House Republicans today unveiled its tax reform plan, touted as perhaps the most significant tax reform since the 1986 Tax Reform Act. The plan includes several significant provisions, which — if implemented — will provide taxpayers and workers with much-needed relief.
The bill now heads to the House Ways and Means Committee, where the bill will be debated and amended. The Senate is expected to release its version of tax reform in the coming days.
“This isn’t the last product,” said Representative Carlos Curbelo, Republican of Florida and a member of the House Ways and Means Committee. “This is just the kickoff to this tax reform exercise.”
According to leaders releasing the plan, the reform will result in a $1.51 trillion tax cut over ten years, reducing taxes on the average American family by nearly $1,200 per year, and reduce the corporate tax burden to a rate far more competitive with other industrialized nations.
Significant changes include:
- Lowering the federal corporate tax rate from 35% to 20%
- Reducing the number of individual tax rates from seven rates to four, while increasing the income threshold for the top tax rate
- Eliminating the exemption for state and local taxes paid
- Doubling of the standard deduction, and increasing the child tax credit
- Capping the home mortgage and property tax deductions
- Changing how international businesses are taxed
- Introducing “full expensing” for business capital investment
- Phasing out of the federal death tax and the alternative minimum tax
- Leaving current tax rules for 401k contributions in place
To evaluate the merits of the tax changes, most economists agree to five key principles for sound tax reform:
- Growth Enhancing– Tax policy should encourage economic growth, job creation, opportunity and increased financial prosperity.
- Neutrality – Economic decisions should be made for economic reasons, not due to tax considerations. The tax structure should therefore minimize distortions to economic decisions made by households and businesses, by treating similar activities the same by eliminating biases in the code.
- Stable– The tax structure should limit fluctuations of revenue during economic booms and busts and be a predictable source of funding for government.
- Transparency – Tax structures should be clear, consistent and predictable, making taxpayers well aware of their tax burden.
- Simplicity – The tax code should be easily understood by taxpayers. Compliance and enforcement costs should be minimized.
Corporate Tax Cut
Today, the combined US corporate tax rate is 39.1 percent (federal rate of 35%, plus an average of the state rate), the highest among all developed nations. This means that US companies are at a significant disadvantage against foreign competitors who face a much lower cost of doing business.
The proposed changes will also lower the top rate for “pass-through” businesses whose income is taxed through the individual code to 25 percent.
Not only will a lower corporate income tax rate attract more investment and at least partially stem the tide of companies moving headquarters and investments to more hospitable countries, the primary beneficiary will be workers.
Contrary to the claims of opponents of corporate tax rate cuts, research shows that most of the benefits of a lower corporate tax rate flow to workers.
According to the Tax Foundation, “studies appear to show that labor bears between 50 percent and 100 percent of the burden of the corporate income tax, with 70 percent or higher the most likely outcome.”
Moreover, in a recent review of the literature, the Heritage Foundation’s Adam Michel concludes that “a 20-point reduction of the corporate income tax to 15 percent could boost the relative market incomes of the poorest Americans by more than twice the increase for the richest. A tax cut for corporations is therefore a tax cut for the average American.”
Many try to argue that reductions in the corporate tax rate only benefit “wealthy shareholders” of the corporations. Due to several factors including the openness of the international economy, the mobility of capital and capital’s sensitivity to tax rates; a higher corporate tax rate actually levies a steep penalty on worker wages. Indeed, a 2006 study by the Congressional Budget Office concluded that “domestic labor bears slightly more than 70 percent of the burden” of the corporate tax.
Other, more recent studies have shown the corporate tax places an even heavier burden on workers.
Therefore, a reduction in corporate tax rates would be growth enhancing for the U.S. economy, with the overwhelming majority of the benefit going to workers.
Personal Income Tax Changes
On the individual tax code, the House Tax bill simplifies the code by reducing the number of brackets from seven to four: 12, 25, 35 and 39.6 percent. These rates differ from current rates of 10, 15, 25, 28, 33, 35 and 39.6; but are accompanied by a nearly doubling of the standard deduction to $12,000 for individuals and $24,000 for families, along with an increase in the child tax credit. And while the top rate of 39.6 percent remains the same, the bill increases the income threshold for the top rate from $470,000 to $1 million for joint filers, meaning far fewer will be exposed to the top rate.
