Eight Important Changes in the House Tax Cuts and Jobs Act
November 2, 2017
Earlier today, House Ways and Means Committee Chairman Kevin Brady (R-TX) unveiled the committee’s tax reform legislation. The widely anticipated tax reform bill includes hundreds of structural changes to the tax code, a summary of which is available here. However, some changes are more significant than others. Thus, here are the eight most important provisions in the House Ways and Means Tax Plan in no particular order.
- The corporate income tax rate would be reduced to 20 percent. The bill would lower the current statutory corporate income tax rate from 35 to 20 percent. This would bring the U.S. in line with the rest of the other 34 industrialized countries in the OECD, which have an average statutory corporate income tax rate of 21.97 percent. For a comparison of corporate income tax rates around the world, click here.
Pass-through business income would be taxed at a maximum rate of 25 percent. In the U.S., small companies are generally organized as pass-through businesses. This means that their income is taxed on their owners’ tax returns and not at the business level. While economists widely agree that C Corporations are less tax-advantaged than pass-through businesses under current law, the House Ways and Means Tax Plan attempts to bring both business types closer to rate parity by setting a maximum rate on pass-through business income.
However, without appropriate anti-abuse rules this could create incentives for individuals to reclassify their personal income as business income to take advantage of the lower rate. Therefore, the plan includes a number of anti-abuse rules, beginning with the assumption that 70 percent of pass-through business income is compensation (subject to ordinary rates) while 30 percent is business income (subject to the lower pass-through rate). Certain specified service industries (including health, law, financial, and professional services) would only be permitted to claim the lower rate to the extent that they can “prove out” the share of income that constitutes business income. Even with these guardrails, the provision is likely to create opportunities for tax arbitrage, and it adds complexity to the tax code. For more on the taxation of pass-through income, click here.
Some of the tax code’s disincentives to investment would be rolled back. Specifically, machinery and equipment could be fully expensed (temporarily). Meanwhile, pass-through businesses would be able to take advantage of higher section 179 caps.
Corporate income taxes are intended to be imposed on net income after expenses, which is why businesses deduct the costs of compensation and most other expenses. Capital expenditures, however, are a special case. When businesses invest in capital expansion, instead of writing down the cost immediately, they must do so across a depreciation schedule that stretches anywhere from three to 39 years. The House Ways and Means Tax Plan would change that—temporarily and in part.
Under the plan, short-lived capital expenditures (currently subject to “bonus” depreciation) could be fully expensed, though this provision would be slated to sunset in five years. Section 179 expensing for pass-through businesses would increase from $500,000 to $5 million, with a higher phaseout threshold. These provisions would remove some of the tax code’s current bias against investment, though the temporary and limited nature of the provisions may mute the economic impact. For more on the economic and budgetary impacts of temporary expensing and other possible approaches to depreciation, click here.
- The U.S. would move to a territorial tax system. In much of the industrialized world, domestic corporations are taxed on their domestic income alone (a so-called territorial tax system). In the U.S., by contrast, companies are taxed on their worldwide income, with credits for taxes paid to other countries (a so-called worldwide tax system). If tax liability is lower in another country in which a controlled foreign corporation operates, the residual amount is paid to the United States. This increases overall liability and makes the U.S. comparatively unattractive as a home for multinational corporations. The proposed tax plan would convert the U.S.’s worldwide tax regime into a territorial system, enhancing competitiveness and undercutting the traditional rationales that encouraged corporate inversion and the offshoring of corporate income. For more on territorial taxation, click here.
- Many itemized deductions would be eliminated. For individuals, the mortgage interest, and charitable deductions, as well as the property tax portion of the state and local tax deduction (capped at $10,000), would remain, but other itemized deductions would be eliminated. The elimination of many itemized deductions would broaden the individual income tax base as a means to pay for lower overall rates. Their elimination would also be offset by an increase in the standard deduction and a higher child tax credit. For more on itemized deductions, click here. For more on the state and local tax deduction, click here or here.
- The estate tax would be repealed. The federal estate tax, which raises very little revenue but encourages significant tax arbitrage and avoidance activity, would be repealed under the plan after six years. The plan immediately increases the exemption to $10 million. Economists tend to see the estate tax as one of the most economically harmful taxes per dollar of revenue raised. For more on the estate tax, click here and here.
- The tax treatment of interest would change. The U.S. tax code is intended to include deductions on interest paid while taxing interest received, but in practice, a substantial portion of interest is untaxed. This results in a tax advantage for debt financing over equity financing, providing a subsidy for some investments while distorting business decision-making. The House Ways and Means Tax Plan would limit business net interest deductibility to 30 percent of a business’s earnings before interest, taxes, depreciation, and amortization (EBITDA) with a five-year carry-forward basis. Businesses with less than $25 million in gross receipts would be exempt from the limitation. For more information on the tax treatment of interest, click here.
- Tax expenditures would be curtailed. The plan would eliminate multiple tax expenditures including the section 199 manufacturing deduction, deductions for like-kind exchanges of personal property, and deductions for entertainment. Credits for orphan drugs, private activity bonds, rehabilitation, and contributions to capital would also be eliminated. With lower business income rates and better treatment of capital expenditures, there would be less need to rely on targeted incentives or industry-specific fixes embedded in the tax code.
Overall, the House Ways and Means Tax Plan represents a move in the direction of greater neutrality and global competitiveness. As the bill goes through markup, and as the Senate takes up tax reform legislation, every provision is subject to change. What happens with these eight proposed changes could be a good benchmark for the degree to which any final plan constitutes meaningful tax reform.