“Lower the rates, broaden the base.” This hallowed principle of tax reform couples tax relief via reduced income tax rates with base broadening by removing tax breaks and preferential tax treatments. Loophole closing produces the tax revenue that pays for lower income tax rates and makes tax reform revenue-neutral.
In theory, all this makes perfect sense. Everyone favors tax relief, fairness and simplification, right? If it’s that simple, why hasn’t Congress been able to do tax reform in 31 years?
“The reality of tax reform is it creates winners and losers, and if we don’t want to create any losers, we’re limited to tax cuts,” said Marc Goldwein, senior policy director at the Committee for a Responsible Federal Budget, in the Washington Post. The winners are the taxpayers who gain more from tax cuts than they lose when tax breaks are repealed. Losers’ tax cut gains are more than offset by the loss of their tax breaks – and they fight tax reform.
Losers can include realtors, home builders, state and local governments, colleges and universities, some charitable organizations and maybe even workers, all of whom benefit from long-standing tax preferences. It’s estimated that the Internal Revenue Code is riddled with 167 special tax breaks, and each benefits somebody.
The tax cuts recently proposed by President Trump and congressional Republicans (see part one in this series, Tax Reform 2017: Why it Matters to Employers) would cost the federal treasury about $5.8 trillion over 10 years. The plan would recoup about $3.6 trillion of this revenue by closing loopholes and repealing certain tax breaks, deductions, exclusions and credits.
Tax Breaks: What Employers Should Be Aware Of
This framework plan spares only two tax breaks from the axe – deductions for charitable contributions and for mortgage interest. While not specified in the framework since detailed legislation is the responsibility of congressional tax writing committees, employers must assume all tax breaks will be on the table.
Assuming the Trump Administration and congressional Republicans stick to Plan A, and therefore must raise $3.6 trillion in new revenue over 10 years to partially pay for a $5.8 trillion tax cut, the central question of Tax Reform 2017 is: which tax breaks will Congress target for extinction?
How Congress answers this question will determine whether a comprehensive package that makes giant cuts in rates in exchange for repealing favored tax breaks succeeds in 2017.
Let’s look at a few of the biggest tax breaks and how much each costs the U.S. Treasury in lost revenue. These may or may not be on the chopping block to pay for tax reform. Some of these can be found on the familiar Form 1040, Schedule A.
Exclusion from employees’ taxable income of the cost of premiums for employer-sponsored health insurance
An underpinning of employer-based health insurance, which covers some 157 million Americans (almost half the population), this “tax exclusion” will cost the government $2.9 trillion in lost income tax revenue over 10 years, according to the U.S. Treasury.
The provision also excludes employer-sponsored premiums from payroll taxes, bringing the total 10-year revenue loss to $4.7 trillion, by far the largest single revenue loser in the Internal Revenue Code. Critics of the exclusion argue that the value of employer-paid health insurance should be treated as taxable compensation, just like other benefits where the employer gets a tax deduction. Others claim it favors those who have access to employer-sponsored coverage and unfairly benefits taxpayers with the highest incomes and the most generous health plans.
Options for slicing this tax preference to help pay for tax rate cuts include capping the exclusion at a certain premium or actuarial value level, or retaining the ACA’s “Cadillac Tax.” While the exclusion is important for employer-sponsored health coverage, it may be difficult for Congress to raise $3.6 trillion in new tax revenue and leave this $2.9 trillion bucket completely untouched.
Deferral of taxes on employer and employee contributions to 401(k)-type plans, defined contribution and defined benefit retirement plans
This tax code provision allows employees to make pre-tax contributions to retirement accounts, and defer taxes on the returns on these savings, while subjecting withdrawals (distributions) to ordinary income taxes.
Including similarly favorable tax treatment for defined benefit pension plans, these incentives for retirement savings are the second-most expensive tax preference, costing the U.S. Treasury some $1.6 trillion between 2017 and 2026.
Here again critics claim that pre-tax retirement saving unfairly favors higher-income taxpayers who can afford to save more and are in higher income tax brackets; that the tax break is not targeted at those who most need to save for retirement.
Based on past tax reform proposals, Congress could consider a few options to pare back this tax incentive and generate tax revenue, including a phase-out of the deferral as earnings rise. Another idea that has been floated is called “Rothification,” i.e. requiring all future defined contribution plan contributions to be Roth-type, after-tax contributions, with tax-free distributions.
