Tax Policy – The Tax Cuts and Jobs Act After A Year
This week is the first anniversary of the passage of the Tax Cuts and Jobs Act. The first meaningful reform to the federal tax code in a generation, the Tax Cuts and Jobs Act was historic, but it was not perfect. A year after its adoption, it’s important to take a step back to review the reforms’ impacts on individuals, businesses, and the U.S. economy.
The Impact on Individuals
The Tax Cuts and Jobs Act lowered tax rates and simplified the individual income tax for most filers. The Act nearly doubled the standard deduction to $12,000 for individuals and $24,000 for married couples in 2018. The number of individuals taking the standard deduction will increase in 2018 from approximately 70 percent of returns to approximately 90 percent, reducing compliance costs by $3 billion to $5 billion annually.
The Tax Cuts and Jobs Act also limited several key deductions, such as the mortgage interest deduction and state and local taxes paid deduction. It reformed the alternative minimum tax and doubled the exemption for the estate tax.
While much ink has been spilled about the impacts of each of those provisions on their own, the net impact of the Tax Cuts and Jobs Act on individuals is that 80 percent of filers will see a lower tax liability in 2018, with another 15 percent having no material change. Only 5 percent of taxpayers will pay more in taxes in 2018 than they did in 2017. And, as the map below shows, on average, taxpayers in every income group in every congressional district in America will see a net tax cut.
Individuals looking to calculate their own tax savings can use our tax calculator.
The Impact on Businesses
The Tax Cuts and Jobs Act made dramatic changes to the business tax code in the U.S. The corporate income tax rate was lowered from 35 percent to 21 percent, capital investments can be fully deducted until 2022, and we moved to a quasi-territorial system, meaning that businesses are only taxed (with notable exceptions) on their income earned in the U.S., not abroad.
Our Taxes and Growth model estimates that lowering the corporate income tax rate will increase long-run GDP by 2.6 percent, increase worker pay, and grow the U.S. capital stock as firms find that more investments are now profitable.
The Act did include a few provisions which will slow economic growth in the long run, such as requiring research and development expenses to be amortized and tightening the interest deduction cap in 2022.
The Impact on the U.S. Economy
All told, the Tax Foundation Taxes and Growth model estimates that the Tax Cuts and Jobs Act will increase long-run GDP by 1.7 percent, create 339,000 jobs, and raise wages by 1.5 percent. It will reduce federal revenues by $1.47 trillion on a conventional basis and $448 billion on a dynamic basis over the 10-year budget window.
Now that we’re a year out since the law’s passage, what evidence can we point to on how the Act has impacted the U.S economy? The answer is, very little.
First, the law’s design is such that the economic impacts are long-run. It takes several years for the lower cost of capital to impact investment. Firms need time to plan, purchase, and permit new investments before they put the items into service. As we noted in our original score, much of the acceleration of growth happens several years after the law’s original passage, before fading as provisions in the law expire.
Second, it is always difficult to spot the impact of policy changes in economic data. Economic data is noisy. The monthly jobs report, for example, has an error rate exceeding 100,000 jobs a month. In November, the U.S. economy is reported to have created 155,000 new jobs, but that number should be understood to mean somewhere between 55,000 or 255,000 jobs. And even if we knew the exact number of jobs created, we can’t say with certainty if that is because of the tax changes made or any other fiscal policy.
When economists discuss the impacts of policies on economic indicators, we discuss it based on a concept known as ceteris paribus, translated as “other things equal.” For instance, when we say that the Tax Cuts and Jobs Act will increase long-run GDP by 1.7 percent in the long run, that means 1.7 percent with all other things being constant. Unfortunately, the U.S. economy isn’t constant. To truly see the 1.7 percent growth, we’d need to look at the U.S. economy a decade (or longer) from now in isolation, but we can’t. Counterfactuals don’t exist in fiscal policy, making this even more difficult. We will never be able to point to a specific data point and say, “That there, that’s the Tax Cuts and Jobs Act.”
Third, other policy changes mitigate the impacts of tax reform on the U.S. economy. The Trump Administration’s tariff policy is a great example. The Taxes and Growth model estimates that the new implemented tariffs will slow GDP by 0.12 percent and cost the U.S. economy 94,000 jobs. That policy works against the interests of tax reform. While the aforementioned jobs report for November said 155,000 new jobs were created, would that have been higher without the tariffs or lower without tax reform? Sadly, this is quite difficult to say with a definite answer.
While this is frustrating for political narratives, it is the reality of economic policy analysis. So, a year after the Tax Cuts and Jobs Act, we know that 80 percent of individuals will pay lower taxes this year than last year; we know that businesses now have a lower cost of capital; and we know taxes are simpler in many ways. We know these things should increase investment and grow the economy. But we also know we can’t say with certainty whether any economic data point is solely due to the Tax Cuts and Jobs Act.
Source: Tax Policy – The Tax Cuts and Jobs Act After A Year
IRS Tax News – 2019 standard mileage rates announced
The IRS released guidance on the standard mileage rate for business, medical and certain moving expenses incurred in 2019.