The bill also simplifies the tax code by eliminating a number of specific tax credits. As a result, most taxpayers will be paying taxes on a smaller share of their income, thereby lowering the effective rate they pay.
Eliminating specific tax credits and moving to a broader base simplifies the tax code, makes it more transparent, and enables lower tax rates across the board. A larger standard deduction provides tax relief for all taxpayers, and reduces the favoritism embedded in the current complex tax code in which only select people engaging in specific activities enjoy relief.
Interestingly, however, a Heritage Foundation analysis shows the major increase in the standard deduction will reduce the number of taxpayers who itemize deductions from 30 to 16 percent, meaning fewer people utilizing property tax, home mortgage, and state and local income tax deductions.
Elimination of State and Local Tax Exemption
The House tax bill would eliminate the state and local income tax deductions.
Currently taxpayers are able to deduct the amount of state and local income taxes paid from their federal taxable income. Some argue that this deduction makes sense because people should not be taxed on income they never take possession of in the first place.
Others argue that eliminating the deduction would be a wise move because it is expected to generate nearly $2 trillion more in federal tax revenue over ten years – freeing up opportunities to reduce taxes elsewhere. According to the Tax Foundation, the state and local tax exemption creates significant benefits to a relatively small group of high-income earners:
- The deduction disproportionately benefits high-income taxpayers. Only 30 percent of Americans itemize deductions on their tax returns, with only 28 percent of filers taking this specific deduction. The overwhelming majority of Americans do not take this deduction.
- Of those that claim the deduction, almost 90 percent of the deduction flows to those with incomes in excess of $100,000. The deduction favors high-income individuals who are concentrated in high-tax states. Six states—California, New York, New Jersey, Illinois, Texas, and Pennsylvania—claim more than half of the value of the deduction.
And with the larger standard deduction lowering the amount of people itemizing deductions, this exemption would impact even fewer people.
Also, some claim that exempting state income taxes from federal taxation enables state governments to levy higher state income tax rates than they otherwise could, because the higher state taxes are offset by lower federal taxes, thus limiting the protests from taxpayers.
To think that high-tax states like New York and California, however, will suddenly reduce their tax rates should the state tax deduction be eliminated is naïve and unrealistic – especially in light of the fact that it is a relatively small percentage of higher income taxpayers that utilize the deduction.
There is no question that – in isolation – the elimination of the state and local tax deduction would be terrible policy. However, within the context of the broader reform proposal, the elimination of this deduction that largely benefits high-income earners in high-tax states would enable lower across-the-board tax rates that would benefit all taxpayers.
The argument thus boils down to the unjust nature of taxing income people never see in the first place (i.e. the federal government taxing income deducted for state income taxes) vs. the possibility of lowering tax rates across the board, allowing more people to keep more of their income.
The pressure to eliminate this deduction, however, would be far less if federal spending cuts were a part of the proposal.
If the end result is a lower tax burden overall, this aspect of reform would be growth enhancing, while the elimination of another targeted deduction further simplifies the tax code and makes it more transparent.
Mortgage and Property Tax Deduction Retained
The House tax bill retains the home mortgage interest deduction for all current homeowners, but future purchases will be capped at $500,000. The property tax deduction, meanwhile, would be capped at $10,000.
Some would argue that eliminating these deductions could free up possibilities for still further broad-based reductions in the tax rate. As such, retaining these targeted deductions goes against the principles of simplicity and neutrality because they favor homeowners over renters.
Medical Expense Deduction Eliminated
The deduction for medical expenses would be eliminated under the House tax plan. Backers of the bill, however, claim that people who normally take this deduction would be made whole courtesy of the larger standard deduction.
Eliminating this deduction makes the tax code simpler, more transparent and more neutral. Some with high medical expenses, however, lose out as a result of this change.
Under current law, people under 50 can deposit up to $18,000 annually in a 401(k) plan before incurring tax liability. There is no tax liability until money is removed from the account, assuming the withdraw is made after a certain age.
