At the end of 2017, the Tax Cuts and Jobs Act was signed into law by President Trump, and the law made more significant changes to the tax code than we’ve seen in 30 years. Now, at the height of tax filing season, James Hines, the Richard A. Musgrave Collegiate Professor of Economics and L. Hart Wright Collegiate Professor of Law, walks LSA through some of the new code’s major changes.
What are the biggest changes made by the 2017 tax reform bill and what are their effects?
James Hines: It’s a big tax cut. Depending on exactly how you do the calculation, it cut somewhere between $1.1 and $1.5 trillion from federal revenues. And if there is less federal revenue, then somebody got a tax cut!
Originally the bill was intended to address the business side of taxation and, in particular, international taxation, because the United States was way out of whack with the rest of the world. But as soon as you start to change taxes, everybody wants a tax cut—unincorporated businesses, corporations, high-income people, and middle-income voters all wanted tax cuts, too.
A little under $350 billion of the cut went to corporations, so $1 trillion went to mostly high-income individuals. They saw the biggest cuts because they're subject to higher rates and they have more income, but the bill lowered tax rates across the board.
For the average person, what are the bill’s main effects?
JH: Not every person and not every company got a tax cut, but the vast majority of the population did. The standard deduction doubled, and the child credit was increased. There were a lot of pieces to it, but for most people the tax cut came from the lower tax rates.
Are the changes going to make filing taxes more confusing?
JH: Definitely, especially in the first year. There are lots of unhappy taxpayers this filing season because of changes to the withholding rules. In the past, tax withholdings were, on average, a little on the high side, which means that when people filed their taxes, more than 70% of people wound up getting refunds. We don't have all the data yet, but in 2018 it appears fewer people were over-withheld. And of course they received that money, it’s just that they got it every week over the course of 2018. Now people are not getting refunds, and they're upset about that.
In terms of overall complexity, the argument is that there is simplification for a lot of people. Because the standard deduction is a lot bigger now, fewer people will be itemizing deductions. And, again, we don't have the data on that yet because we have to wait until the end of the year, but it's pretty clear that a lot fewer people will be itemizing. That usually simplifies tax compliance.
Do you anticipate there will be common errors?
JH: Yes I do. There are complex rules involving the tax cut for small business, and there will surely be a lot of problems with people filing not knowing whether they're eligible for this favorable tax treatment.
The general concept was that if you work for a company, you're not eligible for this small business deduction. But suppose you set yourself up as an independent contractor for the company. Even though you're doing the same job you used to do when you were an employee of the company, would you then be eligible for the deduction?
Really what this goes to is, what do we mean by “small business”? What are we favoring with generous tax treatment? Unfortunately, nobody knows the answer, but the law has to carve out some rules. It will certainly be a mess for the first few years as people are trying to figure it out.
Is that because the criteria aren't clear?
JH: Yes. Congress passes a law, the law has language, and the U.S. Department of the Treasury issues regulations interpreting the language. People are then supposed to abide by the Treasury regulations. Part of the difficulty is that it took a long time for the IRS to interpret some of the provisions of the bill. Plus, the law was not clear and somewhat internally inconsistent, and Treasury has issued regulations to try to clarify things.
The 2017 bill was not drafted in the usual process. They did not release drafts in advance. They didn't get comments from people. They didn't work through the normal Congressional process, and there's good and bad in that. It was done expeditiously, which I suppose is good. It was done with minimal input from interested parties, which some would view as good. Others would view that as bad because interested parties also can identify when you're making a big mistake. And nobody had the chance to do that.
Did the shutdown finally have any material effect on tax returns and refunds?
JH: Of course. The IRS doesn’t work as well when they don't get to go to work or when they are on a skeleton crew. And Treasury, which works on regulations, also could not work, so the regulations are not done as well as they would have been if people were working continuously on them. They also would have been hearing the problems taxpayers run into. People call in and they say, “Hey, I've got this situation, and your rules don't seem to apply to me.” When that happens, people at IRS and Treasury can revise their guidance. But of course, if people aren't at work, they can’t do that.
And getting the refunds out in a timely manner is always a challenge, frankly. This year it's going to be more of a challenge because there will be more mistakes in returns. Some of this is just ordinary administrative challenges, but the shutdown was very badly timed. From the standpoint of tax administration, this was going to be a bad year under the best of circumstances. The shutdown just made it worse.
Is there a standard effect that families can expect to see?
JH: There are quite a few things that affect families. Personal exemptions were removed, but there was an increase in the child tax credit. There is a reduction in what you can deduct for income-earning expenses and casualty losses, but fewer people are going to be itemizing deductions in general because they're taking the standard deduction. If you’re not itemizing deductions, you don't get a charitable contribution deduction or a mortgage interest deduction. But presumably you are getting something that is more valuable to you, which is why you're taking it.
There were people whose taxes went up as a result of the bill. There's no doubt about it. People are in different situations. They were all getting different benefits under the old law. It's almost never going to be the case that everybody's going to get a tax cut, even with a big tax cut like this.
What long-term effects do you expect these changes will have?
JH: It's going to increase the deficit. For some reason we're now in an era where everybody is trying to convince themselves deficits don't matter. That can’t be true. Having a deficit is like having a bigger mortgage on your house. Does that matter? Yeah, it matters. Going forward, the United States will have bigger interest payments every month for the national debt and a bigger portion of the budget will go to that.
Do I think there'll be a lot of economic growth associated with this? There are some provisions in the bill that attempt to stimulate the economy. One of the difficulties is that many of those provisions expire after a few years and so, even if they work, they're probably only going to work for a few years. What do you do after that? Do you just allow them to expire and have people's taxes go way back up again? That's the current projection because that's what the law currently says, so stay tuned. I used to think that I could predict what was going to come out of Congress. I'm trying not to do too much of that anymore.