Explaining the Trump Tax Reform Plan

In the spring of 2019, many taxpayers were surprised to find that they had to pay more taxes than in the previous year. Others received significantly lower refund checks from the Internal Revenue Service (IRS), even though their financial circumstances hadn't changed.

How did this happen? Changes related to the passage of the Tax Cuts and Jobs Act (TCJA)—which took effect on January 1, 2018—may have played a role. Signed into law by President Donald Trump, the legislation was the largest overhaul of the tax code in three decades.

Let's take a closer look at TCJA's changes and how they impacted taxpayers and business owners.

Tax Cuts and Jobs Act Overview

President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017, bringing sweeping changes to the tax code. Reaction to it varied based on a wide range of factors, including public opinion of Trump's presidency. Individually, the impact of the changes depended on details like income level, filing status, and deductions. Those living in a high-tax state with soaring property values may have paid more in taxes in 2019.

For the wealthy, banks, and other corporations, the tax reform package was considered a lopsided victory given its significant cuts to corporate profits, investment income, estate taxes, and more. Financial services companies stood to see huge gains based on the new, lower corporate rate of 21%, as well as the more preferable tax treatment of pass-through companies.

Tax Cuts and Jobs Act Passage

The Senate passed the bill on December 2, 2017, by a party-line vote of 51 to 49. The House successfully passed the bill later that month by a vote of 224 to 201. No House Democrats supported the bill and 12 Republicans voted no—most of them representing California, New York, and New Jersey. Taxpayers who itemized deductions in these high-tax states were likely to be hurt by the legislation's cuts to state and local tax deductions.

It was the House's second vote on the bill in a week. Having passed the legislation on December 19, 2017, they were forced to amend it after the Senate parliamentarian struck down three of its provisions. These could not be passed under the fast-track reconciliation procedure Republicans used to avoid a Democratic filibuster, the parliamentarian ruled.

The overhaul was forecast to significantly raise the federal deficit. The Congressional Budget Office estimated the TCJA would add $1.9 trillion to the deficit over a decade.

The law cut corporate tax rates permanently and individual tax rates temporarily. It permanently removed the individual mandate—a key provision of the Affordable Care Act—which was likely to raise insurance premiums and significantly reduce the number of people with coverage. The highest earners were expected to benefit most from the law, while the lowest earners were believed to pay more in taxes once most individual tax provisions expire after 2025.

Personal Taxes

Income Tax Rates

The law retained the old structure of seven individual income tax brackets, but in most cases, it lowered the rates. The top rate fell from 39.6% to 37%, while the 33% bracket dropped to 32%, the 28% bracket to 24%, the 25% bracket to 22%, and the 15% bracket to 12%. The lowest bracket remained at 10%, and the 35% bracket was also unchanged. The income bands that the new rates applied to are lower, compared to 2018 brackets under current law, for the five highest brackets.

The changes are temporary, expiring after 2025, as is the case with most personal tax breaks included in the law. The expiration date allowed the Senate to comply with reconciliation rules that block a Democratic filibuster—which Republicans did not have the votes to defeat—only if the law does not raise the deficit in any year outside of a 10-year window and if it stays within its $1.5 trillion budget constraint during the 10-year window. As noted, Republican congressional leaders signaled that individual tax cuts could be extended at a later date.

The IRS released new withholding brackets reflecting changes to the personal income tax schedule, which employers began using on February 15, 2018. The following charts indicate the latest marginal rates for each income threshold based on filing status.

Source: Internal Revenue Service

Standard Deduction

The law raised the standard deduction in 2018 to:

• $24,000 from $12,700 for married couples filing jointly  ($27,700 in the 2023 tax year)
• $12,000 from $6,350 for single filers ($13,850 in the 2023 tax year)
• $18,000 from $9,350 for heads of household ($20,800 for the 2023 tax year)

The additional standard deduction, which the House bill would have repealed, has not been affected. In 2019, the inflation gauge used to index the standard deduction changed in a way that is likely to accelerate bracket creep (see below).

