The Trump Administration and the Republican Congressional leadership spent the last several months preparing to tackle legislation for corporate and personal income tax reform. As the 115th Congress sets out to take up this issue during the fall term, the operative questions are whether reform will actually materialize and, if it does, how extensive will it be. Unfortunately, the potential for reform legislation is not looking all that promising. Instead of reform, it’s more likely that Congress will try to push through new, but temporary, tax cuts — a far cry from actual reform. Businesses in the specialty lending and construction industries should keep a close eye on how the tax reform process ends up rolling out as any significant restructuring of the tax code has the potential to unleash robust economic growth. On the other hand, in the current environment, not even modest tax cuts are a sure thing as even implementing temporary tax cuts takes lots of political muscle and some cooperation, both of which are currently in short supply in Washington. And, failure to pass even temporary tax cuts could have a detrimental effect on the economy.

The kick off for reform took place in July of this year, right before Congress left D.C. for the summer recess, when the group called the “Big Six” –the White House and Republican Party Congressional leaders charged with developing tax policies — released a joint statement outlining their joint vision for reform. The Big Six is composed of House Speaker Paul Ryan (R-WI), Senate Majority Leader Mitch McConnell (R-KY), Treasury Secretary Steven Mnuchin, National Economic Council Director Gary Cohn, Senate Finance Committee Chairman Orrin Hatch (R-UT), and House Ways and Means Committee Chairman Kevin Brady (R-TX). The joint statement was not a policy document, but rather a five-paragraph expression of their guiding principles, which had the effect of raising more questions than it settled. Previous plans released by both House Republicans and the administration were more detailed and specific policy documents, conversely, this statement was designed to provide a “template” for what Republicans will take up during the fall term.

The joint statement began with a mission statement that on its own is uncontroversial:

“Above all, the mission of the committees is to protect American jobs and make taxes simpler, fairer and lower for hard-working American families. We have always been in agreement that tax relief for American families should be at the heart of our plan.”

Next the statement described three key matters that the tax reform effort will address, plus one earlier proposal that they have now taken off the table.

1. CORPORATE TAX REDUCTIONS

The statement repeatedly refers to reducing tax rates for corporations and in particular for small businesses. It states, “We also believe there should be a lower tax rate for small businesses so they can compete with larger ones, and lower rates for all American businesses so they can compete with foreign ones.”

It’s valuable to take a look at what U.S. corporations are paying in taxes as a backdrop to what reform may offer. For regular corporate income tax, a system of graduated marginal tax rates is applied to all taxable income, including capital gains. Through 2015, the marginal tax rates on a corporation’s taxable income ranged from 15 percent for corporations earning up to $50,000 of net income to 35 percent for corporations earning above $18.3 million.

Of course, it’s well reported that large corporations take advantage of a myriad of strategies and tax deductions that drastically reduce their marginal rates. These include attributing income to (and leaving the money in) foreign countries where the company operates, R&D tax credits, and stock-based compensation booked to capital. Even the largest and most profitable companies pay far less than the marginal rates.

The average effective tax rate among S&P companies is 24.11 percent — well below the current corporate top rate of 35 percent — according to data compiled by The Earnings Scout, a corporate earnings analysis firm. To underline how this works we note that in their most recent SEC filings, Amazon reserved 17.4 percent for annual federal income taxes, J&J reserved 14.9 percent, and the remarkably profitable Facebook reserved just 4.4 percent.

In contrast, small businesses corporations are generally the ones for whom the marginal tax rate makes a big difference in the amount they pay to the government. According to the SBA, small businesses in the United States pay an estimated average effective tax rate of approximately 19.8 percent on an average of $83,000 of net income. That’s a little over $16,000 per business sent annually to the IRS. According to the U.S. census bureau, there are 28 million small businesses in America and they tend to be job creation engines, so it’s not difficult to make a case to reduce their marginal rates based on both political and economic rationale.

