Reuven S. Avi-Yonah (aviyonah@umich.edu) is the Irwin I. Cohn Professor of Law at the University of Michigan Law School. He thanks David Mitchell and Steve Rosenthal for their helpful comments.
In this installment of Reflections With Reuven Avi-Yonah, Avi-Yonah considers which provisions of the 2017 Tax Cuts and Jobs Act should be retained and which should be allowed to expire at the end of 2025.
The debate over the tax package introduced January 16 by Sen. Ron Wyden, D-Ore., and Rep. Jason Smith, R-Mo., the chairs of the Senate Finance and House Ways and Means committees, is a preview of a much larger issue: What to do about the individual provisions of the 2017 Tax Cuts and Jobs Act that will expire at the end of 2025.1 This will be the most important tax policy issue for the next Congress.
The key question, which has already been the focus of some commentary, is which of the TCJA provisions should be extended. The Cato Institute, for example, has recommended extending the individual tax rates (up to 37 percent), but eliminating the larger standard deduction (scheduled to expire) and the personal exemption (scheduled to be revived). They also advocate eliminating the child tax credit, the mortgage interest deduction, and the deduction for state and local taxes, as well as all miscellaneous deductions. Under current law the child tax credit will be reduced but the other deductions will be increased. Cato also recommends repealing the individual alternative minimum tax, reviving full expensing for all businesses, eliminating the section 199A passthrough deduction, no loss limitations, adopting full territoriality, and repealing the estate and gift taxes. Most of these proposals are probably non-starters, but it is an opening shot in a lively debate.2
To make sense of this, a few facts about the TCJA are useful to remember. The TCJA was primarily driven by the desire of multinational companies to bring back the $3 trillion they accumulated offshore before 2017 by enacting a participation exemption, and by the desire of domestic corporations for a rate cut. The combination of these proposals (exempting foreign-source dividends and cutting the corporate rate from 35 percent to 21 percent) led passthroughs to lobby for their own rate cut, resulting in the section 199A deduction which, in some cases, reduces the passthrough rate from 37 percent to 29.6 percent. But this caused revenue losses that exceeded the $1.5 trillion increase in the deficit permitted by the reconciliation instructions, so Congress enacted various offsetting tax increases.3 These included the limit on the SALT deduction, global intangible low-taxed income, base erosion and antiabuse tax, amortization of research and experimentation expenses, new limits on the interest deduction and on losses, and the one-time mandatory repatriation tax that is the target of Moore.4
Second, the TCJA was skewed to the top of the income distribution. This skew came primarily from two sources: the passthrough deduction (which costs $414.5 billion and is heavily skewed toward the top)5 and the corporate provisions (which cost $653.8 billion, offset by revenue raised by the international provisions — $324.4 billion). A recent paper estimated that 80 percent of the corporate tax rate cut benefited the top 10 percent of the income distribution.6
Third, the corporate tax changes were made permanent (except for expensing), but the individual provisions (including the passthrough deduction) expire at the end of 2025. Of these provisions, the main change was to replace the personal exemption and most of the itemized deductions with a larger standard deduction plus an expanded child tax credit. Overall, these provisions largely offset each other (the net revenue loss over a decade is only $82.3 billion, assuming expiration). For most taxpayers, this led to major simplification, because over 90 percent of them do not have to worry about itemized deductions; if they only have wage income, tax filing is simplified. For the top 10 percent, taxpayers lose some cherished deductions (SALT other than $10,000 in property or income tax, some home mortgage interest), but they can afford it.
On the corporate side, the main change was a reduction of the rate (the United States’ 35 percent rate had been unchanged since 1993 and was the highest in the OECD), plus limited expensing (which was not worth much in 2017 but is worth more in today’s interest rate environment). Expensing was scheduled to expire as well so it would only lose $86.3 billion over a decade. There was also a partial repeal of interest deductibility (total repeal would have been better, given that even 30 percent of earnings before interest and tax deductibility plus expensing and a participation exemption led to negative tax rates and tax sheltering). The other corporate provisions are less important, but they generally raise revenue and partially offset the rate reduction in ways that are reminiscent of the Tax Reform Act of 1986 (which cut the corporate tax rate from 46 percent to 34 percent but significantly expanded the base).
For international provisions, there was a relatively high rate on past offshore cash (15.5 percent) and noncash (8 percent) accumulations, which raises $338.8 billion. The widely supported participation exemption costs money ($223.6 billion) but is more than offset by GILTI ($112.4 billion) and BEAT ($149.6 billion).
Overall, most of these TCJA changes do not strike me as unreasonable, with one big exception: section 199A, discussed below. The corporate rate can be increased to the OECD average of 25 percent or even higher because the corporate tax falls mostly on rents (above-normal returns). This is fair because it’s mostly borne by rich shareholders and efficient because it does not affect behavior.7 Expensing is too generous because it results in exemptions for normal returns and that, plus the participation exemption and interest deductibility, lead to negative tax rates. R&E amortization should also be retained.8 However, the international provisions are a big improvement, except for foreign-derived intangible income — even there, the rate increases in 2026 so the export subsidy is smaller and above the 15 percent minimum rate.9 The individual provisions (the larger standard deduction and the SALT limit) should be retained.
There is one big problem with the TCJA: the passthrough provisions. They cost a lot of money, are distributionally skewed to the top, and are horribly complex.10
The passthrough provisions are totally unnecessary. As noted, the TCJA was driven by two key considerations: the desire for a low corporate tax rate, and the determination not to significantly reduce the top marginal rate on ordinary income. Because owners of passthroughs pay tax at the ordinary income rate, this created the perception that the bill is unfair to passthrough owners.
But this perception is wrong for three reasons.
