Tax Reform for Dummies: 2017 Edition
Tony Nitti , FORBES CONTRIBUTOR, I focus on tax policy, court decisions and planning opportunities. Opinions expressed by Forbes Contributors are their own.
Admit it. As the battle for the future of healthcare divided our nation over the past few months, you remained squarely on the sideline. It’s not that you didn’t have an opinion on whether Obamacare should remain the law of the land or be replaced by one of two Republican offerings — the American Health Care Act or the Better Care Reconciliation Act — it’s just that you felt, well…stupid.
There was so much to understand and keep up with, and when that one guy in your office would give an impassioned defense of the preexisting conditions clause or rail against Medicaid, you felt like perhaps you weren’t quite informed enough to get involved.
LAWRENCE, MA – JULY 20: U.S. House Speaker Paul Ryan (R-WI) meets with the media during a visit to the New Balance shoe factory at which he discussed tax reform on July 20, 2017 in Lawrence, Massachusetts. Ryan said that Republicans are more in step on tax reform than they are with the beleaguered plan to replace Obamacare when asked about recent struggles.
Well, I’ve got news for you: that guy in your office? Total fraud. Nobody understands healthcare in this country. Not the people who receive it, not the people who provide it, and certainly not the lawmakers who determine its fate. Perhaps that last great bastion of journalism in this country, The Onion- put it best with this headline:
The Man Who Understands 8% of Obamacare Vigorously Defends it from the Man Who Understands it 5%
But the healthcare debate is now over, so much as anything is ever “over” when you have a GOP that controls Congress and has made replacing Obamacare the foundation of its campaign speeches for the better part of the past decade. But as we’ve learned, Republicans have found crafting an alternative for Obamacare to be tough sledding, with the latest defeat suffered in the Senate, where the BCRA couldn’t even be brought to a vote.
And with that failure putting an end — at least for the moment — to the healthcare battle, the GOP turned its attention to its next biggest priority: tax reform.
Over the coming months, the discussion regarding what should happen to the tax laws in this country will dominate the airwaves, inter webs and print journalism. And just like with healthcare, everyone will have an opinion.
But unlike healthcare, you don’t have to sit this one out. You can actually understand tax reform, although to be fair, it won’t be easy. The debate surrounding tax reform is rife with terms of art, like “dynamic scoring” and “carried interest” and “budget reconciliation,” and riddled with oxymoron’s like “immediate phase-out” and “GOP leadership.”
But we can make sense of it all by doing what we always do in this space when we want to bring clarity to something complicated: revert to the friendly Q&A format. Let’s get to it.
Q: Why now? Why does tax reform immediately become a priority once the healthcare debate is over? What’s the significance behind the ordering?
A: Whoa…slow down, maestro. That’s actually 3 questions, and if you keep up that pace, it’s going to make this awfully difficult on me. But since it’s kind of 3 ways of asking the same question, I think I can handle it.
The Obamacare Repeal/Tax Reform order has both ideological and procedural significance. When Donald Trump ran for President, two promises formed the foundational pillars of his campaign: he would immediately repeal Obamacare and then cut everyone’s taxes. Of course, there was also that whole thing about building a protective wall along our southern border, but no one was dumb enough to believe that, were they?
I stand corrected. OK, fine, there were 3 promises, and when Trump proved victorious, the GOP found itself controlling the White House, House of Representatives, and the Senate (in which Republicans hold 52 of 100 seats). Thus, Republicans have — to a limited degree and for a potentially finite window of time — carte blanche to push through their agenda. But as we discussed in the opening, repealing Obamacare has proven to be an unmitigated disaster. And as much as the President may publicly paint the Democrats in Congress as obstructionists, the reality is, Republicans have no one to blame but themselves.
