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Financial Planning > Tax Planning > Tax Deductions

4 Good Things in a Bad Tax Bill

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The Tax Reform Act of 1986 was a landmark piece of bipartisan legislation, preceded by years of groundwork by Treasury Department experts and carefully crafted to permanently lower tax rates while not putting a significant dent in tax revenue. Yet a year after its passage, Congress was already tweaking the tax code. In 1990 lawmakers did away with one of the tax reform law’s signature accomplishments, the top income tax rate of 28% (it was raised to 31%). They have been assiduously adding complications to the tax code ever since.

The Tax Cuts and Jobs Act of 2017 has been billed as the biggest rewrite of the tax code since 1986. But if it is enacted this week as expected, it will be entirely along party lines. The legislation is projected to put a major dent in tax revenue — a dent that would be even bigger if so many of its provisions weren’t set to expire in a few years. And it was assembled in rushed, at times haphazard, fashion. As a group of prominent tax scholars argued in an assessment released Monday:

The legislation is … likely to cost more than the current estimates of over $1 trillion, to advantage the well-advised (and their advisors) in ways that are both deliberate and inadvertent, and to face legal roadblocks like WTO non-compliance that could undermine key components of the legislation. Finally, the bill includes glitches that could lead to haphazard and unexpected results that could arbitrarily favor or penalize taxpayers.

So it’s a good bet that Congress will be revisiting the tax code soon! At least, one would hope so.

Still, there are provisions of the tax bill that emerged from conference committee on Friday that strike me as keepers: positive, important changes that, even if imperfectly executed this time around (and in some cases due to expire in 2026), would be good to keep around in some form.

A lower corporate tax rate: While lowering corporate taxes is extremely unpopular with voters, tax experts in both parties agree that the current 35% rate is counterproductively high. Add in average state and local taxes, and the U.S. has the highest statutory corporate rate in the developed world, which gives corporations a big incentive to structure their operations in ways that avoid U.S. taxes. 

President Barack Obama proposed cutting the top corporate rate to 28% in 2012, along with shrinking corporate deductions and loopholes to make up for the revenue loss. The current tax bill shrinks some deductions and loopholes, too, but not nearly enough to make up for the likely revenue loss from cutting the rate to 21% from 35%. So 21% shouldn’t be sacred, and Congress could surely do more on the deduction-and-loophole front. But going back to 35% would be a bad idea.

Restrictions on business interest deductions: Corporations can deduct interest payments from their taxes but not dividends. This means that corporations financed largely with debt effectively don’t pay corporate income taxes. This is bad for the economy because, as former mutual fund industry executive and Brookings Institution senior fellow Robert C. Pozen explained a few years ago:

To begin with, this bias strongly encourages financial institutions and other firms to maximize their leverage — their debt relative to their equity. High leverage increases the risk of bankruptcy and magnifies any financial crisis because a business under pressure has little equity cushion to absorb losses.

The tax bias against equity makes it much more expensive for small businesses and knowledge-based companies to raise capital. Because they do not have the hard assets sought by banks to collateralize loans, such companies are forced to sell large chunks of their equity.

The new tax bill restricts the deduction for business interest to 30% of income. There are some complications regarding how that interest is defined, some dodgy workarounds for pass-through businesses, and an exemption for real estate debt. But on the whole, Pozen told me in an email, “the bill’s limits on deductibility of interest are a substantial step in the right direction.”

The higher standard deduction: OK, we probably won’t all be filing our taxes on a postcard, as House Speaker Paul Ryan promised. Doubling the standard deduction, though, means that fewer American taxpayers will find it worth their while to itemize deductions (the percentage of taxpayers doing so is expected to drop to 6% from 30%). Over time, this should not only make it easier and less time-consuming for most people to fill out their tax forms, but also encourage them to pay less attention to the tax code in their day-to-day economic decision-making.

Now, the fact that the current legislation also gives many high-income taxpayers (those with income from pass-through businesses, mainly) incentive to pay more attention to the tax code in their day-to-day economic decision-making may cancel out much of the positive effect here. But that doesn’t make raising the standard deduction a bad idea.

The smaller mortgage deduction: The current $1 million limit on the mortgage amount for which interest can be deducted dates back to those 1987 tax tweaks I mentioned above. At the time it affected only a few very-high-end home buyers. Now the median single-family home in the San Jose, California, metropolitan area — the nation’s most expensive — costs $1.2 million, according to the National Association of Realtors, and million-dollar-plus houses and condos are common in lots of other metro areas, especially along the coasts.

The new tax bill would reduce the deductibility limit to $750,000 for new mortgages, and do entirely away with the deductibility of interest on home equity loans. This is understandably controversial, but it’s also almost certainly good economic policy. There’s just no good reason to give tax subsidies to upper-middle-class homebuyers, and several good reasons not to: The deduction encourages people to take on more debt than they otherwise would, drives up housing prices, and favors buyers over renters. The change will have no effect on current homeowners’ tax bills, and its impact on homebuyers is incremental: If you take out an $800,000 mortgage, the interest on $750,000 of that will be still be tax-deductible. It would put downward pressure on home prices in expensive cities and suburbs, but (1) the effect is likely to be modest and (2) downward pressure on home prices in very expensive places isn’t necessarily a bad thing.

These mortgage and home equity changes, along with the increase in the standard deduction, are all due to expire in 2026 along with most of the other individual income tax changes in the legislation. This was done to lessen the negative revenue impact of the bill — even though some of the changes, such as those involving mortgages, would raise revenue. The authors of the current legislation hope that future Congresses will extend these provisions. This is a terrible, cynical way to make tax policy. But future Congresses should extend some of the provisions anyway.

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