from 39.6%. The American Taxpayer Relief Act of 2012 extended this an additional year, but has since reverted to the 39.6% rate.

Adding items to the tax code includes deductions and credits as well. Some of the new deductions that have emerged over the years include Earned Income Credit, Child Tax Credit, Education Credits, Energy Credits, and more.

The most recent changes added new lines to the 1040 in 2013. This is in addition to having their own new tax forms. First, the Additional Medicare Tax, a 0.9% surcharge, was implemented for taxpayers exceeding a certain income threshold. Second, the Net Investment Income Tax (NIIT) charged up to an additional 3.8% tax for high income earners. Both of these items put together added a lot of confusion for high income taxpayers.

Oftentimes, certain problems arise with no clear-cut way to approach them. The details of a particular problem may not correspond to legacy tax code policy. After the last financial crisis and recession, many investors lost money through Ponzi schemes. There was a lot of debate as to whether to claim Ponzi scheme losses as investment losses or theft. This was important because determining whether the loss was considered an ordinary loss or a capital loss often had a big impact on a taxpayer’s tax liability.

As a result, new legislation was passed in 2013 to address Ponzi schemes. Investors now have a specific set of requirements to go by to determine if a theft loss deduction can be claimed. This goes to show that sometimes it can take years for Congress to act on addressing new issues that arise. Many losses from Ponzi schemes happened in the 2008-09 recession. Examples like this are what eventually lead to the tax code becoming more complex.

Income tax professionals have to spend considerable time keeping up with the changes in the tax code. But, in the end, it’s to our benefit. First, we want to provide value for clients. We should strive to add much more value than the dollar amount we charge them.

Personally, I would prefer a simplified tax system. This is despite the fact that a complicated tax code helps my business. Many Eastern European countries have had success implementing a flat tax. Although I believe the concept of a flat tax is reasonable, I think it’s highly unlikely any such plan will get adopted in the foreseeable future. The reason for this is it would require the federal government to make many other adjustments. The most important one being reigning in government spending. I don’t expect drastic changes anytime soon. What I do expect, however, is incremental changes to the tax code. This will gradually increase the level of complexity of filing income taxes to an even higher level, which will continue to make knowledgeable tax professionals even more valuable.

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Tax Professionals VS Apps

If you’re thinking that every year it gets harder to fill out a tax form, you are correct. I’ve been at this for over 30 years. I watch the “growth” in terms of the number of lines on the 1040 along with all the new forms and schedules. Don’t get me started with all the rules and their exceptions!

Indeed, an option you have is using online softare like Turbo Tax. If your return is simple and straightforward, I say go for it and do it yourself. It should be relatively easy and painless. This is the option I’d probably take if I were in your position.

Allow me to make a quick analogy. I recently changed my windshield wipers on my car. It was easy to do. There was a diagram in the package showing me how to do it. Since I’m not mechanically inclined, anything that’s more difficult, I take my car to the shop. I would never do my own brake job. I feel your income tax situation should have the same approach.

However, if your return is large and complex in that you own businesses, rental properties, and/or have a lot of questionable deductions, then your time is better spent finding a tax professional. Your time is valuable. And, believe me, I’ve spent countless hours “fixing” tax returns from frustrated software users.

Why the IRS will Find YOUR Return

If you have used online software, while covering your eyes and ears, and hoped for the best, keep in mind that the IRS “data mines” for common statistics of users who aggressively took the wrong deductions or made common mistakes. This will get even easier for the IRS in the future because improvements in technology lead to more efficient ways to analyze data. This often becomes an issue when things get complex because it’s not always clear where something is ‘supposed to go’.

I’ve seen many people “play with the numbers” until their refund is where they wanted. Despite the constraints of online software, it’s amazing how ‘creative’ you can be filling out a tax form. Since most software information is derived from simulated interviews, the system has to interpret what the user is entering. For example, how can you effectively write a software program to distinguish between a Schedule C business expense versus an Employee Business Expense? And make it simple for the user.

User experience (UX) is a common practice in which UX professionals find the best way for humans to interact with an app. User experience involves a person’s behaviors, attitudes, and emotions about using a particular product, system or service (Wikipedia). However, there are what UX professionals would call “edge cases”. Edge cases translate to infrequent situations in which a very small portion of users encounter. The problem with income taxes is the massive heap of rules with most of them having certain exceptions.

