Are Taxes Fairer or Simpler Under the TCJA?
This article is an analysis of what was promised when the Tax Cuts and Jobs Act was enacted compared with what has actually happened to date using nonpartisan, objective and authoritative sources.
Specifically, this piece addresses the key promises and goals of the TCJA making taxes fairer and simpler for tax payers. Here, I analyze the topics above and their intended goals then offer my own personal verdict and opinion as to whether each goal was achieved and if the TCJA has been successful so far.
Make Taxes Fairer
The promise behind this pledge was that the TCJA would broaden the taxable income base by removing many special tax breaks and loopholes. I will look at both business and individual taxes in this regard.
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Business taxes: The TCJA provided all C corporations with a 40 percent cut in their rate, from 35 percent to 21 percent, to allow them to be more competitive with foreign companies. It encouraged the continuation of offshore investments by eliminating most U.S. taxation of normal manufacturing or service profits earned overseas so that those U.S. owned foreign businesses could be more competitive.
The TCJA also created immediate expensing provisions to encourage job creation and investments in the United States and provided a 20 percent exemption for most small-business ordinary income earned as a pass-through entity to be more competitive with larger businesses. However, it also retained many of the loopholes that allowed multinational corporations to enjoy extremely low effective tax rates.
Individual taxes: The TCJA broadened the tax base for many Americans. It eliminated personal exemptions, several deductions for adjusted gross income (AGI), and many itemized deductions. Most Americans, however, regarded these items as “deserving” rather than “special” tax breaks. In return, the TCJA doubled both the standard deduction and child tax credit.
The TCJA, on average, cut individual tax rates by two to three points for most income brackets, with a greater reduction in the lower brackets. For example, a married couple filing jointly (MFJ) with earnings of $50,000 would have paid $6,568 in federal income taxes for 2017, but only $5,619 for 2018. This is a 14.5 percent reduction (assuming the other TCJA changes were neutral to their situation).
On the other hand, an MFJ couple earning $500,000 would have paid $141,883 in federal income taxes for 2017, but 11 percent less (only $126,379) for 2018 – again, assuming other TCJA changes were neutral to their situation. From that perspective, the TCJA provided a greater benefit for lower and middle income taxpayers by appearing to give them a larger percentage reduction in tax burden versus the higher income groups.
However, as discussed below, the higher income groups will almost certainly benefit the most from tax reform as a result of several other factors in the TCJA beyond just an individual rate cut:
- Since (according to one study) over 90 percent of equity investments are owned by the top 20 percent of earners, they benefit much more from the 40 percent corporate rate cut from 35 percent to 21 percent due to greater corporate dividends and valuations.
- This group can share more in the new multinational permanent exemption of U.S. tax on most foreign earnings.
- They can convert their pass-through entity investments into a C corporation, resulting in a 21 percent federal tax rate on investment and business income instead of effective federal rates as high as 37 percent.
- Alternatively, if they keep their businesses as pass-throughs, they may benefit from the 20 percent pass-through deduction that effectively lowers the top marginal rate on pass-through income from 37 percent to 29.6 percent.
- The top portion of this group will benefit from the estate tax exemption doubling from $11 million per couple to $22 million.
Upper income groups argue that they pay a disproportionate amount of the total income tax burden, and therefore should benefit more from tax reform. The Tax Foundation recently published its analysis of IRS data for 2016 and found that the top five percent of income taxpayers (those making above $200,000) pay almost 60 percent of all individual income taxes, even though they only have 35 percent of the total reported taxable income, paying an average effective rate of 23 percent; and the top one percent (those making about $500,000 or more) pay about 37 percent of the total individual tax, paying an average effective rate of 27 percent.
Therefore, when the TCJA was passed, the Tax Policy Center (TPC) projected the following:
- For 2018, 65 percent of the total benefit of tax reform would go to the top 20 percent; 43 percent would go to the top 5 percent; 20 percent would go to the top 1 percent; and 8 percent would go to the top 0.1 percent of taxpayers. (Actual results are not yet available as of the date of this article).
- For 2025 (the last year taxpayers will enjoy the individual tax cuts), 66 percent of the total benefit of tax reform would go to the top 20 percent; 47 percent would go to the top 5 percent; 25 percent would go to the top 1 percent; and 11 percent would go to the top 0.1 percent of taxpayers.
- In 2027 (after the individual provisions have all expired at the end of 2025), almost all income groups will lose all tax reform benefits, and they will be worse off than before the TCJA due to new inflation index increases in the tax tables. The only exception will be for the top 20 percent, who will still enjoy the benefits of C corporation tax reform provisions that will not have expired, with 99 percent of those going to the top 5 percent and 83 percent going to just the top 1 percent.
Data for 2018 tax returns filed regarding the percentage share of total taxes paid by the top 1 percent or 20 percent is not yet available due to the fact that most of the tax returns under extension through October 2019 are from these top income groups.
Tax Fairness Goal Achieved?
Yes, for small businesses and multinational corporations since their stated and effective rates came down substantially in the hope that this would fuel expansion in the United States and more competitiveness internationally; and for higher-income taxpayers because, that group would argue, they were paying a disproportionate share of income taxes to begin with.
But probably not as fair for lower and middle income taxpayers when you look beyond the rate cut and account for the relative greater benefits that will accrue to higher-income taxpayers from all the other provisions of tax reform.
Additionally, one could argue that lower rates overall are not necessarily the “fairest” policy for the country over the longer term since tax cuts to stimulate job growth is apparently limited for the reasons stated above and the cash benefits that are accruing to multinationals and higher-income taxpayers (both with and without small businesses) are projected to raise the federal debt another $2 trillion over 10 years. The growing deficits and related interest costs exacerbated by tax reform may eventually lead to higher income taxes on everyone and/or a reduction in services and safety nets that primarily benefit, and are needed by, the poor and lower middle income taxpayers.