You see, they were planning to repeal Obamacare using something called the “budget reconciliation process,” and pay attention, because this becomes relevant with tax reform. Using this process, Congress can pass a bill that’s attached to a fiscal year budget so long as:
- The bill directly impacts revenue or spending, and
- The bill does not increase the budget deficit after the end of the ten-year budget window (The so-called “Byrd Rule”)
More importantly, using the reconciliation process, Republicans can pass a bill with only a simple majority in the Senate (51 votes), rather than the standard 60. And as mentioned above, the GOP currently holds 52 seats in the Senate, meaning it could have pushed through its signature legislation without a SINGLE VOTE from a Democrat, which is particularly handy considering that vote was never coming.
In rather spectacular fashion, however, the GOP failed to garner the requisite support within its own party for its repeal/replace efforts. Torn apart by internal divide — some Republicans found the bills to be too harsh on Medicaid, while others found it not quite harsh enough, dubbing it “Obamacare-lite”, both bills died on the vine.
So now, with the 2018 mid-term elections looming and voter dissatisfaction threatening Republican control, the GOP is in desperate need of a victory. And tax cuts are the preferred victory of choice, because after all, if the GOP can’t deliver Obamacare repeal or tax breaks, then why would anyone feel compelled to vote Republican in 2018? Unless, of course, they’re in it simply for the xenophobia and automatic weapons.
As I said, there’s also a procedural element to this Obamacare/Tax Reform pivot. Having missed the opportunity to repeal Obamacare using the 2017 FY budget reconciliation process, the GOP proposed its 2018 FY budget last week, and will use the reconciliation provision for that year’s budget to push through tax reform. This way, once again, the GOP will need only a simple majority in the Senate, with no threat of a filibuster.
So that’s how we ended up moving, ever so abruptly, from healthcare to tax reform. It’s a matter of party priorities and Congressional procedures.
Q: I got it. So, what exactly is “tax reform?” And is it different from “tax cuts?”
A: Great, great question. This is likely to be at the root of the ensuing debate, and it’s important to be educated as to the difference. Because make no mistake, we’ve been promised the former but will likely end up getting the latter, and if that comes to pass, we can’t allow the people in charge to proclaim victory.
The tax law, as it stands today, is an unwieldy behemoth. The statute is thousands of pages long, and Americans spend billions of dollars and millions of hours computing and reporting their collective income tax liability every year. The rules are startlingly complex and contain endless exceptions to exceptions and traps for the unwary; hell, I’ve got a Masters in Taxation, and I barely understand any of it.
When we talk about tax “reform,” what we’re really proposing is to take a flame thrower to that entire mess. The process begins by lowering tax rates, but true reform requires far more than just that. It must also create simplicity; fewer rates; fewer deductions, fewer loopholes and preferences and confusing elements. Enough pages should be ripped from the current law to enable every American to confidently prepare their own return. Heck, remove enough of the law, and Republicans could theoretically achieve their stated Holy Grail of tax reform — a tax return so simple, it could be prepared on a form the size of a postcard.
When we talk about tax “cuts,” however, we’re talking about taking the path of least resistance. Simply dropping the tax rates a few percentage points to placate the masses come April, but leaving behind all of the complexity that serves to create confusion, inequity among similarly situated taxpayers, and a global disadvantage for U.S. corporations. Tax cuts are a Band-Aid, and as we’ll discuss later with the interplay between tax cuts and the budget reconciliation process, a very temporary one, at that.
Q: OK, I’m likely to regret asking this, but can you frame for me what tax reform might look like?
A: Sure. I’ll start by giving you the 30,000 ft. view of our current tax system, and I say that not because I’ll write in generalities, but rather because I am actually at 30,000 feet at the moment, flying from NJ to CO.
Under current law, individuals pay tax on ordinary income — things like wages and business income and interest income, at potentially 7 different rates, ranging from 10% to 39.6%. As income goes up, so does the rate you pay on the final dollar of income you earn, but everyone, from Joe Six pack to Mark Zuckerberg, pays the 10% rate on their first dollars of income.
We’re also entitled to the greater of two deductions in computing our tax liability — the standard deduction or the sum of your itemized deductions. The standard deduction is currently $6,300 for single taxpayers, double that for married taxpayers. Itemized deductions include things like state and local income taxes, mortgage interest, real estate taxes, medical expenses, and charitable contributions. If the sum of those itemized deductions exceed the standard deduction, you go with that higher amount.
