- Abiye Alamina
Assessing the Impact of the Proposed Bills (Tax Reform Part II)
The US House of Representatives passed in November the “Tax Cuts and Jobs Act” bill and the Senate followed with its own version shortly after Thanksgiving. Both bills purport comprehensive tax reform and are premised on meeting three objectives:
Reduce Taxes on the middle class and on Americans and American businesses in general.
Make the tax code simple enough so that most filers can file it on a postcard.
Grow the economy through the underlying economics of job growth through supply side incentives.
These three objectives jointly lead me to address three burning questions, each of which is some combination of the three objectives stated above:
What is the true cost of tax reform?
Do the bills in their current form achieve the intended objective on face value?
What exactly does economics project will be the impacts of either bill ultimately becoming law?
This blog post addresses the second question and here I provide a streamlined overview and assessment of the proposed Tax Reform passed by the House and Senate.
Tax Reform to reduce the crushing tax burden on Americans
For individuals, there are four key dimensions here, combinations of which determine the effective tax liability:
The actual statutory marginal tax rates
The standard deduction (should they choose not to itemize)
Exemptions and credits
Other deductions including Itemized deductions (should they choose to itemize)
Under current law we have a progressive income tax structure with 7 income tax brackets, and corresponding marginal tax rates as follows: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. Roughly speaking the tax brackets can be used to categorize earners as low income (10%, 15%), lower middle class (25%, 28%), upper middle class (33%, 35%), and high income or very rich (39.6%).
The House bill passed permanently reduces these to only four brackets and rates: 12%, 25%, 35%, 39.6%. Technically, a single tax rate would correspond to each of each of the four income strata of society. Further, the income limits within each of these bands is expanded significantly.
The Senate version keeps 7 brackets but lowers the marginal rates on 5 of the 7 temporarily with the rates returning back to the existing rates in 2025. Proposed rates are 10%, 12%, 22%, 24%, 32%, 35%, 38.5%. The income range is also broadened for the most part so that absent any adjustments to income, almost everyone either pays the same existing rate or a lower rate, except again for some particular income earners.
Just focusing on this change by itself assuming no deductions, exemptions or credits, the following is observed: In general across the two proposals, the biggest winners roughly speaking are, in the case of married joint filers, those whose taxable income is $76,000 each year (marginal rates drop from 25% to 12%), those with taxable income approximately $233,500-$260,000 each year (marginal rates drop from 33% to 24%/25%), and those with taxable income of approximately $471,000 to $1 million each year (who experience a drop from 39.6% to 35%). The analysis is similar for single filers as well.
The Standard Deduction is approximately doubled under both House and Senate plans – from $12,700 to $24,400 in the House to $24,000 in the Senate for married joint filers. For single filers it goes from $6,350 to $12,200 in the House bill and to $12,000 in the Senate bill.
The standard deduction which is taken in lieu of itemizing deductions reduces taxable income by the amount of the deduction, providing benefits to the roughly 70% of Americans who typically claim this. Among potential big winners might be the very low-income earners, who do not itemize, who may in effect face a zero effective tax rate, if it reduces their tax liability to or below zero. For instance a married joint filer with Adjusted Gross Income (AGI) of $18,650, with the standard deduction of $24,000 under the Senate bill, pays nothing in taxes.
Personal Exemptions are eliminated in both the House and Senate bills. Currently it would be $4,050 for each dependent in the household, including the filer, with a phaseout starting at about $313,800 and completely at $436,300 for married joint filers. This obviously means that what was previously a benefit to tax payers under the current tax code disappears in both bills. To prevent this from creating a worse outcome for taxpayers, both bills, in addition to the expanded standard deduction, increase the child tax credit, with the House bill offering $600 more over the current credit, plus $300 per non-child dependent (family tax credit), and the Senate bill offering $1,000 more, over the current credit per child for qualifying households, including $500 per non-child dependent.
Other than the Standard Deduction, there are two other broadly defined deductions that are of importance: Above the line deductions, which directly lower the AGI and can be claimed by any taxpayer with qualifying expenses regardless of whether they follow through to itemize or claim the standard deduction; and Below the line deductions, also called Itemized deductions, which a taxpayer may choose to deduct from their AGI instead of taking the Standard deduction.
Above the line deductions include Educator expenses, HSA contributions, moving expenses, self-employed retirement plan, self-employed health insurance, alimony paid, contributions to traditional IRA (up to $5500, $6500 for those over 55), student loan interest payments (up to $2500), qualified tuition and fees (up to $4000). Below the line (itemized) deductions include medical expenses (that exceed 10% of AGI), State and Local income tax (SALT), property tax, home mortgage interest (up to $1 million), charitable gifts (up to 50% of AGI), theft and casualty losses, gambling losses (to extent of winnings), tax prep fees and unreimbursed employee expenses (2% limit).
The proposed bills eliminate student loan interest payments and qualified tuition and fees deductions, as well as moving expenses deduction. The House also eliminates educator expenses, but the Senate keeps it and doubles it.
For below the line (itemized) deductions, there are various differences between the House and Senate bills except that they are both agreed to eliminate the SALT deduction. Itemized deductions are claimed by approximately 30% of filers, and the expansion of the standard deduction is projected to reduce that rate to less than 10%. So the varied changes here in whether there is a cap or an elimination of say the Mortgage interest deduction or the Property tax deduction, or medical expenses deduction is one that becomes necessary to the extent that those who itemize, typically itemize all or most of these in addition to charitable donations deduction (which is retained in both bills), and whether these are likely to exceed $24,000 or $24,400 - the respective proposed standard deduction.