Recent reports had surfaced saying that Republican leaders wanted to make changes to the annual limits. In the final bill, however, no changes were made to this retirement program in which millions have invested their nest eggs.
Under current tax law, businesses who invest in relatively short-lived capital goods (such as tools, machinery, computer equipment, etc.) can deduct the cost of acquiring these goods as a business expense – but only over a period of time. A portion of the value of the investment is deducted each year, according to a “depreciation schedule”.
The House tax reform bill would allow “full expensing” of such investments for a five year period. As such, businesses could deduct the full amount of the investment as a business expense in the year it was made.
Full expensing would reduce the cost of investment to the business by reducing the tax burden in the immediate year of the investment.
Furthermore, according to analysis by the Mercatus Center at George Mason University, “businesses spend more than $23 billion a year complying with” the current depreciation rules. Simplifying the code frees up more resources for businesses to invest in workers and improving their business.
This move would also make the tax code more neutral, according to Mercatus: “Full expensing would level the playing field by letting businesses deduct spending on important investments like manufacturing plants and farm equipment in the same way they currently deduct their spending on employee wages, advertising costs and rent.”
The full expensing provision would certainly be growth-enhancing, as it encourages more investment, and would work to make the tax code simpler and more neutral. Unfortunately, the temporary nature of the move significantly blunts the benefits. Indeed, this temporary change may just end up encouraging businesses to move up future planned investments to the present, depressing investment in the out years.
Under current tax law, US corporations are taxed under a worldwide tax system. The US is one of just a few industrialized nations subject to such a system. In short, this means that no matter where a corporation earns income, it will be subject to the federal 35 percent corporate tax rate, even if it is also subject to the taxation of the country where the income was earned.
Companies can avoid this double taxation, however, if they keep their profits in the foreign country.
The system discourages US companies from making domestic investments in their businesses and workers, further reducing economic growth.
Under this bill, the U.S. moves to a “territorial” tax system, in which foreign-source dividends and profits of U.S. companies are not subject to U.S. tax upon repatriation. This move would encourage more American companies to bring their profits to the US for investment and job growth.
This provision would encourage growth, and make the tax code not only more neutral, simple, but also more transparent and stable.
Elimination of Estate Tax and Minimum Alternative Tax
The alternative minimum tax (AMT) is designed to ensure that if certain taxpayers take advantage of deductions and credits to lower their tax burden, they still at least must pay a minimum amount of tax. This bill would eliminate the AMT.
Moreover, the House Tax Reform bill would phase in a repeal of the federal death tax over six years. The current death tax levies a 40 percent tax on estates greater than $5.49 million for individual filers or about $11 million for married couples.
Both of these moves are growth enhancing. Relieving the tax burden for high-income earners keeps more money in the economy for investment and job growth, while repealing the death tax removes a penalty on capital accumulation and encourages more investment. These initiatives will also serve to simplify the tax code and, lessen compliance costs on citizens.
Finally, it is important to address the disappointing fact that the plan is not accompanied by spending reductions. The realization raises concerns that the House Tax Bill will make nation’s debt problem even worse.
As reported by Bloomberg news, Moody’s has stated that the tax plan will likely have a negative impact on the federal government’s credit rating. “Tax cuts would not be offset by equivalent cuts to spending, which would put upward pressure on the federal budget deficit and debt,” while “the tax reform’s effect on economic growth and, in turn, federal government revenue would also affect U.S. credit strength,” Moody’s said in a statement.
Veronique de Rugy, Senior Research Fellow with the Mercatus Center, echoed these sentiments, saying “Unfortunately, no matter how much economic growth this tax plan unleashes, it won’t be enough to get us out of the fiscal mess we are in. Without spending cuts, these tax cuts likely exacerbate our debt problem.”
While far from perfect, the tax plan rolled out by House GOP leaders would mark a significant improvement to our tax code, and provide a boost to our economy.
Without reductions in spending, however, GOP leaders may jeopardize future budgets. That’s a component of overall tax reform that cannot be ignored.
Overall, however, the results of the House Tax Reform plan would be to encourage growth and work to make the tax code more simple, neutral, stable and transparent. And, contrary to its critics, the majority of benefits would accrue to middle-class workers.