Eight Important Changes in the Senate Tax Cuts and Jobs Act

Thursday evening, the Senate Finance Committee unveiled a description of its version of the 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. Cuts and Jobs Act. Like its House counterpart, the Senate plan includes hundreds of structural changes to the tax code, a summary of which is available here. However, some changes are more significant than others. Here are the eight most important provisions in the Senate Tax Cuts and Jobs Act, in no particular order.

1. Starting in 2019, 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 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 businesses would be subject to a slightly lower top rate and could qualify for a significant 17.4 percent business income deduction. 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 instead of at the business level. While economists widely agree that C Corporations are less tax-advantaged than pass-through businesses under current law, the Senate plan addresses the rate disparity by offering a new deduction.

  In addition to the reduction in marginal 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 to which pass-through businesses are exposed, qualifying pass-through businesses would be able to claim a deduction worth 17.4 percent of their business income up to a cap set at 50 percent of wage income. The deduction is disallowed for certain specified service industries, including health, legal, financial, and professional services. For more on the taxation of pass-through income, click here.

• Some of the tax code’s disincentives to investment would be rolled back. The Senate plan modifies taxes on new investment in three ways. First, the bill would allow full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. of short-lived capital investment currently subject to “bonus” 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. , such as equipment and machinery, for five years, allowing businesses to write down these costs immediately rather than across a depreciation schedule. Second, the bill would increase Section 179 expensing from $500,000 to $1 million and increase the phaseout threshold from $2 million to $2.5 million. Finally, the bill also would reduce asset lives for residential and nonresidential real property to 20 years. 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 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. . 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 systemA worldwide tax system for corporations, as opposed to a territorial tax system, includes foreign-earned income in the domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. ). 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. Individuals would retain the charitable contribution deduction as well as the 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 (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. at current levels for purchases, though the latter deduction would be eliminated for equity debt. However, the 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 and local taxes paid, mortgage interest, and charitable contributions. , except for taxes paid or accrued in carrying on a trade or business, and most other itemized deductions would be repealed as well. Elimination of many itemized deductions would broaden the individual income tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. as a means to pay for lower overall rates. Their elimination would also be offset by an increase in 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 (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and a higher 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. . For more on itemized deductions, click here. For more on the state and local tax deduction, click here.
• The estate tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. would be doubled to $11.2 million. The federal 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. , which raises very little revenue but encourages significant tax arbitrage and avoidance activity, would be scaled back significantly by doubling the exemption threshold. 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 Senate version of the Tax Cuts and Jobs Act would limit business net interest deductibility to 30 percent of a business’s earnings before interest and taxes (EBIT). Businesses with less than $15 million in gross receipts would be exempt from the limitation. For more information on the tax treatment of interest, click here.
• Business tax expenditures would be curtailed. The plan would eliminate multiple tax expenditures including the section 199 manufacturing deduction, the FDIC premium deduction, and the deduction for business meals, entertainment, and transport. Credits for orphan drugs would also be changed. 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.

The Senate Tax Cuts and Jobs Act, like its House counterpart, represents a move in the direction of greater neutrality and global competitiveness. As with the House plan, some important provisions are temporary, blunting their impact. Both versions are subject to change, and doubtless there will be many adjustments to the Senate plan. The features outlined here, however, are highly significant, and what happens to them could prove a good measure of the degree to which any final plan constitutes meaningful tax reform.

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