1. Georgetown Tax Law and Public Finance Workshop
Drivers and Effects of the 2017 Tax Act
Eric Solomon
March 6, 2018

2. Introduction
On December 22, 2017, the President signed “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (P.L ), hereinafter called the 2017 Tax Act (or the Act).
The 2017 Tax Act made substantial changes to the Internal Revenue Code, particularly lowering the corporate tax rate and revising the international tax provisions.
In the words of Mark Prater, Deputy Staff Director and Chief Tax Counsel for the Senate Finance Committee, three important factors in the development of this Act were policy, process and politics.

3. Key Drivers for the 2017 Tax Act
There were several key policy drivers for the 2017 Tax Act:
A tax reduction for individual taxpayers, especially the middle class;
A lower corporate tax rate;
Replacement of the U.S. worldwide international tax system with a dividend exemption system;
Inclusion of base erosion measures; and
Encouragement of business activity in the United States rather than abroad.
Each of these drivers and how they were addressed in the Act will be discussed in more detail later.

4. Key Limitations
Because the Senate is nearly equally divided between Republicans and Democrats, and because 60 votes are needed in the Senate to overcome a filibuster, the Republicans needed to employ reconciliation procedures for this tax bill.
Under reconciliation procedures, it takes only 51 votes to pass a law in the Senate and a filibuster can be avoided.
A budget resolution passed by both the House and Senate authorized the use of reconciliation procedures. Because of concerns by some members of Congress about increasing deficits, the budget resolution limited the allowable revenue loss to $1.5 trillion over 10 years.

5. Key Limitations (cont’d)
Reconciliation procedures impose various limitations on a bill, including (under the so-called Byrd rule) that the bill must not lose revenue after the budget window (10 years).
The limitations had a substantial impact on the ultimate shape of the Act. For example, to avoid losing revenue after 10 years, most of the provisions affecting individuals will expire at the end of 2025.

6. Key Driver #1: Tax Cut for Individuals
A goal of the Act was to provide a tax cut for individuals, especially the middle class.
In total, the individual tax provisions provide net tax relief to individuals of over $700 billion over 10 years (not including over $400 billion in tax relief over 10 years as a result of the provision providing a 20% tax deduction to owners of businesses conducted through sole proprietorships and pass-through entities).
The Act includes various taxpayer-favorable provisions. In particular, the Act:
Lowered tax rates;
Raised the tax brackets;
Doubled the standard deduction;
Repealed the overall limitation on itemized deductions (the “Pease” limitation);
Enhanced the child tax credit;
Increased the exemption for alternative minimum tax; and
Increased the exemption for estate tax.

7. Key Driver #1: Tax Cut for Individuals (cont’d)
On the other hand, the Act includes various taxpayer-unfavorable provisions. In particular, the Act:
Repealed personal exemptions;
Limited the deduction for state and local taxes to $10,000;
Limited the deduction for home mortgage interest;
Repealed various itemized deductions;
Limited the use of business losses against other income; and
Selected a slower inflation measure for determining tax brackets.
In addition, the Act repealed the requirement in the Affordable Care Act requiring individuals to obtain healthcare coverage. (This provision raises over $300 billion over 10 years.)

8. Key Driver #1: Tax Cut for Individuals (cont’d)
In general, the individual tax provisions will reduce taxes for individuals.
Higher-income individuals will receive larger benefits in absolute amounts (as compared to percentage amounts), especially as a result of the increase in the estate tax exemption.
However, each individual will need to do the calculation to determine if there is a tax reduction. For example, some taxpayers in states with high state and local taxes may be worse off.
Also note that most of the individual tax provisions will expire at the end of 2025.

9. Key Driver #2: Lower Corporate Tax Rate
Under prior law, the U.S. federal statutory corporate tax rate was 35%, among the highest in the world. The average global statutory corporate tax rate is approximately 25%.
Because of various deductions and other preferences, the effective U.S. corporate tax rate was significantly lower for various industries and companies, but not for others.
The high U.S. tax rate encouraged companies to organize and do business elsewhere.
The high U.S. tax rate encouraged multinational companies to use techniques to reduce U.S. tax liability, such as placing lots of debt in U.S. members of the multinational group, resulting in large U.S. interest deductions.
The Act lowered the U.S. corporate tax rate to 21%. This will encourage U.S. and foreign companies to undertake more business activities in the United States. It will also reduce the incentive to erode the U.S. tax base by deductions.

