Tax Reform’s Long Road
In our July tax reform update, we advised that the scope and timing of tax reform would be clearer once we knew what happened on healthcare. Following the Senate’s failure to pass a healthcare repeal and replace bill prior to the August recess, and looking at a brief September calendar that includes just 12 days to increase the debt limit and pass legislation to keep the government open after the end of the current fiscal year, the chances of accomplishing comprehensive tax reform this fall are challenging. Yet, even though it took more than two years as well as a bipartisan commitment to overhaul the tax code 31 years ago – the last significant tax reform occurred under President Reagan’s tenure in 1986 – Republicans on both sides of Capitol Hill are eager to move on from healthcare and officially launch their tax reform effort. Furthermore, the White House released a one-page tax plan this spring that outlined tax cut goals and President Trump has indicated that he wants to sign a tax reform bill in the fall. If congressional Republicans hope to record a win on tax reform, they will need to do it soon, as it will only become more difficult the deeper it goes into the election year. And to do so, they’ll need to paint the picture that tax reform benefits not just Wall Street, but Main Street as well.
There appear to be three possible paths toward that win. First, Senate Majority Leader Mitch McConnell (R-KY) reaffirmed just before the recess congressional Republicans’ intention to use reconciliation to pass tax reform, relying on Republican votes only. Earlier that week, 45 of the 48 Senate Democrats, all but Senators Heidi Heitkamp (D-ND), Joe Donnelly (D-IN), and Joe Manchin (D-WV), sent a letter calling on Senator McConnell, Senate Finance Committee Chair Orrin Hatch (R-UT), and President Trump to conduct a bipartisan tax debate under regular order, provide relief to the middle class without including tax cuts for the wealthy, and not increase the deficit.
If congressional Republicans were successful in using reconciliation to pass tax reform, what would it look like? Senate Finance Committee staff are examining historical tax proposals for ideas on how to proceed with overhauling the tax code. Senator Hatch has expressed his belief that Congress needs to be flexible about their policy priorities in order to accomplish comprehensive tax reform. He is particularly interested in whether it is feasible for the United States to transition from a global tax system, where corporations based in the U.S. pay income tax on all income, regardless of where it is earned, to a territorial system, where only domestic income is taxed by the U.S. Senator Hatch is also focused on a plan that would eliminate tax on the dividends companies pay by allowing deductions for the distributions. Given Senator McConnell’s leadership, it is unlikely that any tax reform effort includes significant modifications to energy taxes, though there may be some extensions of energy credits not included in the 2015 wind PTC and solar ITC agreements.
While the initial House Republican blueprint called for a border adjustment tax (BAT), which Speaker of the House Paul Ryan (R-WI) and Ways and Means Chair Kevin Brady (R-TX) highly favored, significant Senate opposition to the BAT has eliminated this approach for the time being. Marking the 31st anniversary of the last tax reform legislation’s passage, Chairman Brady delivered a speech August 16 underscoring his intent to achieve tax reform before the end of the year. Though no language is finalized, the committee intends to craft legislation that lowers taxes at every income level; eliminates special interest loopholes; separates wage income from small business income for the first time; repeals the Alternative Minimum Tax (AMT); delivers the lowest tax rates in modern history; increases the standard deduction; ends the estate tax; and cuts in half tax rates on personal savings and investments.
Particularly given the changing nature of our economy, that companies sell more ideas and IP now than products, some members of Congress believe that the United States will ultimately need to transition to some form of a value added tax (VAT). As the rate of economic change continues to rise, we may also need to reform the tax code more often.
The longer the debate goes on, with specifics of a plan remaining elusive in part due to a lack of agreement within the Republican caucus, the more it appears that Senate Republicans will not have the 50 votes necessary to pass permanent comprehensive tax reform under reconciliation. Without consensus in the party, congressional Republicans will have two remaining options to secure their win on tax reform. They could leave comprehensive tax reform to another day, using reconciliation to settle for a package of temporary tax cuts, a reduced tax rate, and some business tax modifications. Or, they could try to bring their Democratic colleagues on board. Though the possibility of a bipartisan effort on an issue as complex as comprehensive tax reform in a narrow window of time in the midst of the current political tumult is a risky, perhaps unlikely, move, we believe that tying tax reform to an infrastructure package could be the Hail Mary pass that wins the game. By bringing Democrats on board with well-funded infrastructure legislation, congressional Republicans could avoid the limitations of passing a bill through reconciliation.