Individuals are also potentially subject to additional taxes like the “Alternative Minimum Tax,” which effectively forces Americans to compute their regular tax liability using rules almost no one understands, and then go back and do it an entirely DIFFERENT way using rules even fewer people understand. When finished, you pay the greater of the two taxes.
Upon death, a small portion of the population is also subject to the estate tax, or as the GOP has coined it in order to express just how evil it is, the “death tax.” This “death tax” imposes a 40% rate on the value of your assets upon your passing, but only in the event that value exceeds $5.4 million. Thus, while every Fox News viewer may decry the death tax, the reality is, the overwhelming majority of them will never feel its touch.
From a business perspective, U.S. corporations pay tax at 35%, an amount President Trump asserts is the highest in the industrialized world. (It is not). Corporations, like individuals, are entitled to a slew of deductions, but because some corporations are eligible to claim certain deductions while others are not, the playing field becomes quite unbalanced across industries, with some businesses paying an effective rate of far lower than 35%.
If tax reform were enacted using basic GOP principals, it would start by consolidating and lowering the ordinary income tax brackets on individuals. For example, President Trump would replace the current seven-bracket system with three rates: 10%, 25%, and 35%.
Next, to help offset some of the revenue lost from those tax cuts while achieving the desired simplicity, the President would RAISE the standard deduction while ELIMINATING all itemized deductions except for mortgage interest and charitable contributions. The combined effect of these two provisions should be obvious, if itemized deductions will decrease at the same time the standard deduction increases, many more Americans — approximately 27 million, to be exact — would claim the standard deduction. This makes preparing a tax return a easier proposition, as you would no longer need to deal with countless charitable contribution receipts and medical expense bills.
The other advantage to increasing the standard deduction, of course, is that more taxpayers would simply have no tax liability, as the increased deduction would wipe out their income. This effectively creates a larger 0% tax bracket, and reduces the compliance burden.
Then, the alternative minimum tax would be eliminated, further simplifying the tax computation. The dreaded death tax would also disappear.
On the corporate side, the President’s plan would reduce the rate from 35% to 15%, while eliminating so many deductions, preferences and credits that all industries would be taxed at pretty much the same 15% rate. The added benefit of reducing the rate, the theory goes, is that it would provide incentive for corporations to stay in the U.S., rather than fleeing for greener tax pastures in foreign jurisdictions.
When it’s all said and done, tax reform would lead to a much smaller and more manageable tax law, with significantly lower rates and far fewer deductions. This would make tax liabilities easier to compute, report, and from the perspective of the IRS, enforce.
Q: That sounds really nice. So why do I keep hearing that “tax reform is hard?”
A: For starters, you’re reading far too many of Richard Rubin’s tweets. But he’s right; tax reform is hard. Very hard. And it’s hard, primarily, for two reasons. The first is because of the effects on the budget. Follow along here…
Remember how I said the GOP wanted to use the reconciliation process to push through its vision for tax reform? Well, remember when I ALSO said that to use the reconciliation process, the legislation can’t add to the deficit after the expiration of the ten-year budget window? Well, that means that tax reform has to be what we call “revenue neutral,” meaning that when we add up all the tax revenue lost to lower rates, and then add up all the tax revenue gained from eliminating deductions, the former can’t exceed the latter. Stated in another way, in revenue neutral tax reform, we need to raise as much tax revenue by eliminating deductions as we give away in the form of tax cuts.
And that is damn tricky, particularly when the GOP is dead set on drastically lowering individual and corporate rates. To wit: if you simply reduced the tax rates to the levels President Trump proposes and did nothing else, it would reduce government tax revenue over the next decade by over $7 trillion dollars. Now, the federal budget is a simple one: we take in tax revenue, and then spend it all on safety net programs and infrastructure and the defense. So, if we drop tax revenue by $7 trillion over the next decade, that adds $7 trillion to the deficit, and there is $7 trillion less we can spend on Medicaid and bridges and weaponized gonorrhea.