Make Taxes Simpler
Some proponents of the TCJA claimed that filing taxes would be so much easier that it would be akin to filling out a postcard. Let’s review how “simple” filing taxes has become.
Individual taxes: In short, tax filings are simpler for millions more Americans if they do not own a pass-through business. The filing simplicity was achieved by the doubling of the standard deduction, the elimination or capping of numerous deductions and higher alternative minimum tax (AMT) thresholds. The Joint Committee on Taxation (JCT) last year estimated that the number of filers who would itemize for 2018 “will fall from 46.5 million in 2017 to just over 18 million in 2018, meaning that about 88 percent of the 150 million households that file taxes will take the increased standard deduction.”
The IRS’s preliminary data for the 2018 tax returns filed through May (after about 90 percent of returns have been filed, representing about 80 percent of taxable income) shows that 90 percent of filers (close to the JCT estimate) used the standard deduction, while 70 percent did last year in the same period (121 million returns used the standard deduction for 2018 out of 135 million returns filed vs. 94 million out of 134 million returns filed for 2017).
Note that it was recently reported that due to the doubling of the standard deduction, Americans contributed $54 billion less to charitable causes in 2018 than the prior year based on IRS preliminary data. This conclusion appears to presume that taxpayers contributed less because they no longer received a tax benefit from itemizing their deductions as they did prior to tax reform.
There is more here than meets the eye, and the first impression is misleading for two reasons. First, the media’s conclusion is based only on tax returns filed through May 2019 vs May 2018, and (per the IRS) excludes the results of 10 percent of all tax returns to be filed that are under extension.
These are primarily upper income taxpayers (i.e., those most likely to have contributed the most). Second, the conclusion ignores the amount of contributions that were still made by the additional 27 million taxpayers to date who now take the standard deduction: just because the IRS does not know that amount – they can only tabulate what is reported as a charitable contribution on the itemized deduction form – it does not necessarily mean there were fewer contribution.
Here is an analogy that would suggest a grossly misleading conclusion: mortgage interest and state and local taxes paid. A comparison of the raw data of itemized deductions for 2018 and 2017 (May to May), shows a drop in the total amount of mortgage interest deduction taken of about $130 billion, and a drop in state and local taxes paid of about $350 billion.
This does not mean there was a drastic drop in those amounts paid by taxpayers, these obligations are usually fixed. It simply means they are now taking the standard deduction. Thus, the charitable contribution “drop” resulted from not knowing what those amounts actually are because more taxpayers took the standard deduction and because limitations were placed on the amounts allowable as a deduction.
In fact, The Hill reported earlier this year that the Fundraising Effectiveness Project had tabulated that charitable giving was actually up about 1.6 percent for 2018, although the number of donors was down about 4.5 percent. As a result of the lower rates and additional credits, the TPC estimated that many Americans would find that they did not have to file at all, or they would file just to get all their withheld federal income taxes back or possible refundable credits.
Specifically, it estimated that the percentage of taxpayers projected to have zero tax or a negative tax liability would increase from 42.7 percent in 2017 to 44.4 percent in 2018 as result of tax reform. (Actual results for 2018 returns are not yet available at the date of this article). Regarding the “postcard size tax return” promise, the IRS did arguably achieve this although most tax preparers saw this as a gimmick since many taxpayers were required to also prepare up to six new schedules of details, most of which had previously been part of the long form version in 2017.
Business taxes: The filing of these taxes was made substantially more complex, especially for small businesses because of the 20 percent possible exemption on their qualifying business income (QBI) and for multinational businesses.
On one hand, the TCJA did simplify business taxation by allowing qualifying small businesses to use simpler accounting methods for up to $25 million in receipts versus $5 million to $10 million in receipts before TCJA. It allowed 100 percent immediate expensing on all new or used machinery and equipment; repealing the AMT for C corporations; repealing like-kind exchange treatment for non real estate; and repealing the Section 199 domestic production activities deduction.
For pass-through businesses, however, the new 20 percent deduction for qualifying business income is extremely complex. The Tax Foundation reports that about 95 percent of business returns are pass-through entities, including sole proprietorships. Therefore, the QBI deduction was, and continues to be, a challenge through individual extension filing season ending this October.
Furthermore, all C corporations and multinational businesses (in exchange for substantial relief from U.S. taxes on foreign earnings), must wrestle with myriad anti-base erosion provisions, such as “Global Intangible Low Tax Income,” “Foreign-Derived Intangible Income,” “Base Erosion and Anti-Abuse Tax,” and various other provisions attacking their foreign special purpose entities. Multinationals must also deal with the complexity of calculating how much tax they owe on their pre-2018 unrepatriated profits.
And, all businesses, including pass-throughs, must deal with the possible application of new interest expense limitations. One could argue that the above business tax complexity is, for the most part, a small price to pay for lowering the C corporation rate from 35 percent to 21 percent and lowering the highest marginal personal tax rate on pass-through business income from 39.6 percent to effectively 29.6 percent, assuming they can take advantage of the full 20 percent QBI deduction.
Make Taxes Simpler Goal Achieved?
Overall, no. The exception would be individual taxpayers without a small business who, for the first time for 2018 returns, did not have to itemize or have no tax liability due to new TCJA provisions.
This article originally appeared as a five-part CPA Now blog that posted July 29, 2019, through Aug. 2, 2019.
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Robert Duquette, CPA, is Professor of Practice in the College of Business at Lehigh University, a member of the Griffin/Stevens & Lee Tax and Consulting Network, and a retired EY tax partner. He has served on PICPA’s Federal Taxation Committee for over 25 years, focusing on federal tax reform and the national debt.