Source: IRS Tax News – 2019 standard mileage rates announced
Tax Policy – The Tax Switch that Could Speed Up December Divorces
A lesser-known section of last year’s Tax Cuts and Jobs Act will soon take effect, changing the tax treatment of alimony payments for divorces occurring after December 31, 2018. While the switch probably isn’t going to cause divorce, it might speed up divorces or separations that are already in the works.
Currently, alimony payments are deducted from the income of the paying spouse, and then taxed as the income of the receiving spouse. The new tax law will change this tax treatment for divorces occurring after December 31 of this year. For these taxpayers, alimony payments will no longer be deductible by the payer or taxed as income by the receiver. For divorces that occur before the switch, the old tax treatment will still apply.
Either way, only one spouse pays the income tax associated with the alimony payment. If both spouses had to pay income taxes on a $1,000 payment, it would in effect be treating $1,000 of income as $2,000 of income. Taxing it once is the appropriate neutral policy—but where to tax it is more ambiguous.
Given that the receiving spouse usually makes less income than the paying spouse, the receiving spouse usually faces a lower marginal tax rate—this can result in the divorced couple paying a lower tax bill for the alimony money than they would have paid on that same income while married. So the current tax treatment can modestly subsidize divorce.
Another problem with the deduction is the discrepancy between the amounts deducted and reported as income: In tax year 2016, taxpayers reported $12.6 billion in alimony paid, while reporting just $10.5 billion in alimony received. According to a 2014 Treasury Inspector General for Tax Administration Report, “Apart from examining a small number of tax returns, the [Internal Revenue Service] generally has no processes or procedures to address this substantial compliance gap.”
The switch will mean no modest subsidy for divorces going forward, and no reporting gap. The Joint Committee on Taxation estimates the switch will increase federal revenues by $6.9 billion over the next decade.
While the new tax treatment won’t likely affect spouses at the margin of “should we work this out or not,” the change could very well quicken the process for spouses at the margin of “should we do the divorce paperwork now or next month.”
Source: Tax Policy – The Tax Switch that Could Speed Up December Divorces
IRS Tax News – Proposed regs. govern tax on base-erosion payments
The IRS issued proposed rules on the Sec.59A base-erosion anti-abuse tax (BEAT), one of a number of new international tax provisions added by the law known as the Tax Cuts and Jobs Act.
Source: IRS Tax News – Proposed regs. govern tax on base-erosion payments
Tax Policy – Unequal Tax Treatment Is Contributing to Rising Debt Levels for Entrepreneurs
A recent paper by Mohsen Mohaghegh of Ohio State University discusses two main trends related to U.S. entrepreneurs: the decrease in the number of entrepreneurs and the increase in their borrowing. Entrepreneurs have increased their debt holdings relative to their assets over the past three decades. Greater opportunities for financing new investments, rising business costs, and modifications to the bankruptcy code are among the different elements influencing the behavior of entrepreneurs. In addition to these factors, the tax treatment of debt financing may also be contributing to how much debt entrepreneurs are willing to take on.
Using flow of funds data, Mohaghegh shows that the debt-to-asset ratio of entrepreneurial firms has risen from about 0.23 in 1975 to nearly 0.40 in 2007. This means entrepreneurs are taking on more debt relative to their assets than they were previously. Several things are driving this trend: improved access to loans from lenders, reduced overhead costs for firms to borrow, and the way our tax system treats debt financing.
Firms with taxable income, including startups, may deduct interest payments on their debt from their gross income. The firm’s tax liability is therefore lower than it would be if interest payments were not deductible. (The lender receives the interest and pays tax on it.) By contrast, a startup financing its activities with equity (i.e., by issuing shares) would not receive any deduction from its income taxes when distributing dividends to its shareholders.
This tax treatment biases corporations toward debt financing. Equity-financed investments have a higher effective tax rate, as a return is taxed both when it is earned by the firm and when it is remitted to shareholders. Debt-financed investments only have a tax applied to the lender when they receive interest payments.
This treatment is exacerbated by the way that we tax some business forms. Firms incorporated as C corporations pay corporate income tax on their returns prior to distributing dividends. Shareholders receiving those dividends also pay income tax on their dividend income. This effectively taxes the corporation’s return twice, as this figure illustrates:
The poor tax treatment of equity financing for startups structured as passthrough firms is less pronounced. Unlike C corporations, passthrough firms do not have their income taxed twice. Instead, income generated by passthrough firms “passes through” to the owner(s), where the income is taxed at the marginal individual income tax rate. This structure reduces some of the benefits of debt financing when compared to raising funding from issuing new shares, as the difference between the two effective tax rates is smaller.
Passthrough firms may still prefer to finance their activity with debt, as the marginal tax rate paid by the borrowing firm may be higher than the rate paid by the lender. This lowers the equilibrium after-tax interest rate for debt financing, making debt cheaper than it otherwise would be for firms looking to raise funds.
The economic distortions generated by the poor tax treatment of equity financing also affects some firms more than others. Startups with physical assets find debt-financing more attractive than startups that rely more heavily on human capital or intellectual property. Physical assets can be more easily liquidated in a default, making debt financing more favorable than it may be for firms with intangible assets.
