United States

Tax plan details would mean major changes for middle market

Overall would only provide modest boost to economic growth

THE REAL ECONOMY  | 

After months of, at times, acrimonious policy dissension, the House GOP delivered a detailed tax proposal on Nov. 2. While the GOP and the administration continue to push the very ambitious timetable of getting the tax-cut package complete by the end of the year, we think a more realistic goal is likely the end of March 2018 if the cuts can be agreed to at all.

Because of the uncertain nature of the debt estimate the tax cuts would create, it is probable that the proposed 20 percent rate for C corporations and 25 percent for pass-through entities will be lifted to reduce the exposure of the economy to the shock of higher interest rates that may result from the $1 trillion-dollar annual operating deficits that would likely follow in the wake of the tax package.

Growth, deficits and rates

In our estimation, the size of the cut at $1.491 trillion likely understates the long-term increase to the national debt, which will probably be closer to $2.2 trillion to $2.5 trillion over the next decade. This is based on our estimate of the probability of higher interest rates that would follow the tax cuts, and the likelihood of temporary credits and expensing that would be made permanent.

As proposed, many of the tax cuts are likely to expire six to 10 years after implementation. The fact that the United States is at full employment, and given the demographic timing of the policy proposal, we do not anticipate a major sustained boost to the economy or wage growth. While the tax cut would be a major boost to growth in 2018 and 2019, in our estimation, growth would soon return to the current trend of near 2 percent, only bolstering overall economic activity by between 0.2 and 0.6 percent over the long term. Moreover, we think that if the tax cut is put in place, the U.S. current account and trade deficits would expand. This expansion would likely be accompanied by U.S. dollar appreciation and rising yields on long-term debt, thus driving up the cost of federal debt issuance.

This macroeconomic overlay, and the controversial treatment of pass-through entities, will frame the tax debate over the next several months. Meanwhile, the late-breaking details of the GOP Senate's plan would tilt more favorably toward the middle class and delay corporate tax cuts until 2019.

Corporate rate reduction and pass-through entities

The central feature of the proposal is the reduction of the corporate income tax to 20 percent from 35 percent. Of course, for individual shareholders an additional tax of up to 20 percent would also apply to corporate dividends and gains on the sale of corporate shares, making the total close to a top rate of 40 percent.

In contrast, individual income from investments in certain pass-through entities, such as partnerships and S corporations, would enjoy an all-in reduced tax top rate of 25 percent. In both cases, a potential 3.8 percent add-on tax would generally apply to help fund Medicare and similar programs.

But not all pass-through entities will receive the full benefit of the 25 percent rate. For owners who are active in their business (other than personal service businesses) the 25 percent rate will generally apply to 30 percent of their income. Owner-operators of personal service businesses will generally get no benefit.

Middle Market Insight: Approximately 50 percent of middle market businesses are structured as pass-through entities.

While that may work for some firms, it won’t for all. The tax proposal has in it another option that permits firms to apply the reduced rate to “capital income” – defined as a rate of return times the capital invested. The tax language specifies the rate of return as 7 percent plus a short-term federal rate, which is currently 1.5 percent.

If we assume that there is $1 million of business income derived from a $10 million capital investment, the 30 percent of income rule would make $300,000 subject to the reduced 25 percent rate. Using the rate of return approach (8.5 percent x $10 million) $850,000 would be subject to the reduced 25 percent rate.

In our estimation, the treatment of pass-through entities, especially family-owned S corporations without major physical assets, and the loosely defined “professional services section,” will likely need to be revisited to obtain the support of firms and advocacy groups associated with the small and medium enterprises throughout the economy.

Expensing and expenditures

One extremely attractive feature for middle market firms is the allowance of immediate expensing of the full costs of capital investments. This would boost fixed business investment in the near-term and productivity over the medium to long term. However, due to the likely understatement of the budget deficits associated with the tax cut, this expires after five years.

Toward that end, the plan limits the deductibility of interest expenses to 30 percent of adjusted taxable income, which should recoup about $172 billion of the plan’s cost over 10 years. The tax plan directly limits, or outright eliminates, tax benefits linked to net operating losses, domestic manufacturing, entertainment, insurance firms, executive compensation and clinical testing, adoption, medical costs and student loans that could save the United States more than $500 billion. In our estimation, many of these may be stripped out by the U.S. Senate or will not survive reconciliation, which will make arriving at an agreement within the rules under reconciliation that much more difficult.

International corporate income

The House GOP plan also moves toward the adoption of a territorial tax to protect the integrity of the U.S. tax base that, in some respects, may be understood as a “backdoor border tax.” While the United States would no longer tax the incomes of foreign subsidiaries of U.S. firms in order to protect the tax base, it would apply the 20 percent tax rate to 50 percent of any high rate firms earn abroad. This is defined as any amount in excess of a “routine return” applied to a firm’s basis of foreign depreciable tangible property.

To prevent further tax avoidance, interest deductions would be disallowed where the subsidiary’s share of its parent’s net interest expense is larger than 110 percent of its earnings before interest depreciation and amortization. In addition, there would be a 20 percent tax on payments made to foreign affiliates. This framework should offset the $205 billion costs of shifting to a territorial system by raising about $258 billion in revenue.

US individual tax treatment

American households would see the current seven tax brackets reduced to four. The top bracket would remain at 39.6 percent, with a small number of households—couples that make between $1.2 million and $1.6 million and single filers making above $1 million—facing a 45.6 percent top rate in an attempt to recapture the tax breaks those individuals and households get from the new 12 percent bracket that applies to incomes of less than $90,000 for couples and $40,000 for individuals. Middle and upper-middle quintile income earners would face a 25 percent bracket up to $260,000 in income and 35 percent up to $1 million in income.

To pay for the costs of reducing both individual and corporate rates, the proposal rolls the maximum mortgage indebtedness eligible for interest deductibility to $500,000 from $1 million and limits state and local tax deductions to $10,000 of property taxes only. The proposal repeals the Alternative Minimum Tax (AMT) and a large number of other exclusions and deductions. The JCT estimates that repealing the AMT would reduce revenues by 695.5 billion over 10 years.

Washington rules

It is important to note that arcane rules associated with reconciliation in the U.S. Senate will play a large role in determining whether there is even a final vote on the proposed tax cut. Depending on the ultimate scoring of the size of the tax cuts, some reductions could expire as soon as six or eight years after enactment. The Byrd Rule governs the use of reconciliation and is designed to prevent an increase in the deficit beyond the adopted budget resolution governing the legislative process and the budget window indicated in the bill.

The proposal, as currently scored, would add $1.5 trillion to the deficit over 10 years, thus meeting the Byrd Rule. However, it would create an additional $156 billion shortfall in 2028, thus Democrats or Republican budget hawks could object to the bill on the floor of the Senate, which would then trigger the Byrd Rule and require 60 votes to overcome the objection.

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