This week, the White House announced a “dramatic” and “ambitious” tax code overhaul, including changes to both the individual tax and business tax structures. The plan only included broad policy overviews, and must still work its way through Congress (where House Republicans have spent significant time crafting their own detailed plan), so any final legislation could differ substantially from this week’s proposal.
Nonetheless, here are some of the changes to the individual income tax structure that the White House is proposing:
Consolidation of the marginal tax brackets from seven (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%) to three (10%, 25%, and 35%). However, without knowing the income ranges that will be subject to this new rate structure, it’s impossible to understand what effect this change will have on taxpayers’ bottom line.
Doubling of the standard deduction and elimination of most itemized deductions. Treasury Secretary Stephen Mnuchin announced that only the mortgage interest and charitable contribution deductions would remain; all others would be eliminated. Currently, deductions for mortgage interest and real estate taxes alone often surpass the standard deduction amount ($6,350 for single filers and $12,700 for joint filers in 2017). Conversely, for taxpayers without a mortgage, allowable deductions for medical expenses, state and local taxes, charitable contributions, and other miscellaneous items rarely exceed the standard deduction. But by doubling the standard deduction, and eliminating most itemized deductions, a substantial number of taxpayers (whether homeowners or not) will suddenly find themselves choosing the standard deduction. These changes won’t merely affect taxpayers’ net income, they will influence their future behavior.
- Homeownership would no longer deliver additional marginal benefits for most taxpayers relative to the standard deduction. Moreover, renters would realize a larger total reduction in taxable income than homeowners, relative to current law. The cumulative effect of these changes would significantly diminish the existing tax subsidy for owning a home.
- Many economists have argued the deduction for state and local taxes similarly subsidizes high-tax states relative to low-tax states, and incentivizes states to keep taxes high. If this were the only change to the tax code, it would have a greater (negative) impact on residents of high-tax states like California and New York, and a much smaller (but still negative) impact for those in low-tax states like Nevada and Tennessee. The average state/local tax deduction reported by Washington taxpayers is near the national median. Regardless, when combined with a substantial increase in the standard deduction, this impacts of this change will be irrelevant for most taxpayers.
Elimination of the Alternative Minimum Tax (AMT) and Net Investment Income Tax (NIIT). These changes will affect relatively few taxpayers — less than 3 percent of tax filers were subject to the AMT (nearly all of whom reported earnings of $200,000 or more), and even fewer owed any NIIT (an additional 3.8% tax levied on investment income of high-income taxpayers). Elimination of these taxes will result in substantial savings for those individuals currently subject to them. It will also save time and accounting expenses for several million taxpayers who are required to calculate potential AMT due, even if no AMT is ultimately owed.
Creation of 15 percent “pass-through” rate. One of the most startling components of the White House’s announcement was that so-called “pass-through” entities (S Corporations, partnerships, and LLCs) would be taxed at the same 15 percent rate as traditional C Corporations. Precisely how Congress and the IRS would implement this change has been a topic of robust speculation by tax practitioners, but in any form it represents a major shift in tax policy. Based on Secretary Mnuchin’s comments, it appears that S Corporation income recognized by an owner would be subject to a special 15 percent rate, analogous to the separate tax rate for long-term capital gains. The IRS will almost certainly continue to require that S Corporation owners be paid “reasonable compensation” (subject to ordinary income rates), but any excess income would receive preferential income tax treatment (not to mention escaping payroll taxes). It’s unclear whether partnership income would then receive the same preferential treatment as S Corporation income under the White House proposal. And regardless of whether this change affects S Corporations, partnerships, or both, Congress and the IRS will need to spend considerable time crafting anti-abuse provisions.
Check back next week for an examination of potential changes to the corporate tax structure.