House and Senate leaders announced their final Tax Reform bill on Friday, and passage seems assured by the end of the year. Enough details have emerged to grade the final product (though I’m sure we’ll learn more in coming days). Because it makes America more competitive, will spur economic growth, and helps families in some important ways, it deserves a solid “B” and should be approved by Congress.
There are two big failings in the bill — it adds between $1 and $1.5 trillion to the debt over 10 years and adds a significant new piece of complexity in the small business arena, but these failings aren’t enough to justify a “no” vote. In this post, we’ll examine the final product. Along the way, I’ll also revisit the questions that we asked a few weeks ago in an earlier post.
The Big Changes
As of this writing, here are the big changes in the Tax Reform Bill:
- The Corporate tax rate will drop from 35% to 21%. Certain businesses that count their business income on their personal tax return (so-called “pass through” entities) will also get a substantial tax cut.
- The standard deduction will double (from $12,700 to $24,000 for married couples) and tax rates are lowered across the board; personal exemptions will go away.
- State/local income and property taxes will still be deductible, but only up to $10,000 per year (vs. unlimited deductibility in current law). This will hurt higher income taxpayers in high-tax states.
- The child tax credit doubles (from $1,000 to $2,000), is refundable up to $1,400, and the income limits have been raised, making the credit available to most taxpayers.
- The Obamacare individual mandate tax penalties will be repealed.
Forbes has a good summary if you want more information.
Revisiting the Four Questions From My Earlier Post
Will the new code be simpler?
It depends on who you are. If you are a middle class taxpayer, the code will be much simpler. The doubling of the standard deduction to $24,000 means that most families will no longer need to track receipts or labor for hours over their tax forms. They will simply fill in the standard deduction and file — that’s good. Also, a very complex scheme known as the Alternative Minimum Tax (which requires some taxpayers to calculate their taxes twice) will now only apply to the very highest income earners. That is also good.
However, the new law’s “pass through” provisions are complex and will create a powerful incentive for small businesses to restructure their operations to take advantage of the tax break. Professional service firms (which generally won’t qualify for the lower tax rates) are already talking about splitting up their various revenue streams or restructuring to get favorable tax treatment. I’m afraid there will be significant gamesmanship throughout the economy — this change will keep accountants very busy.
Simplicity Grade: C+
Does it help families?
First, raising the standard deduction is good news — families will get the benefit of a large standard tax deduction without keeping receipts or jumping through hoops (large families won’t see the benefit due to the elimination of personal exemptions). Also, tax rates for families, like all taxpayers, will go down. The bill also raises the child tax credit from $1000 to $2000 per child and applies the credit to many more families than the current law (from a max income of $110,000 to $400,000 for married couples). A helpful late change championed by Senator Marco Rubio expanded the refundability of the tax credit to low income taxpayers. Families will also no longer be required to pay the Obamacare penalty if they do not purchase a health care plan approved by the federal government. This will save low-income families around $1400 per couple.
Overall, the Tax Reform bill is positive for most families, both in terms of simplification and because their taxes will go down.
Pro-Family Grade: B+
Is it too radical?
Here, the Tax Reform bill ended in the right place. Initially, various proposals were quite radical, eliminating medical expense, home mortgage, and teacher expense deductions, and taxing grad student tuition waivers. All of these provisions were eliminated from the final legislation, and other changes are being phased in to give people a chance to work through the plans they have made. These are helpful changes.
The two most radical remaining changes involve the deductibility of Sales and Local Taxes (SALT) and providing new, potentially distortive, tax breaks for “pass through” entities. It is worth considering the SALT issue in some detail. Under current law, taxpayers can deduct from their federal tax returns all property and income taxes that are paid to their state and local governments. Because of these deductions, federal tax rates must be higher overall to make up for the revenue loss. Thus, residents of low tax states provide a subsidy to those states that charge their residents high taxes. That just doesn’t seem fair. The original proposal, which would have eliminated all SALT deductibility, tilted the balance too far in the other direction. The final bill, which allows for deductibility of up to $10,000 in SALT taxes, seems like a fair middle ground. The limited deductibility will also provide an incentive for high-tax states to lower their tax burden (or at least not raise it further) — that is a win for taxpayers.