The real issue here with Tax Reform is whether compared to the status quo, the expanded standard deduction, child tax credits, and lower marginal tax rates combined offset the adverse effects from eliminating the personal exemptions and some of the above the line deductions, and any loss in no longer needing to itemize under either bill becoming law, for those who would have itemized under the current law.
There are many possible scenarios so I try to use some baseline numbers for incomes, family situations, subject to phaseouts at stipulated income levels, I also use ranges around average values for the deductions to investigate tax liability under current law and under proposed bills. Generally I find that for those who would have taken the standard deduction under the current law, their tax liabilities are lower under the proposed bills. However for low to low middle income married joint filers, who also claim the tuition deduction and student loan payment deductions, and for specific combined numerical values, some are better off under the status quo than with the bills proposed especially if they do not have additional dependents. For those who would have itemized their deductions under the current law, again for lower and some low-middle income married filers, their tax liability is lower under the status quo than under either bill. This is all the more true if under current law they would have taken these above the line deductions that will be eliminated with both bills.
It is worth noting that data from the Tax Foundation suggests that up to 41.7% of returns from the income group $50,000 to $70,000 itemized their deductions. They and the lower income category $25,000 - $50,000, of which approximately 21.4% who file itemize, are the most likely to be adversely affected by the scenarios analyzed.
It is a numbers game, and especially for the lower income households, their reason for itemizing may be related to having high medical expenses as it is the itemization of these, along with other relatively lower deductions that would push the value of itemized deductions into a value higher than the standard deduction.
Low income and lower middle class income earners who itemize under the current law will tend to lose out from tax reform. Otherwise others typically see their tax liabilities go down with tax reform.
Tax Reform to reduce the crushing tax burden on American Businesses
For businesses there are a couple dimensions that highlight how tax reform might affect them:
The corporation tax rate on US profits
The tax rates for other businesses that are not corporations
Business exemptions and credits
How foreign profits are treated
Under current law the corporate tax rate is a fixed 35% on corporation profits. Both the House and Senate bills propose to lower this rate to 20%, with the House bill being immediate but the Senate delayed to until 2019. This is an enormous benefit for US corporations.
The tax rates for other businesses under current law are taxed as business income passed through to the individual owners who pay taxes based on their income tax bracket. The House bill proposes a fixed rate of 25% for most of these businesses except those offering professional services who will continue to pay taxes at individual pass through rates. The Senate bill proposes to keep these business paying taxes at the individual pass through rates, but provides a deduction for them of 23%, except for those businesses offering professional services. For those non professional services businesses who would previously have been paying taxes at the higher income brackets of 28%, 33%, 35% or 39.6%, this benefits them significantly. For the other businesses, they find themselves at a competitive disadvantage with corporations that offer similar services.
Section 179 that allows for business expensing of qualified purchases provides a business deduction up to $500,000 under current law. Both the House and Senate bills increase this significantly to $5 million and $1 million respectively, subject to phaseouts after, so there is a direct benefit to businesses, but especially those who carry out a lot of very costly qualified purchases, so these would not only be small businesses but larger ones as well.
Foreign profits for US firms are currently taxed at the corporate tax rate but only when they are repatriated back to the US. Both the House and Senate bills require a change in this to a territorial tax system, and also provide for a one time repatriation tax on existing profits: 14%/7% in the House and 14.49%/7.49% in the Senate for liquid/illiquid assets. Again, these proposals provide benefits from businesses whose existing profits being repatriated will not be subject to the previous 35% or even lower 20% rate (should that become law) and by moving to a territorial system, thus paying taxes only on US profits, businesses are encouraged to remain domiciled in the US as corporate inversion is reduced. They are further incentivized to carry out foreign investments which is expected to create more jobs domestically, which is needed to support those foreign investments. So this provides benefits for businesses and ultimately the economy as well.
Generally then, both bills provide extensive tax relief to businesses, especially large corporations. With non incorporated businesses, the bills pick and choose winners and are biased against professional service businesses who might be worse off from a competitive perspective, compared to the status quo.
Tax Reform to simplify the Tax Code and encourage Job and Output Growth
The bills from both the House and the Senate do a fair job in trying to simplify the tax code by getting rid of personal exemptions, many deductions and credits both for individuals and for businesses, this helps considerably. Besides, the expanded standard deduction will make it more likely that very few people choose to itemize.
In terms of overall impact on jobs and output growth, in addition to expectations that that tax savings generated by households would spur spending growth, there is also the presumption that the tax relief provided to businesses would also generate output growth which would in turn lead to more jobs and income growth for society.
In addition to these there is the expectation that the treatment of the Federal Estate plan in what is proposed would encourage capital accumulation. The House plan phases out the Estate Tax by 2024 while the Senate plan keeps it but doubles the exemption making far fewer estates subject to the tax.
In the third part of this three part response I expatiate a bit more on this presumption of job growth.
On face value, given the economic arguments behind these, it appears that the objectives of simplifying the tax code and spurring job growth will be achieved through either bill, even if modestly.