The situation is more complex for entrepreneurs who experience net operating losses (NOLs) in the course of maturing their business. Unlike taxable firms, startups with debt financing and NOLs have no tax liability to deduct for their interest payments. This could make equity financing more attractive to startups expecting to realize losses before becoming profitable.
Equalizing the tax treatment of debt and equity financing–perhaps as part of broader reform efforts–would help ensure that bad tax policy isn’t contributing to rising leverage by entrepreneurs. The capital structure of entrepreneurial ventures should be guided by financial markets and investors seeking returns to risk, and not swayed by preferences embedded in our tax code.
 Shareholders with qualified dividends pay the lower long-term capital gains tax rate. Qualified dividends are dividends that are paid by a U.S. corporation or qualifying foreign corporation for stocks which have been held for more than sixty days.
Source: Tax Policy – Unequal Tax Treatment Is Contributing to Rising Debt Levels for Entrepreneurs
Tax Policy – From the EU Digital Services Tax Debate—to the OECD?
The proposal from the European Commission to tax revenues from some digital services at 3 percent has taken on a new form following the lack of agreement among EU member states. The original proposal, introduced in March 2018, had a chance to be adopted or rejected on December 4, 2018, at a meeting of EU finance ministers. Instead, because of efforts by France and Germany, the proposal has been reframed to target only revenues from digital advertising—significantly narrowing the scope from the original proposal in March. The proponents of the narrowed digital services tax (DST) hope to achieve agreement among the current 28 member states on this narrowed proposal by March 2019.
The EU DST has been widely criticized and even a narrower version of the proposal would create serious challenges for tax administration and compliance.
There are many individual countries, including in the EU, that plan to move ahead with their own, separate DST proposals. These include unilateral proposals by Spain and the UK. France is also expected to adopt its own unilateral measure.
There is broad agreement among EU member states and in other parts of the world that something should change in international tax policy to address the challenges of taxation in the digital economy. Discussions on this topic have been ongoing at the Organisation for Economic Co-operation and Development (OECD) for many years, but without much progress on an agreement.
The OECD Base Erosion and Profits Shifting (BEPS) agenda included addressing the tax challenges of the digital economy as its first action item. A report exploring the difficult issues of this debate was released in 2015. Since that report, the OECD held a public consultation in 2017 in the context of the Task Force on the Digital Economy (TFDE) and issued an interim report in March 2018.
Though it did not provide specific recommendations, the OECD interim report laid out the serious challenges to designing tax policy specifically targeted at the digital economy. A key takeaway from the report is that designing tax policy specific to digital business models is not the right approach because the digital economy is rapidly evolving, and most businesses are becoming more digital in some way.
At its core, the digital debate is about reallocating taxable profits from one taxing jurisdiction to another. If a company has no employees or property in a country where it makes lots of sales, should some of that company’s taxable profits be allocated to the market country based on that market activity?
The answer that many countries have to that question is, “Yes,” but they differ in their approaches.
Officials from the U.S. Treasury have recommended to the OECD that a company’s taxable profits should be allocated to a market jurisdiction based on investment in marketing intangibles in that jurisdiction. If a company invests in advertising its valuable trademark or brand in a market jurisdiction, hoping to drive up sales, that level of investment could be a metric to allocate taxable profits to that market country. This would be a broad approach and impact multinational firms operating in a variety of sectors. However, if marketing investment could trigger tax in a jurisdiction where a company previously did not owe tax, then this approach would likely impact the decisions by companies on how and where they market their products.
The United Kingdom has a different approach that it would like to see the OECD pursue. The UK would like profits to be allocated based on the location of users that interact with digital companies. This is based on a theory that the value created by users should be taxed in the jurisdiction where the users are located rather than the location where their data is processed and analyzed. Allocating taxable profits of multinationals based on the location of their digital users could create privacy concerns if governments expect those firms to track the location of their users for tax purposes.
Germany and France are working on a third approach at the OECD. They would prefer to solve this issue with a global minimum tax, perhaps modeled after the Global Intangible Low Tax Income (GILTI) provision in the new U.S. tax law. This approach would effectively set an international floor for corporate tax rates faced by foreign subsidiaries of multinationals and limit tax competition.
Each of these approaches to shifting taxing rights will get more attention as the debate moves forward at the OECD even as the debate over an EU DST narrows its scope.
In January 2019, the OECD is expected to provide an update on its approach to shifting tax policy in light of the digital economy. In the OECD report to the G20 leaders, the various deadlines for moving forward in this discussion were laid out, with an update scheduled for June 2019 and a final report in 2020.
A potential conclusion to this debate at the OECD could reshape the international tax landscape in significant ways and impact investment and business structure decisions by multinational corporations. It is important for policymakers to think of how these changes might impact the stability, transparency, complexity, and neutrality of the international tax system. After global foreign direct investment fell by 23 percent in 2017, it is important to take account of how international tax policy might contribute to roadblocks to new investment and productivity, and avoid policies that could hurt global growth for years to come.
Source: Tax Policy – From the EU Digital Services Tax Debate—to the OECD?