Back during the Affordable Care Act repeal debate I wrote pretty extensively about the threat repeal posed to entrepreneurs and entrepreneurship by preventing self-employed people from being able to sign up for affordable, comprehensive health insurance.
Instead of the doing the same thing for the House and Senate tax “reform” bills, I thought I’d take a different approach and throw out a few broad areas to keep an eye on as these bills are negotiated and debated.
How much will corporate tax reform add to the deficit?
There’s no doubt that America’s corporate tax system could be reformed by eliminating preferential treatment of certain expenses (“loopholes”) and using the resulting revenue to reduce the maximum statutory rate, if we were inclined to do so.
That is not, however, the Republican corporate tax reform plan. Instead, they plan to make modest changes to corporate tax law, radically reduce the top statutory rate, and exclude foreign earnings from taxation.
This accounts for the overwhelming majority of the cost of the GOP plan, so any changes or delays in this part of the bill will make a big difference. A 25% rate instead of the proposed 20% rate, for example, would reduce the impact on the deficit substantially, as would a decision to continuing to tax foreign earnings at the maximum statutory rate instead of a special lower rate on overseas or global activity.
How will repatriated profits be handled?
It’s often said that US corporations “can’t” repatriate their foreign earnings because of the taxes they would have to pay on them. It would be more correct to say that US corporations have been instructed by the Republican Party not to repatriate their foreign earnings and instead wait until Republicans are able to permanently exempt them from taxation.
If they’re able to do so again (there was an earlier repatriation holiday under George W. Bush), it will reinforce the conviction in US boardrooms that they should accrue, on an accounting basis, as much of their earnings as possible in overseas tax havens, until the next opportunity comes around to repatriate them tax-free.
How will passthrough income be handled?
Currently, passthrough business income is taxed at the recipient’s individual tax rate, and is fairly simple to handle on an IRS Form 1040 once you get the hang of it. Will a parallel tax system be created that taxes part of passthrough business income as earned income and part as capital income? If so, how hellishly complicated will that parallel system be, and what kinds of firms will be subject to it?
From a revenue standpoint this discussion has focused on large passthrough enterprises like real estate investors and hedge funds, but the overwhelming majority of US businesses are organized as passthroughs, so introducing unnecessary complexity here would be a massive penalty on small business formation and a direct attack on entrepreneurs and entrepreneurship.
How are deductions changed?
There are three moving parts to keep an eye on when it comes to income tax deductions:
- the standard deduction and individual exemption;
- non-itemized deductions;
- itemized deductions.
Raising the standard deduction has two effects: it increases the amount of money low-income filers have completely exempted from federal income taxation (note as always that FICA taxation starts with your first dollar of earned income) and it reduces the value of itemized deductions since only itemized deductions in excess of the standard deduction reduce filer’s owed taxes.
Non-itemized deductions are available to everyone regardless of whether they itemize deductions, but that means they also complicate everyone’s tax filing process. For example, Line 26 on Form 1040 is simply labeled “Moving expenses. Attach Form 3903.” Since I move fairly frequently, almost every year I have to dig up Form 3903, then complete the “Distance Test Worksheet,” then check if I meet the “Time Test,” then find out I don’t qualify (I’ve never qualified). Eliminating these deductions is unpopular because they all have appealing-sounding names (although Line 24 “Certain business expenses of reservists, performing artists, and fee-basis government officials. Attach Form 2106 or 2106-EZ” needs a press agent) and you can always find a journalist willing to express outrage over eliminating them. I would personally encourage you to resist that temptation.
Itemized deductions, unlike non-itemized deductions, are only available if you don’t take the standard deduction. This means they’re only claimed by people with deductible expenses in excess of the standard deduction. Raising the standard deduction would mechanically reduce the number of people who find it worthwhile to file tax returns with itemized deductions, but focusing on the number of people who actually itemize deductions on their tax return misses the much larger number of people who are forced to calculate whether or not to itemize deductions. Eliminating itemized deductions entirely would be the best approach to tax simplification, but any deductions that are eliminated would constitute an improvement over the status quo by reducing the number of people who are forced to calculate their taxes twice.
How are credits changed?
Here are the Form 1040 tax credits I consider eligible for elimination (there are a few more that work as adjustments to payments made during the year that I’m not including here):
- Credit for child and dependent care expenses;
- Education credits from Form 8863;
- Retirement savings contributions credit;
- Child tax credit;
- Residential energy credits;
- Earned income credit (EIC);
- Nontaxable combat pay election;
- Additional child tax credit;
- American opportunity credit;
- Credit for federal tax on fuels.
If anything these credits have even more appealing names than the deductions I mentioned above, and they elicit even more passionate defenses from the journalists covering this debate.
You can come to your own conclusions about the proper way to go about reforming our tax code. The current proposals cut taxes on corporations by about $2.5 trillion and raises taxes on individuals by about $1 trillion over the next ten years. Another approach might be to make corporate tax reform deficit neutral and individual tax reform deficit-neutral, paying for corporate rate cuts with corporate loophole repeal, and paying for individual rate cuts or refundable credits with individual deduction and credit repeal. Yet another approach could raise taxes on corporations in order to reduce the taxes paid by individuals.
But whichever outcome you personally favor, hopefully these five questions give a sense of where the bodies are buried in the current tax reform debate.