The upcoming change in administration, combined with retained Republican control of both houses of Congress, is expected to result in significant changes in the federal income tax system, on both the domestic and international tax fronts. During the campaign, President-elect Donald Trump outlined several tax proposals, while House Republicans released a tax overhaul plan as well. Since the election, Republican congressional leaders have indicated that they intend to make tax reform a priority in 2017. While the details of the proposals are sketchy, the summary below reflects the basic contours of the Trump and House Republican proposals.
Both the Trump and the House Republican proposals espouse adherence to revenue neutrality – i.e., that the changes would not increase or decrease net revenues to the fisc. Whether this is achievable depends in large part on the tax rates adopted and the extent to which popular deductions can be eliminated. Even when using dynamic scoring, according to economists at one libertarian think tank, the cost of the Trump proposals would exceed $2.5 trillion over 10 years while the House Republican proposals would cost approximately $200 billion over such period (others estimate the latter cost as closer to $1 trillion).
Domestic Changes – Individuals
The federal income tax rate for individuals is currently split into seven tiers. The highest marginal rate is 39.6%, which for a married couple filing a joint return applies to taxable income in excess of $466,950. The Trump proposal would collapse the rate structure into three tiers – 12%, 25% and 33%. Taxable income over $225,000 for a married couple filing a joint return would be taxed at the 33% rate, which for a married couple filing a joint return currently applies once taxable income exceeds $231,450. The rate changes may be accompanied by a cap of $100,000 on itemized deductions and possibly the elimination of many such deductions, including the deduction for state and local taxes, but excluding the deductions for home mortgage interest and charitable contributions. The House Republican proposal would also cut the capital gains rate, currently a maximum of 20%, to half of the taxpayer's marginal tax rate, i.e., 16.5% at the highest bracket.
The Trump proposal would also repeal the net investment income tax, as well as the estate and alternative minimum taxes. The net investment income tax is a 3.8% surtax on investment income over certain thresholds ($250,000 for a married couple filing jointly), as well as a 0.9% surcharge on employment taxes for income over the same thresholds, that was enacted as part of the Affordable Care Act.
The extent to which these changes would result in a tax cut or hike for any particular taxpayer will depend on the taxpayer's income and the amount of the taxpayer's expenses that become nondeductible. For example, assuming the deduction for state and local income taxes is disallowed (and putting aside the possible disallowance of other deductions), a married couple filing jointly living in New York City with ordinary income of $1 million and capital gains of $100,000 would enjoy a tax cut of approximately $16,000, while if the taxable income of such couple was a quarter of such amount, their tax liability would go down only by approximately $600.
The Trump proposal also provides for a reduced tax rate of 15% on business income of noncorporate taxpayers, which would correspond to the proposed reduced corporate rate described below. The scope of this proposal is not clear. For example, it seems unlikely that income from the performance of personal services would be eligible for the reduced rate. Similarly, owners of nonpersonal service businesses presumably would be required to pay tax at ordinary rates on the portion of business profits that reflect reasonable compensation for their services.
In contrast to reducing the rate on noncorporate business income, the Trump proposal also calls for taxing income from "carried interests" at ordinary rates. While similar proposals have been made for many years by members of Congress and the Obama administration, the prospects of Congress enacting a carried interest provision may be significantly greater in 2017 than in the past.
Domestic Changes – Corporations
The Trump proposal would reduce the corporate income tax rate from 35% to 15% and allow the immediate expensing of the cost of equipment, in lieu of depreciating such costs over time. While no specifics have been provided, the Trump proposal would also eliminate most corporate deductions, other than the R&D credit. The House Republican plan similarly would reduce corporate rates, but only to 20%, and would provide more expansive expensing rules (not just limited to equipment).
If all of Trump's proposed changes described above are enacted, they generally would not alter the calculus in determining whether to operate a new business through a C corporation or a pass-through entity. The relative differences in marginal individual and corporate rates would not dramatically change for business income. However, if the reduced rate on noncorporate business income is not enacted, but the other rate reductions become law, C corporations may become more attractive to some taxpayers who plan to reinvest earnings for an extended period. The lower current rate may outweigh the double level of tax inherent in the C corporation model.
International Changes
Unlike many countries, the U.S. taxes all income of U.S. persons, including domestic corporations, regardless of whether earned domestically or abroad. In order to avoid double taxation of the same income, the U.S. provides a credit for taxes paid to other countries. In addition, the U.S. permits the deferral of most operating income earned by foreign subsidiaries of U.S. persons until repatriated. In contrast, many major industrial countries employ a territorial system, in which their resident taxpayers are taxed only on income earned domestically.
The current U.S. system favors both investing abroad and retaining those earnings abroad for as long as possible. In order to reduce the latter incentive, the Trump proposal would tax repatriated cash at a reduced 10% rate and would tax the repatriation of noncash items at a 4% rate. The proposed repatriation rates under the House Republican plan would be 8.75% for liquid assets and 3.5% for other assets. (In 2004, Congress permitted corporations to repatriate income deferred and held abroad at reduced rates, but only for a limited period of time.) Such proposals may decrease, though likely not eliminate, the incentive to keep earnings abroad. However, they would not eliminate the incentive for domestic companies from operating abroad. On the contrary, a permanent lower tax on foreign earnings likely would have the opposite effect. Perhaps to counter this, the Trump proposal also calls for the adoption of an increased tax or tariff on imports and a deduction for exports. It is not clear whether such proposals would withstand challenge as impermissible subsidies, just as the former foreign sales corporation (and similar) rules were invalidated by the World Trade Organization.
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