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In-Depth Article: GOP Releases Tax Reform Blueprint
(Parker Tax Publishing October 2017)
On September 27, the Trump Administration, the House Committee on Ways and Means, and the Senate Committee on Finance released a nine-page framework for overhauling the tax code ("the framework"). The framework calls for: (1) modest cuts in individual tax rates, to be offset by the elimination of most itemized deductions, (2) repeal of the estate and generation skipping transfer taxes, (3) a maximum 25 percent tax rate on pass-through business income, and (4) a sharp cut in the top corporate tax rate to 20 percent, to be partially offset by elimination of corporate tax preferences. GOP Tax Framework (9/27/2017).
While the framework is lighter on specifics than the 2016 Trump campaign tax plan ("2016 Trump tax plan") and the 2016 plan released by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady ("2016 Ryan-Brady plan"), it fills in some of the blanks from the single-page tax reform outline released by the White House in April.
Changes Affecting Individuals
Eliminating Personal Exemptions While Increasing the Standard Deduction. Under the framework, the standard deduction will be nearly doubled to $24,000 for married taxpayers filing jointly, and $12,000 for single filers. However, this larger standard deduction incorporates personal exemptions, which are eliminated. The combined effect for most taxpayers would be a roughly 15% increase in the amount of income excluded from taxation.
Example: Under present law, the first $10,400 of income earned by a single taxpayer under age 65 is exempt from income tax ($6,350 standard deduction plus $4,050 personal exemption). Under the framework, the first $12,000 in income would escape taxation, a $1,600 (or 15.4%) improvement.
Observation: This change will be detrimental to taxpayers who itemize rather than take the standard deduction because they will lose their personal exemptions and receive no benefit from the increased standard deduction.
Replacing Dependency Exemptions with Tax Credits. In lieu of dependency exemptions for children, the framework provides for a significant, but unspecified increase the child tax credit ($1,000 under current law). The first $1,000 of the credit will continue to be refundable. In addition, the framework would add a non-refundable credit of $500 for non-child dependents.
Observation: The framework is silent on the amount of the increase in the child tax credit, but the 2016 Ryan-Brady plan may provide a clue. That plan called for a $500 increase in the credit in conjunction with the elimination of dependency exemptions. Such a tradeoff would be a small win for taxpayers in the current 10 percent bracket, and a loss for most taxpayers in higher brackets, to whom a dependency exemption can be worth as much as $1,337 ($4,050 dependency exemption amount times the top tax rate of 33% that applies before the phaseout of dependency exemption).
Consolidating Seven Tax Brackets into Three Tax Brackets. While current law has seven tax brackets, the framework would reduce that number to three tax brackets - 12%, 25%, and 35%. The framework adds that an additional top rate may apply to the highest-income taxpayers in order to ensure that the reformed tax code is at least as progressive as the existing code. The framework doesn't indicate the thresholds at which the different rates apply.
Observation: The proposed increase in the bottom rate from 10 percent to 12 percent bucks a three-decade trend in tax legislation during which the bottom rate has either been left alone or reduced. The last tax law to increase the bottom rate was the Tax Reform Act of 1986, which offset the change with large increases in both the standard deduction and personal and dependency exemptions.
Eliminating Itemized Deductions Other Than Mortgage Interest and Charitable Donations. The framework states that it will eliminate "most itemized deductions" with the exception of the mortgage interest deduction and the deduction for charitable contributions. On this point, the framework's language departs subtly from the language of the Ryan-Brady plan, which explicitly calls for the elimination of all itemized deduction other than the ones for mortgage interest and charitable contributions. The softer language of the framework appears to signal an expectation that some other deductions may be spared.
Observation: Coming off a highly destructive hurricane season, it will be interesting to see if Congress has the resolve to eliminate the casualty loss deduction - the same deduction that it just enhanced for victims of Hurricanes Harvey, Irma, and Maria with H.R. 3823, The Disaster Tax Relief and Airport and Airway Extension Act of 2017.
Any battle over the casualty loss deduction will pale in comparison to the one over the deduction for state and local taxes (SALT deduction), a tax preference backed by powerful interest groups and dear to tens of millions of middle class taxpayers - many of whom would stand to see their federal taxes increase significantly (despite rate cuts) if it were repealed. The battle over the SALT deduction is expected to play out primarily in the House, where the focus will be on 33 Republican representatives from New York, New Jersey, California, and six other high tax states.
Alternative Minimum Tax (AMT). The framework would repeal the AMT, finding it unnecessary in light of the simplification that the overhaul of the tax code will bring.
Capital Gain Tax Rates. The framework makes no mention of reducing capital gain tax rates. Such reductions were a prominent feature of both the 2016 Trump tax plan and the Ryan-Brady plan.