The main inference of the joint statement is that revisions to the tax code should be made to encourage large corporations to repatriate capital they have been hoarding in international markets, and to lower tax rates for the small businesses that tend to be the big drivers of employment rolls. Taken together the document suggests that reductions to corporate tax rates would create new jobs and stimulate economic growth. There’s not much bipartisan support from the Democrats to reduce corporate tax rates and any legislation would have to pass muster with the Republican deficit hawks in both the House and Senate, the very ones who tripped up health care legislation due to disagreements over the long term impact on the federal debt.

2. FIXING A “BROKEN” TAX CODE AND PROVIDING TAX BREAKS FOR FAMILIES

The joint statement describes an oft-repeated sentiment that the existing tax code is so complex that it is effectively broken, and in so doing, touches on the subject of tax relief for families. It calls for “a plan that reduces tax rates as much as possible,” but doesn’t go into any detail about potential tax breaks for families. The Democrats could have a field day by suggesting that the families the Republican Party has in mind are the super-rich Waltons, Trumps and Koch brothers. However, previously released statements provide clues about Republican Party thinking around individual income taxes.

The House Republican tax reform plan championed by Speaker Ryan and released last year proposed to:

• Replace the existing seven tax brackets with three brackets;
• Nearly double the standard deduction, to reduce the incentive to file itemized returns;
• Eliminate most itemized deductions including for state and local tax payments, with exceptions only for charitable contributions and mortgage interest;
• Eliminate the alternative minimum tax;
• Replace personal exemptions with tax credits.

The White House tax reform statement from April was quite similar to the House plan on most of these points except for personal exemptions (although it didn’t close the door on replacing personal exemptions with tax credits). Otherwise, there are only minor differences in the specific details of the two plans. The House Republican plan proposed tax brackets of 12 percent, 25 percent and 33 percent, while the White House plan proposed tax brackets of 10 percent, 25 percent and 35 percent. Since these two proposals were largely in agreement, it’s likely the upcoming tax reform legislation will look a lot like a marriage of the House Republican plan with the Trump proposal.

3. PERMANENT TAX REFORM

The joint statement stressed the need to develop permanent changes to the existing tax code, and not just temporary revisions. The purpose of developing permanent changes is to keep tax reform intact in future years, so Congress won’t have to decide annually whether or not to continue with the changes. Permanence, however, seems quite unlikely. It’s been a long time since Congress did the heavy lifting to pass and implement any kind of permanent tax changes. Getting tax reform done requires strong political leadership, significant technical expertise from government staffers, and a steady information campaign to galvanize the public around the need for the change to happen. These requirements are necessary to prevent the plethora of special interest groups from overturning the apple cart.

The last major tax reform was in 1986, and only made it through with the forceful leadership of luminaries including President Reagan, the chairs of the Congressional tax-writing committees (Dan Rostenkowski and Bob Packwood), and public champions of tax reform like Senator Bill Bradley and Representative Jack Kemp. Behind the scenes comprehensive work by the tax policy wonks at the Treasury Department and Congressional staffers was undertaken. From the bully pulpit to the media to the public at large, at the time the consensus was that tax rates were just too high and there were too many tax shelters being taken advantage of.

However, in the current political climate there is not a solid track record for enacting permanent legislation around taxes or spending. The American Recovery and Reinvestment Tax Act (ARRA) of 2009 created many temporary tax cuts, but several of them later expired when Congress decided not to renew them. The budget reconciliation rules do not allow Congress to pass any kind of legislation if it adds to the deficit after a ten-year period, so permanent tax breaks must be bundled together with either expense cuts or other sources of revenue to balance the tax reform’s long-term impact on the federal debt. That’s a political hot potato, and as recently seen with “replace and repeal,” the House Freedom Caucus is likely to block anything that adds to the national debt. Most recently, major legislative initiatives have not been able to achieve a plurality in one or the other branch of the legislature, despite Republican majorities, and President Trump has not demonstrated the kind of consistency in using the “bully pulpit” of the presidency to champion the cause among the public in the way that many presidents before him have.

