Trump’s Tax Reform Plan Under the Microscope

SMITH BRAIN TRUST — How will President Donald Trump's proposed tax plan affect your household? Today in Smith Brain Trust, Albert "Pete" Kyle, Charles E. Smith Chair Professor of Finance and Center for Financial Policy senior fellow at the University of Maryland’s Robert H. Smith School of Business Smith finance professor and Associate Dean of Master’s Programs Michael Faulkender serve up a comprehensive breakdown.

Kyle also has served as an economic advisor to NASDAQ, the Financial Industry Regulatory Authority, and the Commodity Futures Trading Commission. Faulkender has published "Taxes and Leverage at Multinational Corporations" in the Journal of Financial Economics (summarized here).

KYLE:

The one-page Trump plan proposes cutting the business tax rate to 15 percent and includes a one-time tax of unspecified size on dollars held overseas. It reduces the top personal tax rate to 35 percent and preserves incentives for home ownership while proposing eliminating other tax loopholes (presumably, the deduction for state and local taxes). 

Fundamental tax reform will require dealing with the difference between the 15 percent rate and the 35 percent rate so that workers do not have perverse incentives to disguise their wage income as business income, Kyle says.

Significantly, corporate profits taxes are levied on profits every year while dividend and capital gains taxes are levied only once, when dividends are paid or assets are sold. This distinction is critical for understanding how tax reform might work.

Territorial Approach

Consider the corporate profits tax. Since this tax is imposed on profits every year, it reduces the after-tax profits corporations can earn in the United States and therefore encourages corporations to conduct business activity abroad, where imposition of the tax can be deferred and tax rates are lower. 

Over time, this encourages business activity to move to foreign corporations, especially foreign business activity.  Reducing the rate to 15 percent will allow U.S. corporations to compete on a more level playing field with foreign corporations, which typically pay similarly low rates in foreign countries. Rather than conducting business abroad or loaning their deferred income to foreign companies that conduct business abroad, this will encourage U.S. companies to conduct U.S. business activity with their accumulated foreign earnings. 

The proposed territorial tax system is consistent with the idea of creating a level playing field for U.S. and foreign businesses in both the U.S. and abroad. This is an improvement over the current tax system, which discourages U.S. business activity by both foreign and U.S. corporations by taxing profits at a rate greater than 30 percent every year.

Dividends, Capital Gains Implications

Next, consider the one-time taxes on dividends and capital gains. These taxes are one-time because they can be delayed, then paid once when the owner needs cash for personal consumption.  While being delayed, they create "trapped equity" in corporations. This trapped equity does not reduce the after-tax rate of return firms earn on profits and therefore does not reduce incentives to invest in the U.S.

With the top personal rate on wage income at 35 percent and the rate on business income is 15 percent, economic activity will tend to migrate from wages to businesses unless there is an additional 20-percent tax on business income. The combined tax rates will be the same if the additional capital gains rate and the tax rate on dividends are both set at 20 percent. Therefore, consistency suggests that, in addition to the business tax rate of 15 percent, there is also a 20-percent tax rate on all distributions of business profits, including dividends paid by corporations, distributions by LLCs and capital gains. This will level the playing field between tax rates on wages and businesses.

For example, a lawyer will be indifferent between paying himself or herself a wage which is taxed at 35 percent or taking the payment through an LLC, where the business income is taxed at 15 percent and the distributions are taxed at an additional 20 percent. If the lawyer decides to leave his or her income in the LLC after paying a tax of 15 percent, then the LLC will be accumulating cash, which can be used to grow or diversify the business. At some later date, when cash is taken out of the business, it will be taxed at 20 percent. If the lawyer decides to pay herself or himself a wage instead of leaving the income in the business, he or she might contribute income not needed for personal consumption to an IRA or pension plan, which would defer the 35 percent tax on such income until retirement, at which point the income is taxed at 35 percent.

