Executive Summary
(Note: For an updated discussion of the final 2017 GOP Tax Plan, see Individual Tax Planning Under The Tax Cuts And Jobs Act Of 2017.)
With the Republican clean sweep of both the White House and both houses of Congress, momentum is building for 2017 to be a major year of tax reform, both for corporations, and for the individuals that financial advisors work with.
Accordingly, in today’s blog post, we delve in depth into both the likelihood of individual tax reform itself, and the details of the proposals from both President Trump, and the House Republicans. In fact, a deeper look reveals significant differences in both the style of tax reform between the President and House GOP proposals, as well as the deficits they imply – which itself could actually prove a stumbling block to getting legislation passed.
Nonetheless, both proposals would drastically simplify the tax brackets, from the current 7 tiers of tax rates, down to just three: 12%, 25%, and a top rate of 33% that kicks in at $225,000 (for married couples, or $112,500 for individuals). Both proposals would still keep preferential rates for capital gains and qualified dividends, although President Trump would retain the current 3 brackets (0%, 15%, and 20%), while the House GOP would simply make the rates 50% of the ordinary tax bracket (which means investment income would be taxed at 6%, 12.5%, and 16.5%).
However, when it comes to deductions, the proposals diverge substantially, with the House GOP suggesting the elimination of virtually all individual tax deductions except the mortgage and charitable deductions (paired with an expanded standard deduction), while President Trump would keep all the current itemized deduction rules, but cap itemized deductions (at $100,000 for individuals, or $200,000 for married couples) while also expanding the standard deduction even more (so only a moderate subset of people between the standard deduction and the cap would ever itemize at all).
Given all these differences, it remains to be seen whether individual tax reform will really happen in 2017, and whether key parts are compromised or delayed to accomplish corporate tax reform instead. In addition, despite now being the minority party in both the House and Senate, the Democrats still retain the ability to filibuster legislation, which will further limit the ability of Republicans to engage in permanent tax reform without compromising some concessions to Democrats. Or alternatively, the Republicans could ultimately pass individual tax reform as budget reconciliation legislation… which, under the Byrd rule, would have to sunset by December 31st of 2026, setting up a reprise of President Bush’s infamous sunset provision on his signature 2001 tax reform!
Individual Income Tax Reform – Are We “Due” In 2017?
The current individual income tax system originated with the 16th Amendment to the Constitution, adopted in 1913, granting the Federal government to levy a tax on income (to supplement the existing Federal revenue from tariffs and excise taxes). The initial income tax rate started at 1% on the first $20,000 (in 1913 dollars), and rose as high as 7% on incomes over $500,000. In today’s dollars, that would be 1% on the first $463,000, and the 7% bracket would kick in at $11.5M.
Over the first few decades, Congress simply amended the tax system by adjusting and assessing new taxes in a series of seventeen Internal Revenue Acts, but in 1939 the series of tax rules were codified into the first formal Internal Revenue Code of 1939, and 15 years later in 1954 it was updated in the first wide-sweeping tax reform – a process of cleaning up what had been a generation’s worth of complex tax layers.
The Internal Revenue Code of 1954 remained the primary framework of the income tax system, but became increasingly complex – a combination of high tax rates (with top rates as high as 91% in 1954), combined with a wide range of tax deductions and shelters (so expansive that many high-income individuals still paid little or no taxes, which in turn led to the creation of the Alternative Minimum Tax). By the 1980s, another generation’s worth of complexity spurred the desire for a fresh round of tax reform, with the Tax Reform Act of 1986 eliminating a wide swath of deductions in exchange for drastically simplifying and reducing the tax rates (and bringing the top tax bracket down to 28%).
In essence, the income tax code has a steady pattern of growing complexity that tends to spur a once-every-generation desire to reform and simplify the process again. In this context, it is not entirely surprising that Congress is again considering tax reform – as 2017 will be 31 years out from the Tax Reform Act of 1986, which in turn was 32 years out from the Internal Revenue Code of 1954! Ironically, it might have happened even sooner, if the advent of the computer and tools like TurboTax hadn’t made modern tax filing so much “easier” for individuals and their accountants!
Tax Reform Proposals From President Trump And The Republicans
While tax reform has been bandied around for several years, the clean sweep of the Republicans in the House and the Senate, combined with Donald Trump’s victory in the Presidential election, suggests a high likelihood that tax reform could actually pass in 2017. Accordingly, it’s worthwhile to look in detail at the current legislative proposals, to understand what might be coming next year.
