With a little extra time after leaving state government this summer, I blithely signed up for a national tax preparation company’s entry-level course. It seemed like a good idea at the time. “How challenging could it possibly be?” I thought smugly. “After all, I have a law degree and more than 20 years’ experience in tax law and tax administration.”
As it turns out, very challenging indeed. The well-organized and well-taught course included some 60 hours of instruction over 10 weeks, multiple assessments, and a mountain of homework. Even though I managed to pass the course (to my considerable relief!), I came away with the uncomfortable realization that I had only just begun to scratch the surface of knowledge when it comes to filing taxes. I also gained a deep respect for my classmates who, despite many fewer advantages and even language barriers, worked incredibly hard to leverage the course as a means of advancing their careers.
Here are some takeaways and a few suggestions for our New Jersey policymakers.
The first takeaway is that I will never, ever, ever again entertain the foolish notion that I can do my own taxes. It’s just too complicated.
In fact, I now believe that the grotesque complexity of our federal personal income tax poses a subtle but real threat to the social contract. I may be old-fashioned, but I believe strongly in maintaining a dynamic connection between the people and their government, in which the citizen is sovereign and consents to the establishment of government -- including taxes -- to secure the common good.
In many ways, taxation is the ultimate expression of, and derives its legitimacy from, this relationship. When a tax system becomes so ridiculously complicated as to make it virtually impossible for an ordinary citizen to understand and participate in that system, is it any wonder that citizens question their commitment to that system and the government it supports? Even if you reject this assessment as hyperbole, consider the ominous implications arising from the fact that, while more than 97 percent of federal revenue is collected through voluntary rather than enforced collections, overall voluntary compliance rates have been trending down for decades. Computer software that uses question-and-answer formats to make compliance appear or feel artificially simple are a welcome and necessary convenience, but do little to bridge the gap in understanding.
A second takeaway is that much of the personal income tax’s complexity for moderate and low-income taxpayers is a function of our political culture’s emphasis on families, children, and education.
The tax code is replete with credits, exemptions, and other “pro-family” tax benefits -- the personal and dependent exemptions, earned-income credit, dependent-care credit, child tax credit, and American opportunity credit -- to name just a few. These are available to low- and moderate-income taxpayers depending on whether they meet certain requirements that touch on factors such as family relationships, living arrangements, income, age, and marital status. In almost every case, the threshold and most important challenge is determining who may claim whom as a qualifying “dependent” for various purposes. In today’s evolving and increasingly complex, multigenerational family structures, this can be wildly complicated and true compliance trap. Whether most of us realize it or not, the reality is that our society’s penchant for using the tax code to promote “family-friendly” policies comes at the price of greatly enhanced complexity for the very families we seek to benefit. Maybe, just maybe, there is a better, more efficient way to help these families?
A third and final takeaway is that the lack of similarity or “conformity” between New Jersey’s personal income tax and its federal counterpart is a source of great complexity and increased compliance costs. The core issue is that New Jersey has a gross income tax with few deductions and exemptions while the federal government and most other states with an income tax impose a tax on net income, centered on the concept of federal adjusted gross income (FAGI). One can make a strong policy argument that a gross income tax is actually preferable to a net income tax, but any such argument is pointless since Congress is unlikely to amend the federal income tax to conform to New Jersey’s tax structure.
It you can’t beat them, join them: New Jersey should conform to federal tax law. However, regardless of the policy and tax administration benefits, I do not believe our political culture has the will or capacity currently to make the major structural changes necessary to achieve complete conformity. But that should not dissuade our policymakers from seeking greater conformity through incremental steps over time. Here is a short list of modest, relatively painless policy changes that could get the ball rolling in the right direction:
Deductions for local assessments: Federal law allows deductions for separately stated local government assessments on real property to the extent they are specifically allocated to repairs, maintenance, or related interest; New Jersey does not. New Jersey should give its property taxpayers a break and conform to federal law.
