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US tax reform - will simplification lead to savings?

  Tax

Ask anyone what they remember about the 2016 US presidential elections and it’s safe to assume that most will recall a certain wall and several controversial statements from the Republican candidate. Although Donald Trump became the first major party nominee since 1976 not to release any tax returns, it’s fair to say his tax proposals didn’t make the more memorable headlines. However, Trump in fact announced a very ambitious income tax plan on his campaign trail to remove several tax brackets, eliminate Alternative Minimum Tax (AMT) and personal exemptions, repeal the Affordable Care Act (ACA, also known as Obamacare) and significantly increase standard deductions from gross income.

The early days of Trump’s presidency saw an attempt to repeal the ACA thwarted by a lack of party support, but otherwise there was no real tax talk, other than a pledge from the Trump administration to announce something “phenomenal” in the weeks that followed.

An announcement finally came on 26 April 2017, containing some very familiar-sounding pledges: cutting the number of tax brackets from seven to three, doubling the standard deduction and repealing AMT among other measures.

A further development came on 4 May when the House of Representatives (House) narrowly passed the American Health Care Act (AHCA), postponing until 2023 the proposed abolition of the 0.9% Additional Medicare levy on high earners introduced under Obamacare.

What happens next?

Following the announcement, the Trump Administration pledged to hold sessions with stakeholders and work with the House and the Senate to formalise the plan.

While Trump has the power to sign new tax legislation, he can’t actually create any; the US Constitution states that all revenue-making bills must originate from the House. Hence, back in June 2016, House Republicans released a tax blueprint, with the intention of developing this into formal legislation to be passed through the chamber in 2017. This contained very similar proposals to Trump’s election pledges and his 26 April announcement, suggesting that he and House Republicans are working towards a shared goal of a simplified tax system. The following table compares both plans with current legislation for married taxpayers filing jointly:

Any bill passed by the House must then be passed by the Senate before it can be delivered to the president, who must sign it into law or veto it. Crucially, the November 2016 elections saw the Republicans maintain their majorities in both the House and Senate, increasing the odds of Trump’s tax vision becoming a reality.

What would the impact be?

The table below illustrates the potential impact of Trump’s proposal for a married taxpayer with two children, filing jointly:
 

  Current Trump
Gross income 100 000 100 000
Standard deduction     (12 700) (24 000)
Personal exemptions (16 200) (0)
     
Taxable income 71 100 76 000
     
Total tax 9 733 ?


This shows that any gain made for taxpayers by doubling the standard deduction could be negated by the abolition of personal exemptions. Furthermore, under the current system, taxpayers choose between claiming the standard deduction or itemised deductions, which include elements such as state tax due, medical expenses and mortgage interest payments. A taxpayer may presently claim more in itemised deductions than the proposed new standard deduction, so the abolition of itemised deductions could increase taxable income even further.

Unfortunately, the 26 April announcement did not specify the income ranges to which the three new tax rates would apply, which will determine the amount of tax due. It was indicated that these would be discussed and released in due course. However, the tax rates Trump announced during his campaign, while being slightly different to those announced on 26 April, did propose accompanying income ranges:

Taxable income (USD) Rate of tax (%)
0 – 75 000 12
75 000 – 225 000 25
Over 225 000 33

Applying theses rates to the taxable income of USD 76 000 calculated above results in a total tax figure of USD 9 250, a saving of USD 483 compared to the amount due under existing rules, although the income ranges which are eventually released could produce a very different result.

Even if the proposals become law, several changes could be made along the way. Although the Republicans have majorities in both the House and Senate, compromises may have to be made to secure the required votes and the signature of the president.

When will this take effect?

Unsurprisingly, this is very difficult to predict, but the last major US tax reform (Tax Reform Act of 1986) took almost 11 months to become law after first being introduced in the House. The provisions of a new tax law could theoretically become effective on any date, but in practice this usually happens immediately, on the first day of the following tax year or retroactively from the first day of the current tax year.

In the meantime, we will be monitoring events in the US closely and will report on further developments.

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