Today, the natural question for those of us in business or the tax world is, “What does the election mean for tax policy in general, and tax reform in particular?”
The answer is somewhat mixed. To be sure, Republicans generally have supported lower taxes and the idea of tax reform, but they are not currently unified behind any particular plan or approach. In fact, there are meaningful differences among the policies being considered in the House and the Senate versus the tax plan proposed by President Trump. So it will be interesting to see how, or if, those differences will be resolved.
Here are five issues we think will be important in the coming discussion over tax reform. *
The Estate Tax
A number of factors make the estate tax an issue to watch in the coming year. Repeal of the estate tax is a feature of both the Trump and House Republican tax plans. Furthermore, it is a policy proposal that has fairly strong popular support. Third, it collects less than 1 percent of federal revenue, making it less of a deficit concern than many other tax-cutting priorities. And finally, the repeal of a tax is a relatively simple policy negotiation that could move quickly if it became a priority.
The House voted last year to repeal the estate tax, and the composition of the chamber has not changed much with Tuesday’s election. The main questions on this policy are whether any change to step-up basis would happen in an estate tax repeal, and whether it has the votes to pass the Senate. All in all, though, repeal of this tax seems like a priority that would have relatively little in its way.
Under current law, the tax code distinguishes between two major types of businesses. The first type of business is the traditional C corporation, which is taxed twice: once at the entity level at 35 percent, then again at the shareholder level when individuals pay tax on their dividends and capital gains. The second business form is known as a “pass-through” business. These businesses are not taxed at the entity level. Instead, their profits are passed immediately to their owners and are subject to the individual income tax.
The different treatment of these businesses is a challenge for tax reform. Most agree that the statutory marginal tax rate on C corporations is too high. Yet, if a tax plan only cut the corporate income tax rate, pass-through businesses would not receive a tax cut. In fact, if the corporate rate were cut in concert with base broadening, pass-through businesses could face a tax increase. As such, some plans attempt to deal with this by also cutting the ordinary income tax rate. However, cutting individual income tax rates is very expensive.
One way lawmakers have proposed to deal with this political issue is to provide pass-through business income a special, reduced rate compared to wage income. Both the House GOP tax plan and Trump’s tax plan provide a special low rate or system for pass-through businesses. Both plans have a top ordinary rate of 33 percent, but the House GOP plan caps the pass-through rate at 25 percent; Trump’s plan caps the pass-through rate at 15 percent. However, it is still unclear exactly how Trump’s tax plan would treat pass-through businesses.
While this deals with the political problem of pass-through businesses feeling left out of tax reform, there are significant policy concerns. Creating a special rate for pass-through businesses can encourage gaming. Individuals who own businesses would have an incentive to re-categorize their wage income to business income. There is no strong theoretical case that pass-through business income should be taxed at a lower rate than wage income. It would also increase the tax differential between corporate investment and pass-through investment.
It is worth noting that there is a tax reform proposal that could address this. Specifically, the corporate integration proposal from Senator Hatch (R-UT). His yet-to-be-released proposal would integrate the individual and business tax code by allowing corporations to deduct their dividends against their taxable income. It would also tax dividends at ordinary income tax rates. There are a lot of moving pieces with this plan, but the goal of this plan is make sure that all business and individual income are taxed at roughly the same marginal tax rate. If this is included in reform, lawmakers could reduce the marginal tax rate on corporate investment and make sure that pass-through and corporate income are taxed more equally.
Individual Income Tax
The Trump Plan will collapse the current seven tax brackets to three brackets. The rates and breakpoints are as shown below. Low-income Americans will have an effective income tax rate of 0. The tax brackets are similar to those in the House GOP tax blueprint.
Brackets & Rates for Married-Joint filers:
Less than $75,000: 12%
More than $75,000 but less than $225,000: 25%
More than $225,000: 33%
*Brackets for single filers are ½ of these amounts
The Trump Plan will retain the existing capital gains rate structure (maximum rate of 20 percent) with tax brackets shown above. Carried interest will be taxed as ordinary income.
The 3.8 percent Obamacare tax on investment income will be repealed, as will the alternative minimum tax.
The Trump Plan will increase the standard deduction for joint filers to $30,000, from $12,600, and the standard deduction for single filers will be $15,000. The personal exemptions will be eliminated as will the head-of-household filing status.
