The Mielke Way on Tax Reform: Can It Really Be Done in One?
Dr. David Mielke, Retired Dean of the College of Business at Eastern Michigan University
U.S. House Republicans unveiled their tax reform last week, Tax Cuts and Jobs Act. There are reforms for individuals, corporations and universities. Because there are so many changes , the discussion will be done over a two week period. This week we will discuss corporate and university proposed changes and next week the changes impacting individuals. The Republicans passed budget guidelines that essentially limit the overall impact of the tax reform to a maximum increase in the federal debt of $1.5 trillion over a decade. It is also interesting to note that the final bill, if passed would not take effect until 2018. The biggest part of the projected debt increase would result from the corporate tax reform. Critics argue that this is corporate welfare. Others argue that since the current US corporate tax rate is the highest in the developed world that the US is no longer competitive and the high rate has caused companies to move overseas. There is also the issue of trillions of corporate profits sitting overseas because of the potential taxation if the foreign profits are returned to the US. Should corporate tax rates be reduced? Should companies have an incentive to repatriate earnings to the US? Or will those returned profits, rather than be invested merely be passed on to shareholders in higher dividends and stock repurchases—supposedly benefiting the wealthy? Should endowment earnings at private universities be taxed? What is the “Right Thing to do?” Let’s look at some issues:
1. Currently, at 35%, the US corporate tax rate is the highest in the developed world. The tax plan would reduce that rate to 20%. The reduction in the rate is estimated to cost $1.46 trillion over a decade and by itself would basically exhaust to $1.5 trillion pledged by the Republicans. The rate change would be permanent.
2. It creates a one time tax on overseas profits set at 12% for cash holdings and 5% for illiquid assets, a provision meant to force companies to repatriate profits. Companies are estimated to have over $2 trillion in profits overseas. It is estimated that this change would generate $223 billion.
3. Advocates of this change argue that the cash returning to the US would be invested here, increasing productivity for our workers and as a result, higher pay. Critics say the companies will just pay higher dividends or buy back shares, again benefiting the wealthy.
4. Taxes would no longer be assessed on profits worldwide, but rather basically on just income earned in the US. This is the standard in all other developed countries.
5. The plan sets a 25% rate for pass through businesses such as S corporations, LLCs and partnerships. The plan includes complicated guardrails that limit people from turning what would otherwise be wage income taxed at up to 39.6% into business income taxed at a lower rate.
6. Companies would be allowed to immediately deduct capital investments such as factories and machinery. Currently, companies depreciate these investments, but at different times the government has allowed accelerated depreciation to boost weak economies.
7. There would be new limits on corporate interest deductions, which would be capped at 30% earnings before interest, taxes, depreciation and amortization, which is a measure of cash flow. This may have the effect of companies borrowing less and instead financing new purchases with the sale of stock. Some in the bond market and banks are already concerned this will reduce the amount of corporate borrowing.
8. Businesses would lose the ability to deduct certain executive compensation above $1 million, which they can now do for performance based pay.
9. An interesting change that had not been discussed previously is that tax exempt bonds could not be used to finance professional sports stadiums.
10. We will discuss the changes for students next week, but for large private universities, there would be a 1.4% excise tax on net investment income if they have at least 500 students and assets of at least $100,000 per full-time student.
Economists have long debated that corporate taxes are paid by someone else, either workers in lower wages, customers in higher prices or shareholders in lower after tax returns. A recent study found that cutting the corporate tax rate to 20% would raise average wages by $4,000, up to $9,000, another study predicted a 4% to 7% wage gain, others predicted closer to $1,000 per worker. The debate is over the magnitude of the raise, not the fact that American workers will benefit if taxes are reduced. Yet the Democrats criticize any reductions as corporate welfare. Should the US lower corporate rates? Should corporations be able to repatriate profits at a lower tax rate? Should the rate for pass through income be reduced? Should the deduction for executive pay be restricted, interest deductions be limited, financing for sports stadiums with tax exempt bonds be stopped—what about taxing private university endowments? What is the “Right Thing to do?” As with all attempts to reform any laws there is good news and bad news—something to like and something to dislike. However, from the overall picture, the corporate side of tax reform should be passed–in my mind a no-brainer. The tax rate reduction will cost is estimated at $1.46 billion, reduced by the increase in revenue from the repatriation of earnings of about $223 billion and further reduced by the limitation on executive pay deductions and interest expense deductions—the result, a net impact on the debt of less than $1.25 trillion over 10 years. Add to reducing the cost through the stimulus to the economy in terms of economic growth as well as the increase in wages to workers that will also generate more tax revenues. The problem is however, that as with the corporate side, there are critics—there are even more critics on the individual side of tax reform—much to like, but for many, much more to dislike. Even though the Republicans can use reconciliation requiring only 51 votes in the Senate, by packaging corporate and individual tax reform in one bill the question arises, “Can it Really Be Done in One?” More next week.