Monthly Archives: July 2014

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.

Federal_individual_income_tax_receipts_2000-2009

Licensed under CC BY-SA 3.0 via Wikimedia Commons

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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