In the Nation's Interest

Thoughts on President Trump’s Tax Principles

The following is a walk through President Trump’s newly released principles for his proposed changes to the tax law (available here).

1. This document has been widely described as principles for tax “reform.” However, tax “reform” and tax “cuts” are two different things. Traditionally, tax “reform” has denoted changes in the law that reduce unequal treatment of different taxpayers with different sources and uses of income, eliminate exceptions from the tax base, and use the revenue proceeds to reduce tax rates. The Trump Administration’s own heading on its principles reads, “The Biggest Individual and Corporate Tax Cut in American History,” and its description of its revenue-losing provisions is far deeper than that of its elimination of preferential tax provisions. By the traditional standards, and pending release of additional details, Administration’s proposal is more a tax cut than a tax reform.

2. The Administration’s stated goals (in the first section of the one-page document) – economic growth, job creation, simplification, relief for middle-income families, and lower business tax rates – are laudable and unexceptionable.

3. The first operative step in the document is “reducing the [seven] tax brackets to [three] brackets of 10%, 25% and 35%.” Arguably, the widely perceived benefits of reducing the number of tax brackets are much exaggerated. The simplification value is nil. Virtually no taxpayers actually consult the table of tax rate brackets to calculate their taxes. Taxpayers who use tax preparation software (or accountants) have the tax computation done by computer. Almost all of the very few taxpayers who still use paper make reference to the many lines of the “lookup tables” which were introduced precisely to save taxpayers the need to multiply, as is required in using the tax bracket schedules.

There is a very narrow argument for a reduced number of tax rate brackets, but the inclusion of a 10 percent bracket in the Trump principles almost certainly undermines that case. For individuals who have constantly and significantly fluctuating incomes – a distinct minority of the population – there can be economic and tax planning complexity introduced when incomes bounce from one tax bracket into another from year to year. So, for example, taxpayers might try to anticipate when their incomes would reach a higher tax rate bracket, and to make most of their charitable contributions in those years. That inducement to low-social-value tax planning was one reason why the Tax Reform Act of 1986 introduced a very large bottom 15 percent tax rate bracket (in fact increasing the lowest tax rate to achieve that) that was the only tax bracket for 75 percent of all taxpayers. Those taxpayers could ignore tax-timing issues because they would know that their tax rate almost certainly would be 15 percent year after year. The Trump proposal, however (as does the current law), apparently would split that bottom bracket into a 10 percent segment and a 25 percent segment, which will make tax timing relevant again for a larger number of taxpayers.

4. The Trump principles state that the plan will “double” the standard deduction. For 2016, the standard deduction for a non-aged, non-blind married couple was $12,600; so doubling that amount would make it $25,200 (plus subsequent inflation). There is some simplification value in increasing the standard deduction, but it should not be exaggerated. Most taxpayers who itemize (fewer than 30 percent of the total) claim deductions only for home mortgage interest, property taxes, and charitable contributions. The home mortgage interest and property tax deduction amounts are reported to the taxpayer by the mortgage lender, and are simply transferred from the lender’s report to the tax return. That is not a great deal of complexity. (Incidentally, the Administration’s principles hint that the deduction for property taxes – and all other state and local taxes – will be proposed for repeal. More below.) The taxpayer must keep records of charitable contributions; that might be seen as complex. But those many Americans who advocate a tax incentive for charitable giving cannot then complain that the consequent record keeping is an excessive burden. (An alternative system would have the federal government instead match all charitable contributions by all taxpayers at some uniform rate based on reporting by the charities, which would relieve the record-keeping burden for taxpayers.) Perhaps the greatest simplification argument for such an increase in the standard deduction would be that many taxpayers would recognize from January 1 that they almost certainly would not itemize for the coming year, and so they would not need to keep records at all.

