It's tough to say whether there's one piece of legislation on Donald Trump's "to-do list" that takes precedence over all others, but tax reform could be the centerpiece legislation that defines his presidency.
Tax reform takes center stage
During his campaign, Trump pounded the table on individual and corporate tax reforms. On the individual side, he suggested that he'd like to see the number of income-tax brackets narrowed from seven to three and said individual income taxes should be simplified by slashing the number of credits and deductions. In lieu of fewer credits and deductions, Trump proposed doubling, or more than doubling, the standard deduction.
But the foundation of Trump's tax reform plan has always involved a major cut to corporate income-tax rates from their current peak levels of 35% -- one of the highest in the world -- to 15%. This 15% rate is what the president referred to as "ideal," but it was considered a major stretch by lawmakers. In fact, the initial details of Trump's tax plan released this past week suggest lawmakers may aim for a 20% corporate tax rate.
The reason corporate income-tax cuts are so crucial is that corporations play a critical role in boosting long-term economic growth. The hypothesis is that cutting corporate income-tax rates will allow businesses to reinvest in new technology, hire new employees, and pay higher wages. A more business-friendly tax system could also encourage domestic companies not to move production overseas, and it might even spur more foreign investment in the United States.
How would the Trump administration come up with $2 trillion?
Hypothetically speaking, in order for Trump to balance out a corporate income-tax cut to 15%, he'd need to find a way to come up with $2 trillion over the next 10 years. That's the amount such a tax cut would reduce federal revenue over the following 10 years, according to the Tax Foundation.
The reason Republicans need to make up this lost revenue is because they probably have no chance of passing tax reforms with a 60% majority in the Senate. Thus budget reconciliation, which only requires a majority vote, is the likeliest way to pass a tax-reform bill. Under reconciliation, the bill will have to be revenue-neutral. In short, the GOP would need to find a way to come up with, or save, $2 trillion over the next 10 years.
If we break things down into their most basic components, the Trump administration could do two things: make serious cuts in order to reduce spending or raise additional revenue via higher tax rates in certain situations. Chances are we'd see a combination of the two.
Two cuts that could lead to big savings
What might be cut? To begin with, Trump's budget proposal showed a marked decline in funding for a number of federal agencies, including the Environmental Protection Agency and the State Department, to name a few. But budget cuts to these agencies are peanuts when we're talking about an estimated $2 trillion revenue reduction.
Further, healthcare reform is off the table for this year. Republicans and Trump had been counting on some $100 billion to $300 billion in 10-year savings from the repeal and replacement of the Affordable Care Act, but they're not going to get it -- at least not this year.
The entities that would likely pay the most to achieve that 15% corporate tax rate are the corporations themselves and homeowners.
First, the Trump administration could remove the subsidy corporations receive in the form of interest being treated as a deductible expense. According to the Tax Policy Center, eliminating the deductibility of interest on corporate debt could save the federal government about $700 billion over the next 10 years. That would pay for roughly 35% of the corporate tax cut right there, and it may even receive bipartisan support.
The second idea that's been floated around Capitol Hill is reducing the mortgage interest deduction. Currently, homeowners can write off interest expenses on up to $1 million in mortgage debt. As reported by The Los Angeles Times, rumor had it that lawmakers have considered halving the deductibility amount to $500,000. Doing so would affect 0.8% of all tax filers in the U.S., resulting in an average tax increase of $3,100 for that group. Just to be clear, the Trump tax plan released this past week left the mortgage interest deduction alone, but it's always possible that future iterations of tax reform could seek changes.
Tax hikes could also generate added income
In addition to cutting expenditures, the Trump administration could look to boost tax rates in certain situations in order to increase revenue for the federal government over the next decade. Working Americans and investors could be among those who are in line for tax hikes.
According to a report from Politico, some lawmakers in Washington have considered an adjustment to how employer-sponsored 401(k)s are taxed. 401(ks) are tax-deferred retirement plans that are funded by pre-tax dollars, meaning workers only pay tax when they begin making withdrawals during retirement. It also means contributions can reduce current-year liability for some workers. Around 55 million workers had more than $5 trillion invested in 401(k)s as of March 2017.
The rumor had been that the GOP was considering taxing 401(k) contributions up front instead of when workers begin taking withdrawals during retirement. Doing so would generate extra cash for the federal government now and potentially leave them shorthanded many years down the road. According to the details of this past week's tax plan, the tax treatment of 401(k)s wouldn't change, but the idea may still be on the table.
The other possibility is that Republicans could consider lifting the tax rates on capital gains and dividend income, which might also find bipartisan support. Currently, long-term capital gains tax rates for the wealthiest Americans (20%) are nearly half of their peak ordinary income tax rate (39.6%). You see, the wealthy are the most likely to benefit by owning stocks and receiving dividend income, so increasing the taxes on capital gains or dividend income -- perhaps to the ordinary income-tax rate -- would be more likely to require the wealthy to pay more than lower- or middle-income Americans.
It's worth remembering that this is merely a hypothetical look at what could happen with tax reform if the "ideal" corporate tax rate were targeted, and we're likely to see changes to Trump's outlined tax plan in the weeks and months to come. Therefore it's important to keep your eyes open and ears to the ground to understand best how tax reforms could impact you.
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