The 2017 Tax Cuts and Jobs Act (TCJA) was the most far-reaching tax legislation since the Tax Reform Act of 1986 (TRA86). It also put the final nail in the coffin of a tax reform movement whose major goal was to tax all forms of income equally.
TRA86 broadened the tax base, reduced individual and corporate tax rates, and equalized treatment of earnings, dividends, interest, capital gains, and business income of individual taxpayers. But Congress has been slowing chipping away at TRA86 for years, raising the top individual rate, reducing rates on capital gains and dividends, and increasing tax preferences. TCJA went much further, mostly in response to concerns about the impact of the corporate income tax. It widened the differential between the top individual and corporate income tax rates, introduced a new differential between ordinary income and income from pass-through businesses and added new differentials among different forms of foreign-source income of US corporations. We now have in all but name replaced the income tax with a schedular system that applies separate rules to different forms of income.
And maybe that is not such a bad outcome because the logic of TRA86 was flawed to begin with. It assumed taxing all sources of easily taxable income equally would make the tax law fairer, simpler, and more conducive to economic efficiency. But when some forms of income remain tax-free, neither efficiency nor fairness dictates that we apply the same rates to all remaining income. And both practical and political considerations dictate that we will never tax the value that people generate from non-market work they perform for themselves (home repairs, food preparation, child care) or the value of the services they receive from household assets such as homes and cars and will only tax in a very limited way the unrealized gains they receive on investment assets. These items all constitute economic income, but for measurement and reporting reasons are rarely taxable in income tax systems.
The tax system has for many years allowed special benefits for forms of income that are close substitutes for tax-free income. Examples are the preferential rates for realized long-term capital gains, which offset in part the tax costs of selling assets instead of accruing tax-free gains and the tax benefit for child care expenses, which offset in part the tax costs of working for taxable wages instead of performing tax-free household services.
The long-standing problems with taxing US multinational corporations stem from a similar inability to tax all sources of income. Because we cannot impose US income taxes on the foreign-source income of foreign companies, we face an unhappy choice of how to tax US-based multinational firms. Either we tax their foreign income at the same rate as domestic income, eliminating their incentives to shift investment and reported profits overseas, but placing them at a disadvantage with foreign resident companies. Or we exempt their foreign income, eliminating that competitive disadvantage, but encouraging them to shift even more investment and reported profits to low-tax countries.
TCJA addressed these problems by reducing the corporate income tax rate to 21 percent and eliminating the tax imposed when US companies access the profits of their foreign subsidiaries, bringing our corporate and international tax rules closer to those of our major trading partners. But this restructuring of the way we tax multinational firms created new problems. It increased incentives for US companies to shift profits to tax havens and created an incentive for companies currently taxed as pass-through businesses (S corporations, partnerships, limited liability companies) to convert to C corporations to benefit from the much larger gap between the corporate rate and the top individual income tax rate.
TCJA’s solution to these new distortions among activities was to add additional special provisions. To limit the shifting of intangible assets to tax havens, TCJA introduced a new minimum tax on “high-return” foreign-source income and provided a special low rate for domestic intangible assets that generate export sales. To address the new incentive for pass-through businesses to incorporate, TCJA introduced a new deduction of 20 percent of “business income”, creating a distinction between income tax rates on wages and on the profits of pass-through businesses that go to their owners. To prevent unlimited recharacterization of wages as profits, TCJA prohibited the use of this preference by high-earning professionals (accountants, lawyers, doctors) who are compensated with partnership profits in lieu of wages.
The result is the creation of many new boundaries that taxpayers can exploit by re-characterizing their income to claim the lower rates applied to favored forms of income. Boundary problems in the tax law are nothing new; the debate over carried interest illustrates that we are still arguing about what income should qualify for treatment as tax-preferred capital gain instead of compensation taxed as ordinary income. The distinctions among income types that TCJA added will be very hard to manage not only because they are new, but also because the TCJA was enacted quickly and not well vetted. Yet, with time and the proper regulatory and legislative fixes, we may eventually either learn how to manage these new boundaries or narrow or eliminate some of them.
We can continue to argue that the income tax would be much simpler and fairer if only we taxed all income the same. But that change will not happen soon and we will inevitably end up with some distinctions among income sources. The harder and more necessary task is to figure out which distinctions we should retain and how best to define and police their boundaries. Beyond this, we still face the challenge of raising enough revenue to pay for the rising costs of health and retirement spending as the baby boomer generation leaves the work force – a problem that the tax cuts in TCJA worsened and that a future Congress may worsen further by extending its temporary tax reductions.