In order for that particular proposal to be “revenue neutral,” we would next have to find a way to RAISE $7 trillion in tax revenue over the next decade. We do this by eliminating deductions, but as the GOP is quickly learning, there are only so many ways to do that, and the revenue raisers that have been proposed have caused more consternation among powerful, old white men than anything since segregated baseball.
For example, you might have heard about a proposal pitched by Speaker of the House Paul Ryan for something called a “destination-based cash-flow tax;” a fundamental shift in the way the U.S. taxes corporations. The real beauty of the tax, in Ryan’s eyes, is that it would raise $1 trillion in tax revenue over the next decade, which could be used to offset, at least in part, the lost tax revenue resulting from tax cuts. But this new tax effectively subsidized exporters while punishing importers, causing powerful companies like Target and Best Buy and Wal-Mart to lose their collective minds, which effectively spelled its doom.
Alternatively, Ryan had proposed eliminating the business deduction for loan interest, a move that would not only reduce corporate dependency on debt and eliminate one manner in which a U.S. corporation can shift profits overseas, but that also had the added benefit of raising $1 trillion in revenue over the next decade. This proposal, however, was once again met with harsh criticism, particularly from the banking industry, which foresaw the impact eliminating tax breaks for interest payments would have on its ability to make loans.
So, as you can see, cutting tax rates is the easy part. It’s eliminating the deductions and offsetting those cuts from a revenue perspective that is difficult. And it’s no different at the individual level: it takes no effort to say, “let’s simplify the law by eliminating all itemized deductions except for mortgage interest and real estate taxes.” But when push comes to shove? Try to eliminate the state and local income tax deduction, and the Congressional representatives from high-tax states like New Jersey, New York and California revolt. Try to pull back the real estate tax deduction, and the real estate lobby argues that it will kill their ability to sell homes. You get the idea: these deductions are firmly entrenched in the tax law, and extricating them is no easy task.
And if you can’t do that, the math simply doesn’t work. Actually, even if you can do that, the math doesn’t really work. To illustrate, the Tax Policy Center recently concluded that all of the eliminated deductions in President Trump’s plan for tax reform would generate only $3.6 trillion in tax revenue over the next decade, meaning the plan is $3.4 trillion away from being revenue neutral ($7 – $3.6) Thus, even after accounting for the additional revenue garnered from eliminating deductions, the plan would add $3.4 trillion to the deficit over the next decade. And if you’ve been following along, that’s particularly problematic, because to use the reconciliation process and pass a tax bill without Democratic buy-in, the plan needs to be revenue neutral after ten years, a marker the Trump proposal misses by several trillion dollars.
Q: So devising a revenue neutral plan is problem #1. Got it. But let’s just say you could do that; everyone would be on board for tax reform, right?
A: Unlikely, and here’s why: tax reform, by its very nature, creates winners and losers. Let’s keep this simple: assume a plan could be devised with lower rates and eliminated deductions that brings simplicity, but more importantly, nets to zero in terms of revenue impact. President Trump campaigned on a tax proposal that, by even the most conservative estimates, would have put huge tax savings in the hands of the richest 1% — with one distributional analysis determining that the average savings for those earning more than $750,000 would be approximately $200K.
If tax reform is to be a sum zero game, and the richest 1% are going to receive the tax breaks they were promised, well…you can see the problem already. When the richest 1% wins, by definition the lower and middle class have to lose if the government isn’t going to give up any tax revenue in total. And this creates a major political hurdle; while some will argue that in order to kick-start the economy, you should put more tax dollars in the hands of the rich than anyone else, with the divide in this country between the 1% and 99% at an all-time high, any plan that proposes to give large benefits to the rich at the expense of the masses would be headline fodder.
And, of course, the opposite is true as well: if a revenue neutral plan is to be developed that provides savings to the lower and middle class, then the rich are going to end up with higher tax bills, and that is NOT what they were promised under the tax plan Trump campaigned on.
You get the idea: if the plan is going to both 1) be revenue neutral, and 2) not benefit one segment of the population over the others, it is going to have to be VERY carefully configured, and even then, somebody is going to be left pissed off, because they didn’t get what they were promised.