4. BORDER ADJUSTABILITY

One noticeable reversal in the Big Six joint statement from earlier Republican Party tax strategy documents is the jettisoning of what is called “border adjustability,” which would have offered up increased taxes on imports. The border adjustment tax was a favorite of Speaker Ryan’s. As proposed by the House of Representatives it would have prevented businesses from deducting the cost of imports they purchased, while removing taxes on revenue from exports. The thinking behind it was to boost the U.S. domestic manufacturing sector, but it ran into early opposition from large global business interests including the energy industry, large retailers and the powerful Koch brothers.

The joint statement articulated the retreat from Ryan’s pet project rather delicately, stating that the White House and Congressional leadership “… appreciate that there are many unknowns associated with it and have decided to set this policy aside in order to advance tax reform.” It’s very likely that border adjustability would have caused deep rifts in Congress and have been challenged as an illegal protectionist action by the World Trade Organization, so it was eliminated in order to give tax reform a better chance of making it through the House and Senate.

The early fate of the border adjustment tax serves as a cautionary tale and a good preview of how difficult it will be to make other big changes to the tax code. When the border tax was proposed, masses of lobbyists moved rapidly to dispatch it, and they are ready to ply their trade and battle either for or against whichever proposals benefit or harm their clients. Lobbying muscle will be particularly intense around the issues of taxation of small businesses, deductions for corporate interest expenses, and deductions for state and local taxes.

LOOKING AHEAD

Any tax bill which reduces revenue will naturally raise worries about increasing the federal budget deficit and face hurdles from congressional budget rules. Like the health care debate that preceded it, any tax legislation will need to stay as part of a budget reconciliation process to avoid being subject to a Senate filibuster that effectively would require 60 votes for passage. There are ways to get around the budgetary rules, including requiring the tax cuts to expire after 10 years, as was done in 2001, or using “dynamic scoring” with excessively optimistic assumptions about how economic growth will soar after tax cuts; the rising tide lifts all boats argument. These options have substantial drawbacks and are limited in how far they can propel the legislation, and scoring from the non-partisan Congressional Board Office will be taken more seriously.

Unfortunately for the public, the combination of political polarization and the narrow, one-party control of Congress will make it very hard to get any real tax reform done. The Republican majority is likely to work to enact reform without trying to get any bipartisan buy-in. Just as likely, the Democrats will remain unified in their opposition, with an eye to the midterm Congressional elections in 2018.

The anticipated absence of any real measure of bi-partisanship naturally empowers the deficit hawks and conservatives on the far right, including the House Freedom Caucus, which has sufficient votes in that chamber to torpedo any legislation assuming the Democrats vote “No” as a bloc. In the Senate, just three opposing Republican votes can topple their majority firewall as seen in the last round of health care legislation. The narrowness of this plurality, the strength of the conservative bloc, and the highly partisan approach of the lawmakers’ legislative work will make it tough for tax reform legislation to withstand opposition from all the special interest groups that will want to defeat it.

Instead, based on the joint statement and other information made public so far, legislation will likely center around short-term tax cuts with only partial revenue offsets. Certain tax breaks may be reduced if they are the ones that Republicans oppose on ideological or political grounds. For example, the legislation is likely to try to repeal the state and local income tax deduction, which promotes state and local public expenditures and largely benefits residents of states that have voted for Democrats in recent presidential elections. But even this repeal may be too challenging to ram through over the objections of Republican members from high-tax states like California, New York, and New Jersey.

So, will we see real, permanent tax reform legislation being signed on President Trump’s desk this year? That is a highly unlikely outcome. Will we see some short-term cuts or the elimination of some deductions? That is a possibility. And will we see a bruising legislative battle, tweet storms, partisan wrangling and bare-knuckle politics? That is a certainty. It should be a very interesting autumn.