In addition, the Trump Plan will cap itemized deductions at $200,000 for Married-Joint filers or $100,000 for Single filers.
Americans will be able to take an above-the-line deduction for children under age 13 that will be capped at state average for age of child, and for eldercare for a dependent. The exclusion will not be available to taxpayers with total income over $500,000 Married-Joint /$250,000 Single, and because of the cap on the size of the benefit, working and middle class families will see the largest percentage reduction in their taxable income.
The childcare exclusion would be provided to families who use stay-at-home parents or grandparents as well as those who use paid caregivers, and would be limited to 4 children per taxpayer. The eldercare exclusion would be capped at $5,000 per year. The cap would increase each year at the rate of inflation.
The Trump Plan would offer spending rebates for childcare expenses to certain low-income taxpayers through the Earned Income Tax Credit (EITC). The rebate would be equal to 7.65 percent of remaining eligible childcare expenses, subject to a cap of half of the payroll taxes paid by the taxpayer (based on the lower-earning parent in a two-earner household).
This rebate would be available to married joint filers earning $62,400 ($31,200 for single taxpayers) or less. Limitations on costs eligible for exclusion and the number of beneficiaries would be the same as for the basic exclusion. The ceiling would increase with inflation each year.
All taxpayers would be able to establish Dependent Care Savings Accounts (DCSAs) for the benefit of specific individuals, including unborn children. Total annual contributions to a DCSA are limited to $2,000 per year from all sources, which include the account owner (parent in the case of a minor or the person establishing elder care account), immediate family members of the account owner, and the employer of the account owner. When established for children, the funds remaining in the account when the child reaches 18 can be used for education expenses, but additional contributions could not be made.
To encourage lower-income families to establish DCSAs for their children, the government will provide a 50 percent match on parental contributions of up to $1,000 per year for these households. When parents fill out their taxes they can check a box to directly deposit any portion of their EITC into their Dependent Care Savings Account. All deposits and earnings thereon will be free from taxation, and unused balances can rollover from year to year.
Trump will enter office promising a large increase in infrastructure spending, additional military spending, and a pledge to not touch entitlements. At the same time, he will bring with him a tax plan that would reduce federal revenues by about $6 trillion over the next decade. Without adjustments, Trump’s plan would significantly increase the federal deficit, which is already projected to increase significantly under current law. According to the Committee for a Responsible Federal Budget, his complete fiscal plan would increase federal debt by $5.3 trillion over the next decade
Given this disconnect, it is likely that Trump will need to either revisit his spending priorities, his tax plan, or both. If he revisits his tax plan and wants to keep the marginal rates the way they are, he will need to find ways to reduce the cost.
Trump could reduce the cost of his tax plan if he follows the lead of the House GOP tax reform plan and takes base broadening more seriously. Overall, the House GOP plan has a significantly smaller impact on the federal budget and could be more realistically matched with spending cuts. We estimated that the House GOP plan would reduce federal revenue by $2.4 trillion over the next decade. However, when accounting for economy growth, the cost is about $200 billion (a little more if you include the elimination of the ACA-related taxes). It maintains a relatively small impact on the deficit compared to Trump’s plan by significantly broadening the individual and business tax bases. It limits itemized deductions for individuals, eliminates the net interest expense deduction for businesses, and border-adjusts the corporate income tax.
The Corporate Tax Rate
Both the Trump plan and the House GOP plan include substantial reductions in the corporate tax rate, from its current 35 percent to top rates of 15 percent and 20 percent, respectively. The current rate is the highest in the developed world. The Trump plan would be a bold step that leapfrogs the United States all the way to having one of the lowest rates in the developed world, while the House GOP plan is more modest in its reduction.
The House GOP plan, furthermore, contained a number of significant base broadeners in order to offset the revenue lost from lower rates. The Trump plan does not have those base broadeners, and as a result its corporate income tax raises substantially less revenue than that of the House GOP plan. If Trump decides to scale back the size of his net tax cut, he may give the House GOP’s 20 percent corporate rate, or its base broadeners, another look.
Please let us know of any questions - and we'll keep you informed as matters develop.
Bill Roeser, CPA, CFP, CVA
*Reference and Credit to: TaxFoundation.org