First, many passthrough owners (for example, hedge fund managers and investors) pay tax at a 23.8 percent rate on capital gains and dividends, not the ordinary income rate.
Second, taxable individual shareholders in C corporations are subject to a second level of tax on distributions and capital gains at 23.8 percent, so the after-tax return under the TCJA’s rate structure is (100 - 21 = 79 - (23.8 * 0.79) = 60.2), which is almost identical to the after-tax return on a passthrough investment, even if there was no rate reduction for passthrough income (100 - 37 = 63).
Third, if owners of passthroughs do not like the 37 percent tax on passthrough income, they need only check the box and their passthrough magically becomes a C corporation taxed at 21 percent. If you hate the rate, incorporate.
The problem is that TCJA tried to accommodate these spurious concerns by allowing a 20 percent deduction for some passthrough owners, resulting in an effective tax rate of 29.6 percent, which is much better than the C corporation combined corporate and shareholder rate (39.8 percent). Even that would not be a problem except that it leads to the desire to segregate income from some services (for example, by lawyers, accountants, and physicians) from income from capital, which creates an unworkable, unadministrable mess.11
Section 199A should therefore be allowed to expire as scheduled.
Overall, extending the individual provisions increases the budget deficit well above the $1.5 trillion envisaged by the TCJA. But if it makes sense as a tax policy matter, Congress should do it. After all, the U.S. public debt is approaching $20 trillion, and actuarial deficits of the main entitlement programs are about $28 trillion. So, in comparison, even another $250 billion per year is not a huge increase. The basic problem is the debt and the future actuarial deficit, not the deficit increase because of the TCJA, although the increase in interest rates does make the extension more expensive.
But isn’t it imprudent to add to the debt when it is already so high, and is likely to go much higher as baby boomers retire? I think the real question is why savvy investors are willing to buy U.S. 30-year Treasury bonds when they know that (according to the actuaries) by 2047 the entitlements (Social Security, Medicare, and Medicaid) will consume all the U.S. government’s revenue, leaving nothing for servicing their debt. Do they really expect the entitlements to be cut so the government can pay interest and principal to foreign bondholders? Surely that is politically implausible (seniors vote in very high percentages).
There are three reasons investors are willing to buy U.S. bonds under these circumstances: They know that the U.S. federal government has never defaulted since 1787, the United States borrows in its own currency (unlike Greece or Argentina), and the United States is an undertaxed country (31st out of 35 members of OECD). If necessary, the United States can increase taxes and pay off $20 trillion or more. I see a federal VAT in our future, which will not be a bad thing, as almost every other country has discovered. A broad-based federal VAT at 15 percent (the lower end of EU VATs) can raise $1.5 trillion in a single year, instantly wiping out the 10-year TCJA deficit increase. It can also be used to bolster the entitlements, which is the best way to address inequality.12
FOOTNOTES
1 See Reuven S. Avi-Yonah, “The Case Against Expensing R&E,” Tax Notes Int’l, Feb. 5, 2024, p. 743.
2 Adam N. Michel, “2026 Tax Increases in One Chart,” Cato Institute Blog, Dec. 12, 2023.
3 A few months later, CBO/JCT acknowledged they misestimated the increase, which was actually about $1.9 trillion; see Benjamin R. Page, “CBO Thinks the TCJA Will Cost $433 Billion More Than Last December’s Estimate. What Happened?” Tax Policy Center (Apr. 30, 2018).
4 Moore v. United States, No. 22-800.
5 See Chuck Marr, “JCT Highlights Pass-Through Deduction’s Tilt Toward the Top,” CBPP (Apr. 24, 2018).
6 See Patrick J. Kennedy et al., “The Efficiency-Equity Tradeoff of the Corporate Income Tax: Evidence From the Tax Cuts and Jobs Act” (Nov. 14, 2023).
7 Kimberly A. Clausing, “Capital Taxation and Market Power,” SSRN (Dec. 8, 2023).
8 Avi-Yonah, supra note 1.
9 The problem with BEAT is that at 10 percent, it allows deductions to offset over half the 21 percent corporate rate, but that can be addressed by raising the BEAT rate to 21 percent. The problem with GILTI is the difference between the 10.5 percent rate on some foreign income and the 21 percent rate on some domestic income, but that difference can be reduced by raising the GILTI rate to at least 75 percent of the regular corporate rate. See Steve Rosenthal, “Current Tax Reform Bills Could Encourage US Jobs, Factories and Profits to Shift Overseas,” Tax Policy Center (Nov. 28, 2017). The problem with FDII is the 13.125 percent rate, which is significantly less than 21 percent and therefore a prohibited export subsidy, but that too can be made more WTO-compatible by raising the FDII rate. The GILTI and FDII rates will increase to 16.406 percent in 2026, and the corporate AMT also increases the overall corporate tax on book income.
10 See Marr, supra note 5; Edward Kleinbard, “Congress’ Worst Tax Idea Ever,” The Hill (Mar. 25, 2019); Daniel Shaviro, “Evaluating the New US Pass-Through Rules,” 1 Brit. Tax Rev. 49 (2018). See also Lucas Goodman et al., “How Do Business Owners Respond to a Tax Cut? Examining the 199A Deduction for Passthrough Firms,” National Bureau of Economic Research Working Paper 28680 (Apr. 2021) (“[W]e find little evidence of changes in real economic activity as measured by physical investment, wages to non-owners, or employment.”).
11 See David Kamin et al., “The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the 2017 Tax Legislation,” 103 Minn. L. Rev. 1439 (2019).
12 Avi-Yonah, “What Matters in Moore,” Tax Notes Int’l, Feb. 12, 2024, p. 883.
END FOOTNOTES