The main blemish in this area is the new and complex “pass through” rules discussed above. I’m afraid that there will be many unintended consequences from this change that Congress will have to revisit.
Anti-Radicalism Grade: B+
The Estate Tax
Initially, the House bill fully repealed the Estate Tax. While considering death as a taxable event is a bit unseemly, the Estate Tax actually affects very few Americans, and the revenue lost in a full repeal limited the ability to provide other types of tax relief. This was a poor trade-off, and the final bill fixed the issue by retaining the Estate Tax, but doubling the exemption to only apply to estates larger than $11 million. This effectively eliminates any impact on all but the very rich (and they also benefit from the increased exemption) — Congress landed in the right place.
Estate Tax Grade: A
The Corporate Tax Cuts Will Help Competitiveness
The centerpiece of the Tax Reform is a reduction in the corporate tax rate from 35% to 21%. Currently, the U.S. has the third highest corporate rate in the world, and it is well above the 22% average across the world’s major economies. Over the past decade, most countries have reduced their rates, and the growing tax gap has disadvantaged U.S. companies versus their foreign competitors. As a result, many companies have moved their tax headquarters overseas. The new, lower rates will make U.S. corporations more competitive and encourage companies to maintain their headquarters in the U.S. These changes will unquestionably help U.S. workers and the economy in general.
Corporate Tax Grade: A
The Debt will Rise
The major downside of the Tax Reform Act is that it is slated to add $1.5 trillion in new debt over ten years to the already massive $20 trillion federal debt already owed by the American people. There has been virtually no discussion of any offsetting spending cuts to pay for the loss of revenue. Optimistic Republicans are counting on growth spurred by the tax cuts to generate additional tax revenues to cover the gap. While most economists agree that the tax plan will drive growth, most credible analysts believe that well over $1 trillion of additional debt will result from the tax cuts even after the new growth is factored in.
This is really poor public policy. Already, the U.S. has more debt than its entire yearly economic output. We should be finding ways to reduce our debt, not increase it. History is replete with debtor nations sailing along for quite awhile with high debt levels. Then, a crisis comes, and debtors grow nervous about the nation’s ability to repay. As Greece recently discovered, the consequences of that occurrence are dire — creditors begin to direct the country, taxes must be raised, the economy slows, and jobs are lost. The U.S. needs to act soon to avoid this scenario, and the Tax Reform bill only makes matters worse.
The best that can be said about the Tax Reform bill is is that it will have a relatively small impact on the debt — “only” $150 billion per year. That is less than 4% of the federal budget. And, the argument goes, when Congress eventually makes the hard decisions on spending, the added debt from the Tax Reform bill can be easily handled given that the economy will be in a strong footing due in part to the economic growth spurred by the lower tax rates. While this argument strikes me as very hopeful, the relatively small impact of the bill on the debt does diminish the overall level of concern. However, it is still a significant negative point.
Deficit Grade: F
The Final Analysis
Overall, the Tax Reform is positive for the country. It will strengthen the competitiveness of U.S. companies and therefore spur economic growth. It simplifies taxes for many, and helps families. Lawmakers avoided the most radical and disruptive provisions, and states will have a new incentive to cut their own taxes. On the downside, the bill only worsens our already poor debt situation, and I worry that the “pass through” provisions will prove to be too complex and lead to significant gamesmanship. However, the positive parts of the bill outweigh the negative. Congratulations to President Trump, Speaker Paul Ryan, Senate Leader Mitch McConnell, and Ways and Means Chairman Kevin Brady. Congress should pass the Tax Reform bill, and the President should sign it.
Tax Reform Final Grade: B