Personal Exemption and Health Care Mandate

The law suspended the personal exemption, which was $4,150, through 2025. The law also ended the individual mandate, a provision of the Affordable Care Act (ACA) or Obamacare that provided tax penalties for individuals who did not obtain health insurance coverage, in 2019. (While the mandate technically remains in place, the penalty falls to $0 for tax years 2019 and beyond. If a taxpayer files a prior year's tax return (i.e., 2018 or 2017) the taxpayer will still be exposed to a penalty for not being covered by health insurance all year.)

According to the Congressional Budget Office, repealing the measure is likely to reduce federal deficits by around $338 billion from 2018 to 2027, but lead 13 million more people to live without insurance at the end of that period, pushing premiums up by an average of around 10%. Unlike other individual tax changes, the repeal will not be reversed in 2025.

Senators Lamar Alexander (R-Tenn.) and Patty Murray (D-Wash.) proposed a bill, the Bipartisan Health Care Stabilization Act, on March 19, 2018, to mitigate the effects of repealing the individual mandate. The CBO estimated that this legislation would still leave 13 million more people uninsured after a decade. The bill failed to make it into the $1.3 trillion spending bill that was passed on Mar. 23, 2018. As such, the burden of providing affordable health insurance will be on states and health insurers.

Inflation Gauge

The law changed the measure of inflation used for tax indexing. The IRS' use of the consumer price index for all urban consumers (CPI-U) was replaced with the chain-weighted CPI-U. The latter takes account of changes consumers make to their spending habits in response to price shifts, so it is considered to be more rigorous than standard CPI.

It also tends to rise more slowly than standard CPI, so substituting it will likely accelerate bracket creep. The value of the standard deduction and other inflation-linked elements of the tax code will also erode over time, gradually pushing up tax burdens. The change is not set to expire.

Family Credits and Deductions

The law temporarily raised the child tax credit to $2,000, with the first $1,400 refundable ($1,600 in 2023), and creates a non-refundable $500 credit for non-child dependents. The child tax credit can only be claimed if the taxpayer provides the child's Social Security number (SSN).

Qualifying children must be younger than 17 years of age. The child credit begins to phase out when adjusted gross income (AGI) exceeds $400,000 (for married couples filing jointly, not indexed to inflation). These changes expire in 2025.

Head of Household

Trump's revised campaign plan, released in 2016, would have scrapped the head of household filing status, potentially raising taxes on millions of single-parent households, according to an estimate by the Tax Policy Center (TPC). The law left the head of household filing status in place.

Estate Tax

The law temporarily raised the estate tax exemption for single filers to $11.2 million from $5.6 million in 2018, indexed for inflation. This figure is adjusted to $12.92 million for the 2023 tax year. This change will be reversed after 2025. 

Student Loans and Tuition

The House bill would have repealed the deduction for student loan interest expenses and the exclusion from gross income and wages of qualified tuition reductions. The new law left these breaks intact and allowed 529 plans to be used to fund K to 12 private school tuition—up to $10,000 per year, per child.

Under the SECURE Act of 2019, the benefits of 529 plans were expanded, allowing plan holders to also withdraw a maximum lifetime amount of $10,000 per beneficiary penalty-free to pay down qualified student debt.

Retirement Plans and HSAs

Health savings accounts (HSAs) were not affected by the law, and the traditional 401(k) plan contribution limit in 2019 increased to $19,000 ($22,500 in 2023) with a $6,000 catch-up contribution ($7,500 for 2023) for those aged 50 and older.

The law left these limits unchanged but repealed the ability to recharacterize one kind of contribution as the other, that is, to retroactively designate a Roth contribution as a traditional one, or vice-versa. Since the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019, though, people can now contribute to their individual retirement accounts (IRAs) past the age of 70½.

