As the tax filing deadline nears, Americans continue to navigate tax season with curiosity and caution as they see the ways in which they are personally affected by the Trump administration’s 2017 tax legislation (originally known as the Tax Cuts and Jobs Act of 2017, but officially called An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018.). Criticized by congressional Democrats as rushed and ambiguous, the law was defended by Republicans as a necessary overhaul to previous tax laws and a means to provide economic relief for the middle class. The dueling partisan narratives left many taxpayers with a murky understanding of the law’s impact.
To gain a better grasp on the intricacies of the 2017 Act, NYU News turned to professors David Kamin (Law '09), Lily Batchelder, and Daniel Shaviro—tax law experts from the NYU School of Law—who co-authored a paper analyzing the sweeping legislation titled “The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the 2017 Tax Legislation.” According to the authors, “Many of the new changes fundamentally undermine the integrity of the tax code and allow well-advised taxpayers to game the new rules through strategic planning.”
We asked the authors to describe how some may take advantage of the new system, and how changes to the tax laws may affect the U.S. economy.
On Gaming the System:
“Very hard for the IRS to catch”
David Kamin: One of the largest tax cuts in the legislation goes to “pass-through” businesses—where income is taxed at the level of the owner rather than the business. But, to be eligible for this tax cut, owners need to meet certain very complex criteria. For those with higher incomes, this includes being in the “right” line of business. That means being an architect (eligible) and not a lawyer (not eligible). Selling skincare products (eligible) but not being a dermatologist (not eligible). The formalistic and largely arbitrary lines then allow for much gaming, including what we—borrowing from the election law context—call “cracking and packing,” pulling apart and combining businesses. For instance, a dermatologist office might “crack” apart a skincare products business run out of the same office, share overhead expenses, and then try to assign as much of those overhead expenses as possible to the dermatology practice to maximize profits eligible for the deduction. ?Possibly abusive? Yes, but very hard for the IRS to catch.
“Creates large incentives for the wealthy”
Lily Batchelder: The bill creates large incentives for the wealthy to convert their labor income into business income. This was already an issue in the tax code because of the carried interest loophole and loopholes in the payroll tax. But the bill makes a bad situation much, much worse. If a wealthy individual hires an elite tax advisor to make their labor income look like pass-through business income, they can cut their marginal tax rate by more than 7 percentage points. And if they don’t need to spend the income anytime soon and treat it as corporate income, they can cut their tax rate by 20 percentage points. Theoretically, middle class families could engage in the same games but they are much less likely to do so for at least three reasons. First, middle class families would receive much smaller tax benefits from such gaming and in many cases, none. Second, they often have little leverage over their employers to restructure their compensation and, even if they did, probably would have to give up all of their employee benefits in exchange. This includes their health insurance, 401(k), and disability insurance. Last, they are less likely to be able to afford a tax advisor with the expertise to structure this kind of arrangement in the first place!? ?
“Failure to address opportunities for sheltering labor income”
Daniel Shaviro: One of the many disappointing aspects of the 2017 act was its failure to address the opportunities for sheltering labor income from tax at full individual rates, through use of the corporate tax. Pre-2017, the top corporate rate was far closer to the top individual rate than it is post-2017. The main rationale for the corporate rate reduction pertained to global tax competition for scarce capital. This has no bearing on the case where the owner-employee of a corporation pays herself far less than the market value of her work. For example, suppose I create a wildly successful new start-up and pay myself zero salary, despite my becoming, in net worth terms, a billionaire via the stock appreciation. The income that my efforts yield will show up in the corporate tax base, and be taxed at only 21%. True, I would face a second level of tax on paying myself dividends or selling my stock, but even this would be at a reduced rate. And what’s more, I may not need to make such payments if I am sufficiently financially liquid, e.g., by reason of borrowing against the value of the stock.
Opinions in the “biz” differ on how frequently taxpayers will find it worthwhile to do this, given the difficulty of extracting funds from one’s company tax-free. What is plain, however, is that Congress in 2017 deliberately did nothing to prevent this from happening. Indeed, the final version of the 2017 Act?reduced?the efficacy of a provision in the House bill that would have slightly addressed the problem by setting the tax rate for “personal service corporations” (PSCs) at 25% rather than just 21%. In the final act that rate is just 21%, like the general corporate rate, causing the PSC rules to be close to meaningless as a defense against using corporations as a tax shelter for labor income.
