Republican sweep creates potential for major tax changes

The stunning upset victory of businessman Donald Trump and the Republican sweep of the House and Senate open up the possibility for significant tax legislation over the next two years.

Both Trump and House Republicans campaigned on ambitious tax reform platforms that would dramatically cut rates on business income and reshape the tax code. Although Republicans will control the White House and both chambers of Congress, major tax changes still face hurdles, and the unexpected election results and divisive campaign create significant legislative uncertainty.

Trump won only a narrow victory in the Electoral College, winning battleground states by razor-thin margins and losing the popular vote. It may be difficult for him to claim a strong mandate, and he has proven divisive in his own party. During the campaign Trump had a frosty relationship with House Speaker Paul Ryan, R-Wis., one of the GOP’s strongest advocate for tax reform. Trump has also broken with key senators like John McCain, R-Ariz., and Lindsey Graham, R-S.C., whose votes might be needed in a narrowly divided Senate. McCain famously voted against both the 2001 and 2003 tax cuts after losing the Republican primary to President George W. Bush.

Republicans held onto their majorities in both the Senate and the House but lost two seats in the Senate. They now have just 52 seats. Senate rules allow the minority party to use many procedural techniques, such as filibusters, to effectively block legislation that falls short of 60 votes. Senate Democrats may be emboldened by Trump’s loss in the national vote count and his unpopularity with their Democratic constituencies to pursue a pure obstructionist agenda.

There are budget procedures such as reconciliation that allow tax bills to pass the Senate on simple majority votes, but they present their own set of challenges. Reconciliation was used to pass both the 2001 and 2003 tax cuts, but both had to be written to expire within the 10-year budget window. In addition, reconciliation can generally only be used only once per budget cycle, and repeal of the Affordable Care Act (ACA) is a top candidate for this procedure.

Trump has said he wants to move aggressively on tax legislation in 2017, but he will have other top priorities competing for attention. In addition, there are several tax items on the potential lame duck agenda. The following contains more information on the Trump and House tax plans and the outlook for tax legislation in the lame duck session and the next Congress.

New leadership The congressional leaders who will drive the tax legislative agenda in 2017 will be key. Despite rumblings that the Freedom Caucus, a far-right-leaning wing of House Republicans, could seek to replace Speaker Paul Ryan, R-Wisc., he was approved easily on Nov. 15. Ryan and Trump also appear to have patched up their difficult relationship from the campaign.

The show of unity improves the chances for significant tax legislation. Ryan is the former chair of the House Ways and Means Committee and is heavily invested in pursuing tax reform. He and current Ways and Means Committee Chair Kevin Brady, R-Texas, released a tax reform blueprint this year that they hope to introduce as a full bill in 2017. Trump’s political inexperience could allow congressional Republicans significant leeway in driving the legislative agenda unless he seeks to be heavy-handed with his victory.

Senators Mitch McConnell, R-Ky., and Orrin Hatch, R-Utah, respectively remain Senate Majority Leader and chair of the Finance Committee. Hatch has been working on a corporate integration proposal that provides C corporations a deduction for dividends paid to shareholders, while imposing a withholding tax on those dividends paid.

Sen. Chuck Schumer, D-N.Y., was chosen by Democrats to replace Senate Minority Leader Harry Reid, D-Nev. Schumer has been a supporter of compromising with Republicans on an international reform and infrastructure bill, and he has quietly opposed efforts to change the taxation of carried interest. Ron Wyden, D-Ore., remains the ranking minority member of the Senate Finance Committee. He has released tax reform discussion drafts on depreciation, financial instruments and retirement incentives.

Lame duck session Congress returned on Nov. 14. The top item on the agenda is extending government funding beyond its Dec. 9 expiration date. But the longer it takes for members to agree on spending, the more opportunities there will be to move last-minute tax bills. House Republicans are currently pushing for a short-term extension of funding through March that would allow Congress to adjourn early. If they prevail, there will be little or no time for tax legislation.

Lawmakers have discussed attaching expiring tax provisions to a spending agreement, or trying to move a package on its own if Congress stays in for longer. Brady has recently said, however, that it might be better to address the expiring provisions through tax reform next year. Still, many tax writers will be pushing to extend some of the more than 30 provisions that are set to expire at the end of 2016, including:

  • Mortgage insurance deduction
  • Exclusion for home debt forgiveness
  • Accelerated depreciation for racehorses and motorsport tracks
  • Empowerment zone incentives
  • Alternative fuel and biofuel and biodiesel credits
  • Energy efficient new homes credit
  • Energy efficient home improvement credit
  • Section 179D deduction for energy efficient commercial buildings
  • Credits for nonwind and nonsolar energy property under Sections 45 and 48

Democrats have argued in particular that the Section 45 and 48 credits for energy property in addition to wind and solar were inadvertently excluded under last year’s tax bill. Earlier in the year, Republicans seemed to acknowledge the oversight and pledged a remedy, but it is unclear how valid those assurances remain.