Alternative Minimum Tax

The law temporarily raised the exemption amount and exemption phase-out threshold for the alternative minimum tax (AMT), a device intended to curb tax avoidance among high earners by making them estimate their liability twice and pay the higher amount. For married couples filing jointly, the exemption rose to $109,400 and phaseout increases to $1,000,000—both amounts are indexed to inflation. The provision expires after 2025.

Itemized Deductions

Mortgage Interest Deduction

The law limited the application of the mortgage interest deduction for married couples filing jointly to $750,000 worth of debt, down from $1,000,000 under the old law, but up from $500,000 under the House bill. Mortgages that are taken out before December 15, 2017, are still subject to the current cap. The change expires after 2025.

State and Local Tax Deduction

The new law capped the deduction for state and local taxes at $10,000 through 2025. A number of Republican members of Congress representing high-tax states opposed attempts to eliminate the deduction, as the Senate bill would have done.

The Senate bill was amended on December 1, 2017, apparently to win Susan Collins' (R-Maine) support:

The Senate tax bill will include my SALT amendment to allow taxpayers to deduct up to $10,000 for state and local property taxes.
— Sen. Susan Collins (@SenatorCollins) Dec. 1, 2017

Pease Limitation

The law repeals the Pease limitation on itemized deductions. This provision did not cap itemized deductions but gradually reduced their value when adjusted gross income exceeds a certain threshold—$266,700 for single filers in 2018. The reduction was limited to 80% of the deductions' combined value.

Other Itemized Deductions

The law left the charitable contributions deduction intact, with minor alterations. So, for example, if a donation is made in exchange for seats at college athletic events, it cannot be deducted. The student loan interest deduction was not affected (see "Student Loans and Tuition" below).

Medical expenses in excess of 7.5% of adjusted gross income were deductible for all taxpayers—not just those aged 65 or older.

The law did, however, suspend a number of miscellaneous itemized deductions through 2025, including:

• deductions for moving expenses, except for active-duty military personnel
• home office expenses
• laboratory breakage fees
• licensing and regulatory fees
• union dues; professional society dues
• business bad debts
• work clothes that are not suitable for everyday use

Alimony payments are no longer deductible after 2019, which is a permanent change.

Business Taxes

Corporate Tax Rate

The law created a single corporate tax rate of 21% and repealed the corporate AMT. Unlike tax breaks for individuals, these provisions do not expire. Combined with state and local taxes, the statutory rate under the new law is 26.5%. That puts the U.S. just below the weighted average for EU countries (26.9%).

U.S. companies' effective tax rate defined as the tax paid on investments earning the market rate of return after taxes—was 18.6% in 2012, according to the Congressional Budget Office. That was the fourth-highest rate in the G20. 

Supporters of cutting the corporate tax rate argue that it will reduce incentives for corporate inversions, in which companies shift their tax base to low- or no-tax jurisdictions, often through mergers with foreign firms.

Immediate Expensing

The law allowed full expensing of short-lived capital investments rather than requiring them to be depreciated over time—for five years—but phase the change out by 20 percentage points per year thereafter. The section 179 deduction cap doubles to $1 million, and phaseout begins after $2.5 million of equipment spending, up from $2 million. 

Pass-Through Income

Owners of pass-through businesses—which include sole proprietorships, partnerships, and S-corporations—gained a 20% deduction for pass-through income. Certain industries, including health, law, and financial services, were excluded from the preferential rate unless taxable income is below $157,500 for single filers.

To discourage high earners from recharacterizing regular wages as pass-through income, the deduction is capped at 50% of wage income or 25% of wage income plus 2.5% of the cost of qualifying property.

Interest

The net interest deduction was limited to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA). After four years, it will be capped at 30% of earnings before interest and taxes (EBIT).

Cash Accounting

Businesses with up to $25 million in average annual gross receipts over the preceding three years are eligible to use cash accounting—up from $5 million from the old tax code.