Technically, although Republicans swept the White House and Congress, the individual income tax proposals from President Trump are not fully aligned with the current “Better Way for Tax Reform” proposal from House Republicans (via the House Ways and Means Committee). Though since his campaign speech in August at the Detroit Economic Club, President Trump’s tax reform proposals have converged closer to the House GOP version.
Proposed 2017 House GOP And Trump Tax Brackets
While President Trump’s original tax plan called for three tax brackets – 10%, 20%, and 25% – his current proposal would have a slightly different series of three brackets, with rates at 12%, 25%, and 33%. This is identical to the House GOP plan.
Notably, though, the House GOP plan is silent on where, exactly, the thresholds would come for each tax bracket, while President Trump’s tax brackets proposal would set the 12% bracket for married couples at the first $75,000 of income, the 25% from there up to $225,000, and the 33% bracket for all income over $225,000. (For individuals, the brackets would simply be 50% of these amounts.)
Notably, these thresholds are very similar to where the 2017 tax brackets are already projected, which include a 15% bracket up to $75,900, a 25% (and 28%) bracket that extends to $233,350, and then top rates (at 33%, and then rising to 35% and 39.6%) above that threshold. However, the shift would be somewhat more significant for individuals, where the end of the 15% bracket and beginning of the 25% bracket is already at $37,950 (similar to the $37,500 under President Trump’s proposal), but the 33% bracket currently doesn’t kick in until $191,650 today (whereas it would begin at $112,500 under the new system).
Proposed 2017 Capital Gains Rates (And Qualified Dividends)
Under President Trump’s proposal, the current 3-tier capital gains tax structure, with 0%, 15%, and 20% rates, would remain in place (and continue to apply to qualified dividends as well). The three capital gains rates would correspond directly to the 3 individual income tax brackets – thus, those paying 12% ordinary income rates would pay 0% capital gains, those in the 25% bracket would get the 15% capital gains rate, and those in the top 33% bracket would get the 20% rate. In addition, the 3.8% Medicare surtax on net investment income would be repealed.
By contrast, the House GOP proposal would simply allow all individuals to exclude 50% of their investment income – including both capital gains, qualified dividends, and even interest income – and then tax it at ordinary income rates. The fact that 50% of the income is excluded effectively means that all these types of investment income are taxed at half the ordinary income tax rates, which would mean capital gains (and qualified dividend, and interest) tax rates of 6%, 12.5%, and 16.5%. The House GOP proposal would also repeal the 3.8% Medicare surtax.
Notably, the House GOP version that treats bond interest as “investment income” eligible for preferential rates would be a significant tax savings on bond interest compared to today (and also to President Trump’s plan, which would continue to tax bond interest as ordinary income).
Proposed 2017 Standard Deduction, Personal Exemption, and Itemized Deduction Changes
When it comes to the treatment of deductions, President Trump’s proposals diverge even further from the House GOP.
The original proposal from President Trump would keep all itemized deductions, but enact a more aggressive version of the Pease limitation (phasing out many deductions at higher income levels). But perhaps given the reality that the Pease limitation is really just an income surtax, the current proposal shifts to simply capping itemized deductions at $200,000 (for married couples, or $100,000 for individuals). In addition, President Trump would consolidate the standard deduction and personal exemptions into a single, larger standard deduction of $15,000 for individuals, and $30,000 for married couples.
By contrast, the House GOP plan would keep the mortgage and charitable deductions (along with some incentives for retirement accounts and college savings), but eliminate virtually all other deductions altogether. In addition, the standard deduction and personal exemptions would again be combined into a larger standard deduction – in this case, $12,000 for individuals, $18,000 for individuals with a child, and $24,000 for married couples – which effectively means that those with a significant mortgage and /or a lot of charitable giving would itemize to claim those two deductions, but everyone else would just claim the standard deduction.
Notably, such limitations on deductions (under either proposal), combined with the lower tax brackets, would also render the Alternative Minimum Tax (AMT) a moot point, and thus the AMT would be repealed under both proposals.
Proposed New Above-The-Line Tax Deductions And Preferential Accounts For Families
In addition to President Trump’s proposed changes to the income tax brackets, capital gains, and the standard and itemized deductions, he has also proposed several new tax breaks that would apply specifically for families supporting dependents – either children or adult parents.
The first would be an above-the-line deduction for child care expenses, available for up to four children. The deduction would only be available for kids under age 13, and would be capped at the average cost of child care in the state for a child of that age. In addition, the deduction would apply for both third-party child care facilities, and the implied (average) cost of child care would still be deductible if care is provided by stay-at-home parents or (unpaid) relatives serving as caretakers.
