I had just started my public accounting career in the tax department of a Big 8 firm in 1986 when the Internal Revenue Code of 1954 was renamed the Internal Revenue Code of 1986. Although the 1986 Act amended many sections of the 1954 Code, it was not a recodification or reorganization of the overall structure of the 1954 Code. Tax laws enacted since 1954, including those in 1986 and now in 2017, have taken the form of amendments to the 1954 Code. Stated more directly, the 2017 “Tax Cuts and Jobs Act” was not the simplification of the Internal Revenue Code many had hoped it would be.
When President Reagan signed the Tax Reform Act of 1986, the legislation had been a partisan effort. In 1986, the economy and inflation were barely under control, some individual tax rates were close to 50%, and full employment had not yet been achieved. While growth in the economy was one of President Reagan’s goals, the 1986 Act was focused on “tax reform”, was politically popular, and revenue neutral. It goes without saying the Tax Cuts and Jobs Act of 2017 was not bipartisan, even called the “GOP Tax Plan”, and we only have to go back to the last administration to see what happens with unpopular or non-partisan legislation.
Tax Cuts and Jobs Act of 2017 Overview
The 2017 Act is not revenue neutral and results in a deficit of $1.5 trillion driven from a reduction in the corporate tax rate from a maximum marginal 35% to a flat 21%, and the elimination of the corporate Alternative Minimum Tax (AMT). The theory is that lower corporate tax rates will provide an incentive to corporations to create domestic jobs from the extra profits and therefore eliminate the projected deficit through economic growth. In contrast to 1986, today the US is at full employment and the possibility of greater economic growth may prove challenging even with a tax cut.
The winners are supposed to be the big corporations, but in a twist, corporations are now reporting negative financial impacts from the accounting restatements required to comply with the 2017 Act. According to the US Treasury, corporations contribute about 9% of all US tax revenues, and while that contribution just got smaller, so have their profits.
Curiously enough, the 2017 Act does not include “specific” job-creating incentives. For example, during the Great Recession, the 2010 New Hire Retention Tax Credit (Hire Act) offered incentives for companies to hire new employees and tax credits for retaining those employees. No new incentives for any category from military veterans to economic development zones were added in the Tax Cuts and Jobs Act of 2017. Of most interest from a political perspective, the issue of American jobs moving overseas was not tackled at all, even with a mention.
Pass-Through Entities–Small and Medium Businesses
Pass-through corporations like partnerships, S Corporations, and sole-proprietor businesses, pay the higher individual tax rates. For generations of small business owners, the lobbying goal has been to close the tax rate gap between what large corporations pay and what pass-through businesses pay. While a 20% deduction was added for pass-through businesses, the income-limitation means there is only a benefit to small businesses. In addition, personal service corporations like law and accounting firms were excluded, meaning the available pool of beneficiaries is not as widespread as could have been.
Foreign Income Repatriation
The Tax Cuts and Jobs Act of 2017 attempts to repatriate US corporate foreign profits with an exception based low tax rate and a new territorial tax approach to bring US corporations more “in-line” with the tax rates enjoyed by their global trading partners. We’ve seen many unsuccessful attempts to repatriate profits, with the last being in 2015 when President Obama tried the same tactic of a one-time low tax rate. Unfortunately, no one has figured out a way to motivate a corporation to pay even a small amount in taxes when they can pay zero by legally not repatriating their profits.
The 2017 Act included an attempt to repeal Obamacare, but this was not achieved. The only part that was changed was the tax enforcement of the Individual Mandate – not the Corporate Mandate. The Individual Mandate includes either a tax penalty for not buying health insurance or a tax credit to offset the cost of the health insurance. The tax credit elimination will particularly hurt those in the lower income category as they were the only ones that qualified. The decision not to “enforce” the Individual Mandate doesn’t change the simple fact that the Corporate Mandate is where most taxpayers are impacted by Obamacare. Corporations are still required to provide health insurance, and corporations will still receive a tax credit to offset their cost.
From an individual perspective, who wins from the Tax Cuts and Jobs Act of 2017? On the surface, it appears like the answer should be everybody. But this a mixed bag as it depends on an individual’s unique tax situation. If I were to classify taxpayers in three broad categories of income from low, middle to high, there is little doubt that high-income taxpayers will benefit most from the changes, followed somewhat by the low-income taxpayers, with the middle class impacted negatively in many areas. There will, of course, be exceptions, but even with the Estate, Gift and other area amendments, the changes are skewed towards the high-income taxpayers. Don’t let the seemingly lower tax rates fool you without doing some analysis on your particular situation.
For example, while the deduction for State and Local taxes and Mortgage Interest for individuals was not repealed as had been proposed, the maximum deduction will certainly impact taxpayers in every State as it doesn’t take a lot of combined personal State income tax and real estate tax to reach the new maximum of $10,000.
One area where relief for the middle class was really needed was in the individual Alternative Minimum Tax (AMT). But the individual AMT was not repealed and means the middle class will continue having to apply higher tax rates if they have enough itemized deductions. The only saving grace, if we can call it that, is that itemized deductions for the middle class have been significantly reduced.
With regards to job growth, the major problem with the Tax Cuts and Jobs Act of 2017 is that it makes the same primary mistake of the 1986 Act – it confuses economic policy with tax policy. Although tax policy is meant to influence taxpayer behavior, and sometimes that approach works, the targeted areas have to be very specific. The reality is that few corporations will build a new plant or hire more workers simply because of lower tax rates. Demand for products and services has to increase and multiple other variables have to be considered. With that respect, every study I’m familiar with has shown corporate tax windfalls are typically not used for job creation. Results also show that the supply side economics of the 1986 era didn’t work, yet the theories remain politically popular even today. Let’s hope this time the results are different.
Dr. Alfred Sanders is a professor of finance at the Jack Welch Management Institute, and a Partner, Capital Markets Consulting at Genpact.