2017 Tax Reform: proposed overhaul raises concerns on deficit & abuse of pass-through rate

As reported by Reuters, following the release of a “framework” for tax reform by the Trump Administration and several key Republicans in Congress (see ¶ 2 for more details), a number of critics voiced concerns about how these reforms would affect the deficit. In addition, some commentators noted that the new lower rate for pass-through businesses could be subject to abuse.
Deficit concerns. The proposal drew a swift, skeptical response from Senator Bob Corker (R-TN), a leading Republican “fiscal hawk,” who vowed not to vote for any federal tax package financed with borrowed money. “What I can tell you is that I’m not about to vote for any bill that increases our deficit, period,” Corker told reporters.
Trump said his tax plan was aimed at helping working people, creating jobs and making the tax code simpler and fairer. But it faces an uphill battle in the U.S. Congress with Trump’s own Republican Party divided over it and Democrats generally opposed.
The plan would lower corporate and small-business income tax rates, reduce the top income tax rate for high-earning American individuals, and scrap some popular tax breaks—including the state and local tax deduction, which primarily benefits people in high-tax states dominated by Democrats.
Forged during months of talks among Trump’s aides and top congressional Republicans, the plan contained few details on how to pay for the tax cuts without expanding the budget deficit and adding to the nation’s $20 trillion national debt.
The Committee for a Responsible Federal Budget, a Washington-based policy group, estimated on Wednesday the plan contained about $5.8 trillion of total tax cuts over a decade, with $3.6 trillion of base broadening, resulting in a net cost of $2.2 trillion through 2027.
Analysts have warned huge tax cuts would balloon the deficit if economic growth projected by Republicans to offset the costs fails to materialize amid rising interest rates.
The plan still must be turned into legislation, which was not expected until after Congress makes progress on the fiscal 2018 budget. It must then be debated by the Republican-led congressional tax-writing committees, who also must fill in a number of gaps in the framework.
Pass-through abuse concerns. The plan would set a new 25% tax rate for “the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations.” Pass-throughs represent about 95% of all U.S. businesses.
Under current law, the profits of those companies “pass through” directly to their owners and are taxed as personal income, at as much as a 39.6% individual income rate—which is higher than the 35% statutory corporate tax rate. Business owners have long complained that the disparity is unfair, especially in view of the fact that the effective tax rate paid by many corporations is often much less than the 35% statutory rate.
Cutting that to 25% could mean big tax savings for small-business owners, but it could also be vulnerable to abuse by other individuals and companies, analysts said. The problem, according to the plan’s critics, is that financial entities such as private-equity, venture-capital and hedge funds are all partnerships whose wealthy partners could see substantial tax savings on large portions of their income unless congressional tax writers find a way to exclude them.
The framework signaled that the Administration was aware of the potential problem but would leave addressing it up to Congress. Specifically, it provided that “the committees [i.e., Ways and Means, and the Senate Finance Committee] will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”
Treasury Secretary Steven Mnuchin said two weeks ago that the Administration would ensure partners at services firms such as accounting, law and financial firms would not benefit from a new, lower pass-through rate. Tax experts, however, have said it would be difficult for congressional tax writers to exempt partners at services firms from using the new pass-through rate.