Q: That is a pickle. Riddle me this, though: how does one determine whether a tax plan is “revenue neutral?” Aren’t those imaginary numbers in part? Isn’t there some leeway there?
A: There is some leeway, and it’s called “dynamic scoring.” It works like so: the numbers we worked through above were the product of “static scoring.” This means that in determining that President Trump’s proposed lower tax rates would add $7 trillion to the deficit, the Tax Policy Center simply took the cuts and applied them to the current landscape, with no anticipated change in taxpayer behavior or the economy at large.
But if you cut taxes, there WILL be reaction from both taxpayers and the economy. For example, if you cut the corporate rate, while you undeniably lose tax revenue, you also — at least in theory — motivate corporations to invest in Michigan rather than Mexico. Thus, more corporations stay home than otherwise would, and you bring some revenue BACK to the U.S.
Similarly, if you cut the individual rates, you put more money in the hands of business owners, who, in turn, may hire more people and pay higher wages. This means more people are making more money, which brings in additional tax revenue and partly offsets the impact of the tax cuts.
As a result, tax plans are usually measured via dynamic scoring, which anticipates the fact that tax cuts will change behavior and grow the economy. It’s standard practice, but what is unsettled is exactly how much economic growth is generated from those cuts. If you believe the Tax Policy Center, not much. Their latest analysis reveals that when you take the $3.4 trillion in lost static revenue from the Trump plan and score it dynamically, you lose$3.4 trillion in tax revenue over the next ten years. In other words, it anticipates no economic growth from the proposal.
If you believe the people who prepared the GOP’s budget proposal last week, however, we’re in for an explosion of growth, from 1.9% to 2.6% annually. And when you factor in that kind of growth, the GOP’s version of the plan is likely to get a whole lot closer to revenue neutral than anyone else’s version when using dynamic scoring.
Q: So is that the stated goal of the GOP? To institute revenue-neutral tax reform after accounting for its own vision of economic growth?
A: That is a question that neither I nor, apparently, anyone within the Trump administration, can answer. The President has never been particularly concerned with his plan adding to the deficit, as evidenced by the $3.4 trillion his most recent proposal would add to the ol’ country credit card. Secretary of the Treasury Steven Mnuchin however, has stated that the plan will in fact be revenue-neutral, but only AFTER considering economic growth. And Mitch Mulvaney, the administration’s budget director, has said he expects the tax plan to be revenue-neutral BEFORE considering economic growth, which means there’s approximately a $3.4 trillion gap between Trump’s proposal and Mulvaney’s contention.
Q: That’s quite the gap. Are there tweaks that can be made to the Trump plan to get to Mulvaney’s — or even Mnuchin’s — position?
A: Well, you could start by not dropping the rates quite as far. After all, every percentage point you drop the current 35% corporate rate decreases federal revenue by $100 billion, so by simply dropping the rate from 35% to 25% — rather than the 15% proposed by the President — you could save $1 trillion over the next decade.
Another alternative, one that would both save tax revenue, simply the law and make it more progressive, meaning the rich won’t enjoy a disproportionate break from the changes, would be to do away with preferential rates currently afforded certain types of income, like long-term capital gains and dividends. Under current law, these types of income are taxed at a high of 23.9%, but the reality is, 85% of all capital gains are recognized by the wealthiest 2%. Thus, if you adopt the same brackets for capital gains that President Trump has proposed for ordinary income — 10%, 25% and 33% — the plan could be much closer to revenue neutral and much more progressive.
Such a move, however, would be a huge departure from standard Republican principals, which maintain that taxing capital gains and dividends at ordinary rates stifles investment and the sales of assets. Compelling arguments can be made for both points.
Q: I thought I read somewhere that the failure to repeal Obamacare could make tax reform even more difficult? Is that true?