On top of that, the system cannot do an effective job at understanding what a user needs when things get complicated. If you’re inclined (or just extremely bored), read through the 1040 Instructions booklet and you’ll find plenty things in which you have to read multiple times just to understand.

Tubro Tax and other similar applications aren’t for everyone. If you’re self employed, have investments, or involved in a partnership, online software will be a painful experience. Not to mention, it’s time better spent doing something else.

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When to Advertise Your Tax Practice

If you’re a tax professional, don’t assume that the only time customers look for your services is during tax season. When it’s not tax season, I continue to place a huge emphasis on marketing. In fact, I can focus more on marketing my business because I have ample time since I’m not overwhelmed with working.

It is a common mistake I see among other tax professionals who eliminate their advertising budgets and put no time into networking/marketing. There is still a lot going on from May until the end of the year. People have IRS problems, businesses are on fiscal years, and many people file extensions. In fact, I have obtained some of my best customers in the off-season.

If you are starting out or have a tight advertising budget, you should be spending your time networking and building relationships. This will pay off over the long run.

Only through testing will you be able to best allocate capital for advertising. If you don’t try new creative things, you will have no way of knowing what works best for you. That said, I didn’t realize how many people look for a tax preparer in the middle of the summer until I started using Google Adwords and SEO after establishing an online presence. By this point, I had been in this profession for 20 years!

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1000 True Fans Principle for Consultants

When I was studying online marketing, I came across the idea of 1000 True Fans. This was an ‘aha’ moment where everything clicked. The “1000 true fans” principle is that your biggest fans (or happiest customers) are those in which not only buy form you but also tell all of their friends about you.

Over the years, I have steadily accumulated these types of clients. in fact, I have some true fans in which I’ve been preparing their income taxes for over 25 years! And many of them are still referring me new customers!

Now, you may be thinking 1000 fans is too many and is a huge number. Bear with me here. 1000 is just a guideline for internet marketers. However, tax professionals can succeed with far fewer true fans. Depending on your client base, you may only need a fraction of this. But, the point is, you should be striving to establish a fan base. Charlie Munger was quoted saying that if you do great work, you will simply get more work.

That being said, I’m generally not conformable when a single client exceeds over 15% of my income. This is because I prefer to have many sources of income. Therefore, I don’t sweat it when I lose a single customer. Therefore, I want some diversification in my fan base and attract an array of fans.

I have found that my personality and way of connecting with certain customers makes them happy. I am unique and may not appeal to everybody. But that’s perfectly OK. Tax preparers vary about as much as different makes and models of cars. And buyers all have different tastes. I used spend time thinking about how I should change to appeal to everybody. Alas, this is not only impossible, but this only dumps energy down the drain.

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Slideshow of the Fiscal Cliff Resolution

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Fiscal Cliff Resolution’s Impact on Taxes and Investing

Given the large US budget deficits of the past several years, tax increases were inevitable. No doubt, this will be a drag on economic growth going forward. For starters, those earning wages will experience an increase in payroll taxes. The withholding for Social Security taxes will revert back to 6.2%, the amount it was before the financial crisis.

The Bush-era tax cuts will remain in effect for those earning less than $400,000 per year with the top tax bracket being 39.6%. Long-term capital gains and dividends will remain at 15% for those earning less than the $400,000 threshold. The top rate for long-term capital gains and dividends has risen to 20%.

Most importantly, however, is the permanent patch to Alternative Minimum Tax (AMT). Previously, AMT had to be patched every single year, leaving an element of uncertainty for many filers. Had this not been resolved this year, many taxpayers would have been caught by surprise with a stiff tax increase.

Although this resolution will be a fairly minor drag on the economy, it will not be sufficient for solving our budget problems. Our budget deficits are too massive and spending cuts will still be needed to bring our budget to a reasonable level. Simply put, the government will still spend far more than it receives in taxes.

One of the buggest dangers is a sharp increase in interest payments for the national debt. Interest alone on the national debt is around $29 billion per month. A spike in inflation and interest rates could make this amount multiply. Currently rates on US government bonds are near zero with the 30 year bond being around 3%. This is why any increase will be huge. These rates are historically low and cannot get much lower. That being said, the risk involved does not favor US taxpayers.