10. Key Driver #2: Lower Corporate Tax Rate (cont’d)
The Act also includes a provision to lower the tax rate on business earnings of owners of sole proprietorships and pass-through entities, including partnerships, limited liability companies taxed as partnerships, and S corporations.
The provision provides a 20% deduction for such earnings, reducing the tax rate on qualifying earnings from the highest individual rate of 37% to 29.6%.
Because of the continuing disparity between the corporate tax rate (21%) and the pass-through rate (29.6% or more), an entity might consider converting from pass-through status to a corporation taxable at the 21% rate.
Note that this strategy is less helpful to the extent the corporation intends to pay dividends that will be subject to an additional tax to the shareholders.

11. Key Driver #3: Replacement of U.S. International Tax System
Under prior law, active foreign earnings of foreign subsidiaries of U.S. corporations were subject to local tax in the foreign jurisdiction, but were not subject to immediate U.S. tax.
Some foreign jurisdictions, such as Ireland, have a low tax rate.
The foreign earnings were subject to U.S. tax only when they were repatriated to the U.S corporation. The U.S. tax on repatriation was reduced by foreign tax credits for the tax paid to the foreign jurisdiction.
In other words, the United States imposed tax on earnings around the world, but the tax on foreign earnings was deferred. It was a worldwide tax system with deferral.

12. Key Driver #3: Replacement of U.S. International Tax System (cont’d)
Very few countries have a worldwide tax system. Most other countries have a system that does not impose tax on earnings from outside the country (an exemption system).
The U.S. international tax system encouraged U.S. companies to move their income and activities offshore to lower-tax jurisdictions, and encouraged them to keep their foreign earnings offshore and not repatriate them to the United States.
At the end of 2017, U.S. multinational had over $2 trillion in unrepatriated foreign earnings.
The Act includes a provision requiring an immediate tax on previously unrepatriated foreign earnings (at a 15.5% rate for foreign earnings held in cash, and at an 8% rate on foreign earnings held in other assets).
The U.S. tax system also encouraged U.S. companies to emigrate by so-called inversions.

13. Key Driver #3: Replacement of the U. S
Key Driver #3: Replacement of the U.S. International Tax System (cont’d)
The Act replaces the U.S. international tax system with a modified exemption system.
In general, active foreign earnings of foreign subsidiaries of U.S. corporations are not subject to U.S. tax when earned. Furthermore, the earnings are not subject to tax when repatriated to the U.S. corporation. This result is accomplished by including the repatriated amounts in the U.S. corporation’s income, and by providing an offsetting deduction for these amounts.
It is a “modified” exemption system because of base erosion provisions, discussed next.

14. Key Driver #4: Base Erosion
If there is no U.S. tax on active foreign earnings, either when earned or when repatriated to the United States, there is an an incentive to move activities and income offshore to lower-tax jurisdictions, as under old law.
In fact, as compared to old law, under which active offshore earnings were subject to U.S. tax upon repatriation, under new law the active offshore earnings will never be subject to U.S. tax, which might increase the incentive to move activities and income offshore.
On the other hand, the reduced U.S. corporate tax rate may offset any increased incentive to move income and activities offshore.
In addition, despite the reduced U.S. corporate tax rate, there may still be an incentive for multinational companies to use techniques to reduce U.S. tax liability, for example by placing debt and interest deductions in U.S. members of the multinational group.

15. Key Driver #4: Base Erosion (cont’d)
Because of concerns about erosion of the U.S. tax base, the Act includes various provisions to prevent it, including:
An immediate 10.5% tax on low-taxed offshore earnings (the tax on global intangible low-taxed income, otherwise called the GILTI tax);
An alternative tax calculation that adds back deductible payments by a U.S. corporation to a foreign related party (the base erosion and anti-abuse tax, otherwise called the BEAT);
Denial of deductions for interest or royalty payments that are excluded from income for foreign tax purposes, or that are paid by or to an entity that is treated as disregarded for U.S. tax purposes and not disregarded for foreign tax purposes (or vice versa); and
Denial of business interest deductions in excess of 30% of earnings before interest and depreciation deductions.

