Tax Reform, Explained — Well, Some of It
Lawmakers are talking about tax reform, tax cuts, and something called budget reconciliation. Here’s what it means and where we stand.
By Lillian Mills
It’s fall 2017, and lawmakers in Washington, D.C. are talking about tax reform, tax cuts, tax overhaul. By the time you read this, the details will probably be different (again). But understanding the constraints and processes shaping the debate will help.
Let’s start with the politics.
We’ve had tax reform before in 1986. What’s so hard this time?
Many readers might not even remember that we’ve had tax reform before. Well, we did, and it worked, but things were much different in the ’80s.
President Reagan won re-election in 1984 on a platform of tax reform. He carried 49 states, so he arrived with a mandate, which means he had broad public support. At the same time, most lawmakers were moderates, and both sides were willing to work together and with the president.
That’s not the case now. Today, the Senate is nearly evenly split (52 Republicans, 48 Democrats), and political parties are polarized. We don’t enjoy the cooperative political environment as we did back then. President Trump has, to date, shown little gift for bridging those divisions.
Now what is motivating the effort for reform?
President Trump’s main goal — and that of Republicans — is to decrease the corporate tax rate so it’s more competitive internationally. Why? Well, there is some evidence that high U.S. corporate tax rates contribute to jobs (and money) going overseas and companies leaving the U.S. — either by relocating their headquarters or by being takeover targets of foreign buyers. While it’s clear that U.S. statutory rates are nearly the highest in the world, it’s less clear that U.S. companies actually pay those rates after they enjoy various tax credits and other subsidies.
Lawmakers are also proposing that we make our international tax system more like those of our major trading partners. This is because, as it stands now, if a company operates in multiple countries, the U.S. eventually taxes that company on all of its profits, even if they weren’t generated here. Our trading partners don’t do that: They only tax income earned in their country. And many argue this is preferable because it doesn’t create an incentive to leave profits overseas.
So why don’t the Republicans just propose corporate tax reform?
There are two problems with this — both political.
First, it’s hard to convince voters that corporate tax cuts are good for ordinary Americans.
Suppose Exxon Mobil gets a tax cut. Maybe Exxon Mobil pays its workers more — that would mean more money in paychecks in the state of Texas. Maybe Exxon Mobil expands its operations, hiring more people and buying more equipment. Maybe Exxon Mobil uses the tax cut to drop its prices, making gasoline and oil products cheaper. Those choices have an obvious benefit to individuals. But Exxon Mobil could do something else, too: pay higher dividends to its shareholders.
It’s this latter choice that ordinary Americans are suspicious about — that corporate tax cuts benefit rich people who hold stocks.
However, it’s worth noting here that even if it is rich investors who receive those dividends, that money might wind up being spent on things like Longhorn T-shirts, pizza, haircuts, cars — you get the idea. And that spending helps the individuals and companies doing the selling. Also, many middle-class Americans hold stocks or mutual funds in their 401(k) accounts, so those dividends help them, too.
But those individual benefits aren’t quite so obvious or direct, and Republicans know this. The result is that Republicans do not want to go into the mid-term elections in 2018 with just a corporate tax cut as their only achievement.
Second, the corporate tax rate cut alone is a revenue loser, even with some of the revenue raisers from proposed international tax reforms. That is, it increases deficits substantially. Deficit tax reform under the normal Senate voting rules requires 60 votes out of 100 to pass. But remember: The Senate only has 52 Republicans, and Democrats would be even less happy about corporate-only reform. They won’t vote for it.
So can President Trump and the Republicans get 60 votes for anything?
I don’t know about anything, but probably not related to taxes.
So what can they do?
Another workaround in the Senate is called budget reconciliation. The main thing to know here is that unlike trying to pass major tax reform legislation, budget reconciliation requires only a simple majority — 51 votes. That’s feasible for Republicans.
Ok, what is it?
It’s part of how Congress passes a budget. First, both the House and Senate propose budget resolutions that set targets for spending and tax revenue. These resolutions are binding on both bodies but do not require a presidential signature. If that resolution passes — which it did on October 20 — Republicans get another chance to change tax policy.
In the resolution, Congress set a future tax revenue target that is $1.5 trillion lower than it is currently. In other words, $1.5 trillion in tax cuts. But that’s just a goal. How they make it happen is through a process called budget reconciliation. Here, committees propose policy changes, such as changes to existing tax laws, to hit those targets. These changes go up for debate and are likely to be contentious, but debates are limited to 20 hours, Democrats cannot filibuster, and Republicans only need that simple majority to win.
Budget reconciliation bills proceed through both houses and a joint conference committee to resolve disagreements. Then, both the House and Senate vote on the joint bill before it moves to the president for action. A reconciliation bill is only good through the next 10-year budget cycle, though, and must be revenue neutral, which is why this is considered a workaround to tax reform. It’s not ideal, but it’s Republicans’ best hope.