A: Most likely, yes. That’s because there are about $700 billion in taxes (over a decade) that are part of the Obamacare legislation, These taxes, which range from an indoor tanning tax to an additional 0.9% Medicare tax to an additional 3.8% tax on net investment income,were supposed to die along with Obamacare. If those taxes aren’t repealed as part of a healthcare bill, then the GOP would seek to eliminate them as part of the tax bill. But as we’ve spent 3,000 words discussing, in order to use the reconciliation process, this tax reform bill needs to be revenue neutral, and we just made clear how tall a task that was BEFORE we threw another $700 billion of tax cuts into the mix. In other words, by not repealing the Obamacare taxes as part of a repeal/replace bill, and instead repealing them as part of the tax package, the GOP will have to come up with ANOTHER $700 billion in tax revenue to pay for the cuts. This is just one more reason why the GOP prioritized Obamacare repeal before tax reform.
Q: So, what happens if the GOP can’t come together and craft a revenue-neutral plan?
A: Things could get really ugly, really quickly. At the moment, no one appears to be on the same page. As we said, President Trump proposed “the biggest tax cuts in history” on the campaign trail, but Mulvaney, his own budget director, said the plan would be revenue-neutral without economic growth, which is another way of saying “no cuts for anyone.” And Paul Ryan and Kevin Brady were big proponents of the destination-based cash-flow tax and the disallowance of the interest deduction, with the President never embracing the former and appearing lukewarm, at best, to the idea of the latter. Leaders of NJ, NY and CA are angry at the prospect of a lost itemized deduction for state and local income taxes. Lobbying groups are bending the ears of their representatives. Divisions even greater than what we witnessed with healthcare could arise, threatening the idea of the once-in-a-generation reform we’ve been promised.
Q: And let me guess, that’s where the concept of “tax cuts,” rather than “tax reform,” comes in, right?
A: Now you’re getting it. The GOP simply can’t afford another embarrassment like the one healthcare inflicted upon them. After all, for eight years Republicans proposed legislation to repeal Obamacare and told voters how easy it would be to replace once they were granted control of Congress. That never materialized, as the party was torn apart by factions of moderates and conservatives.
The same could easily happen with tax reform. And should that come to fruition, the GOP could very well scrap its plans for an overhaul of the tax law, and simply drop the tax rates while retaining all of the problems: the complexity, the confusion, the inconsistencies.
Q: But that doesn’t make sense. You said for the GOP to push through legislation without Democratic approval, the plan couldn’t add to the deficit. Tax cuts with no offsets would obviously do just that. What gives?
A: Ah…I said the Byrd rule prohibited a tax plan proposed as part of the budget reconciliation process from adding to the deficit AFTER the ten-year budget window. As a result, the GOP could enact the tax cuts with a “sunset provision,” meaning that after ten years, the rates would automatically revert back to what they are today. This was the tactic used by George W. Bush to enact tax cuts in 2001 and 2003. This way, we’d enjoy huge cuts — and huge additional deficits — for the next ten years, and then — POOF — ten years from now everything goes back to the way it is today. Budget magic.
But understand this, even tax cuts aren’t a foregone conclusion. After all, there are more than a few Republicans who will oppose tax cuts that significantly add to the deficit in the short term and obviously, any cuts done without significant offsets would do just that.
Q: So when will we know if we’re getting tax reform or tax cuts?
A: Hard to say. Right now, there is NOTHING. No proposed legislation, no blueprint, nothing more than a one-pager of bullet points released by the White House in May. When the last substantial tax reform took place in 1986, it took over two years from inception to enactment. Considering we haven’t even begun drafting legislation at this moment, the belief that tax reform could be done by the end of 2018 let alone 2017, seems misplaced.
That being said, we’ve been told that we can expect to see proposed legislation in September, and at that point, we can reconvene, take inventory of the prospective changes, and compute the revenue effects. This will give us a much greater idea of whether tax reform will be possible, or if we should resign ourselves to a best-case scenario of mere cuts.
Q: Thanks. But you do realize, you said this was tax reform “for dummies,” and yet you spent 4,500 words explaining the process. Not really simplifying things, are you?
A: Hey, I did my best. But as my pal Rubin likes to say, tax reform is hard. Perhaps it’s just not meant for dummies.
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