The home-building and -lending industries have opposed the Trump plan. The substantial increase in the standard deduction, and the potential repeal of the property tax deduction, surely are why. Some numbers: The current conforming mortgage loan limit, which is a de facto limit for the size of virtually all mortgage loans, is $424,100. For the interest cost to reach $25,200 of interest paid (the size of the proposed standard deduction) for the first year only (in subsequent years the interest paid declines, of course), a mortgage loan at the full conforming limit would have to carry an interest rate of 6 percent – much above current market rates. This is not a definitive standard, of course, because some taxpayers might have high medical expenses, or give large amounts to charity. But almost certainly, the vast majority of homeowners would be claiming the standard deduction, negating the “tax break” argument that has forever been such an important selling point for homeownership in this country. Thus, the opposition of the home industry is by no means surprising, although home builders and sellers will have some difficulty convincing taxpayers that they should oppose what still will amount to a substantial tax cut.

Which raises one more point: If the read-between-the-lines interpretation of the President’s principles proves correct and the deductions for state and local taxes are repealed, the Administration will almost certainly claim a revenue gain for that step as paying for some of the generous tax-cut provisions of their plan. But don’t take that money to the bank (or to the bond market, for that matter): The revenue lost from the big increase in the standard deduction will swamp the amount gained by eliminating the state and local tax deduction. Claiming the latter as an indication of fiscal virtue would be a bit of a misdirection play.

And one further thought: Doubling the standard deduction would make many more taxpayers nontaxable (that is, reduce their tax liability to zero). Those who have expressed unhappiness at how many Americans owe no taxes, and the high percentage of total tax liability that is owed by the very highest earners, should not miss the connection.

5. The principles memo states a desire to provide “tax relief for families with child and dependent care expenses.” There is no further detail. But earlier indications from the Trump presidential campaign were that the relief would be delivered through a tax deduction or exclusion. Without significant caps or limits, such a policy would deliver large sums to upper-income families who have no problem obtaining quality child care, but would give very little help to lower-income families for whom the absence of adequate child care can be an insurmountable barrier to work.

6. The fact sheet proposes to “eliminate targeted tax breaks that mainly benefit the wealthiest taxpayers” and “special interests.” That is the most important ingredient of tax “reform.” But there is no more information on precisely which tax breaks are so referenced.

7. The principles document states the intention to “protect the home ownership and charitable gift deductions.” This is the source of the inference that the deduction for state and local taxes, not included in this item, might be proposed to be repealed. (It is perhaps also possible that the deduction for local property taxes is a “home ownership” deduction as referenced in this point.)

8. The principles would “[r]epeal the Alternative Minimum Tax.” From the perspective of simplification, this would be a significant step. In many instances, the alternative minimum tax (AMT) has more influence on the timing of tax liability than on its ultimate amount. Many tax experts would argue that several of the tax preferences included in the alternative minimum tax should be repealed for purposes of the ordinary income tax, and then the AMT itself should be repealed. If that is what is contemplated in this point and in point (6) above, it would be a favorable outcome.

9. The principles would “[r]epeal the death tax.” The estate tax (referred to by some critics as the “death tax”) is a progressive tax on the net value of estates in excess of $5.49 million (in 2017; double that, in effect, for married couples), whose rates on the excess over the exempt amounts range from 18 percent on the first dollars to 40 percent on the highest amounts. So in round numbers, a married couple pays no estate tax on their first $11 million of net wealth, and pays 18 percent on the first dollars over $11 million, rising to 40 percent on those dollars over $13 million. Thus, repeal of the estate tax is relevant only to persons with fairly considerable wealth; in 2013, according to the Federal Reserve’s Survey of Consumer Finances, the 90th percentile of family net worth was barely $4 million – less than half of the threshold before families would pay any estate tax at all. In 2015, the estate tax (and the associated gift tax) collected almost $20 billion, and so repeal would be of some consequence to the federal budget and the accumulated public debt. Some would argue that the estate tax is some remedy for what otherwise would be (or they might claim already is) an excessive concentration of wealth. Others believe that the estate tax is a significant deterrent to saving on the part of the very wealthy, and that when it is considered along with the income tax constitutes a double tax.

