November 30, 2017. By Mark Barry:
As we near the end of 2017, Washington’s efforts to pass tax reform legislation have dominated headlines, with Congress working on the final iterations of the Tax Cuts and Jobs Act. A central piece of the Trump administration’s legislative agenda, tax reform is a relatively complicated subject, and we wanted to provide a few brief highlights regarding the process and expected framework.
How It Works
The House already passed its version of the tax reform bill on November 16th. Now the Senate is working on its own (similar) version of the bill, which they hope to pass soon. After this happens, a committee with members from both the House and Senate will meet to resolve differences and merge the two variations into one final bill. Once this final bill is agreed upon, it goes to both the House and the Senate for a vote, and should it pass, on to President Trump for signing.
Goal of Tax Reform Package
The proposed tax reform package is intended to boost economic growth through simplification of the tax code and reductions in both corporate and individual tax rates. While businesses accrue more benefits than individuals under the proposed legislation, the idea is that this will translate into faster economic growth, benefitting individuals in the form of greater employment and higher wages. However, a major tradeoff is that corporate and individual tax cuts will need to be offset at least in part by limiting certain deductions and exemptions, which could potentially result in certain industries and segments of the population actually seeing their taxes increase.
Selected Highlights of Proposed Legislation
Dividends and Capital Gains:
Neither bill includes changes to the 20% top tax rate on dividends and capital gains, nor do the bills eliminate the 3.8% ACA surtax on investment income. One change however is that the Senate bill mandates the use of FIFO to calculate gains when selling shares of stock, which may complicate tax planning for investors. On a more positive note, there has been discussion about eliminating the double taxation of dividends by allowing companies to deduct dividends paid.
State and Local Tax (SALT) Deduction
The repeal of the SALT deduction, proposed in both bills, will impact individuals in high tax states such as New York and California the hardest, in turn potentially increasing demand for municipal bonds from those states as the value of tax-exempt interest increases. There are several other items in the bill that would also impact municipal bonds, including the repeal of the Alternative Minimum Tax (AMT) and the elimination of tax-exempt status for advance refunding bonds and private activity issues, the latter of which would reduce the supply of bonds in future years.
Other Individual Tax Issues
The House and Senate bills both raise the standard deduction to $12k ($24k for married couples), allowing more people to avoid itemizing, while also increasing the estate tax exclusion to $11.2M ($22.4M for married couples). Also in play is the mortgage interest deduction, (which may be capped under the new bill) with any changes having the potential to have a significant impact on both homeowners and the broader real estate industry.
Corporate Taxation
Both bills reduce the tax rate on corporations from 35% to 20% but vary with respect to the timing of its implementation. The average effective tax rate that corporations pay currently is typically well under the stated 35% rate, so this reduction will benefit some more than others, particularly smaller companies. Other key changes include those related to corporate interest deductibility, intellectual property held offshore, and business income earned by pass-through entities. Lastly, a proposed repatriation tax holiday would benefit multinationals that hold cash from foreign profits overseas, as they would be able to use the proceeds for capital expenditures, dividends, and/or stock buybacks.
Conclusion
The US economy remains strong, as evidenced by the recent upward revision in GDP growth to the highest rate in more than three years. However, the health of the economy is not dependent on the success or failure of this legislation’s passage, and while we may see some market volatility in the near-term, it is not something which investors should base long-term asset allocation decisions on. Tax reform will remain in the news over the coming weeks, with headlines both good and bad as edits and revisions are made, and of course plenty of the accompanying political theater. We would emphasize that a final bill is still a ways off and investors should take a wait and see approach until then, which may be before the end of the year but more likely in early 2018.