October 20, 2017

Tax Reform 2017: Why It Matters to Employers

Jim O'Connell

With more than 30 years of experience in federal legislative and regulatory affairs, Jim O’Connell focuses on HR and PAYROLL POLICY ISSUES, keeping customers informed about fast-changing and complex compliance regulations and workforce trends. Follow him on Twitter JOCWashDC

On September 27, a group of six Republican leaders from the U.S. Senate, House of Representatives and the White House announced a new tax reform framework.

Congress last accomplished comprehensive tax reform 31 years ago under President Ronald Reagan, which is testament not only to the substantive and political difficulty of reforming the tax code but to the reality that updating America’s tax law is long overdue. Creating a 21st Century tax code that would be simpler, fairer and more supportive of economic growth and innovation has long been a goal of Democrats and Republicans.

This blog is the first in a series about the new framework, covering why it matters for employers, and its main pillars. Subsequent blogs will explain the controversy over repealing long-standing tax breaks to pay for rate cuts, as well as the process expected to unfold as Congress works to enact tax reform this year.

Why does tax reform matter to employers?

Employers small, medium and large are paying close attention to what happens on Capitol Hill with regards to tax reform for two main reasons: One, unlike the effort to repeal the Affordable Care Act, today’s Internal Revenue Code has few defenders. Tax reform in principle is something everyone can support and for Republicans and President Trump in particular is “must-do” legislation. Insiders believe tax reform will happen in 2017 and take effect in 2018.

Two, tax reform has the potential to upend the present law tax treatment of employee health and retirement benefits in the competitive scramble to keep tax reform “revenue neutral.” Historically, tax reform has involved simple arithmetic: losses in federal tax revenue from cuts in individual and corporate taxes are “paid for” or “offset,” dollar-for-dollar, by new tax revenue from eliminating or curtailing preferences, incentives, credits and loopholes, called “broadening the revenue base.” Total U.S. Treasury revenue stays more or less the same over time, but the burden is redistributed – so tax reform is “revenue neutral.”

Employers are rightly concerned that a push for revenue neutral tax reform, particularly with a very large middle class tax cut, will inevitably produce winners and losers among tax code preferences, and that one of the losers could be employer-sponsored health and retirement benefits.

Tax reform 2017 rests on several key pillars

The big picture: the nonpartisan Committee for a Responsible Federal Budget (CRFB) estimates that the tax cuts in the group of six framework plan would cost the federal government about $5.8 trillion (a trillion is a thousand billion!) over 10 years through 2027.

Tax cuts would be partially “offset” by revenue increases of $3.6 trillion, attributed to cutting back various present law tax benefits, credits and preferences. The plan would therefore result in a net tax cut of $2.2 trillion over 10 years, as annual federal budget deficits rise potentially by some $200 billion a year.

Tax reform’s key pillars:

  • Consolidate and reduce individual income tax rates from today’s seven brackets (10%, 15%, 25%, 28%, 33%, 35% and 39.6%) to three brackets – 12%, 25% and 35%, leaving open the possibility of a higher top rate. Congressional committees with jurisdiction over tax law will specify in forthcoming legislation the income ranges that will fall into each of these brackets and, indeed, whether to add a fourth, higher, bracket.
  • Nearly double the standard deduction to $12,000 (now $6,350) for individuals and $24,000 (now $12,700) for families. It’s been estimated that some 80% of taxpayers who presently itemize deductions would take the standard deduction if it were doubled. And doubling the standard deduction creates a “zero tax bracket” by eliminating taxes on the first $24,000 of income earned by a couple.
  • Establish a new $500 non-child dependent tax credit and significantly increase the existing child credit. Some senators have called for doubling the existing $1,000 per child tax credit.
  • Repeal the personal and dependent exemptions (now $4,050 per person) and similar deductions in light of the higher standard deduction and other credits.
  • Eliminate the Alternative Minimum Tax (AMT) for both individuals and corporations.
  • Repeal most itemized deductions, leaving only those for mortgage interest and charitable giving. The Framework is not specific on exactly which itemized deductions, also known as tax preferences, would face the chopping block.

The battle over eliminating certain sacrosanct tax preferences is expected to be fierce and could easily derail the entire project. For example, the Framework implies that the present law deduction for state and local income and property taxes will be thrown under the bus, resulting in some taxpayers in states like NY, NJ, CA and CT facing higher taxes.

  • Repeal the federal estate tax completely.
  • Reduce the corporate tax rate from the present law of 35% to 20%. The idea here is to stimulate new investments in plants, equipment and technology, and thus spur innovation and competitiveness. The U.S. currently has the highest statutory corporate tax rate in the industrialized world, according to the OECD.
  • Enact “full expensing” of business investments in depreciable assets other than structures for a period of at least five years, again to encourage new capital investments in equipment and technology.
  • Move to a “territorial” system for overseas earnings as opposed to the current “worldwide” system. The authors of the framework document believe that the current system, which subjects both the domestic and some foreign income of U.S. firms to federal income taxation, encourages U.S. headquartered global companies to outsource operations and jobs, as well as to “park” billions of dollars abroad to defer U.S. taxes.
  • Create a new 25 percent tax rate for “pass-through” businesses like sole proprietorships that currently pay taxes based on the individual tax rate of the owners. Such “pass-throughs” account for the vast majority of businesses in the U.S.

Goals for tax reform 2017

The group of six White House and congressional leaders believe that if the framework tax reform plan is ultimately signed into law this year it will achieve five major goals:

  • Tax relief for middle class families.
  • The simplicity of “postcard” tax filing for the vast majority of Americans.
  • Tax relief for businesses, especially small business.
  • Ending incentives to ship jobs, capital and tax revenue overseas.
  • Broadening the tax base and providing greater fairness for all Americans by closing special interest tax breaks and loopholes.

While Republicans and most Democrats agree on the broad goals of tax reform, employers can expect partisan warfare on Capitol Hill over specifics, especially efforts to pay for mammoth tax cuts by eliminating or paring back favored tax preferences like the state and local tax deduction.

The present law tax exclusion for employer-sponsored health benefits, as well as the tax deduction for contributions to defined benefit and defined contribution retirement plans, could very well get caught in the crossfire.

The next installment of this series will explore the most contentious issues in tax reform 2017 and explain why health and retirement benefits may be vulnerable.

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