Tax Changes Coming in 2017 and Beyond
By David J. Haas CFP®
December 21, 2016
We are in the midst of an administration changeover in Washington with the Republicans taking over the White House and maintaining control of both houses of Congress. Both President-elect Trump as well as congressional leaders have made promises regarding tax changes. Mr. Trump has promised tax-cuts to corporations and the middle class as well as tax reform. Congressional leaders have promised revenue-neutral tax reform and want to find a solution to the corporate tax problem as well.
How Did We Get Into This Mess Anyway?
I think most Americans agree that our tax code is extremely complicated. The convoluted nature of the tax code is because government expects it to do a lot of different things at the same time. At it’s simplest, the income tax is supposed to raise money for the Federal Government to operate. To do that, income tax could be as simple as: send in 25% of your income every year. The problem with this is that the US also believes in a progressive tax system. Let’s say Justin, who makes $400,000, will send $100,000 to Uncle Sam and then keep and live off $300,000. No problem, since $300,000 is still a lot of money and Justin will still be living large. But Mike only makes $40,000 per year. It’s much tougher to live on $40,000 per year and if he has to send in 25% of that, or $10,000 to Uncle Sam, he will only end up with $30,000 per year to live on. We usually think that if you work for a living, being poor is not your fault. So it’s not really fair that for Justin, the government is taking money he probably wouldn’t spend anyway, but for Mike, that 25% is taking food off his table. The solution is tax brackets that make Justin pay a larger percentage of his income than Mike. So maybe Justin has to pay 35% and Mike only pays 10%.
The government is also trying to help certain Americans and promote certain behaviors because its good for society. That’s how we get deductions for retirement plan contributions. It’s good for America overall if people save for their own retirement and we don’t have stories about seniors eating dog food and living in shelters. Similarly, we want people to donate to charity, get the healthcare they need, and buy their own house. So we provide deductions for all those things. And some people live in states with high taxes and maybe that’s not fair, so we provide a deduction for state taxes.
On top of all this, there is a fear that people are gaming the system and not paying their fair share. So they came up with the Alternative Minimum Tax to make sure you can’t have too many deductions and pay little or no tax. On top of all that, President Obama implemented Obamacare using the tax system to both pay for it, enforce it, and provide subsidies for people who can’t afford their premiums.
More and more complexity.
Competing Tax Reform Plans
Both the Republican Congress and President-Elect Trump have promoted tax reform, but their plans have differed. While Mr. Trump wants a tax cut to stimulate the economy, the Congress has some very conservative Republicans who want a balanced budget. Both Mr. Trump and the GOP Congress want to cut corporate taxes to make the US more competitive and stop corporations from fleeing overseas. Frankly, this makes a significant permanent personal income tax cut fairly unlikely. The Administration is probably constrained from cutting spending too much. They won’t want to cut the defense budget and cuts to social programs like Social Security and Medicare will be very unpopular with retirees and pre-retirees (who tend to vote). The spending that’s left when you take out the debt-service is really a drop-in-the-bucket when it comes to the overall budget. Still, expect long lines at border crossings and more cuts in National Parks. It just won’t make much overall difference to the budget.
Proposals for new tax brackets
Mr. Trump’s current proposal is to have only three tax brackets: 12%, 25%, and 33%. This is identical to the House GOP Proposal, but its still not totally clear where the brackets would start. Mr. Trump’s plan calls for the 12% bracket to end at $75,000 for Married Filing Jointly, with the 25% bracket going up to $225,000 and the 33% bracket above that figure. Although there is currently 7 brackets, from 10% to 39.6%, the breakpoints for the current 25% and 33% brackets are very similar. This is primarily a tax cut for taxpayers currently in the 35% and 39.6% brackets.
Changes to Capital Gains Taxes and Qualified Dividends
The House GOP plan makes a significant simplification for Capital Gains taxpayers. Individuals would simply exclude 50% of their investment income; capital gains, qualified dividends, and interest income. The balance would be taxed at ordinary rates. So the effective rates in the 3 brackets would be 6%, 12.5%, and 16.5%.
President-Elect Trump’s plan would continue the current capital gains rates of 0%, 15%, and 20% corresponding to the proposed 3 ordinary rates (12%, 25%, and 33%). So you would pay 15% on long-term capital gains if your ordinary income was taxed at 25%.
Since repealing Obamacare is a given, the 3.8% Medicare surtax on net investment income would be repealed with both plans. This will probably make Medicare insolvent almost immediately, so it’s not clear how this revenue will be replaced.
Deductions and Personal Exemptions
The House GOP plan keeps the mortgage and charitable deductions and adds in some deductions for college and retirement savings. All other deductions will be eliminated including medical. The standard deduction and personal exemption get combined and be raised slightly from the current ones.
President-Elect Trump’s proposal will keep all current deductions, but phase out deductions more aggressively for taxpayers with higher incomes. He would also combine the standard deduction and personal exemption and raise them.
Alternative Minimum Tax
Under both proposals, the hated AMT would be done away with. Since both proposals lower the ability to use deductions for wealthier taxpayers, the current AMT wouldn’t work anyway.
New Deductions and Credits
President Trump has proposed a new above-the-line deduction for child care expenses which phases out at income levels above $500,000 for married couples. The deduction would be capped at the average cost of child care in the taxpayer’s state. For lower-income families and individuals the deduction becomes a refundable credit. Elder Care expenses for a dependent parent living in a taxpayer’s home would also be deductible up to $5,000 per year.
President-Elect Trump has proposed a new Dependent Care Savings Account similar to Health Care Savings Accounts to pay for dependent care as well.
The House GOP have been talking about enhancing the current Health Care Savings Accounts as part of their replacement of Obamacare.
Will Tax Reform Happen and When?
The GOP controls both the White House and Congress, so you would think tax reform will be no problem. Unfortunately, the GOP is not a very unified party and the new President might not have the same goals as the members of Congress. Once the current honeymoon period is over and the serious work begins, these different factions are going to have to compromise to get anything done. I think we will get some tax reform as well as some tax cuts, but I think the reform will not go nearly as far as some think and the tax cuts will be combined with removal of tax breaks to make the cuts revenue-neutral. Not what was promised, but something.
Tax reform is complicated and while I think the new government will want to give some taste of tax cuts or reform in 2017, I think it will be too hard to implement most of it and make it apply to 2017. Instead look for some token change in 2017 and the majority of the change implemented in 2018.
What would I do?
Well, no one actually asked me. But I’ll tell you anyway. I believe in a progressive tax system, but I hate the idea of brackets and phase-outs. They make people hire individuals like myself to make suggestions on how to lower income to get it into a certain bracket or under a certain phaseout. Let’s get rid of all that and create a continuously progressive tax system where your bracket changes in very small increments as you make more money. Most people do their taxes on a computer anyway and instead of having the IRS issue forms, make them provide a tax website that will do the calculations for you. It will be easy, stop people from having to do complex tax planning, and put a lot of tax planners and tax preparers out of business.
The other thing I would make sure to do is stop linking healthcare with the tax system. Whatever subsidies or premiums are going to be part of the Obamacare replacement, don’t make them part of the tax system. Figure out a different way to implement it.
Lucky thing I’m not in charge!