Net Operating Losses

The law scrapped net operating loss (NOL) carrybacks and caps carryforwards at 90% of taxable income, falling to 80% after 2022.

The 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act, in response to the economic fallout of the COVID-19 pandemic, temporarily reinstated a carryback period for all net operating losses generated in years beginning after December 31, 2017, and before January 1, 2021 (i.e., for tax years 2018, 2019, and 2020).

The carryback period for those tax years is five years under the CARES Act (including for farming and non-life insurance losses). Therefore, a NOL generated in the 2018 tax year can still be carried back to the 2013 tax year, assuming there was taxable income in 2013.

Because the top corporate tax rate was 35% prior to its reduction by the TCJA to 21% for tax years after 2017, carrying back an NOL from 2018, 2019, or 2020 could result in a greater benefit than carrying the NOL forward.

Section 199

The law eliminated the section 199 (domestic production activities) deduction for businesses that engage in domestic manufacturing and certain other production work. This is also known as the domestic manufacturing deduction, U.S. production activities deduction, and domestic production deduction.

Foreign Earnings

The law enacted a deemed repatriation of overseas profits at a rate of 15.5% for cash and equivalents and 8% for reinvested earnings.

The law introduced a territorial tax system, under which only domestic earnings are subject to tax. Companies with over $500 million in annual gross receipts are subject to the base erosion anti-abuse tax, which is designed to counteract base erosion and profit shifting, a tax-planning strategy that involves moving taxable profits made in one country to another with low or no taxes. BEAT is calculated by subtracting a company's regular corporate tax liability from 10% of its taxable income, ignoring base-eroding payments. Tax credits can offset up to 80% of BEAT liabilities.

The law altered the treatment of an intangible property that is held abroad. It did not define intangibles. But it probably refers to intellectual property such as patents, trademarks, and copyrights. For instance, Nike (NKE) houses its Swoosh trademark in an untaxed Dutch subsidiary. When the foreign tax rate on foreign earnings in excess of a 10% standard rate of return is below 13.125%, the law taxes these excess returns at 21%, after a 50% deduction and a deduction worth 37.5% of FDII (see below). This excess income, which the law assumes to be derived from intangible assets, is called global intangible low-taxed income (GILTI). Credits can offset up to 80% of GILTI liability.

Foreign-derived intangible income refers to income from the export of intangibles held domestically, which will be taxed at a 13.125% effective rate, rising to 16.406% after 2025.The European Union has accused the U.S. of subsidizing exports through this preferential rate, a violation of World Trade Organization (WTO) rules.

Potential Loophole

According to Harvard Law School senior lecturer Stephen Shay (a former Treasury official in the Obama and Reagan administrations who helped develop the 1986 tax reform), the deemed repatriation left open a loophole for multinational corporations with fiscal years beginning before January 1. These include Apple, which Shay estimated could save $4 billion by taking advantage of the oversight. 

By shifting cash from foreign subsidiaries, Shay stated, multinationals with offset fiscal years have the chance to shift cash to the U.S. through tax-free dividends, paying the 8% rate on remaining overseas assets—as opposed to the 15.5% cash rate.

Growth and Budgetary Impacts

Treasury Secretary Steven Mnuchin claimed that the Republican tax plan would spur sufficient economic growth to pay for itself and more, saying of the "Unified Framework" released by Senate, House, and Trump administration negotiators in September 2017:

"On a static basis our plan will increase the deficit by a trillion and a half. Having said that, you have to look at the economic impact. There's $500 billion that's the difference between policy and baseline. That takes it down to a trillion dollars. And there's two trillion dollars of growth. So with our plan we actually pay down the deficit by a trillion dollars, and we think that's very fiscally responsible."

The idea that cutting taxes boosts growth to the extent that government revenue actually increases is almost universally rejected by economists, and for a long time, the Treasury did not release the analysis Mnuchin bases his predictions on. The New York Times reported that a Treasury employee, speaking anonymously, said no such analysis exists, prompting a request from Sen. Elizabeth Warren (D-Mass.) that the Treasury's inspector general investigate.