Revenue neutral? How is that possible if Congress just passed a budget resolution with a $1.5 trillion increase to the deficit?
It might seem mathematically impossible, but here’s a way to think about this with your own money.
If you have kids in college, you have probably (re)negotiated deficit budgets with them. Our freshmen start college with a tuition bill, a meal plan, and a dorm room, and we think the budget we set is sufficient. But then their needs and wants are higher. However, they may be unable to cover these new expenses, so many parents renegotiate the budget — sometimes with additional deficit spending, like more co-signed loans.
So, passing a budget with an additional deficit is like that. Congress agrees to go deeper into the hole, and to offset that, the U.S. will issue more bonds (bought by people, companies, and governments both here and abroad). That’s how an increase to the deficit becomes “neutral.”
Congress can now entertain a tax overhaul that doesn’t lose more than $1.5 trillion over 10 years, if they can get 51 votes.
So will Congress try to pass corporate tax reform after all?
Remember, that’s not popular enough all on its own, so they need to make it look like it’s good for ordinary Americans.
I’m hearing I’ll be better off. Is that right?
That’s the current sales pitch. Lawmakers are touting individual tax rate cuts, particularly for business income of partnerships and proprietorships, much larger standard deductions ($24,000 married filing jointly), higher child credits, a repeal of the Alternative Minimum Tax, and a repeal of the Estate Tax.
What’s the catch?
The catch is that Congress really doesn’t have enough money to do this. They can’t cut corporate and individual rates without raising more money (i.e., taxes) elsewhere in the system by making taxable income larger. That’s what we call “base broadening.” Basically, we tax more revenues (like taxing the interest income on bonds to build sports stadiums) or eliminate deductions.
What deductions might I be losing?
The House bill eliminates personal and dependent exemptions (currently set at $4,050 per qualifying person, or $16,200 for a family of four).
Many itemized deductions will also be eliminated under the proposed Tax Cuts and Jobs Act, including medical expenses, sales taxes, state and local income taxes, interest on home equity loans, and most miscellaneous deductions. The act retains the deduction for charity and for mortgage interest (but only on the first $500,000 of debt to buy a house), and a limited deduction for property taxes. (A note to Longhorn fans: The act eliminates the charitable deduction for the right to purchase tickets for athletic events.)
One effect of raising the standard deduction is that even fewer people will choose to itemize. Many of those who still do will receive a lesser benefit because the retained deductions will not exceed the higher standard deduction by as much.
I just heard about limits on retirement savings. What’s that about?
Remember that with budget reconciliations, we have to stay neutral — so if tax cuts make the deficit increase by more than $1.5 trillion, we have to offset that with money from someplace else. One possibility was to limit the deductible amount people can contribute to their 401(k)s each year. The money in your 401(k) is taxable, but not until you begin withdrawing funds. That means it increases money the government gets in the future, but that doesn’t help the budget now, when we need funds to offset a tax deficit. The idea was to cap what individuals sock away in their retirement accounts, which would mean more of your paycheck is taxable today.
Whether or not this was a good idea seems moot. It died in a President Trump tweet almost as soon as it arose and does not appear in H.R. 1.
So will I be better off or worse off?
It’s too soon to tell. Even if low-income and middle-income taxpayers see a tax decrease of a few hundred dollars, it is still politically challenging to pass tax changes where high-income taxpayers receive thousands or millions of dollars in benefits.
Do you think the Republican majority can pass a tax reform package, even with the advantageous majority-only reconciliation rules?
It will be difficult. The many interest groups that represent people losing deductions will lobby hard. The only hope is Republican unity presenting a cohesive argument for net benefits. President Trump will need to display patience and be less reactive, and that seems unlikely. If he responds to public pressure with tweets that take various base-broadening provisions off the table one by one, as he did with 401(k)s, the whole plan can’t stay inside the budget constraints. And if the initial proposal doesn’t gain traction this fall, the infighting will get worse as spring and summer approach the fall 2018 mid-term elections.
As part of a McCombs School of Business initiative, on October 6, 2018, Accounting Professor Lillian Mills and Law Professor Robert Peroni hosted Manal Corwin, J.D. and Stephen Blough, Ph.D., from KPMG’s Washington National Tax Office for a panel discussion on tax reform. The panel discussion preceded a dinner attended by local tax directors and faculty from UT’s McCombs School of Business, Department of Economics, School of Law, and the LBJ School of Public Affairs. This article primarily reflects Professor Mills’ views, but she appreciates and acknowledges the insights from these respected colleagues.
The panel and dinner followed the September 27, 2017 release of a tax reform framework by the Trump Administration, the House Committee on Ways and Means, and the Senate Committee on Finance. On November 2, 2017, the Ways and Means committee released and summarized H.R.1, the Tax Cuts and Jobs Act.
Originally published at www.texasenterprise.utexas.edu on November 3, 2017.
http://www.texasenterprise.utexas.edu/2017/11/03/debt/tax-reform-explainer