With a packed schedule ahead of us in September, we’re still weeks, if not months, away from having a clear picture on tax reform. When Congress returns, they will first have to tackle the FY18 budget resolution, FY18 appropriations, and the debt ceiling, at a minimum, while also deciding how to proceed with a host of expiring provisions and the ongoing debate to modify the Affordable Care Act (ACA). Yet, following Congress’ latest failed attempt at healthcare reform, and fueled by an increasing desire to move past the recent Administration controversies, congressional Republicans are desperate for a win, and they may pivot quickly to tax reform when they return from the August recess. If they’re going to be successful, they’ll need to portray tax reform as not just something that benefits Wall Street and the wealthy, but also Main Street and the middle class. To that end, significant progress has been made behind the scenes in both the House Ways and Means Committee and the Senate Finance Committee. Of course, members still have to reach a consensus on the contents of a tax package, but the best chance they may have to secure victory is to pass a bill in each chamber and conference it in early 2018, before it gets to be too deep into the election year.
Tax Reform Scorecard: Where Parties Stand on the Major Issues
Temporary cuts vs. Permanent reform: Senator McConnell indicated this month that there is “some internal debate” over passing temporary tax cuts instead of permanent changes. Treasury Secretary Mnuchin prefers permanent to temporary, but temporary over no changes to tax policy. House leadership prefers permanent reform, but the need for some win on taxes could propel a temporary cut to win out.
Corporate tax rate: Currently at 35 percent, likely to be reduced to somewhere between 22-28 percent. Most people involved in the process believe that it cannot realistically go below 20 percent without some new tax in place. President Trump favors a 15 percent rate. The Senate Finance Committee is encouraging Chairman Orrin Hatch to reduce effective corporate tax rate by adopting a corporate integration approach: shifting part of their burden to shareholders. Ways and Means Committee Chairman Kevin Brady released a plan last year with a 20 percent rate. The House Freedom Caucus prefers a corporate tax rate of 16 percent, and would have difficulty supporting a rate beyond 19 or 20 percent.
Repatriation: The Big 6 (National Economic Council Director Gary Cohn, Treasury Secretary Mnuchin, Senator McConnell, House Speaker Paul Ryan, Senate Finance Chairman Hatch, and House Ways and Means Chairman Kevin Brady) has agreed that any tax proposal will require American companies to return overseas earnings at a one-time reduced tax rate, likely somewhere between 22 and 25 percent.
Border Adjustment Tax: Off the table.
Foreign Minimum Tax: The Big 6 have agreed to impose a foreign minimum tax to fund tax revenue in lieu of border adjustment.
60 votes, revenue neutral, not favoring the wealthy: Senator Schumer and 45 of 48 Senate Democrats outlined their priorities in a letter earlier this month. Senator McConnell said earlier this month that Congress is likely to pass a revenue-neutral bill. In order to use reconciliation, a tax measure would currently have to skip adding to the deficit over a 10-year period. The Administration is not concerned about adding to the deficit, though the House especially may be opposed to it.
Home-mortgage deductions: Senator McConnell thinks that nearly all other all tax incentives, should be considered under tax reform, though the Big 6 has identified capping mortgage interest deductions as one of the best ways to pay for individual and corporate tax rates.
Interest Deductibility: The Big 6 has identified eliminating businesses’ ability to deduct interest as one of the best ways to pay for individual and corporate tax rates.
Expensing: The Big 6 has identified phasing out full expensing, which allows businesses to deduct capital investments like the cost of new equipment or facilities, as one of the best ways to pay for individual and corporate tax rates.
Limited carried interest: Treasury Secretary Mnuchin has hinted that the Administration may retain the tax breaks for firms that create jobs but eliminate them for hedge fund managers, though others in the administration have said that a decision has not been made.
Standard deduction: The Administration’s March plan called for a 15 percent corporate tax rate, doubling the individual standard deduction, and collapsing the number of tax brackets to three, with the highest rate at 35 percent.
Charitable giving: Senator McConnell thinks that nearly all other all tax incentives, should be considered under tax reform. This one is safe.
State and Local Taxes: Eliminating the deduction, which disproportionately impacts states like California, Massachusetts, New Jersey, and New York, provides a significant revenue raiser that is under consideration.
Municipal Bonds: President Trump has indicated his support for protecting them, and though there could always be some tinkering, municipal bonds appear safe. Furthermore, among the Administration’s proposals includes phasing out the AMT, which could significantly benefit the $140 billion of outstanding municipal bonds covered by that tax.
401(k): An idea from the Camp tax plan, up-front taxing is being discussed, as it would raise billions in the short term, but budget hawks, the financial service industry, and nonprofits that encourage Americans to save for retirement oppose the policy.