The estate tax is plainly a matter of enormous controversy, particularly among persons with highly valuable small businesses or farms that are not liquid and so do not readily provide the cash to pay an estate tax liability. For such instances, the law provides for payment of the estate tax liability to the Treasury over a period of years at modest interest rates. However, even that can leave horror stories, depending on two accidents of nature: among how many heirs the small business is to be divided, and whether the heirs wish to participate in the business. For a single heir who wishes to run the business, the payment over time provides a full remedy. (If all of any number of heirs have no interest in running the business, of course, they can simply sell it, and pay the tax out of the proceeds.) But serious problems can arise if there are (say) 10 heirs of whom only one wishes to run the business, and the other nine want their shares immediately and in cash. To retain the business, the interested heir would have to incur a liability equal to 90 percent of the value of the business (to divide among the other nine heirs, which liability would include their shares of the estate tax owed) plus his or her own estate tax liability. (This computation might be less daunting considering that the first $5.5 million or $11.0 million (single or married decedent(s)) is free of estate tax. The outcome might be worse, of course, given that all of the heirs might want to participate in the business, and they might not get along with one another.)

10. The principles propose to “repeal the 3.8% Obamacare tax that hits small businesses and investment income.” The Affordable Care Act is financed in part by a 3.8 percent tax on net investment income, including income from both privately owned firms and public corporations. (This tax to some degree mirrors the Medicare payroll tax, which unlike the Social Security payroll tax applies to all income from labor without limit at a 2.9 percent combined employer-employee rate.) Precisely how any observer reacts to this recommendation probably depends in some measure on the ultimate disposition of the Affordable Care Act. If the ACA is not repealed outright or at least significantly cut back, but this investment income tax is repealed, it might be unfair then to criticize the ACA for not being fully paid for and adding to the deficit and debt.

11. The principles document includes a proposal for a 15 percent business tax rate, applying to both public corporations and privately owned businesses. The Trump Administration has claimed that its tax proposal will recover the revenue lost directly and statically as a result of its tax rate reductions and other tax cuts because they will generate faster economic growth. Because the current corporate tax rate is 35 percent, and the current top-bracket individual income tax rate is 39.6 percent (and the proposal includes the large increase in the standard deduction and a reduction of individual income tax rates), recovering the first-round (or “static”) revenue loss at the much-lower 15 percent rates would require a massive increase in business taxable income, and an enormous increase in wage income to make up for these and the other proposed decreases in individual income tax rates. Such an increase of taxable income could arise either through a substantial increase of economic growth, or an equally substantial decrease in the use of various tax avoidance devices. An alternative means of financing would be a reduction of spending, although the Administration has made clear that 1) it will not decrease benefits under Medicare or Social Security, the two main cost drivers in the budget; 2) its proposed reductions in Medicaid spending will be used to finance its replacement for “Obamacare;” and 3) its proposed reductions in domestic appropriated spending will be transferred to defense appropriated spending.

The tax rate cut for unincorporated businesses may prove problematic for another reason. Very high-income taxpayers will be confronted with a 35 percent rate on their labor and portfolio income, but a 15 percent rate on their income from solely owned businesses (or “pass-through entities”). That 20 percent difference in tax rates is sure to motivate some of the sharpest minds in tax law practice to create personal-service contracts (to convert labor income into pass-through business income) and small investment companies (to convert portfolio income into pass-through business income). Success in such manipulation would reduce not only aggregate revenues, but also the tax liabilities of exclusively the highest-income individuals. The Trump team has issued its assurances that such manipulation will not be allowed, but has not indicated how it will be prevented. Many experts fear that the potential reward to such legal maneuvering would be so large that the pressure on tax enforcement will prove unbearable. Others believe that such manipulation can be policed and prevented with authorities under the current law and regulations. Given the amounts of income to which this reduced business rate will apply, and the substantial difference between the 35 percent ordinary income rate and the 15 percent business rate, this issue will be critical to prospects for fiscal sustainability and to perceptions of fairness in the income tax – including on the part of those upper-income individuals who would be required to pay the much higher ordinary rate relative to other taxpayers with the same net income.

