The tax reform proposal offered last week by President Trump and Republicans in Congress would be an improvement over the current system, but more so for corporate income taxes than for individual income taxes. It appears that the biggest advantage the proposal offers individual taxpayers is a simplified tax structure, whereas significant cuts are in the works for corporate taxes.
Individual Income Taxes The proposal reduces tax brackets from seven to three: 12%, 25%, and 35%. The degree to which this might represent a tax cut remains to be seen because the proposal does not say at what income levels those brackets would be effective. The standard deduction would almost double, meaning that those at the bottom end of the income distribution would surely enjoy a reduction in income taxes.
Listen to Exodus: The Great American Tax Inversion
The proposal would broaden the tax base by eliminating many deductions and credits. The home mortgage interest deduction and deduction for charitable contributions would be retained, but deductions for payments of state and local taxes are eliminated. This deduction favored taxpayers in high-tax states and effectively provides a subsidy to high-tax states financed by taxpayers in low-tax states.
Eliminating the deduction for state and local taxes would be a good move. There is little justification for having the federal tax code provides a tax advantage to support higher state and local expenditures. Eliminating the home mortgage interest deduction, which disproportionately favors higher-income taxpayers would also be reasonable, but retaining it shows the political orientation of the proposal. States with high state and local taxes mostly lean Democratic, which is not so true of those who benefit from the home mortgage interest deduction.
The proposal also eliminates the Alternative Minimum Tax, which was originally designed to target high-income taxpayers who took lots of deductions but has increasingly impacted middle-income taxpayers.
Corporate Income Taxes The corporate income tax rate would fall to 20% under the proposal and would transition to a territorial system in which American corporations are taxed on their domestic profits rather than on their global profits. A temporary low tax rate would be levied on cash held overseas that is brought back to the US, but the specifics of this element of the proposal were not given.
The proposal also allows expensing of business investments except for structures, which is advantageous to grow businesses. It provides a little financial advantage to stable (or shrinking) businesses, but would greatly simplify bookkeeping for assets that are now depreciated.
The lower tax rate and shift to a territorial system are the big advantages the proposal provides to business, which should improve the global competitiveness of American businesses.
Bottom Line The proposal gives an overview of tax reform, with many details left to come. The proposed reform would result in a fairer and more efficient tax structure and would have a bigger impact on corporate taxes than individual taxes. We can expect lots of political bickering over ways the proposal falls short, but the bottom line is that what is proposed would be an improvement over the current system.
By Randall Holcombe