Deductions for health insurance premiums: Federal law excludes from income the value of any employer-provided accident/health plan coverage or employer-provided reimbursements for medical care for an employee’s adult child under the age of 27, whether or not the child is a dependent. New Jersey permits taxpayers to deduct (not exclude) health insurance payments for a dependent child. Although exclusions and deductions are distinct concepts, it would avoid confusion for New Jersey to drop the dependent requirement and allow deductions consistent with the federal exclusion with respect to adult children under the age of 27.
Deductions for Medical and Dental Expenses: New Jersey allows deductions for medical and dental expenses to the extent such expenses exceed 2 percent of New Jersey gross income; federal law imposes a floor of 10% (or 7.5 percent if the taxpayer or their spouse is age 65 or older). Adopting the federal thresholds would be a modest revenue-raiser that also eliminates a significant distinction between federal and sta mte law. As an offset, New Jersey should consider joining the federal government and most other states in permitting pre-tax treatment for employer-paid medical premiums and cafeteria or flexible benefits plans provided under Section 125 of the Internal Revenue Code, currently taxable as wages for New Jersey purposes.
Lottery winnings: Federal law taxes all lottery winnings as a form of taxable income, while New Jersey maintains a $10,000 threshold. Unless someone can make a real case that this exemption is crucial to boosting ticket sales -- questionable -- New Jersey should simply conform to federal law.
Filing status: In general, New Jersey follows federal law regarding filing status [i.e., “single,” “married filing jointly,” “married filing separately,” “head of household,” or “qualifying widow(er)”]. Taxpayers must use the same filing status on their federal and state returns, with two exceptions. First, partners in a civil union recognized under New Jersey law must file as a spouse; they cannot file “single” even if they do so for federal income tax purposes. Second, if one spouse/civil union partner is a resident of New Jersey and the other a nonresident, the resident may file a separate state return even if the spouses file a joint federal return. Although these exceptions impact very few taxpayers, New Jersey should explore whether there is any compelling rationale for maintaining them.
1099-Gs for unemployment income: New Jerseyans who receive unemployment compensation must report the amount received as income for federal income tax purposes (but not for New Jersey purposes) using a Form 1099-G prepared by the Department of Labor and Workforce Development (LWD). Instead of mailing 1099-Gs, LWD makes 1099-Gs available electronically through its website. Some practitioners complain that obtaining a 1099-G from the LWD website involves a more cumbersome process than obtaining 1099-Gs for state tax refunds from the Division of Taxation within the Department of the Treasury. The two departments should explore ways to coordinate and perhaps consolidate 1099-G issuance.
Employee vs. independent contractor: The classification of workers as employees versus independent contractors has important legal consequences for employers under both tax and labor laws. As one might expect, the federal tax rules are slightly different from the New Jersey standards by administered by LWD, such that it is possible for an employer to face an inconsistent state versus federal classification. Once again, this represents an opportunity to LWD and the Division of Taxation to work together to rationalize state law toward closer consistency with federal law.
Retirement income: Federal law and New Jersey law proscribe distinct methodologies for determining what portion of a contributory plan distribution is subject to tax as opposed to a nontaxable return of after-tax contributions. New Jersey should consider bringing its methodology into conformity with federal law.
Reporting disability income – earned-income credit: One significant distinction is that the federal government does, but New Jersey does not, tax certain disability payments from various retirement accounts such as pensions, annuities, retirement plans, and IRAs. This distinction can affect taxpayers’ ability to qualify for the state earned-income credit (EIC). As its name implies, the EIC requires “earned income,” which for this purpose includes disability distributions subject to federal tax. When New Jersey taxpayers do not report these distributions on their New Jersey return (because they are not taxable by New Jersey) they risk receiving a notice from the Division of Taxation requesting proof of earned income. Providing additional information -- in this case obtaining and submitting a transcript of their federal tax return -- is always a hassle. As a simple potential “fix,” the Division of Taxation should explore the feasibility of adding a line on the NJ-1040 for taxpayers to report federally taxable disability payments.
The list above only scratches the surface and intentionally avoids a direct assault on some of the most contentious points of nonconformity, including such issues as the treatment of capital gains, loss carryforwards, and bonus depreciation. These and other matters will have to wait for New Jersey’s angry, insular political culture to gather the will and capacity to pursue comprehensive conformity.
Sadly, it may be a very long wait indeed.