Tax writers have also discussed passing technical corrections, which could include more substantive changes to the new partnership audit rules. Other possible tax bills that could be considered include:

  • Mobile Workforce State Income Tax Simplification Act of 2015 – Bars states from taxing the income of nonresident employees who stay less than 30 days
  • The Retirement and Enhancement and Savings Act of 2016 – Expands the ability of smaller employers to pool together and create multi-employer qualified plans and makes other retirement incentive changes

Trump and House tax platforms Trump made an effort during the campaign to bring his tax platform closer to the House Republican blueprint from Ryan and Brady. Both share many similarities, although the House plan provides a more complete picture. Ways and Means staff have been working for several months on filling in the details. Details are lacking for many of Trump’s proposed changes, and campaign surrogates have sometimes offered contradictory explanations. The key proposals include the following:

  • Individuals – Both Trump and the House plan would cut the top tax rate from 39.6% to 33%. The House plan proposes to tax long-term capital gains and dividends at ordinary rates, but with a 50% deduction for an effective rate of 16.5%. Trump would retain the top rate of 20%. Both plans generally support limiting or repealing many individual deductions but retaining incentives for mortgage interest and charitable giving.
  • Estate tax – Both plans would repeal the estate and gift tax, although Trump would remove the step up in basis at death and tax the capital gain of inherited assets after a $10 million exemption. This issue has long been popular with the Republican base and could in particular see renewed interest.
  • Corporations – The House plan would cut the corporate rate to 20% while Trump proposes a 15% rate.
  • Pass-through rate – The House plan proposes a 25% rate on active business income from a pass-through after assigning some portion as compensation. Trump has offered conflicting information on this issue. He has proposed extending the 15% corporate rate to pass-throughs, but only “small businesses” would enjoy the rate and pass-through treatment. “Large businesses” would be required to be taxed as C corporations to get the lower rate. He has offered no information on what the large businesses threshold would be.
  • Business incentives – Both plans would generally repeal all business incentives except the R&D tax credit. Both would also repeal the alternative minimum tax, although the House plan would retain the 90% limitation on net operating losses.
  • Depreciation – The House plan provides for full business expensing as part of an effort to reshape the business tax code into more of a consumption tax. Businesses would not be allowed to take an interest deduction in excess of interest income, with an exception for the financial and leasing industries. Trump offers a narrower expensing provision only for manufacturing equipment if the company forgoes interest deductions.
  • International – The international proposals show the greatest divergence. The House plan would create a 100% dividends-received deduction and repeal Subpart F so that offshore income would essentially be free of U.S. tax. Trump proposes to eliminate deferral so that all foreign income would be taxed in the U.S. immediately, but at the low 15% corporate rate. Trump would impose a one-time 10% tax on unrepatriated earnings, while the House plan would use an 8.75% rate on cash and cash equivalents and 3% on all other earnings. The House plan also seeks to make the U.S. tax border adjustable in a move to make business taxes more like a consumption or value-added tax.

Political outlook for reform The similarity in the Trump and House tax proposals and the Republican control of all the levers of government would seem to make tax reform likely. In reality, it’s not so simple. The cost estimates of both plans are high, even those scored by Republican-friendly economists. The right-leaning Tax Foundation estimates that on a static basis, the Trump plan would cost more than $4 trillion and the House plan would cost $2.4 trillion. Even if projected revenue increases from economic growth are included, the costs present political problems.

It is unclear whether Republicans are willing to spend their political capital on debt-financed legislation that Democrats would quickly characterize as tax cuts for large corporations and high-income taxpayers. A tax reform package that focuses on big businesses and high-income investors could also alienate the more middle-income voters who are largely responsible for Trump’s victory. He may need to tweak his tax goals to satisfy his electoral base. On top of that, it is unclear whether Republicans can muster the necessary votes in the Senate after considering the 60-vote procedural hurdles.

Reconciliation is an option, but has drawbacks. Republicans were able to pass the 2001 tax cuts using reconciliation, but the climate was much different. They were operating in a period of projected budget surplus, and even then, it took a Democratic vote and a vice-presidential tie breaker vote to enact that legislation. Reconciliation also bars revenue losses outside the budget window, so the tax cuts were set to expire in 2010 and were eventually rolled back under President Obama. Republicans may be reluctant to enact sweeping tax reform that would require an expiration date.

Republicans could also seek to pursue bipartisan tax legislation with Democrats. There has been some common ground in the past. The Obama administration proposed a cut in the corporate rate, and both Obama and Schumer have supported tying international reform to infrastructure. But like Republicans during the debate over Obama’s health care reform bill, Democrats might find it more politically expedient to unite in pure opposition to the Republican agenda.

ACA repeal Trump and most Republicans in Congress have fervently called for repealing the ACA in almost its entirety. They may have their opportunity now, but will run into the same 60-vote hurdle in the Senate, not to mention potential political trouble from being seen as cutting off health insurance for millions of Americans. Budget reconciliation could be used to overcome this hurdle, but that would leave it unavailable immediately for tax reform. Republicans have discussed passing two budgets this spring, one for the current fiscal year and one for the upcoming fiscal year. This would allow them to begin work on two reconciliation bills at once. They still need to work out the parliamentary wrinkles, and the party is far from unified on how to move forward.

ACA repeal could also get messy. Republicans want to retain some of the rule changes on coverage, and they will likely to have phase in repeal slowly so that they have time to craft legislation to replace it. They may find more common ground with Democrats on repealing the unpopular ACA taxes. The 2.3% medical device excise tax is currently suspended for sales in 2016 and 2017, and there is a one-year moratorium for 2017 on the health insurance industry fee. The 40% excise “Cadillac” tax on high-cost health plans that is currently scheduled to take effect in 2020 could also be on the chopping block.

Contact Mel Schwarz
Partner, Washington National Tax Office
T +1 202 521 1564

Dustin Stamper
Director, Washington National Tax Office
T +1 202 861 4144

Shamik Trivedi
Manager, Washington National Tax Office
T +1 202 521 1511

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