Tax Reform: Unified Framework

Recently, a tax reform plan was released by the current administration and conservative supporters.  The details behind this plan have not been fully released because it hasn’t become an actual bill.  Regardless of political affiliation, one cannot deny that this plan makes a huge step toward reforming the tax code.  Some frequently asked questions are: 

• Will this be a positive or negative step? 

• Who will bear the burden of the reduction of tax rates? 

• Who benefits the most in this tax reform?

• How will the economy be affected directly or indirectly?

Some of these questions cannot yet be answered, because of the lack of detailed information.  However, here are the details that we know so far:​

Business Tax Changes:

• Corporate Tax Rate Reduction to 20% – The corporate tax rate has always been an item for discussion because the reduction of the rate has received bipartisan support in the past.  There was a caveat to the a 2016 proposal which might still be instituted.  This caveat is a border adjustment feature that would tax imports but exempt corporate exports.  One must also remember that if the corporate rate is reduced too much it can be costly to be government.  Over a decade this reduction to 20% would be a tax of nearly $1.8 trillion.  The 2016 plan put in place the border adjustment tax to attempt to soften the blow.  

• 25% tax rate for Pass Through Entities – Instead of getting taxed at the individual rate for business income, people who own their own businesses would pay at the pass-through rate.  The plan says that it will consider rules that will prevent personal income bing taxed at this rate.  Lastly, it is uncertain exactly which pass-through entities will receive this proposed rate.  

• Elimination of Some Business Deductions, Industry-Specific Incentives, etc. – There are very few details around the specifics of this area.

• One-time Repatriation Tax – All overseas earnings and assets from US companies would be considered repatriated and taxed at a lower rate.  Non-liquid assets such as foreign real estate would be taxed at an even lower rate (possibly 10%).

Personal Tax Changes:

• Tax Rate Consolidation – Instead of having seven tax rates brackets, the proposal would consolidate to 3 tax rate brackets (12%, 25%, and 35%).  For the new tax rates, the actual income brackets are not specified.  What we do know is the following: 1) Those who were in the 10% tax rate bracket will be classified in the 12% tax rate bracket.  2) The top individual rate of 39.6% goes away, which pushes the rate down to 35% for those upper income taxpayers.  

• A Larger Standard Deduction – In an attempt to prevent tax increases for those previously in the 10% tax bracket, the plan almost doubles the standard deduction for individuals and families.  Individuals will receive a standard deduction of $12,000 (up from $6,350).  Married taxpayers will receive a standard deduction of $24,000 (up from $12,700).  It is said that this may save taxpayers money, but with the removal of other possible deductions and secondary deductions, there may not actually be a savings.  Lastly, it is also mentioned that there is a possibility of eliminating the Head of Household filing status.  

• Eliminates Most Itemized Deductions – The only deductions that seem to explicitly remain are charitable contributions and home mortgage interest.  

• Increase the Income Level for the Child Tax Credit – There is a possibility that the income phaseout amounts will be expanded for the child tax credit.  This could possibly qualify more taxpayers for the $1,000 child tax credit which can be claimed until a child is 17 years of age.  

• Elimination of State and Local Tax Deductions – The removal of this itemized deduction can negatively affect those taxpayers who live in high state and local tax areas (i.e. California, New York, and New Jersey).  California has one of the highest state income tax rates in the country.  The removal of this deduction will affect all income levels in the state.

• Elimination of Estate Taxes – Estate taxes (also known as death taxes) typically apply to inherited income in excess of $5.49 million.

In order to give some clarity, we will provide you with a simple example of how taxpayers could be affected with the change in tax rates.  Let’s assume a taxpayer earns around $30,000 per year.  Under the current tax law, the taxpayer is entitled to a standard deduction of $6,350 and a personal exemption of $4,050.  Therefore, the taxable income would be roughly $19,600. The first $9,350 would be taxed at 10%, while the rest is taxed at 15%, with a total tax of roughly $2,472.  

Under the new proposed plan, with a 12% tax rate and doubling the standard deduction to $12,700, only $17,300 of the taxpayer’s income would be taxed.  Now if it is assumed that the remainder of the income is also subject to the %12 rate, the total tax would be roughly $2,075 ($400 less).  However, it is yet to be determined what the income ranges are so therefore no one is certain that this holds true.  With consolidating to only 3 tax rates, it is known that the income ranges will be expanded.  Therefore, we predict that a group of taxpayers could more than likely be negatively affected.  

There’s one thing that we didn’t include in the analysis above.  We didn’t further reduce the taxpayer’s income by $4,050 for their personal exemption.  This is because the GOP plans on getting rid of the personal exemptions for taxpayers (individuals, their spouses and other dependents such as children).  By eliminating the personal exemption there will be a point where lower and middle class families are better off under the current tax law with the current standard deductions and the current personal exemptions.  

As we previously stated, this isn’t an official bill yet.  Therefore details of this plan are not final.  Also, the plan doesn’t list out the new income ranges for the proposed tax brackets.  For individuals, this makes it difficult to predict how taxpayers will be affected.  However, by running different scenario analyses (such as above), one can assume that taxpayers will be affected either negatively or not at all.  However, by just looking at the information that is proposed, the direct winners here are corporations and upper income taxpayers.  One could also look at the reduction in the corporate tax rate as a possible positive effect for employees and possible reinvestment in domestic production along with research and development.  We also wonder how the real estate market could be affected given the fact that with a higher standard deduction, there could be less of a tax incentive for home ownership.  Lastly, the question that seems to be on a lot of economists and tax professionals minds is, with all these reductions in tax rates, how is this going to be paid for?  Most economists say that this could lead to an increase in governmental debt which essentially means increasing the debt ceiling.