Tax Reform: Five Headlines You’re Sure to Read

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It’s not often that tax law rises to the forefront of the public consciousness. But that’s where it is heading…maybe for mere weeks, but possibly for months or years.  A time where discussions of deductions and talk of tax brackets will dominate newspaper pages, Facebook timelines, and Twitter feeds.

Sure, these rare moments serve as career validation for people who have made the ill-advised choice to spend their lives in the bowels of the tax law, but debates over reform of those laws shouldn’t be preserved solely for us. Everyone should get in on the fun, and to that end, here’s a little primer for you: five headlines you’re sure to read about tax reform as the process unfolds.

How Will the GOP Pay For Tax Cuts?

For all the talk of tax reform in 2017 as a foregone conclusion, one thing has been noticeably absent: proposed legislation. But once we get that bill, rest assured: it will offer sweeping tax cuts. The GOP proposals have promised to drastically reduce tax rates on individuals, businesses, and estates.

But here’s the thing…when you drastically reduce tax rates, unless you fully offset the lost tax revenue through other revenue-raising means — such as removing deductions or otherwise broadening the tax base — those tax cuts will add to the deficit. And that’s the first thing that will command attention when we get our hands on a formal bill.

Keep in mind, when the Tax Policy Center scored President Trump’s informal proposal — the details of which you can read about here — it determined that the plan would add $6.2 trillion to the deficit over the next ten years. After accounting for economic growth, the price came down to $4.6 trillion, but as you might imagine, that number will cause an uproar among deficit hawks, Republican and Democrat alike.

The Kevin Brady/Paul Ryan blueprint scored only slightly better; the cost of the tax proposal has been pegged anywhere from $450 billion to $2.5 trillion over the next decade.

Any plan that adds significantly to the deficit could be a non-starter with many Republicans. But the importance of any tax reform bill’s price tag goes beyond fiscal concerns; it has procedural implications as well.

The GOP would prefer to use the budget reconciliation process to push through tax reform without the need for Democratic buy-in, as the bill would require only a simple majority in the Senate, where Republicans occupy 52 seats. In order to use the reconciliation process, the Byrd Rule requires that the bill cannot add to the deficit over the 10-year budget window, and as indicated above, neither the Trump proposal nor the Brady/Ryan blueprint currently meet that standard. This leaves the GOP with only a few options:

  1. Scale back the cuts found in the Trump and Brady/Ryan proposals far enough to make the plan revenue neutral,
  2. Enact the cuts with an expiration date — a so-called “sunset provision” — that coincides with the end of the budget window, similar to the Bush tax cuts of 2001 and 2003, so as not to run afoul of the Byrd Rule

None of these options are ideal. The Trump plan — which is the plan the White House insists will be the first thing we see in the form of proposed legislation — would need quite a bit of massaging to achieve revenue neutrality. While the Brady/Ryan plan can get there, particularly with the help of some dynamic scoring parlor tricks, as we’ll discuss below, $1 trillion of tax revenue currently being generated in their blueprint stems from the controversial “border adjustment tax,” which may kill their proposal before it gets off the ground.

Who Benefits

If proposed legislation is anything like the original plans put forth by Trump and Brady/Ryan, it will not cause political journalists to have to work hard in search of headlines. That’s because both proposals are what we call “regressive,” meaning they benefit the the wealthiest Americans.

Some Large, Low Income Families Will Pay Higher Taxes

Every taxpayer is entitled to reduce taxable income by deductions for things like charitable contributions, mortgage interest, and real estate taxes. Not every taxpayer accumulates those types of “itemized deductions,’ however, which is why the law affords an individual the right to deduct the greater of itemized deductions or the “standard deduction,” which sits at $12,600 (if married, $6,300 if single).

In addition, each taxpayer is entitled to claim a $4,050 personal exemption for themselves, their spouse, and any dependents.

Both the Trump and Brady/Ryan tax proposals, in an effort to simplify tax filings and remove millions of Americans from the tax rolls, have proposed to increase the standard deduction: in the case of the Trump proposal to $30,000 (if married, $15,000 if single), and in the Brady/Ryan proposal, to $24,000 (if married, $12,000 if single).

At the same time, however, both proposals promise to completely eliminate the personal exemption. Say you’re a married taxpayer with three children: would you rather have a $12,600 standard deduction and five $4,050 personal exemptions, as exists under current law? Or a $30,000 standard deduction and nothing else, as would be the case under the Trump proposal? The former will afford you an additional $2,850 of deductions, a disparity that will only grow as the family does.