12. The principles include a “[t]erritorial tax system to level the playing field for American companies.” CED has presented its views on the territorial alternative, available here, and in Sustaining Capitalism by Steve Odland and Joseph J. Minarik (see here).

13. The principles also propose a “one-time tax on trillions of dollars held overseas,” making reference to accumulated foreign profits of U.S. based corporations. Again, opinions are mixed. Some favor an opportunity for firms to repatriate foreign profits at a reduced rate as at least a partial concession toward the territorial systems of other nations, believing that dollars are being diverted from valuable domestic uses because of the tax that would be due upon repatriation. There are at least two grounds for concern, however. First, including the revenues from a one-time tax in a cumulative multi-year revenue estimate might mask an on-going revenue loss in a difficult budgetary environment. Second, U.S. firms that have invested in production facilities overseas so that they can be more competitive globally will be on a much less solid footing under such a mandatory repatriation tax than would other firms that are sitting on cash balances that have been invested in portfolio assets overseas. This distinction is rarely discussed in the context of a mandatory one-time tax on foreign balances.

14. The prospects of this statement of principles are less than bright. There are numerous complications. One is that in an apparent reaction to the negative outcome when the Administration signed on to the House Republican Obamacare repeal-and-replace proposal, the Administration in this instance put forward its own statement of principles without so much as notifying the congressional leadership. The absence of prior consultation and negotiation, when the House Republicans had their own far more thoroughly articulated proposal, does not bode well.

Second, the revenue implications of this statement of principles are troubling. The current document is obviously rather sketchy. The apparently identical ideas put forward by then-candidate Trump were estimated by nonpartisan nongovernmental groups to entail substantial revenue losses. The Tax Foundation estimated in its most favorable “static” estimate that the Trump proposal would lose $4.4 trillion over 10 years, and in its most favorable “dynamic” estimate that it would lose $2.6 trillion. The Tax Policy Center estimated a $6.1 trillion static revenue loss, and a $6.0 trillion dynamic revenue loss (and in fact concluded that beyond the first 10 years the proposal would actually slow economic growth because of the burden of its added public debt).

The Administration, as was noted earlier, has claimed that its tax cuts would pay for themselves through faster economic growth, though it has offered no supporting analyses. But even that might be an unsustainable outcome, given that the budget at current revenue levels is projected to face an ever-increasing ratio of debt to GDP, and the Administration has been quite open that it does not intend to address the existing cost drivers of Social Security and Medicare, and that it intends to increase annual defense appropriations by fully as much as it proposes to cut annual domestic appropriations. So even a “pays-for-itself” outcome would leave the current unsustainable budget outlook in place.

And that of course leaves open the question of the consequences if the Administration’s proposal is enacted, and the private budget estimates prove to be right, and the Administration’s claim proves to be wrong. Adding even more deficits and debt on top of the current projections of a debt burden that is already growing without limit would sooner or later prove intolerable.

The new Administration obviously cannot be held responsible for the federal government’s already excessive debt burden. Some would assign considerable responsibility to the preceding Obama Administration; some would instead emphasize the economic downturn and the pre-existing level of debt that the Obama Administration inherited. Whatever the opinion of any observer, there is no doubt that the tax proposals now on the table – their clearly substantial statically estimated revenue cost, and their implications for future economic growth – bear risks bordering on the existential.

In short, the tax debate will be crucial to the economy and the nation. If and when the legislative process over Obamacare ends and the debate over tax reform begins, we will have much to discuss and contemplate.