On December 11, 2017, the Treasury released a one-page analysis claiming that the law will increase revenues by $1.8 trillion over 10 years, more than paying for itself, based on high growth projections:

• 2.5% real gross domestic product (GDP) growth in 2018
• 2.8% in 2019
• 3.0% for the following eight years

By contrast, the Federal Reserve projected growth of 2.5% in 2018, 2.1% in 2019, 2.0% in 2020, and 1.8% over the longer run.

Scott Greenberg, an analyst at the think tank, told The New York Times that the Treasury's one-page analysis "does not appear to be a projection of the economic effects of a tax bill," but rather, "a thought experiment on how federal revenues would vary under different economic effects of overall government policies. Which is, needless to say, an odd way to analyze a tax bill."

In 2017, the Tax Foundation forecast a 1.7% increase in long-run GDP, clarifying that most of this extra growth is likely to be front-loaded: "Economic growth is borrowed from the future, but the plan, in aggregate, still increases economic growth over the long run."

The most pessimistic estimate of the legislation's budget effects came from the Committee for a Responsible Federal Budget, which argued that Congress is using a flawed baseline to measure the law's budget effects. The organization's baseline assumes, for example, that current policies with set expiration dates would continue indefinitely.

These gimmicks, the think tank argued, obscure $570 billion to $725 billion in extra costs over 10 years, bringing the price of the law to $2 to $2.2 trillion. Factoring in expected economic growth (the CRFB uses the JCT's feedback estimates for the Senate bill), the cost falls to $1.5 trillion to $1.7 trillion—triple the Tax Foundation's dynamic estimate. That does not count additional debt service costs, though. With interest, the law could cost $1.9 trillion to $2 trillion.

The Oil Addendum 

The continuing resolution that authorized the use of reconciliation to reform the tax code permitted the Senate Finance Committee to pass legislation increasing the federal budget by up to $1.5 trillion over 10 years.

That same budget resolution tasked the Senate Energy and Natural Resources Committee with achieving at least $1 trillion in savings over 10 years. The law achieves that by allowing oil and gas drilling in the Arctic National Wildlife Refuge, which is located in committee chair Sen. Lisa Murkowski's (R-Alaska) home state. Murkowski voted against multiple Obamacare repeal bills over the summer, making it important for Republicans to secure her support for tax reform.

Automatic Spending Cuts

The idea of a fiscal trigger, a mechanism to enact automatic tax hikes or spending cuts that some senators pushed for in case optimistic growth forecasts did not come to fruition, was rejected on procedural grounds. The law could potentially lead to automatic spending cuts anyway. However, as a result of the 2010 Statutory Pay-As-You-Go Act, that law requires cuts to federal programs if Congress passes legislation increasing the deficit.

The Office of Management and Budget, an executive agency, is in charge of determining these budget effects. Medicare cuts are limited to 4% of the program's budget, and some programs such as Social Security are protected entirely, but others could see deep cuts. 

On December 1, 2017, Senate Majority Leader Mitch McConnell (R-Ky.) and former House Speaker Paul Ryan (R-Wis.) promised that across-the-board cuts "will not happen," but waiving "Paygo" would require Democratic support, meaning that was a tough assertion for GOP congressional leaders to make.

Who Benefited From TCJA?

According to a December 2017 analysis released by the Tax Policy Center (TPC), the law was expected to raise the after-tax income of 80.4% of households in 2018, but that cut was not distributed evenly or progressively. The analysis revealed that the tax break would hit 93.7% of taxpayers in the highest-earning quintile, and only 53.9% of those in the lowest quintile. Even so, on average, every quintile was expected to receive a tax break. 