State and Local Taxes (SALT)
Present law allows taxpayers to deduct any income and real property taxes paid to state and local governments from their taxable income. This provision, in law in some form since 1862, favors higher-income households in high-tax states like New York, New Jersey and California.
SALT is one of the most expensive federal tax breaks, with property tax deductibility for owner-occupied homes costing Uncle Sam $486 billion over 10 years, and deductibility of non-business SALT taxes costing $783 billion.
The framework tax plan announced by President Trump and the Republican congressional leadership would repeal the federal tax deduction for state and local taxes to help pay for tax reform’s deep rate cuts for individuals and businesses.
Options short of repeal include allowing deductions for property taxes but not income taxes, or allowing deductions for mortgage interest or state and local taxes but not both.
Deduction from taxable income of interest paid on mortgages
Under present law, taxpayers may deduct mortgage interest costs associated with up to $1 million in mortgage debt.
While this tax break clearly favors higher-income households and home ownership over rental housing, and costs some $895 billion over 10 years, the framework plan would preserve the present-law tax deduction.
Other high-profile itemized deductions
In developing tax reform legislation this fall, congressional committees will also put the microscope on other big-ticket tax preferences, including:
- The deductibility of charitable contributions other than education and health ($633 billion cost over 10 years)
- The exclusion of interest on state and local bonds ($422 billion)
- The special tax rate on capital gains ($1.1 trillion)
- The tax treatment of qualified dividends ($343 billion)
Obviously, with a total of 167 tax preferences making the Internal Revenue Code look like Swiss cheese, Congress will take a very hard look at each one to raise $3.6 trillion over 10 years.
At the end of the day, however, Congress must think like the notorious 1950s bank robber Willie Sutton who, when asked why he robbed banks, answered, “Because that’s where the money is.” Congress will undoubtedly go where the money is when deciding how to pay for tax reform.
Standard Deduction Issue
One other key part of the Republicans’ framework plan has a direct bearing on itemized deductions: it would nearly double the present law “standard deduction” to $12,000 (now $6,350) for individuals and $24,000 (now $12,700) for families.
If approved, this move toward tax filing simplification could have a profound effect on taxpayers – increasing the percentage who do not itemize their deductions from 70% to 95%, according to Wall Street Journal tax analyst Richard Rubin.
Put another way, doubling the standard deduction could, in some ways, moot the question of which deductions go and which stay. Special tax breaks would matter only for 5% of taxpayers, which explains why some interest groups are likely to oppose doubling the standard deduction.
To be sure, lawmakers anticipate strong opposition from beneficiaries of present law tax breaks and loopholes. Employer and labor groups, for example, will fight attempts to abolish or cap the tax deduction for employer-paid health insurance or to “Rothify” 401(k) savings incentives.
And Blue State senators, representatives, governors and mayors, as well as realtors and homebuilders, likely will oppose efforts to scale back SALT deductions because it would expose their taxpayers to the full tax cost of high state and local tax burdens.
An idea to pay for tax cuts without picking winners and losers
When President Obama last considered tax reform, mainly to address exploding federal budget deficits, the White House proposed an alternative to repealing sacred cow tax breaks – a cap on total itemized deductions.
The Obama Administration proposed capping itemized deductions at the 28% tax bracket. In other words, taxpayers in the 33%, 35% and 39.6% brackets could still itemize their deductions, but the maximum benefit from any deduction would be 28%. A $1,000 charitable deduction, for example, could save a taxpayer in the 39.6% bracket only $280 in taxes, not $396. Likewise, $20,000 paid in state and local taxes could save the taxpayer $5,600, not $7,920.
While capping all itemized deductions would avoid the winners-losers battle, there is some question whether it would generate nearly enough money to pay for the tax cuts under consideration.
Implications for Tax Reform 2017
With a total tax cut of $5.8 trillion, the framework plan needs to identify at least $3.6 trillion in new revenue – and that assumes the plan allows cumulative federal deficits, and the U.S. public debt, to grow over 10 years by an astonishing $2.2 trillion.
Even if tax reform ignites economic growth beyond conventional forecasts, and closes the projected deficit gap completely, Congress will still need to repeal enough tax breaks to raise $3.6 trillion.
The central question of Tax Reform 2017, therefore, will be: which tax breaks will be targeted? How lawmakers answer this question will determine not only the tax burden of Americans for years to come but the trajectory of U.S. economic growth, jobs, innovation and competitiveness. Tax reform matters.
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 JOCWashDCView Collection