This above-the-line deduction – effectively, an exclusion from income for a significant portion of child care expenses – would phase out at income levels above $250,000 for individuals, or $500,000 for married couples, but become available as a refundable credit for those with little or no income tax liability (through the Earned Income Tax Credit [EITC] system).
A similar above-the-line deduction would be available for “elder care” expenses for a dependent parent living in the home. The deduction for eldercare expenses would have a dollar cap of $5,000/year, though.
In addition, President Trump has also proposed a new Dependent Care Savings Account (DCSA). Similar to Health Savings Accounts, contributions would be tax-deductible (up to a $2,000/year limit from all sources), and growth would be tax-free (with no “use-it-or-lose-it” requirements). Ostensibly, tax-free growth could only be spent for related expenses, which would include expenditures to foster child development (e.g., after-school enrichment programs or even school tuition) or to support expenses for dependent parents (e.g., for in-home nursing or long-term care). To further encourage contributions, low-income households (eligible for the EITC) would be able to get an up-to-50% match (with a maximum of $1,000/year) by requesting to have their EITC credit directly deposited into the account.
Notably, these new tax deductions and credits, and tax-preferenced accounts, are unique to President Trump’s proposals, and are not included in the House GOP plan. In fact, the House GOP plan explicitly notes an intended goal to simplify (e.g., consolidate) the number of different types of retirement, college, and other tax-preferenced accounts, as opposed to creating new ones.
Assessing The Political Feasibility Of Income Tax Reform
Notwithstanding the fact that the Republicans control both the White House and both houses of Congress, it’s crucial to recognize that tax reform in 2017 is still not a “done deal” at all.
The first is that while both President Trump and the House GOP plan are represented as “tax reform”, in reality the President’s proposals do not really fit the classic tax reform mold of simplification. While the tax brackets themselves are simplified – from 7 brackets down to 3 – the proposal to keep special tax rates for long-term capital gains and qualified dividends, along with keeping the current complexity of itemized deductions (albeit with a cap), and the introduction of new above-the-line deductions (for child and dependent care) and new tax-preferenced accounts (with the DCSA), would ultimately maintain or even add to the complexity. By contrast, the House GOP tax reform aims to truly simplify the tax system, down to the point that many individual tax returns could effectively be filed on a postcard. In other words, it’s not clear that the House Republicans will acquiesce to pass President Trump’s version of “tax reform” over their own, and some compromise may be necessary.
In addition, it’s important to note that President Trump’s proposals are projected to create a substantial increase in the Federal deficit, even under “dynamic scoring” methods that consider the potential that positive economic growth (as a result of the tax cuts) could partially offset the economic impact. By contrast, the House Republicans have generally indicated a goal of keeping their tax reforms revenue neutral (at least on a dynamic scoring basis). Which means that even President Trump’s own Republican party may not be willing to vote in favor of his proposals as they currently stand, necessitating some further compromises. And of course, current reform proposals are looking at both corporate tax reform and individual tax reform, and it’s not clear whether some of the President’s individual tax proposals might have to be compromised to win corporate tax reform concessions.
And of course, there’s still the reality that while the Republicans do have a majority in both the Senate and House of Representatives, they do not have the infamous 60 votes required to avoid a filibuster, which means the Senate Democrats still have the potential to block substantive permanent tax reform. Which means the President and Congressional Republicans may still need to engage in further compromises to actually get legislation passed, whether on individual tax reform, corporate tax reform, or perhaps conceding their attempt to repeal the estate tax. Alternatively, the Republicans could aim to pass the legislation under the budget reconciliation rules, which can be accomplished with a simple majority vote. However, under the so-called “Byrd” rule for budget reconciliations, proposals that have a negative impact on revenue beyond 10 years must sunset at the end of that time period, which means if Republicans seek to accomplish tax reform this way, there’s a good chance that it will be scheduled to sunset on December 31st of 2026! (In point of fact, President Bush’s 2001 tax reform legislation also had a sunset provision at the end of 2010, for this exact same reason!)
The bottom line is simply to recognize that even with the Republicans holding the White House and both houses of Congress, and some similarities at a high level about how to reform the tax code (e.g., consolidating to three tax brackets), substantial disagreements still remain, both within the Republican party and between parties, that may need to be compromised. In addition, while the Democrats are now the House and Senate minority, they are not powerless in their ability to negotiate and try to extract at least some promises. Which means, ultimately, it remains to be seen whether tax reform can truly happen in 2017 or not!
So what do you think? Are we "due" for tax reform in 2017? Will President-Elect Trump and the House GOP be able to come to a compromise on reforms? Will Republicans be willing to further compromise in order to satisfy Democrats? Please share your thoughts in the comments below!