Consumption Tax; Eliminating State-Local Deductions 

In my opinion, the optimal tax reform would move the U.S. economy to a consumption tax, which is implemented by granting deductions to all forms of saving (similar to what is current given to contributions to IRAs) and taxes withdrawals from saving vehicles at a consumption tax rate. The efficiency of a consumption tax is that income is taxed once, not multiple times. 

Trump's tax plan makes a major move toward this goal by taxing income multiple times at 15 percent instead of multiple times at 35 percent. But Trump’s plan differs from a consumption tax in several respects.

First, the large gap between the 35-percent personal tax rate and 15-percent business tax rate, combined with preserving tax breaks for home ownership, will encourage small business owners to take out more debt against their homes and less debt against their businesses. It will encourage overinvestment in homes that people live in. It may encourage people to avoid taxes by using larger homes for business purposes to get a tax deduction worth 35 percent, rather than 15 percent.

Eliminating the tax deductibility of state income taxes, while preserving the tax deductibility of property taxes, would encourage states like California and New York to lower income taxes and increase property taxes. In particular, I would expect property tax caps in California to be phased out over time if these changes are made.

One-Time Tax on Overseas Dollars

The effect of implementing the plan on corporate distributions will depend on how the one-time tax on dollars held overseas is implemented. One possibility is to levy an immediate, 15-percent tax, perhaps adjusted with credits for taxes paid to other countries, then another 20-percent when the dollars are distributed. This would be a logical, consistent way to implement a reform, which taxes all income once at a maximum rate of 35 percent. Such a 15-percent tax might reduce the dollars these corporations have available to lend to other businesses. In order for this to avoid creating a credit squeeze, the U.S. government, operating through the Fed, would need to sterilize the reduction in credit by loaning more to the corporate sector. In the long run, it would encourage corporations to accumulate more cash, not reduce it.

More Cash to Shareholders?

I do not think Trump's plan will encourage corporations to distribute more cash to shareholders by paying dividends or by buying back shares. There are numerous transition issues which might confer windfall gains or losses on particular types of taxpayers, including President Trump himself. 

Consider, for example, an individual who owns commercial real estate as an individual, rather than through an LLC. To be consistent, the individual-owned business real estate should be taxed a rate of 15 percent plus 20 percent, which equals 35 percent, rather than at a lower rate. Consistency also requires that distributions from LLCs not be taxed additionally at 20 percent if the income has already been previously taxed. Business owners should get credit for taxes they have previously paid and not get a windfall for taxes they have not paid. 

Trump's plan is consistent with fundamental tax reform that taxes all cash flows from wages and business activity once, at a maximum rate of 35 percent, at the time the income is converted from savings or business assets into personal consumption.

FAULKENDER:

‘Pass-Through’ Proposal Asking for Abuse 

President Trump’s pass-through proposal is asking for abuse. Small business owners could easily reclassify expenses to be net income and vice versa. If one mechanism has a lower tax rate than the other, the reclassifications will take place. Ideally, all income is subject to the same rate at the personal level, thus eliminating the incentive to reclassify the income.

Housing Volatility 

Keeping the mortgage interest deduction and eliminating interest deductions at the corporate level would mean that housing becomes even more debt financed and companies more equity financed. This would make housing increasingly volatile.

Gaming the System

A one-time tax on accumulated foreign earnings rewards corporations that have moved operations to foreign jurisdictions for gaming the tax system. Firms in position to move profits abroad (by transfer pricing of intellectual capital) and who anticipated being subject to the tax on the differential, would see that tax liability fall from as high as 35 percent to perhaps 5-to-8-percent.

While Trump’s proposal disincentivizes stockpiling cash, it does not incentivize returning capital. Mature firms would have little use internally for repatriated cash. They would already have raised the money for any activity needing such funds… There is nothing wrong with dividends and repurchases [in the context of] returning capital to the owners of that capital so that they can optimally reallocate it to where better opportunities for using that capital exist.