Today, the natural question for those of us in the tax world is, “What does the election mean for 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. 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-elect Donald 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 taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. 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.
The Treatment of Foreign Profits of U.S. Multinationals
A big question in tax reform for the past few years has been: How should America tax the foreign profits of its multinational corporations? The current tax system applies the corporate income tax of 35 percent to the worldwide profits of U.S.-based multinationals. So if a corporation earns profits in the United Kingdom, it would need to pay the 20 percent rate to the British government, then an additional 15 percent to the U.S. government. However, the additional 15 percent tax bill to the U.S. can be deferred until those profits are brought back to the U.S. This discourages corporations to bring profits back to the United States.
There is general agreement that this system is flawed, but little agreement on how, exactly, to fix it. Some Democrats would eliminate the ability to defer the additional tax paid to the U.S., meaning all corporations would face a 35 percent tax on their profits every year. Most Republicans and some Democrats would rather move to a “territorial” tax system that exempts foreign profits from the additional U.S. tax altogether. This would be more consistent with the systems employed by the rest of the developed world.
Republicans, with majorities in both the Senate and House, generally prefer moving to a territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. , but it isn’t clear that this is exactly where reform would head. There are a couple of proposals out there with different approaches to international tax reform. The Senate Finance Committee, specifically, Senators Schumer (D-NY) and Portman (R-OH), put forth a framework for international tax reform in 2015. This framework would move the U.S. system to a territorial system, enact a “patent box,” and enact anti-avoidance measures. The House GOP, however, would move a step further than a territorial system and would enact a “destination-based” corporate tax, which would tax businesses based on their domestic sales. In stark contrast, Trump’s original tax plan (released in September 2015) would move in the opposite direction and would eliminate deferral. However, his most recent plan (September 2016) is silent on the issue of international tax policy.
Pass-through Businesses
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 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. on C corporations is too high. Yet, if a tax plan only cut 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, pass-through businesses would not receive a tax cut. In fact, if the corporate rate were cut in concert with base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. , 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 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. rates is very expensive.
One way lawmakers have proposed to deal with this political issue is to provide 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. 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 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. . 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.
Federal Revenue
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.
See our full analysis of Trump’s Tax Reform Plan
See our full analysis of the House GOP’s Tax Reform Plan
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