|Last Friday night’s tax legislation journey into Saturday morning will be a bad memory for a long time to come. After the Senate passed its version of the Tax Cuts and Jobs Act, the process formally moved to conferencing, though the Senate bill was substantially pre-conferenced. There, outstanding differences are being sorted out, with the final conference call expected ten days to two weeks from now.
GOP leadership expects a smooth reconciliation of the House and Senate bills. But the Freedom Caucus has already held out on a procedural vote to send the House bill to conference. The Senate, which passed its bill 51-49, faces the possibility of losing a seat in Alabama and an even narrower margin for victory, possibly complicating a Senate vote on final passage.
Amid this background and the fluid negotiations, which provisions are in contention as negotiators work out differences and where do they stand today? See below.
- Brackets — The House bill reduced the number of brackets from seven to four and maintains the top rate of 39.6 percent, although it raised the income level at which that rate applies. The Senate, by contrast, keeps seven brackets, but drops the top rate down to 38.5 percent for filers with income over $500,000. To pay for the these decreases, the Senate sunsets these tax breaks after 2025– a point that has raised the ire of conservatives in the House who want individual rate cuts to be permanent. The Senate bill also changed to a slower way of measuring inflation– the chained Consumer Price Index for adjust tax brackets. A slower measure of inflation would push middle class taxpayers into higher brackets over a longer period of time.
- State and Local Property Tax Deductions — State and local property tax deductions are a major sticking point for House Republicans in high tax states such as New York, New Jersey and California. Both the House and Senate bills would eliminate SALT income tax deductions and cap SALT property tax deductions at $10,000. Ways and Means Chairman Kevin Brady signaled that lawmakers may open up the $10,000 cap on state and local property taxes to include income tax on a combined basis, which would bring minor relief to high tax states.
- ACA Individual Mandate — The Senate bill would zero out the penalty under the Affordable Care Act’s individual mandate. The House, by contrast, resisted the urge to combine the Republican’s two major legislative goals (ACA repeal and tax reform). The move was a revenue-raising gamble for Byrd-rule constrained Senate Republicans that would see some 13 million Americans lose healthcare over the next decade. On Tuesday, Rep. Brady said he expects the House to adopt the individual mandate repeal in conference.
- Deduction Grabbag — The House version of the bill eliminated a number of deductions that the Senate retains. Most significantly, the House limited the mortgage interest deduction on first mortgage principal of $500,000, where as the Senate retains the current $1,000,000 limit. Two other important deductions that the Senate bill protects are the medical expense deduction (which the Senate bill temporarily expands) and the student loan interest rate deduction.
- Child Tax Credit — To accommodate the concerns of Senators Lee and Rubio, the Senate bill expands the child tax credit to $2,000. This is more generous than the $1,600 credit in the House version.
- Estate Tax — Both the House and the Senate bills nearly double the estate tax exemption from $5.6 million to $11 million. The House bill repeals the estate tax in 2025, where the Senate retains the estate tax makes the $11 million exemption permanent.
- Timing on Corporate Rate and Full Expensing — Both the Senate and the House versions reduce the corporate tax rate to 20 percent, but the two chambers differ on timing. The House bill cuts the corporate rate beginning in 2018, whereas the Senate cut begins in 2019. Close observers of the process expect the corporate rate reduction to be applied in 2019 after conferencing is complete, provided full expensing and denial of interest deductions begins in 2018.
With immediate expensing and a tax cut in year two, Republicans believe this will spur economic activity in 2018 as corporations would be motivated to acquire property in 2018 and deduct the full cost at a 35 percent tax rate as opposed to a 20 percent tax rate in 2019 and beyond. The House bill would expand expensing to “used” property, while the Senate bill only applies it to new property.
