President-elect Donald Trump has taken the “bull by the horns,” so to speak, and proposed a sweeping tax reform plan that will diminish what goes to the US Treasury in the form of tax revenues in the hopes of stimulating the economy. It should be worth emphasizing that the Trump tax plan is merely a proposal at the time of this writing, and Congress must still approve any final proposal that Trump and his cabinet create once Trump is sworn into office.
What follows is a brief discussion surrounding some of the more significant elements to the Trump plan.
Individual Tax Cuts
Trump has proposed cutting the tax brackets to three: 12%, 25%, and 33%. He would also eliminate Obamacare’s 3.8% net investment income tax. As a result, the top rate would be 33%, with the top rate on capital gains and dividends a firm 20%.
In addition, Trump’s tax plans call for slashing itemized deductions. Under Trump’s plan, personal exemptions are eliminated. High earners already do not deduct personal exemptions due to the phase out, so this should have little impact.
More consequential, though, is that itemized deductions would be capped at $200,000 for married couples, as noted by Forbes.
Business Tax Cuts
Businesses are supposed to be in for big tax cuts. Corporations currently pay 35%. President-elect Trump would cut it to 15%, but he would also eliminate most business deductions. Instead of depreciation over many years, Trump would allow up-front deductions, but forget deducting interest on debt, he has suggested.
LLCs, partnerships and S corporations would have changes too. Trump has suggested that the owners of these entities should pay the same 15% rate as corporations. Astoundingly, that could mean someone taxed at 39.6% or even 43.4% on flow-through business income could see their tax rate slashed to 15%! Of all the proposed tax changes, this one—if it happens—may be the most momentous.
Pass-Through Taxation in the Trump Plan
An excellent summary found on TaxFoundation.org notes how one particular policy question that has received quite a bit of attention is the tax rate on individual income derived from pass-through businesses such as LLCs, partnerships, and Sub-S Corps. Tax Foundation makes the following points:
1. Pass-throughs are businesses that pay their taxes through the individual income tax code rather than through the corporate code.
Under current law, such businesses distribute all of their earnings to their owners every year, and such earnings immediately appear only on the owners’ tax returns. They are taxed at ordinary individual income tax rates.
2. In contrast, traditional C corporations can retain earnings without distributing them immediately to any particular shareholder.
This allows shareholders to defer, but not permanently avoid, personal income tax liability on the gain in wealth that is tied up in the corporation. A substantial tax drawback to C corporations, though, is that they have to pay two layers of tax: an entity level tax on retained profits, and the personal income taxes for the shareholders who receive the profits when they are disbursed
3. However, there are multiple interpretations of the plan because the plan is not finalized.
The topic can be confusing because there are multiple interpretations of the way that pass-through businesses would be taxed under the Trump plan.
As Tax Foundation notes, one particular tax rate--the individual income tax rate on pass-through business income--is not clearly specified in the current plan:
Assuming that the individual income tax rate on pass-through business income is the same as the rates on other individual income, the Trump tax plan would reduce federal tax revenue by $4.4 trillion over the next decade. But if the tax rate on this income is instead intended to be the same as the tax rate on corporate business income, the plan would then reduce federal revenue by $5.9 trillion.
Currently, the clearest understand of the current plan is as follows:
- Pass-throughs are not eligible for a single 15 percent tax rate on the individual income that their owners report.
- At best, they may be allowed to adopt some kind of tax status similar to that of C-corporations, either on a temporary or permanent basis.
Trump’s plan means big tax cuts, mostly for individual and corporate income. It will cut down the cost of capital as well as the marginal tax rate on labor. The plan will change incentives to work and invest, and, in the long run--as the Tax Foundation explains:
- The U. S. economy would increase
- Wages would be boosted
- Full-time equivalent jobs would increase
In summary, it would boost after-tax incomes for every income group, but also decrease revenue to the United States Treasury.