House Ways and Means Chairman Dave Camp (R-MI) released a plan today to reform the federal taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code. He set out with the goal of simplification while maintaining revenue neutrality. While his plan maintains revenue neutrality, on first blush it appears to do little by way of addressing the complexity of the tax code, and in some ways, makes the tax code more complex.
We’ll have more analysis on the plan soon – it will take us days to get through the 979 pages of legislative text – but in the meantime, here are the basics.
Individual Income TaxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. es
Tax BracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s Consolidated to Three Brackets with a Top Rate of 35 Percent
The plan consolidates the existing seven tax brackets down to three brackets of 10, 25, and 35 percent. The 10 percent rate would apply to individual filers with taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. below $35,600 and joint filers with income below $71,200. On taxable income above those levels, taxpayers will pay a rate of 25 percent. The individual AMT is eliminated and the brackets remain indexed to inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. , but based on chained CPI.
The additional surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. of 10 percent (the third bracket with a rate of 35 percent) will be levied on certain income based on a modified definition of AGI (MAGI) for individual filers above $400,000 and joint filers above $450,000.
The MAGI measure is adjusted gross income minus charitable contributions and qualified domestic manufacturing income, plus multiple streams of income excluded or deducted from AGI under current law, including employer provided health benefits, the self-employment health deduction, foreign income, tax exempt interest, untaxed social security benefits, and currently excluded 401(k) contributions.
The standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. increases to $11,000 for an individual and $22,000 for joint filers. There is also an additional deduction of $5,500 for single taxpayers with at least one qualifying child, which begins to phase out at $30,000 of AGI.
It is worth noting that this proposal does not take any steps to eliminate the marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples. inherent in the rate structure.
Phase-Outs in Plan Create Additional Marginal Tax RateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s
The proposal creates multiple implicit marginal tax rates due to multiple phase-outs and the income surtax. A major change would be the phase out of the 10 percent rate bracket for individual filers with income above $250,000 and joint filers with income above $300,000. In effect, this would phase in a tax claw back, where individual filers who make over $250,000 ($300,000 for joint filers) would face a 25 percent tax rate on all income below the 35 percent bracket on income over $400,000 for single, $450,000 for filing jointly.
The standard deduction and the child tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. would face a phase-out as well. (Personal exemptions are eliminated, so no need for a phase-out there.) This would create new implicit marginal tax rates for taxpayers as their income increases and these provisions phase out.
The phase out for all of these provisions occur sequentially starting at $250,000 for singles and $300,000 for filing jointly, in this order: (1) the 10 percent bracket, (2) the standard deduction or equivalent amount of itemized deductionItemized deductions allow individuals to subtract designated expenses from their taxable income and can be claimed in lieu of the standard deduction. Itemized deductions include those for state and local taxes, charitable contributions, and mortgage interest. An estimated 13.7 percent of filers itemized in 2019, most being high-income taxpayers. s, and (3), the child tax credit.
Proposal Makes Significant Changes to Individual Tax ExpenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit, child tax credit, deduction for employer health-care contributions, and tax-advantaged savings plans. s
Chairman Camp’s proposal makes changes to a significant number of individual tax expenditures. The lists below are not all inclusive. For a complete list, see the Ways and Means section by section summary.
- Eliminates the personal exemption
- Eliminates the Pease provision which limits itemized deductions
- Eliminates state and local tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions.
- Eliminates the alternative minimum tax
- Eliminates deduction of interest on education loans.
- Eliminates adoption tax credit
- Eliminates credit for green energy residential improvements
- Eliminates credits for qualified electric vehicles and alternative motor vehicles
- Eliminates first time homebuyer credit
- Eliminates deduction for tax preparation expenses
- Eliminates deduction for medical expenses
- Eliminates deduction for moving expenses
- Reduces the principal cap for the home mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act reduced the amount of principal and limited the types of loans that qualify for the deduction. from new mortgages from $1 million to $500,000 over four years.
- Reduces the maximum credits for the EITC to $200 for joint filers with no children, $2,400 with filers with one child, and $4,000 for joint filers with two or more children. For taxpayers with children, phase outs begin at $20,000 for single filers and $27,000 for joint filers.
- Converts some excludable 401(k) contributions to Roth-style retirement accounts for those contributing more than $8,750.
- Modifies allowable contributions to Roth IRAs, eliminating the income eligibility limit for contributors and prohibiting contributions to traditional IRAs.
- Consolidates the four higher education tax credits into a reformed American Opportunity Tax Credit. The new credit would provide a 100 percent credit on the first $2,000 of certain education expenses, and a 25 percent credit on the next $2,000 of expenses. The first $1,500 of the credit would be refundable.
- Expands the child tax credit from $1,000 per child to $1,500 per child and $500 for non-child dependents. Credits will be indexed to chained CPI.
- Increases in the standard deduction to $11,000 for an individual and $22,000 for joint filers, with an additional deduction of $5,500 per qualifying child.
Capital Gains and Dividend Taxes Increase from 23.8 Percent to 24.8 Percent
Under the plan, capital gains and dividends would be taxed at the ordinary rate with a 40 percent exclusion. This means, with a top rate of 35 percent, the top effective rate capital gains and dividend rate would be 21 percent. Add this to the 3.8 percent Affordable Care Act surtax, for a total of 24.8 percent. However, it’s likely taxpayers will face higher marginal rates due to the phase out of the standard deduction, child tax credit, and 10 percent bracket.