- Corporate Alternative Minimum Tax (AMT) — In their haste to pass an unpopular bill, Republicans appear to have made a mistake at the eleventh hour. Scrambling to find revenues for Byrd Rule compliance, Republicans decided to keep the 20 percent corporate AMT to raise at least $40 billion over a decade. The AMT currently applies at a lower rate (20 percent) than the current corporate tax (35 percent), but denies a number of deductions to prevent corporations from taking advantage of deductions and credits to bring their cash tax rate below 20 percent. To the horror of the business groups, however, under the Senate bill, both the corporate tax rate and the AMT are at 20 percent so it effectively denies certain deductions.
House Majority Leader Kevin McCarthy insisted negotiators remove the corporate AMT. Including the provision in final passage would undermine policy changes for international firms looking to benefit from research and development and new markets tax credits, and the reduced rates for profits earned overseas or from patents. The Chamber of Commerce characterized the Senate’s maintaining the tax as “an unpleasant surprise.” A compromise position is being discussed to lower the AMT rate to 15 percent or less to audit the problem of disallowing the litany of AMT preference.
Rather than debating a maximum rate at which pass-through entities (PTEs) would be taxed, as the House did, the Senate pursued a tax deduction.
According to the initial bill from the Senate, PTEs could qualify for a 17.4 percent deduction in their income tax rate. This rate increased to 23 percent as Senators Johnson and Daines advocated for a higher deduction rate for PTEs. With a top individual tax rate in the Senate bill of 38.5 percent, after the deduction is applied, PTEs would be taxed at just 29.6 percent.
The Senate bill does provide caveats for its application. PTE owners making less than $250,000 if single and $500,000 if married could benefit from the deduction with few limitations. For those whose income exceeds these thresholds, the following limitations would apply. “Personal service businesses”, including services in law, accounting, consulting, etc., that earn income above these thresholds do not qualify for the 23 percent deduction rate. Owners of firms outside these industries who earn income above these thresholds are subject to a deduction limit equivalent to their share of 50 percent of W-2 wages or partnership guaranteed payments.
The purpose of these limitations is to prevent wealthy business owners from benefitting from the reduced rates for labor income. The House attempted to account for this loophole in its version of the tax bill by implementing the 70/30 rule where only 30 percent of PTE income would qualify for the 25 percent rate; the other 70 percent would be deemed attributable to labor and taxed at the top individual rate of 39.6 percent.
Both bills deliver a win for PTEs since current law imposes a tax rate of 39.6 percent, but expect to see PTEs lean towards the Senate version since the provisions are overall more generous towards those who earn more. The House rate, after the 70/30 rule is applied, turns out to be 35.2 percent, whereas the Senate rate is 29.6 percent. Sens. Johnson and Daines are likely to stand strong firmly by their negotiated rate as the bill moves to committee.
The Senate and House bills will require quite a bit of work to harmonize, yet on one issue they are in lock step. Both bills add $1.5 trillion to the deficit over the next decade. The Republican Party plans to add more to the deficit than TARP and the Stimulus combined. While Sen. Corker and the Freedom Caucus attempted to reign in the figure when the budget resolution was up for debate, a $1.5 trillion concession shows that the GOP has fundamentally changed its position on the importance of balanced budgets.
Senator Sanders has been sounding the alarm that the GOP has set aside their deficit concerns only temporarily, and that they will be eager to trigger “Paygo” rules to slash entitlement spending when deficits begin to rise. Has the GOP has abandoned its deficit-hawk ideology, or has it simply developed a strategy to force massive entitlement cuts through the back door?
President Trump wants a final tax deal before December 22. On Monday, House Republicans in the Freedom Caucus injected drama into a vote to proceed to conference committee in order to extract concessions over debt ceiling negotiations.
Next week, the Alabama Senate special election could send a 49th Democrat to the Senate who would vote against a conferenced tax bill, leaving Republicans no margin for error. Mitch McConnell has already reminded his “friends in the House” that “we have a very, very slim margin in the Senate.” The Republican ideal is to finish up conferencing before Alabama’s special election on the twelfth. Given the major differences between the bills, the reality is it will likely be delayed until a few days after, but still prior to Dec. 22.