Other Provisions Affecting Individuals. According to the framework, numerous other exemptions, deductions and credits for individuals riddle the tax code and the repeal of many of these provisions is envisioned in order to make the system simpler and fairer for all families and individuals, and allow for lower tax rates. However, without being specific, the framework states that tax benefits that encourage work, higher education and retirement security will be retained.
Eliminating the Estate Tax and Generation-Skipping Transfer Taxes. The framework repeals the estate tax and the generation-skipping transfer tax.
Changes Affecting Domestic Businesses
Limiting Tax Rate Applicable to Passthrough Income. The framework limits the maximum tax rate that applies to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships, and S corporations to 25 percent.
Reduction in Top Corporate Tax Rate. The framework reduces the corporate tax rate to 20 percent and notes that this is below the 22.5 percent average of the industrialized world. The corporate AMT is also slated for repeal.
Enhanced Expensing. Another big boost for businesses is the framework's proposal to allow businesses to immediately write off the cost of new investments in depreciable assets (other than structures) made after September 27, 2017.
Limitation of Interest Expense Deduction; Repeal of Other Business Deductions. The framework proposes to partially limit the deduction for net interest expense incurred by C corporations. Because of the framework's substantial rate reduction for all businesses, it proposes the elimination of the Code Sec. 199 domestic production activities deduction. In addition, the framework advises that numerous other special exclusions and deductions will be repealed or restricted, without mentioning them by name.
Business Tax Credits. The framework explicitly preserves business credits in two areas where it says that tax incentives have proven to be effective in promoting policy goals important in the American economy: research and development (R&D) and low-income housing. While the framework envisions repeal of other business credits, it notes that Congressional committees may decide to retain some other business credits to the extent budgetary limitations allow.
Changes Affecting International Businesses
The framework aims to transform the existing "offshoring" model to an American model by eliminating incentives to keep foreign profits offshore by exempting them when they are repatriated to the United States. It will replace the existing, outdated worldwide tax system with a 100 percent exemption for dividends from foreign subsidiaries (in which the U.S. parent owns at least a 10 percent stake), resulting in a new "territorial" tax system.
To transition to this new territorial system, the framework treats foreign earnings that have accumulated overseas under the old system as repatriated. Accumulated foreign earnings held in illiquid assets will be subject to a lower tax rate than foreign earnings held in cash or cash equivalents. Payment of the tax liability will be spread out over several years.
To prevent companies from shifting profits to tax havens, the framework includes rules to protect the U.S. tax base by taxing at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations. The framework anticipates that Congressional committees will incorporate rules to level the playing field between U.S.-headquartered parent companies and foreign-headquartered parent companies.
Effects on Deficit; Distributional Effects
Because the framework does not specify thresholds for individual tax rates, key amounts such as the additional child tax credit, and which corporate tax preferences will be curtailed, it can only be scored for its effect on the deficit by making assumptions about the missing details.
The Tax Policy Center (TPC), a well-respected tax policy think tank, has done just that, using information from the 2016 Trump tax plan, the 2016 Ryan-Brady plan, and statements from the Trump Administration and Congressional leaders to fill in the blanks.
The conclusion of their preliminary analysis is that the framework would reduce federal revenue by $2.4 trillion over the next decade, followed by a reduction of $3.2 trillion over the following decade, and that taxpayers with incomes in the top 1 percent would get the lion's share of the tax benefits (50 percent of the benefits in 2018; 80 percent by 2027). The TPC also concluded that by 2027, nearly 30 percent of taxpayers with incomes between $50,000 and $150,000 would see their federal tax bill rise, as would 60 percent of those with incomes between $150,000 and $300,000.
Although the numbers are preliminary and somewhat speculative, they conform with an emerging consensus that implementation of the framework would create several relatively narrow groups of winners and a few broad groups of losers. Big winners would include most C corporations and their shareholders, highly affluent individuals, heirs to large estates, and owners of passthrough businesses with enough income to benefit from the proposed 25 percent rate cap. Losers would include taxpayers outside those groups who currently itemize, and taxpayers in the middle tax brackets (25, 28, and 33 percent) with multiple dependents.
What's Next for Tax Reform
In public comments, Treasury Secretary Steve Mnuchin and National Economic Council Director Gary Cohn have stood by an aggressive timeline that would have the President signing tax reform into law by year's end. Most informed sources outside the White House are skeptical about that time frame.
Before a legislative push can even begin in earnest, the House and Senate will have to pass and then reconcile competing budget resolutions to unlock the reconciliation process in the Senate (which is necessary for tax reform to be able to pass the Senate with a simple majority).
When that hurdle is cleared, legislators will face the arduous task of filling in all of the blanks in the tax framework, including specifying which business tax breaks will be eliminated to pay for sharp reductions in the top corporate and passthrough tax rates, and the details of a new territorial tax system for multinationals. The fact that none of the heavy lifting required to complete corporate tax reform has been done, looms as the single biggest obstacle to getting tax reform done this year, and raises questions about whether it can even be accomplished without bipartisan support.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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