Now that’s what I call tax reform
Canadians will have to wait and see whether the Republicans’ tax- reform plan for the U. S. succeeds, but certainly the big push is happening with breathtaking speed. The House of Representatives passed its bill on November 16th. The Senate’s finance committee recommended a bill to the Senate on the same day. From what I hear, the idea is for the Senate to pass legislation by December 1st. Both congressional bodies would then pass a bill after their reconciliation conference in December, perhaps before Alabama holds its Senate election on December 12th, where the Democrats are favoured to take away a Republican seat.
It’s now very possible that the U.S. will accomplish a better tax structure that reduces distortions, minimizes complexity and is fair. Since tax reform is political, the plan is inevitably a mixed bag, but overall, the reform would be a major success.
On the plus side, both the House and Senate bills differ little in creating a more competitive and neutral business tax system. Both reduce the federal corporate rate to 20 per cent ( only the start date differs, with the Senate implementing it a year later, in 2019) and reduce taxes in a less straightforward way for other businesses. Both introduce a new limitation on interest deduction that will discourage excessive corporate leverage. Both will expense rather than depreciate machinery investments for five years (which favours one type of investment over another, contrary to the goal of minimizing distortions). As a major reform, both will enable U. S. companies to repatriate dividends from foreign affiliates without paying U. S. tax, a system used by all advanced countries including Canada today.
As shown in the nearby chart, the U.S. combined federal-state tax on new investment will plummet by almost half with the new House and Senate corporate- tax provisions. In the ranking of 34 OECD countries, the U. S. would fall from the thirdhighest to the 14th- highest rate, better than 12th- place Canada. Still, both Canada and the U.S. would have higher rates than the simple average OECD effective tax rate on new investment of 17.3 per cent.
On the personal tax side, the House and Senate bills differ more, albeit with the same goal of reducing taxes on all taxpayers. Personal tax rates are reduced for lower- and middle- income taxpayers. The House bill includes four brackets with the same top rate as today of 39.6 per cent ( it kicks in at income of US$1 million and US$500,000 for joint and individual filers respectively). The Senate has seven brackets with lower rates for the middle class and a top rate of 38.6 per cent (with similar top brackets as the House). Both increase the standard deduction, exempting the first US$24,400 or US$12,200 of joint and individual filers respectively. Both provide a generous child tax credit: US$1,600 per child under the House bill and US$2,000 per child under the Senate bill.
Both the House and Senate recommend that state and local taxes no longer be deductible from federal taxable income ( the House plan provides a property-tax deduction up to US$ 10,000 per year). As a result, highincome taxpayers will face higher, not lower, marginal tax rates. The average state income tax rate is currently 6.65 per cent, so on average under the House bill the top rate rises by four points while the Senate bill increases it three points.
This increase in top rates will somewhat discourage labour effort and savings, as well as encourage some tax avoidance. Nonetheless, eliminating the state and local tax deductibility will discourage sub- national governments from raising rates at the cost of the federal government. The same point could be made with respect to corporate taxes, but the state and local taxes will remain deductible.
The House and Senate bills eliminate several itemized deductions and credits with the aim of offering most taxpayers a tax form so simple it could be filed as a postcard. Both eliminate the alternative minimum tax ( for individuals and corporations). The exemption under the estate tax is doubled for both, although the House bill will eliminate the estate tax altogether by 2023.
Overall, high- income taxpayers, who now pay a majority of personal income taxes, get a larger tax break in dollars, especially due to the small- business income tax breaks. With the increased top rate and some basebroadening measures ( like the House- proposed cancellation of electric vehicle tax credits, which have been so enjoyed by the rich), some high- income earners might even pay more in taxes.
There are two points to criticize, though: The first is that many incentives remain that probably should have been eliminated altogether, such as mortgage- interest deductibility. The second is that the plan leaves a US$1.5trillion debt burden after 10 years for future generations, although a share of this cost will be offset by growth and the attraction of profits from other countries by cutting corporate rates ( these are not taken into account when preparing revenue estimates).
Although there are some differences between t he House and Senate bills, they are remarkably similar, especially with respect to big-ticket items. Overall, the reform, especially on the business side, will have a significant impact on American competitiveness if the Republicans, desperate for a big win, ultimately adopt a tax package this December. The way it looks now, I give that two-toone odds.