Tax Changes are Coming

By Julie Welch and Steve Browne

This week President Trump and congressional Republicans are expected to release a framework for tax reform legislation.  Here is an article printed in Ingram’s Magazine earlier this year about the tax changes coming.

With a newly elected President, many are expecting major tax changes.  Looking through the Trump Tax Plan, it appears to mirror the Reagan tax cuts (the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986), with some of the largest tax cuts in American history.  That said, those plans were over 30 years ago, so let’s look at what happened then.  The top tax bracket dropped from 70% to 28%, and the number of tax brackets was reduced from around 15 to 2.  Many deductions, such as interest on personal loans, were significantly reduced or eliminated.  However, subsequently there were tax increases and by 1993 the number of tax brackets had increased to 5 (15%, 28%, 31%, 35%, 39.6%).  Currently we still have these brackets as well as phase-outs of many benefits, such as personal exemptions and itemized deductions, and surtaxes related to the Affordable Care Act.  The IRS data shows that in 1981 the top 1% of taxpayers paid about 18 % of the individual income taxes collected.  By 1989, the top 1% paid 25%.  Currently the top 1% pay about 38%.

Now look at the share of the income – the top 1% had 8% of the income in 1981, and by 1989 it was up to 14%.  Currently the top 1% have 19% of the income.  But analyzing tax proposals goes further than just the top rates and determining who pays that tax.

During his campaign, Trump proposed cutting the top individual tax rate to 33% and reducing the number of tax brackets to 3 – 12%, 25%, and 33%.  It would maintain a maximum rate of 20% on capital gains.  The alternative minimum tax and the 3.8% Affordable Care surtax on investment income would be eliminated.  As far as deductions go, the plan would cap itemized deductions at $200,000 for married filers and $100,000 for single.  The standard deduction would increase to $30,000 for married filers ($15,000 for single).  All personal exemptions and the head-of-household filing status would be eliminated.  The plan would allow income from pass-through entities (partnerships and S corporations) to be taxed a 15% rate.

Further, the estate tax would be eliminated.  There would be no step-up in basis of assets allowed for estates exceeding $10 million.

As for corporations, there are currently 4 brackets (15%, 25%, 34%, and 35%) but the benefit of the lowest brackets is eliminated once taxable income exceeds $235,000.  The Trump proposals would reduce the top rate to 15%.  It would also eliminate the corporate alternative minimum tax, eliminate all business tax credits except the Research and Development credit, eliminate the domestic production activities deduction (Section 199 deduction), tax carried interests as ordinary income, and tax amounts repatriated from foreign countries at 10%.

Since 1996, a 10-year budget window has been used by Congress when evaluating tax legislation.  The 10-year budget projections are officially prepared by the Congressional Budget Office.  If a bill is estimated to produce a revenue loss over the 10-year budget window, it is a more complicated procedure to get the bill through Congress.  So a bill with a revenue increase over the 10-year budget window is generally desirable.

Two organizations independently evaluate tax proposals.  Tax Policy Center, is a joint venture of the Urban Institute and Brookings Institution aimed at providing independent analysis of current and emerging tax policy issues, and the Tax Foundation, a nonpartisan tax research group devoted to educating taxpayers, the media, and policymakers.   When evaluating the tax proposals, both organizations include the increased interest costs and macroeconomic effects to analyze how the economy would fare under the tax proposal.  Both organizations estimate that tax revenue would be significantly reduced over the 10-year budget window and be required to take the more complicated route through congress.  The Tax Policy estimates tax revenue will decrease by $6.2 trillion; the Tax Foundation estimates tax revenue will fall between $4.4 trillion and $5.9 trillion.  However, their estimates of the impact on the economy vary drastically.  The Tax Policy Center estimates the federal deficit would rise by $7 trillion over the next decade.  The Tax Foundation does not provide an estimate of the effect on the deficit but it does estimate that after accounting for the larger economy and the broader tax base, it would reduce revenue by between $2.6 trillion and $3.9 trillion.  There are a number of reasons for the great disparity in these forecasts, including the effects on supply (i.e., the labor force, investments in new business and assets) and consumer demand.  Modeling the long term macroeconomic effects of legislative policy is fraught with uncertainty. We need only look at the mortgage bubble of 2008 and the dot com bubble of 2000 for (relatively) recent examples.

Other potential changes, that could dramatically alter tax policy, include changes proposed by the House Republicans in June, 2016.  These include a full expensing for business costs under a border-adjustable destination-based cash-flow business tax system.   A border-adjusted tax is applied to domestic consumption and does not tax any goods or services that are produced domestically, but consumed elsewhere.  In other words, it’s a shift from an earnings based tax to a consumption based tax that focuses on raising revenues from sales of goods within the United States. Changes of this sort would obviously require transition rules that would have to occur over years.

At the end of the day, the details of the Trump Tax Plan are yet to be seen.  It seems that the only thing that is presently known is policy change is coming.