“Created a new regime”
Shaviro: In the international realm, the 2017 Act may actually have improved the law marginally. At a minimum, it created a new regime that could be tweaked by future Congresses to yield a better system than the previous one. However, the main new international rules that it added to the code unnecessarily created multiple opportunities for game-playing. Just to give some quick examples without getting too deep into the weeds:
- The foreign-derived intangible income (FDII) rules, which provide a special deduction for exports by companies, such as Apple and Facebook, that have valuable intellectual property, create incentives for “round-tripping” goods—e.g., selling them to a foreign taxpayer, then buying them back with just enough bells and whistles to prevent the entire transaction from being disregarded.
- Both FDII and the global intangible low-taxed income (GILTI) rules can create incentives to locate business assets abroad rather than at home.
- The base erosion anti-avoidance tax (BEAT) can be gamed through such means as restructuring supply chains so one is purchasing sale items for customers from one’s foreign affiliates. The BEAT can also be gamed by adding lots of extra deductions (offset by lots of extra income so the sum total is a wash), so that so-called “base erosion tax benefits” will fall below an arbitrary “floor” (as a percentage of total deductions) that the BEAT imposes for no discernible reason.
“The rules almost certainly violate the World Trade Organization treaty”
Shaviro: The FDII rules almost certainly violate the World Trade Organization treaty, of which the U.S. is a signatory. They are expressly an export subsidy, and the WTO makes export subsidies illegal. If other treaty signatories challenge the FDII rules, there is a very high probability that they’ll be held illegal, with the consequence that peer countries will be authorized to respond with targeted provisions of their own. In the last 30 or so years, the U.S. has enacted illegal export subsidy rules on three separate occasions. Each time the rule was held violative and the U.S. backed down. Why do this again? I think the main answer was cynicism, but ironically the prospect of an overturn makes the U.S. companies that wanted favorable tax treatment more leery than they would otherwise have been of setting up complex structures to take maximum advantage of the FDII rules.? ?
“An array of mistakes—some minor and some large”
Kamin: The legislation was written at an extremely rapid clip, leaving an array of mistakes—some minor and some large. An early one to emerge was the “grain glitch.” In attempting to apply the pass-through deduction to businesses organized as cooperatives, especially prevalent in agriculture, legislators wrote in an even larger loophole by accident. Effectively, farmers selling to these cooperatives (think Ocean Spray cranberries) could potentially entirely wipe out their tax liability because of the glitch. This one was large enough—and was causing sufficient chaos in the agricultural sector—that it was fixed. But most haven’t been. So, take another: one of the largest revenue raisers in the legislation was limiting the deductibility of state and local taxes for individuals to $10,000. However, the letter of the law seems to fail to apply that to another form of cooperative, a housing cooperative. So, owners of pricey cooperatives in NYC may be able to deduct their property taxes without limit; by contrast, owners of traditional condominiums and houses will not. And the list could go on.
“Heavily tilted towards the wealthy”
Batchelder: The bill is heavily tilted towards the wealthy. According to the official Congressional budget scorekeepers, this year the average millionaire will get a tax cut of more than $27,000 on their personal tax return, compared to a tax cut of $431 for an average middle-class family earning $40,000 to $50,000. Even as a share of their after-tax income, the tax cut for the average millionaire is three times as large. It is also a very costly bill. The Congressional Budget Office estimates that it will increase our national debt by?$1.9 trillion?by 2028, even after including its effects on the economy. These large tax cuts will eventually have to be paid for. If Congress pays for them by raising revenues in proportion to income, the?vast majority?of middle class and low-income families will end up worse off. These families will be hit even harder if the bill is paid for by cuts to programs like Social Security, Medicare, and Medicaid.
“An act of class warfare”
Shaviro:?It’s often said that tax legislation should be judged by four main criteria: fairness, efficiency, complexity, and revenue adequacy. The 2017 Act, despite having good particular rules here and there, egregiously failed on all four counts. It was an act of class warfare benefiting those at the top relative to everyone else, for the most part it reduced economic efficiency by creating perverse incentives and arbitrary distinctions between different activities, it made tax planning more complicated for those who can afford sophisticated tax advice, and it will probably lose on the order of $2 trillion of net revenue over 10 years, even if all supposedly expiring provisions are actually allowed to expire. It was also the sloppiest, most poorly drafted tax legislation that I have ever seen, despite all the talent and effort deployed by hard-pressed staffers, because the process was so secretive and rushed.