Off to the Races on Tax Reform

Today, the Trump administration and Republican Congressional leaders released their long-awaited tax reform framework. Though the document does not explain every detail about what the group hopes to see from tax reform legislation, it provides a solid foundation that NTUF finds to be an encouraging sign.

What we know:

  • Individual income taxation

    • The framework calls for consolidation of the current seven individual income tax brackets to three, and lowering of the top income tax rate to 35 percent. The lowest bracket would have a rate of 12 percent, while the middle rate would be set at 25 percent. How exactly this would affect low- and middle-income earners depends on the income levels the brackets would be set at, but the framework promises that the new tax code will be “at least as progressive” as the current brackets.

    • Under the framework, the standard deduction would be roughly doubled to $24,000 for married couples and $12,000 for single filers. The standard deduction for 2017 is currently set at $6,350 for individuals and $12,700 for couples. Increasing the standard deduction is an important component of middle-class tax reform. The majority of Americans claim the standard deduction rather than itemizing deductions: in 2014, only about 30 percent of Americans itemized their deductions. Three-quarters of these filers reported adjusted gross incomes over $50,000. Thus, increasing the standard deduction would largely benefit lower-income filers.

    • Itemized deductions will also be substantially altered under the framework. The state and local tax deduction will be eliminated, but the mortgage interest and charitable contributions deductions would be retained. However, the mortgage interest and charitable contributions deductions are the second- and third-largest deductions in the tax code. Further reforms to deductions would be welcome efforts that could drive additional rate cuts.

    • The Child Tax Credit (CTC) will be altered. The first $1,000 of the CTC will remain refundable, but an additional $500 “non-child dependent” nonrefundable credit will be put in place as well. The framework also promises to make the CTC available for more middle-income families.

    • The alternative minimum tax (AMT) for individuals would be repealed under the framework. The AMT complicates tax planning and primarily targets Americans between the $200,000-$500,000 income range using legal tax credits, rather than the wealthiest Americans avoiding taxes as originally intended.

    • The death tax and generation-skipping transfer taxes would be repealed. These taxes discourage savings and investment and create a massive deadweight loss in tax preparation fees to avoid the tax.

  • Corporate taxation

    • The framework calls for a 20 percent corporate tax rate. Though not as low as the 15 percent rate that the President had pushed for on the campaign trail, a 20 percent rate would still place the United States below the average rate of 24 percent for countries in the Organization for Economic Cooperation and Development (though state levies would push combined burdens back to roughly 24 percent on average). A low corporate tax rate is important to improve the international competitiveness of U.S. businesses and reverse the ongoing erosion of the tax base.

    • The framework also targets a 25 percent rate on pass-through businesses, which are companies with income that “passes through” to individuals, and is therefore taxed at individual income tax rates. Because of this, pass-through businesses can currently be forced to pay taxes at the 39.6 percent top marginal individual income tax rate, or 43.4 percent when including the Obamacare surtax. When combined with state and local individual income taxes, pass-through businesses can be faced with income tax liabilities exceeding 50 percent. There are multiple types of pass-through businesses, but they are generally smaller businesses. Reforming pass-through business income tax rates is therefore an important aspect of middle-class tax reform.

    • The plan commits to “at least” a temporary, five-year business expensing regime. Going further and making full expensing a permanent feature of law would provide the best “bang for the buck” in terms of GDP growth relative to foregone revenue. Full cost recovery encourages the kinds of investments that drive growth by providing a full deduction upfront rather than requiring businesses to decipher a complex depreciation regime. Temporary expensing, on the other hand, would provide less of a benefit.

    • The framework would shift our current “global” system of taxation to a territorial system by enacting a “deemed repatriation” of accumulated foreign assets, then deducting future repatriated dividends from U.S. taxation. These provisions, along with the lower corporate tax rate, are intended to prevent American multinationals from shifting profits overseas, a process known as “base erosion.” Read NTUF’s recent report on other proposed solutions to base erosion here.

What we don’t know:

  • Individual income taxation

    • The framework encourages “simplification” of work, higher education, and retirement benefits. How this would take place would be left up to Congress.

    • Exactly which itemized deductions would be preserved, with the exception of the three deductions enumerated earlier, is left up to Congress. The framework states only that it “envisions the repeal of many of these provisions.”

  • Corporate taxation

    • The framework calls for a “partial limit” to the deduction for net interest expenses incurred by C corporations, while leaving the treatment of interest expenses for pass-through businesses up to Congress. The extent to which a net interest deduction remains will be important going forward, as it has significant impact on business tax burdens and, thus, on likely lobbying efforts surrounding the package.

    • Exactly which business tax credits remain is largely left up to Congress in the framework. The framework calls for the preservation of research and development and low-income housing business credits, while calling for the removal of the domestic production deduction. For all other credits, Congress is directed to decide based on “budgetary limitations.”

    • What happens after five years of full expensing (assuming it is that long)? Congress could either revert to the current “bonus depreciation” system in which a percentage of an asset’s value can be immediately expensed and the remainder depreciated, or switch completely to a depreciation regime. A switch back to bonus depreciation as opposed to a full depreciation regime would represent a less jarring shift for businesses, and likely reduce any possible economic distortions caused by temporary expensing.

    • The framework also does not go into great deal of detail on how corporate inversions would be reduced. The framework largely relies on cuts to the corporate tax rate and a switch to a territorial tax system to address base erosion issues, but mentions are made of “rules to level the playing field” between domestic corporations and foreign corporations. What exactly these rules are will be up to Congress to decide.