16. Key Driver #5: Encouragement of U.S. Business Activity
The Act seeks to encourage activity in the United States rather than elsewhere.
The Act includes a provision allowing a deduction that reduces the U.S. tax rate on foreign-derived income of a U.S. corporation (the deduction for foreign-derived intangible income, otherwise called the FDII deduction).
In effect, the deduction reduces the U.S. tax rate on the foreign income to %.

17. Effect of the 2017 Tax Act on the Business Community
The business community favors the 21% corporate tax rate and the exemption for active foreign earnings.
Other business provisions that are taxpayer-favorable include:
Expensing of new and used property (until it is gradually phased out starting in 2023); and
Repeal of the corporate alternative minimum tax.
There are some business provisions that are taxpayer-unfavorable, such as:
The limitation on interest deductions;
The immediate tax on previously unrepatriated foreign earnings;
The GILTI tax;
The BEAT;
Limitations on the use of net operating loss carryovers; and
Required amortization of research and experimentation expenditures.

18. Effect of the 2017 Tax Act on the Business Community (cont’d)
The 2017 Tax Act will also have financial statement impacts, some of which might not be favorable, such as:
The impact of the immediate tax on previously unrepatriated foreign earnings; and
The reduction in deferred tax assets as a result of the lowering of the corporate tax rate from 35% to 21%.
The Act will have differing effects on different industries. In general, all types of industries should benefit, but the benefit will vary among industries and among businesses depending on their profiles.

19. Effect of the 2017 Tax Act on the Business Community (cont’d)
What will U.S. companies do as a result of the 2017 Tax Act?
More capital investment?
More compensation to workers?
More dividends and stock buybacks?
More acquisitions? More cash acquisitions (because of limitations on interest deductions)? More asset acquisitions (because of expensing)?
All of the above? Some of the above?

20. What Policy Objectives Did the 2017 Tax Act Not Achieve?
Two other important objectives of a tax reform bill would be (1) simplification, and (2) permanence.
For many years policymakers and commentators have criticized the Internal Revenue Code for its complexity.
Other than the doubling of the standard deduction, which reduces the number of individual taxpayers itemizing their deductions, the 2017 Tax Act does not meaningfully simplify the Code.
For many years policymakers and commentators have criticized the Internal Revenue Code for the instability caused by expiring provisions. Expiring provisions make it difficult for taxpayers to plan with certainty.
The 2017 Tax Act includes numerous expiring provisions, in particular most of the individual provisions will expire at the end of 2025.

21. How Will Other Countries React?
Other countries will continue to compete for investment, including by lowering their corporate tax rates or providing other incentives.
Other countries might respond by including income, denying deductions or otherwise increasing taxes on U.S. multinationals doing business in their countries.
The World Trade Organization might challenge the FDII deduction as an illegal export subsidy.
The European Commission will continue to pursue cases asserting that agreements between U.S. multinational companies and certain countries (such as Ireland) violate trade rules about unfair competition (the State Aid rules).

22. Closing Comments
It is not yet known how the states will react to the 2017 Tax Act. States that piggyback on the federal system will need to decide what to do.
The Act has many glitches and ambiguities. The chances of technical corrections or other correcting legislation are slim in the near future.
Responsibility has been passed to Treasury’s Office of Tax Policy and the IRS to provide administrative guidance to clarify and interpret the Act.
The guidance will be in the form of notices, as well as proposed, temporary and final regulations.
Because it will take some time for the government to issue guidance, there will be a period of time when taxpayers and their advisors will need to interpret the Act without guidance. Presumably guidance will be prospective.
The IRS will have to administer the new law with limited resources.

23. Closing Comments (cont’d)
The Act is likely to increase deficits. How will our government address this? Spending reform, such as reducing entitlement programs (e.g., Medicare, Medicaid and Social Security)?
Are we done with tax reform?
At some point in the future, will we need new taxes, such as a value- added tax or a carbon tax?
The End