In fact, the demise of personal exemptions is part of a confluence of three factors — the others being the increase in the bottom tax rate from 10% to 12%, and the elimination of the head of household filing status.

What Will Become Of The Obamacare Taxes?

As you might have heard, the GOP’s attempt to dismantle Obamacare suddenly hit a brick wall last week when the party couldn’t garner enough votes to move the American Health Care Act through the House. As a result, Obamacare is still the law of the land, and remaining in place with it are a host of taxes.

When you add up the 3.8% net investment tax, the 0.9% additional Medicare tax, the medical device tax, tanning tax, individual and employer mandates — Obamacare taxes all — it amounts to nearly $900 billion in tax revenue over the next decade. Brady and Ryan’s bill to repeal Obamacare would have taken these taxes with it.

So what do Trump or Brady/Ryan do now? Are they going to allow those $900 billion in taxes — the majority of which fall on the richest 1% — to remain in place until a viable healthcare alternative is unearthed? Or will they attempt to repeal some or all of those taxes as part of tax reform? It’s an important question, because remember…to fit through reconciliation, the tax bill will need to be revenue neutral. So if Trump or Brady/Ryan hope to repeal the $900 billion as part of tax reform, they’re going to have to either 1) come up with $900 billion of additional revenue raisers, or 2) forego $900 billion of tax cuts elsewhere, perhaps by not reducing rates as steeply as originally hoped. Easier said than done, however, because coming up with a $1 trillion revenue raiser is no easy task, particularly if the GOP gives up on…

The Border Adjustment Tax

Exporters love it. Importers hate it. Brady and Ryan created it. Trump is indifferent, at best. It’s a provision of the Brady/Ryan blueprint that has become so controversial, so hotly-contested, that it’s achieved the ultimate symbol of relevancy in today’s age, its own hashtag on twitter. All this debate hasn’t led to a consensus, however, as there appears to be no agreement as to the efficacy of the proposed “destination-based cash-flow tax.”

The tax would represent a fundamental shift in the way the U.S. taxes corporate income, trending away from the current direct current income tax — with its rate of 35% — and towards a value-added tax like those commonly used in Europe, with a rate of 20%.

The real magic, however, is not in the rate reduction, but in the border adjustment feature. Sales by U.S. corporations to foreign buyers would not be subject to the 20% U.S. tax. On the other end of the spectrum, U.S. importers will not be entitled to deduct the cost of goods or parts purchased from overseas and then sold within the U.S.. In effect, this taxes imports and exempts exports, which some would have you believe will encourage U.S. corporations to stay home and turn the country into a manufacturing hub once more.

The reality, however, is that the border adjustment tax would not swing the trade balance one bit; the U.S. would continue to operate at an annual trade deficit. Brady and Ryan, who proposed the tax as part of their blueprint, are not dissuaded by the that fact; rather, they’re counting on it.

If you’re assessing a 20% tax on imports but not exports, you’re only collecting net tax revenue from the provision if the U.S. imports more goods than it exports. And despite claims of bringing jobs back to the U.S., the real reason Brady and Ryan love the destination-based cash-flow tax is because it is projected to generate over $1 trillion in revenue over the next ten years. Brady and Ryan would like their plan to be revenue neutral — so it can be pushed through via reconciliation — generating $1 trillion in revenue from importers frees up the ability to make $1 trillion of tax cuts elsewhere. Without this tax, the Brady/Ryan plan must either come up with another $1 trillion in revenue, lose $1 trillion in tax cuts, or require buy-in from the Democrats.

Battle lines have already been drawn: large importers like Target, Wal-Mart and Best Buy have already spoken out about the tax, arguing that the 20% surtax on imported goods will force the retailers to increase their prices. They have been joined by the Americans for Prosperity, a Koch brothers-founded group that vehemently opposes the border adjustment tax.

Large exporters, of course, favor the feature, as they would find themselves in the enviable position of having billions of financial statement income while potentially getting a refund from the IRS because the majority of their sales are exempt from tax.

Many GOP leaders have called the border adjustment tax a non-starter. And if it is, what then? Brady and Ryan are adamant it needs to remain, but if they concede, where will they make up the tax revenue? And if they don’t concede, could any proposal for tax reform go the way of the American Health Care Act, causing so much division within the GOP that Democratic opposition is irrelevant?

The next few weeks, months, or years promise to be full of intrigue, in-fighting and indecision as the prospect of tax reform becomes daily front-page news. And just as was the case with the Obamacare debate, it will be the hard-earned cash of the American people that hang in the balance.

Ask the Experts

Tony Nitti, CPA, MST, Partner
T (970) 925 7382
tnitti@withum.com

To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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