United States

Trump administration, Congress publish framework for tax reform

Can a divided DC enact sweeping reform?

THE REAL ECONOMY  | 

In our estimation the probability of any substantial tax reform or tax cuts, at least for 2017, is rapidly diminishing even after the Sept. 27 release of the joint framework for possible legislation. If tax legislation is passed at all, it will likely be a first half of 2018 event, with some members of Congress probably pushing for retroactivity to Jan. 1, 2018.

If anything gets done, either this year or next, it will most likely be more modest tax cuts directed at the corporate sector with minor adjustments for individual households.

Meanwhile, priority will be given to reducing the corporate rate based on congressional assumptions that the biggest bang for the buck lies with targeting growth, productivity and job creation. Despite the proposed doubling of the standard deduction for individuals and married couples, the optics on lifting taxes (to 12 percent from 10 percent) for those at the lower portion of the income ladder will be difficult to overcome.

The Committee for a Responsible Federal Budget estimates that the proposed framework would increase the U.S. debt by about $2.2 trillion over 10 years. Based on our estimates of the cost of reducing corporate and individual rates, the true cost would likely be well above $2 trillion with growth increasing between 0.2 and 0.6 percent on an annual basis over that span, the majority of it clustered in the first three years after passage.

The deficit, interest rates and the Fed

It is important to note that if initial estimates of the size of the budget deficit are understated, the middle market should anticipate more aggressive monetary policy tightening by the Federal Reserve (Fed) and for interest rates at the longer end of the maturity spectrum to increase.

The current forecast from the central bank is that the market should anticipate an additional increase of 100 basis points in the policy rate by the end of 2018, and that is before any potential tax cut. The consensus forecast on the 10-year treasury is that it will average 2.96 percent in 2018. Both the Fed’s and the market’s rate forecast at the short and long end of the treasury curve will surely increase if the offsets to pay for the tax cuts are watered down.

Political fallout

The political fallout from the two Affordable Care Act repeal and replace attempts this year is that Arizona Senator John McCain has called for regular order in the Senate and a bipartisan approach to broader tax reform or tax cuts. Due to the narrow majority the GOP holds in the Senate, the difficulty in moving tax legislation through Congress in a way that satisfies the party’s different factions increases exponentially if regular order is imposed.

If regular order is followed, special interests inside the beltway will probably try to preserve current tax entitlements--especially the state and local tax deductions on federal filings--and shape the legislation in a way that would likely make it too expensive for the budget hawks inside the GOP and its Freedom Caucus to support. Despite the need for tax reform, there is a non-trivial possibility that nothing will come from any of this. 

MIDDLE MARKET INSIGHT: The major takeaway from the proposed tax plan for the middle market involves the non-equal treatment of C corporations and pass-through entities. Pass-through income of individual owners would be taxed only once at an overall rate of 25 percent, while C corporation income would be taxed once at 20 percent and a second time at the level of the individual shareholder typically producing an overall rate of around 36 percent. 

The following is a quick thumbnail sketch of the GOP tax plan:

Inside the numbers

The economics of the tax plan are straightforward. The plan, which resembles the GOP’s House Blueprint--minus the border adjustment tax (BAT)--is an attempt to shore up the integrity of the U.S. tax base by providing incentives to reduce tax avoidance, lowering taxes on corporations to stimulate productivity-enhancing investment, and simplifying taxes for individual households.

With the loss of the BAT, the House Ways and Means Committee and the Senate Finance Committee will have to do some very heavy lifting on imposing a territorial system that eliminates double taxation for firms that operate abroad while addressing the deferral of income for foreign corporations. That would mean a loss of $1.5 trillion in government revenues during the next decade.

For each point in deductions of the corporate tax rate, the loss in government revenues is about $110 billion. So a reduction in the corporate rate to 20 percent from 35 percent would cost about $1.65 trillion over the next 10 years. The cost of reducing the rate of taxation by 1 percent on all ordinary income would be about $800 billion, the cost for those in the 28 percent bracket $170 billion, and the cost for those in the 35 percent bracket $70 billion, all over a 10-year time span. Thus, the total tax cut, before eliminations of tax expenditures, is going to be nearly $5.8 trillion.

Bye-bye, deductions

Because the tax cut proposal is so expensive, there will need to be offsets via the elimination of many, if not most, of the tax deductions that litter the tax code. With only about 15 percent of those deductions located in the corporate tax code, this means targeting tax deductions in the individual code, which will be politically difficult at best, and which may result in a significant scaling back of the tax plan as it works through the House and Senate.

So what tax deductions will likely be targets for elimination? First, state and local tax deductions on federal filings would provide a $1.27 trillion offset. This will directly affect high-tax states, such as California, Illinois and New York. Without the elimination of state and local tax deductions, the plan, in its current form, is simply a non-starter.

Second, there is $2.9 trillion over the 10-year period located in the exclusion of employer-provided health insurance from taxable income that could be tapped to offset the cost of the GOP tax plan. However, this would be politically difficult. It is important to note that the “Cadillac Tax” embedded in the 2010 Affordable Health Care Act on lavish insurance plans has been postponed until 2020 due to its general unpopularity among both political parties.

Third, tax writers are likely to look closely at the $2.3 trillion associated with the exclusion of taxable income of 401K, IRA and other pension contributions. There will also be a focus in the Senate Finance Committee on revenues that can be raised by eliminating the exclusion of taxes on home sales, the exemption of municipal bond interest payments from federal taxes and the lower tax rates applied to dividends and capital gains. 

Fourth, there eventually is going to have to be an agreement on repatriation of what the RSM Washington National Tax office estimates is the nearly 2.6 trillion in liquid assets held abroad. We still anticipate that this will not be part of the first round of tax cuts and more likely will be linked to potential infrastructure legislation in 2018 or 2019.

In our estimation the serious debate will revolve around the nearly $1.3 trillion in tax expenditures on state and local tax deductions, the $900 billion in mortgage interest deductions, $800 billion in charitable giving and the $1.55 trillion in deferral of income from foreign corporations. That would provide $4.55 trillion in offsets for a $5.8 trillion tax cut, which would put it under the agreement in the Senate of a $1.5 trillion in additional debt added over the 10-year window. It would not, however, meet the revenue neutrality threshold that is the preference of the majority of the GOP House caucus. 

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