Lowers the Corporate Income TaxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. Rate
Today, the top federal corporate tax rate is 35 percent. Chairman Camp’s plan would lower the top marginal corporate income tax rate to 25 percent. The rate reduction will be phased in over 5 years from 2015 to 2019.
Lengthens Asset Lives, Changes Tax Treatment of R&D and Advertisement
One of the major changes to the corporate code is the way in which the code treats business investment. The proposal would eliminate the current modified accelerated cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. system (MACRS) and replace it with a system similar to the alternative depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. system (ADS). This will lengthen asset lives, reduce the present value of capital cost write-offs, and boost taxable business income relative to current law.
However, to mitigate some of the damage a switch to a system like ADS creates, the basis of the depreciable assets would be adjusted for inflation.
The plan would also alter the way in which tax law treats research and development (R&D) and advertisement costs. Rather than allowing a business to fully expense most R&D expenses, the business will have to deduct these costs over 5 years. Likewise, advertising will no longer be completely deducted in the year in which the expense was incurred. Certain advertising costs will be 50 percent deductible in the first year and rest will be amortized over 10 years.
Tax Rates Lowered for Pass-Through BusinessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es to 35 percent, 25 Percent for Those Engaged in Manufacturing
More than 50 percent of business income is taxed through the individual income tax code. As a result, these “pass-through” businesses face top marginal tax rates as high as 39.6 percent on their income.
Chairman Camp’s proposal would reduce the top marginal income tax rate faced by pass-through businesses from 39.6 percent to 35 percent. However, domestic manufacturing pass-through income will be exempt from the 10 percent “surtax” on incomes over $400,000, meaning this income would only face a lower 25 percent rate.
A Shift to a Territorial System, with a Retroactive Tax on Foreign Earned Income
Currently, U.S. corporations are taxed on their worldwide income, but allowed to defer taxes on foreign income that remains actively invested abroad. When corporations earn income overseas and bring this income back to the United States, the United States taxes it at 35 percent, minus any foreign taxes paid on the income.
The Camp proposal would deem accumulated past foreign earnings currently held abroad in cash as repatriated and retroactively tax it once at an 8.75 percent rate. Remaining non-cash accumulated foreign earnings held abroad (income that has already been reinvested in property, plant, and equipment) would be retroactively taxed at a lower 3.5 percent rate. The corporation has the option to pay this tax over an eight year period.
Going forward, the United States would switch to a territorial corporate tax system, which would exempt from domestic corporate taxation 95 percent of all active foreign income. Look-through rules, which allow corporations to move money between foreign subsidiaries without triggering U.S. tax liability, would be made permanent. Subpart F will be modified so that intangible income (such as royalties) will be taxed at a 15 percent rate, whether it is earned domestically or abroad. This is similar to the "patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. es" found in other countries. There will also be a "thin-cap" rule that limits deductions for interest expense based on the leverage of the U.S. parent relative to foreign subsidiaries.
New Excise TaxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. on Big Banks
The proposal introduces a .035 percent excise tax on banks that are deemed “important.” This tax will be levied quarterly on these banks’ total consolidated assets in excess of $500 billion beginning in 2015.
Businesses are currently allowed to choose one of two ways to account for the cost of inventory: Last-in, First-out (LIFO)Last-In, First-Out (LIFO) inventory deductions allow companies to deduct the cost of inventory at the price of the most recently acquired items and assumes that the last inventory purchased is the first to be sold. LIFO limits the impacts of volatile prices or inflation and lowers the tax cost of new inventory. and First-in, First-out (FIFO).
The proposal would repeal LIFO accounting. Existing corporate LIFO reserve would be added back into taxable income in four phases between 2018 and 2020, retroactively taxing this inventory.
Elimination of Many Energy Provisions
Under the Camp proposal, a number of credits and deductions for the oil and gas industry and green energy are repealed:
- Eliminates percentage depletion
- Eliminates credit for producing oil and gas from marginal wells
- Eliminates enhanced oil recovery credit
- Eliminates deduction for energy efficient commercial buildings
- Eliminates credit for alcohol used as fuel
- Eliminates credit for biodiesel and renewable diesel used as fuel
- Eliminates passive activity exception for working interests in oil and gas property
- Phases-out credit for electricity produced from certain renewable resources
- Eliminates credit for production of low sulfur diesel fuel
- Eliminates credit for production from advanced nuclear power facilities
- Eliminates credit for producing fuel from a nonconventional source
- Eliminates new energy efficient home credit
- Eliminates energy efficient appliance credit
- Eliminates credit for carbon dioxide sequestration
- Eliminates solar energy credit
Other Business Provisions
- Section 179 currently allows small businesses to expense up to $25,000 of the cost of qualifying property. The proposal would increase that amount to $250,000 and make it permanent.
- Section 199 manufacturing deduction allows businesses to deduct 9 percent of qualifying manufacturing expenses (6 percent for integrated oil and gas companies). This deduction is phased out completely.
- The Research and Development (R&D) tax credit gives businesses a tax credit for research and development expenses. The Proposal will make the R&D credit permanent while modifying how it is calculated.
- Disallows businesses from deducting the cost of executive bonuses if they are in stock and imposes a 25 percent excise tax on compensation over $1 million paid by non-profit, tax-exempt organizations.
- The Obamacare 2.3 percent excise tax on medical devices would be repealed.