The Fiscal Cliff consisted of mostly media hype. The real problem involves the mushrooming amount of debt. If this is not dealt with, then we will experience a real crisis. According to Reinhart and Rogoff’s This Time is Different, once debt-to-GDP rises to over 90%, it becomes a significant drag on the economy (We have already passed this level). In most cases cited by the authors, governments eventually default. Currency devaluations, resulting in inflation from printing money, are considered to be an indirect form of default. And is the most common method used by governments with fiat currencies.

Slower Growth Impacts Equities

Currently, the stock market is priced with the assumption of GDP growing at the rate of its historical trend. This is roughly 3% per year. Since the Great Recession, we have not been anywhere near that. Corporate earnings for the majority of S&P 500 companies have been disappointing for the last 2 quarters. This suggests that earnings are near their peak for this business cycle.

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Medicare Taxes Set to Rise

Medicare surtaxes will be levied on high income earners. As it stands now, there will be 2 separate taxes for both earned income and unearned income.

The 3.8% Medicare surtax policy was passed in 2010 and is scheduled to take effect in 2013. This will affect those making over $200,000 per year ($250,000 if married). Currently, the top tax rate on dividends and capital gains is 15%. The surtax alone would increase this to 18.8%. Bear in mind that this does not take into account the expiring Bush tax cuts. That said, more increases for tax on investment income could be coming.

What effect will this have? It will make dividends worth less than what they are today. Because of the anticipation of higher dividends, many companies are currently paying special, lump sum dividends to avoid shareholders paying higher rates. Dividends you receive before the end of 2012 will still have a maximum tax rate of 15%.

The tax increase will have unintended consequences. If dividends are worth less in the future, companies will be more reluctant pay them. They will likely use other “tricks” like share repurchases. This increases earnings per share because it reduces the number of shares in the market.

Higher taxes for dividends will place downward pressure on stock prices. Because we are in a low yield environment, many investors have deployed more cash into dividend paying stocks. This is because interest rates are too low to provide a reasonable return.

If you plan on selling stocks in the near future, selling large gains before the end of 2012 will likely result in tax savings. This is especially true for high income earners.

The Medicare payroll tax will also increase for high income earners. An extra 0.9% will affect single filers with earned income over $200,000, married couples filing joint with income over $250,000, and married filing separate taxpayers with an income over $125,000. The top rate on Medicare overall will be a combined total of 2.35%.

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Fiscal Cliff is Mostly Media Hype

Each time I turn on CNBC, there’s a clock showing the countdown of the fiscal cliff (regardless of which show is on). This is merely a recurring theme: make you think the world is ending in dramatic fashion to keep you watching the news. CEO’s like to come on the shows to tells us it’s armageddon if we raise taxes. Isn’t this just an attempt by them to avoid paying more taxes themselves?

The real truth is that the economy is already weak. Corporate profits have been below analysts’ forecasts in the second half of 2012. In addition, we are interwoven in a global economy which includes a European recession and a slowing Chinese economy. Because the global economy is so interconnected, recessions elsewhere will have an impact.

Politicians also add drama. That is, they have an interest in “standing tough”. If an agreement were reached right off the bat, it would appear as one side lost the battle or was not doing it’s job. In other words, the longer they drag this out, the more it appears they are not letting the other party win.

In the end, the US government will be forced to deal with its budget problems. Because of the massive gap between tax revenue and its expenditures, there will be no options left except higher taxes and reduced benefits. Whether a consensus is reached in the short term or not, the huge deficit will be a drag on the economy for years to come.

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How I Estimate My Taxes Without Preparing the Whole Return

You may have a ballpark idea of how much income you have. Or, how much money you will make next year. Perhaps you need to just get an idea of what your tax situation is likely to be quickly and easily. Taxes PhD Tax Estimator will accurately calculate Form 1040 components without all the clutter of standard income tax software.

The aim: to understand your tax situation in as few steps as possible and see how changes will affect you going forward. This productivity tool will aid in:

  • Predicting a refund or balance due amount
  • Calculating accurate estimated tax payments
  • Revealing the impact of deductions and credits
  • Adjusting withholding amounts

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Taxes PhD is also available on Android smartphones.

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