A 101 of Trump’s Tax Reform And Its Implications For Taxpayers

John W. Diamond, Director of the Center for Public Finance at Baker Institute, breaks down the new tax framework: What changes, what doesn’t and some specifics implications for Houston’s residents

A statue of former Treasury Secretary Albert Gallatin stands guard outside the Treasury Building in Washington. Trump’s campaign plans for a total overhaul the U.S. tax code — while maintaining the revenues flowing into the federal government — may have missed their chance in Congress.

On Sept. 27 the Trump administration released its framework for tax reform. Note the word “framework” instead of “plan” since many important details are unspecified in the initial release.

The intent is likely to leave room for negotiation in the legislative process. But this makes it hard to analyze the proposal in detail. However, the framework does provide an overview of the changes being proposed, and some broad generalizations are possible.

  1. The changes to the individual income tax system include collapsing the seven tax brackets under current law into three tax brackets with tax rates equal to 12 percent, 25 percent and 35 percent, with the possibility of a fourth bracket to tax high-income individuals.
  2. In addition, the proposal would increase the standard deduction to $12,000 for single filers and $24,000 for married filers, eliminate most deductions and the personal exemption but would maintain the mortgage interest and charitable donations deductions, increase the child credit and add a credit for other dependent care expenses, eliminate the alternative minimum tax and the estate tax, and allow “small” business income to be taxed at a maximum rate of 25 percent.
  3. Without knowing the details, such as the income cutoffs for the new brackets or the size of the child tax credit, it is difficult to assess the effects of the proposed framework. Another issue is that creating a small-business tax rate below the highest individual tax rate of 35 percent would create an incentive for taxpayers to reclassify wage income to minimize their tax burden. It is unclear how this will be prevented.

While detailed conclusions are impossible, some broad conclusions are possible.

  1. Many individuals that previously itemized deductions would no longer do so if the standard deduction is increased and the state and local tax deduction is repealed; this would be particularly true for lower- and middle-income families. In this case, the mortgage interest deduction would become a tax preference that benefits only the highest-income households, and thus the argument that it increases homeownership would be greatly diminished.
  1. In addition, the charitable deduction would also be limited to mostly high-income taxpayers. Eliminating the state and local tax deduction would have a significant impact on Houston taxpayers since property taxes would no longer be deductible from federal income taxes. However, in relative terms, the elimination of the state and local tax deduction would be more detrimental for high-tax states and areas with a relatively high cost of living.
  2. The corporate tax rate would be decreased from 35 percent to 20 percent. The proposal would eliminate the taxation of income earned abroad (i.e., the U.S. would move to a territorial corporate tax system) but impose a one-time repatriation tax on corporate income currently held abroad.
  3. It is unclear what anti-base erosion provisions would be included to limit the amount of tax avoidance under this framework.
  4. In addition, the proposal would allow for immediate expensing of capital purchases for five years, limit the interest-expense deduction and eliminate many tax preferences of businesses.
  5. The research and experimentation tax credit and the low-income housing tax credit would be maintained.
  6. Major questions remain about which business purchases would be allowed to be expensed (only equipment, structures and equipment, etc.) and to what extent interest deductions would be limited. One issue is that if you allow full expensing and maintain the interest deduction you will be subsidizing capital formation, which would be inefficient. In addition, if expensing is limited to only equipment, the tax system will inefficiently favor investment in equipment relative to other inputs such as structures. Note that keeping the interest deduction maintains the current preference for debt finance relative to equity finance.

This proposal  will almost certainly increase the federal deficit. It is worth noting that the proposal will be temporary — that is, the provisions will expire at the end of the budget window, and we will return to current law 10 years after enactment, since getting 60 votes, as required under Senate rules for policies that affect the long-term deficits, will be nearly impossible.


John W. Diamond 

John W. Diamond is Edward A. and Hermena Hancock Kelly Fellow in Public Finance |
Director, Center for Public Finance at Rice University’s Baker Institute for Public Policy