Tax Strategy: The broad principles of tax reform
On Sept. 27, 2017, the Trump administration and Republican congressional leaders issued a nine-page outline on tax reform titled a “Unified Framework for Fixing Our Broken Tax Code.” At the start of the year we were, of course, supposed to have tax reform enacted by September. Instead, we have had a one-page outline followed now by a nine-page outline.
The outline does not provide much more detail than we had before from the administration and Congress, and leaves much still to be worked out in the tax-writing committees of Congress. However, it does provide the areas in which the administration and Republican congressional leaders have so far reached agreement.
For individuals, there is agreement on three new tax bracket rates of 12, 25 and 35 percent, but no agreement on the income levels to which they will apply. Mention is also made of a possible higher fourth tax rate if necessary to maintain the current progressivity of the Tax Code.
There is agreement on a near doubling of the standard deduction to $24,000 for married filing jointly and $12,000 for single filers, along with eliminating the personal exemption, but for some taxpayers it still appears that the loss of the personal exemption may not be fully offset by the increase in the standard deduction.
There is agreement to increase the Child Tax Credit and its income phase-out limits, but by undetermined amounts. The agreement calls for a new $500 credit for caring for non-child dependents, but it is not clear if this is in place of or in addition to the current dependent care credit.
The only itemized deductions specifically identified for retention are the home mortgage interest deduction and the charitable contribution deduction, with vague references to retaining but simplifying tax breaks for work, higher education and retirement, and even proposing to enhance retirement plan participation and resources available in retirement. It appears by implication that the state and local tax deduction is one of the items on the chopping block, although there appears to be a sufficiently significant block of Republicans from high-tax states in the House that this deduction may be revived in some form. The casualty loss deduction also appears to be on the chopping block at the same time that Congress has passed legislation to enhance the casualty loss deduction for victims of Harvey, Irma and Maria.
The agreement also calls for repeal of the Alternative Minimum Tax, the estate tax, and the generation-skipping transfer tax. There is also a call for more accurate inflation adjustments going forward, which has been generally interpreted to mean smaller inflation adjustments.
Similarly for businesses, there is agreement on a new top corporate tax rate of 20 percent, and there is general language, apparently to appease Sen. Orrin Hatch, R-Utah, about promising an effort to look at reducing double taxation of corporate earnings. There is also agreement on a new top tax rate of 25 percent for small businesses conducted as partnerships, S corporations or sole proprietorships, but the agreement only generally promises to try to distinguish business income from personal income without specifying how. The inclusion of sole proprietorships is significant, since some prior proposals did not appear to include them. Treasury Secretary Steven Mnuchin has also talked of generally excluding professional entities where the earnings can be primarily attributable to the labor of individuals. These distinctions would probably contribute to additional Tax Code complexity.
The agreement calls for unlimited expensing of depreciable assets starting on September 27, 2017, the only effective date specified in the outline, but only for five years. There is also a general reference to further enhancements of small-business expensing. The agreement also speaks of a partial limit on net interest deductions, with possible distinctions between corporate and non-corporate taxpayers, without providing any further details.
Only two credits are specifically preserved — the Research & Development Credit and the Low-Income Housing Credit — while the domestic production activities deduction under Code Sec. 199 would be eliminated. The agreement states generally that other business exclusions and deductions may be repealed or restricted, and industry-specific tax breaks will be reviewed to better reflect economic reality and prevent tax avoidance.
The corporate AMT would also be repealed.
In the international area, the agreement calls for a territorial tax system. It also calls for an unspecified tax on unrepatriated earnings spread over several years, indicating probably an inability to reach a compromise on the various rates proposed in earlier tax reform versions and also perhaps a desire to maintain flexibility to see what rate might be needed to help pay for the tax cuts.
The agreement also calls for a tax at an unspecified reduced rate to prevent shifting profits to off-shore tax havens. This is a somewhat new concept, probably inserted to replace the House proposal for a border adjustment tax and President Trump’s proposal for tariffs on trading partners viewed as having an unfair trading advantage. How this tax might be structured and applied is still uncertain at this point, but it is unlikely to contribute to tax simplification.
The revenue raisers
As has been the case throughout the tax reform process so far, the tax reform proposals have been much more detailed on the tax cuts than how they will be paid for. This unified framework is no exception to the rule. Aside from the unspecified tax on unrepatriated earnings and the implication that certain unnamed current tax breaks will go away, the unified framework focuses primarily on the good news from tax reform rather than the bad news.
The last effort to put tax reform into serious legislative language was Rep. Dave Camp’s effort in 2014, which was sufficiently detailed to contain provisions that upset just about everyone. Republicans will push to rely on economic growth projections as much as possible as an innocuous way to pay for tax reform without upsetting any constituency, but the Congressional Budget Office seems unlikely to put as much money into that pot as the drafters might hope. They are also no longer talking about a revenue-neutral tax reform bill, but that could also mean only temporary tax cuts to preserve the 51-vote requirement under budget reconciliation, but which also requires no projected deficits beyond the 10-year point. If forced to start specifically identifying other tax breaks that will be eliminated, then the lobbyists will get to work and, as we saw with the Camp tax reform plan and the current proposal to curtail the state and local tax deduction, the legislative process is likely to bog down again.
The unified framework has advanced tax reform only to the extent of providing more agreement on the easy issues while still leaving the tough issues to be worked out in Congress. The stated goal of the administration is to have tax reform legislation through the House by the end of October, through the Senate by the end of November, and to the president in December. Very few people outside of the administration and Republican congressional leaders think that will happen, except for a possible much-reduced effort to provide some modest rate cuts effective retroactively to the beginning of 2017. Most people expect that the process will bog down as the details start to emerge. The lack of progress from January to now is certainly not a good sign that significant tax reform will happen by year-end.
Treasury Secretary Mnuchin has also expressed a desire that tax reform will, as much as possible, be retroactive to the beginning of 2017. This will be easier for the tax cuts than for any revenue-raisers, especially the elimination of any tax breaks on which taxpayers have been relying during 2017. If tax reform slips to 2018, retroactivity to 2017 will become much more difficult. Year-end tax changes affecting 2017 will still be difficult for the Internal Revenue Service to incorporate in its forms and software and still start the tax filing season on time.
While the administration states that its goal in tax reform is primarily to reduce taxes for the middle class, most analysts seem to be finding it hard to see how the current proposals could achieve that goal. Like health care reform, it may be that Congressional Budget Office projections could help to doom the tax reform effort by peeling away votes from those concerned that those promises are not being kept.