That is no longer expected to be true once individual tax cuts expire after 2025. At that point, the TPC estimates that the majority of taxpayers—53.4%—will face a tax increase: 69.7% of those in the middle quintile (40th to 60th percentile) will pay more, compared to just 8% of the highest-earning 0.1%.

With the exception of the top 0.1%, higher earners will enjoy larger tax breaks as a proportion of their income:

The Joint Committee on Taxation echoed this conclusion, estimating that the 22,000 households making $20,000 to $30,000 will collectively pay 26.6% more in 2027 than they would under the previous statute in that year. The 629 households making over $1,000,000 will pay 1% less.

These were not the results Republican backers of the tax overhaul promised. Speaking at a rally in 2018 in Indiana shortly after the release of a preliminary tax reform framework in September, President Trump repeatedly stressed that the "largest tax cut in our country's history" will "protect low-income and middle-income households, not the wealthy and well-connected."

In its finalized form, however, the TCJA cut the corporate tax rate, benefiting shareholders—who tend to be higher earners. It only cuts individuals' taxes for a limited period of time. It scales back the AMT and estate tax, as well as reduces the taxes levied on pass-through income (70% of which goes to the highest-earning 1%). It does not close the carried interest loophole, which benefits professional investors. It scraps the individual mandate, likely driving up premiums and making health insurance unaffordable for millions.

These provisions taken together are likely to benefit high earners disproportionately and—particularly as a result of scrapping the individual mandate—hurt some working- and middle-class taxpayers.

Nor was Trump the only one to promise a tax break for ordinary households. McConnell said on November 4, 2017, that no one in the middle class will experience a tax hike:

McCONNELL: “At the end of the day, nobody in the middle class is going to get a tax increase.”
A bold promise the House bill doesn’t keep.
— Sahil Kapur (@sahilkapur) Nov. 4, 2017

Less than a week later, he told The New York Times he "misspoke": "You can't guarantee that absolutely no one sees a tax increase, but what we are doing is targeting levels of income and looking at the average in those levels and the average will be tax relief for the average taxpayer in each of those segments."

Did Cutting Corporate Taxes Boost the Economy?

In his Indiana speech of 2018, Trump said that cutting the top corporate tax rate would cause jobs to "start pouring into our country, as companies start competing for American labor and as wages start going up at levels that you haven't seen in many years." The "biggest winners will be the everyday American workers," he added.

The next day, The Wall Street Journal reported that the Treasury Department deleted a paper saying the exact opposite from its site. Written by non-political Treasury staff during the Obama administration, the paper estimated that workers pay 18% of corporate tax through depressed wages, while shareholders pay 82%. Those findings were corroborated by other research done by the government and think tanks. Mnuchin sold the Big Six proposal in part through the assertion that "over 80% of business taxes is borne by the worker," as he put it in Louisville in August.

A Treasury spokeswoman told the Journal, "The paper was a dated staff analysis from the previous administration. It does not represent our current thinking and analysis," adding, "studies show that 70% of the tax burden falls on American workers." The Treasury did not respond to Investopedia's request to identify the studies in question. The department's website continues to host other papers dating back to the 1970s. 

The White House continued to press the point, however, releasing an analysis in October 2017 predicting that lowering the top corporate tax rate to 20% will "increase average household income in the United States by, very conservatively, $4,000 annually." The executives who were supposed to be giving these raises, however, signaled some hesitation at the Wall Street Journal CEO Conference in November 2017, when the paper's associate editor John Bussey asked the audience to raise their hands if they planned to increase capital investment due to a corporate tax cut. Few hands went up, prompting National Economic Council director Gary Cohn (who was on stage) to ask, "Why aren't the other hands up?"

The Bottom Line

Did the new tax code provide what it promised Americans? It depends on who you ask. According to the Tax Policy Center, 65% of Americans did receive a tax cut thanks to the new code. H&R Block reports that the average tax cut was approximately $1,200 based on the returns the company processed. But, according to some reports, the tax bill has not lived up to all of the hype surrounding it.