On Dec. 22, 2017, the president signed into law major tax reform legislation. This legislation had been known as the Tax Cuts and Jobs Act but at the last minute, due to quirks in the Senate parliamentarians’ interpretation of parliamentary procedure, the Act’s name was stripped from the bill. It is, therefore, nameless.
Because the new law reduces marginal tax rates, reduces the user cost of capital and makes other policy improvements, the legislation will have a positive impact on the U.S. economy. The positive economic impact, however, will be substantially less than had tax reform initiatives offered earlier in the legislative process been enacted. Politically plausible well-crafted major tax reform had the potential to increase long-run gross domestic product (GDP) – economic output – by about 10 percent. The tax legislation signed into law will probably increase GDP in the long-run by about two percent relative to baseline. Most of this gain is likely to occur in the first five or six years.
The Joint Committee on Taxation (JCT) provides the official estimates used by Congress. JCT maintains three models: (1) the Macroeconomic Equilibrium Growth (MEG) model; (2) the overlapping generations (OLG) model; and (3) the dynamic stochastic general equilibrium model (DSGE) model. It is not clear which model contributed to what degree in arriving at the JCT staff’s estimate of a 0.7 percent increase in GDP. Both the Tax Foundation and the Heritage Foundation models are neo-classical models that focus on the impact of the tax system on incentives or, in other words, have microeconomic or price theoretic foundations. The Urban Institute-Brookings Institution Tax Policy Center uses a neo-Keynesian model in which “aggregate demand” is a central factor. Although they receive much press coverage, the Tax Policy Center’s estimates are based on faulty economic thinking and are not credible.
The most important pro-growth aspect of the legislation is the permanent reduction in the U.S. corporate tax rate to 21 percent starting in 2018. This will reduce the cost of capital and increase investment and productivity. It will make the U.S. a more attractive to place to invest and in which to headquarter a multinational company. The corporate alternative minimum tax (AMT) is repealed.
Under U.S. law, pass-through businesses (primarily S corporations, partnerships, limited liability companies, sole proprietorships, real estate investment trusts and cooperatives) do not pay tax at the entity level. Instead, the owners of the business pay tax at the individual level on their share of the business’s income. The legislation reduces the tax rate for many pass-through businesses by introducing for the first time a lower tax rate for certain pass-through businesses than applies to other forms of individual income. These new rules, overwhelmingly applicable to smaller businesses, are complex.
In general, pass-through businesses are accorded a 20 percent deduction, which means that the tax rate is 4/5ths of what it otherwise would be. Thus, a 25 percent bracket taxpayer would have an effective marginal tax rate on his or her pass-through income of 20 percent. However, this deduction is not allowed for certain service businesses in the fields of health, law, consulting, athletics, financial services, brokerage services, nor any “trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.” Engineering and architecture services were excluded from the definition of service business in the final bill, so they are eligible for the rate reduction. The limitation on the deduction for specified service businesses only applies to the extent a taxpayer’s taxable income exceeds $157,500 ($315,000 joint). The 20 percent deduction also cannot exceed the greater of (a) 50 percent of the wages paid with respect to the trade or business, or (b) the sum of 25 of percent of the wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis in depreciable property. This latter limitation does not apply to lower income individuals. The 20 percent deduction only applies with respect to U.S. source income. It does not apply to investment income such as dividends, interest and capital gains. It does not apply to income that must be treated as “reasonable compensation” under existing rules. There are also a series of special rules governing various particular situations.
The cost of most equipment purchased by businesses will be expensed (i.e. immediately deducted rather than depreciated) for five years. Beginning in 2023, these rules phase-out and by 2023 normal capital cost recovery rules will apply. The legislation, however, increases the section 179 threshold to $1 million, so small business will be able to deduct the cost of equipment purchases.
In general, the deduction for business interest expense may not exceed the sum of business interest income plus 30 percent of adjusted taxable income. Adjusted taxable income is determined without regard to depreciation, amortization, or depletion for the first five years. This limitation applies to both C corporations and pass-through entities.
The tax bill moves the U.S. tax system substantially towards a territorial system. It deems as repatriated previous overseas earnings on which taxes have been deferred and taxes them at a reduced rate. In contains a number of base erosion prevention provisions that effectively retain aspects of the current world-wide U.S. tax system. On balance, these provisions will make the U.S. a more attractive place to headquarter a multinational business and should, combined with the substantially reduction in the corporate tax rate, substantially reduce inversions and the acquisition of U.S. corporations by foreign corporations.
The legislation provides a 100-percent deduction – a dividend received deduction or DRD – for the foreign-source portion of dividends received by U.S. corporation from specified 10-percent or more owned foreign corporations. The DRD is available only to C corporations that are not Regulated Investment Companies or Real Estate Investment Trusts. In general, the foreign tax credit is repealed.
In general, accumulated post-1986 foreign earnings and profits (E&P) that have not been previously taxed must be included in gross income. This provision applies to all controlled foreign corporations (CFCs) and certain other foreign corporations. These earnings will be taxed at a rate of 15.5 percent for earnings held in the form of cash or cash equivalents and 8 percent on other earnings. This deemed repatriation tax may be paid over eight years with the bulk of the liability being due toward the end of the eight-year period.
The legislation provides for current taxation of some foreign source income at reduced tax rates. The effective tax rate on foreign-derived intangible income (FDII) is 13.125 percent and the effective U.S. tax rate on global intangible low-taxed income (GILTI) is 10.5 percent. The rules governing what is FDII or GILTI are extremely complex and it is not immediately apparent what their actual effect will be. In general, however, intangible income is all income in excess of the product of 10 percent and the net of depreciation value of depreciable property. There is also a new base erosion minimum tax designed to target related party transactions.
From 2018 through 2025, the legislation reduces federal individual tax rates. The top tax bracket is reduced from 39.6 percent to 37 percent and most other taxpayers will see their federal tax bracket reduced by one to four points. The thresholds for the lower brackets are also increased. However, because the state and local tax deduction is limited to $10,000 the combined effective marginal tax rate for many upper middle and upper income taxpayers, especially those in high-tax states, will increase.
The standard deduction is nearly doubled but the personal and dependent exemptions are repealed. The child tax credit is doubled to $2,000 and up to $1,400 per child is refundable (paid even if no tax is due). Mortgage interest is deductible except that interest on acquisition indebtedness of over $750,000 is not. Only the first $10,000 of state and local taxes are generally deductible.
Estate and gift tax
The bill increases the size of estate exempt from the estate and gift tax from $5 million to $10 million. The $10 million amount is indexed for inflation occurring after 2011, so in 2018 it will be nearly $11 million. The exemption returns to $5 million (indexed from 2011) in 2026.
Because of lower marginal tax rates for businesses, expensing for equipment and international tax improvements, the legislation will improve the U.S. economy. Investment will increase, productivity will improve and the size of the economy can be expected to increase relative to baseline by about two percent over a period of five or six years. Accountants and tax lawyers can, however, rest easy. The tax reform bill in many cases increases complexity – especially for businesses.