Wharton’s Jennifer Blouin discusses the potential impacts of U.S. tax reform.
With a new administration in Washington, D.C., tax reform is a topic of conversation this year. The White House would like to get something in place for 2018. But many questions surround the complex issue, both on the personal and the corporate tax side. Wharton accounting professor Jennifer Blouin recently gave a presentation on the issue to congressional staffers as part of an effort by the Penn Wharton Public Policy Initiative. Blouin joined the Knowledge@Wharton show on SiriusXM’s channel 111 to discuss the potential impacts of changes to business and personal income taxes.
An edited transcript of the conversation follows.
Knowledge@Wharton: The tax plan proposal from President Trump would drop the number of personal income tax brackets from seven to three. What would the impacts of that be?
Jennifer Blouin: Ultimately, the issue is that the bulk of our tax revenue comes from the individual base. There are about 150 million individual returns, relative to 10 million corporate returns. The problem is we want to have some sort of sweeping reform, but how do we pay for it? Ultimately, it’s going to have to be some give and take with regard to the individual items.
The White House proposal is really more about simplification. Bringing it down from seven rates to three, saying let’s just give one big standard deduction and take away the deductibility of the state and local taxes, get rid of AMT (alternative minimum tax), and of course my personal favorite, get rid of the death tax. Wrap all those together and it sounds pretty feasible. But the big item with regard to individual taxation is this treatment of pass-through income [when the income of an entity is treated like income of its investors or owners. Trump’s tax plan proposes to cut the rate for these taxpayers to 15%, the same as his proposed maximum cut for corporations.] Does it seem equitable that we should give some sort of rate reduction to business income that is from a corporation, like a publicly traded corporation, relative to the moms and pops who are running a shop or business and have a meaningful number of employees, yet they should be subject to the high 35% tax rate, which is even a proposed reduction from 40%. I think you get an equity or fairness discussion.
The current proposal says, “No, that [pass through] income should be subject to a lower tax rate.” That’s great. But then where do you define business income versus labor income or salary income? Is it fair that because I do my teaching through a university, I will be subject to a 35% tax rate, but if I set up as my own mom-and-pop shop and contract with the university, I would get a 15% rate? It also has self-employment implications in terms of Social Security and FICA. If you’re self-employed, everybody has a responsibility to pay their appropriate payroll taxes. So can you have 15% business income without it being self-employed? There’s a lot of dynamics in play. We just have the bare bones of an outline of what might happen.
Knowledge@Wharton: How much of a structural change are we talking about with the tax system under this simplification plan?
Blouin: This would be a massive undertaking. Every time you say simplification, I think all we do is multiply the number of code and regulation pages that we’ll ultimately have to wade through. It’s easy to say we’re going to make something simple. If we just say flatly, which is what this proposal does, that it’s a 15% [rate] for everybody that has business income, then somebody has to score it and say, “Do you recognize that bringing us down to 15%, each percent costs [the federal government] an enormous sum of money? Multiply that over a number of years and you’ve got some sort of significant fiscal deficit.”
“Once we start talking about reducing the tax rate to 15% percent on all business income, then we have to start thinking about some back stops or some additional limitations that we have to have.”
Knowledge@Wharton: A lot of people don’t realize that a lot of corporations aren’t paying 35%. They’re paying lower than that number already. So, this narrative about every business paying 35%, it’s not the case.
Blouin: This is a conversation about what is your average tax rate versus your marginal tax rate. If you and I were to look at our personal returns, we might look like we’re falling into what would be a 28% statutory tax rate. But if you take our total taxes paid over all our income, including our dividends and everything else, that tax rate is going to be lower just merely because we know we have a preference for what we call investment income in the United States.
I’m going to talk now specifically about corporations relative to the mom-and-pops and the pass-through business income. Corporations get things like depreciation. Bonus depreciation is something we have right now. If you buy a $1 million machine, you get to deduct it immediately. That makes the cost of buying that machine a little bit cheaper because now you get a 35% shield on that income, and that’s good news. But what it means then is when I look at their average tax rate this year on the income, it’s something less than 35%. The argument that’s been made is the corporations really aren’t paying 35%.
So, they’ve bought their $1 million machine and they make $5 million or $10 million more. Recognize that their average tax rate is going to rise because every time they make an additional dollar, they’re not going to buy an additional dollar of machine. At the margin, I would make the argument that they are paying 35%. Ultimately, I think the decision-making comes in at the margin. Will I do this activity and how expensive it is to me? That’s the rate that I think is relevant that we don’t see in a lot of the data because it’s always looking at some aggregate burden over a notion of income.
Knowledge@Wharton: There is an element to this tax reform that plays into whatever the rates may end up being. The possible growth on the back end ends up bumping up the tax rate. That’s a discussion happening on both the personal and the corporate side. A lot of people on the personal side believe if you’re lowering the tax rate, people are going to spend more money and have the potential to get a better job and make more money, and that bumps up the tax rate. It’s the same thing for corporate.
Blouin: That’s right. Right now, if you’re collecting something less than 35% on $1 billion, but if I can grow that to $30 billion and collect 15%, I’m still better off. That’s ultimately the notion of this proposed legislation. The proposed change in the system would say growth will help us pay for it, and I think there is some evidence to that. We can look back to some of the capital gains tax rates cuts and dividend