Fundamental Analysis

Tax Package Next Steps: Reconciling Differences

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Executive Summary

Late last week Senate Republicans passed their version of a $1.4 trillion tax package, while the House passed its version on November 16. While progress on getting a final tax package passed has been made, there is one final hurdle before enactment: the two bills must be reconciled and a single version passed through both the House and the Senate. In this report, we summarize the next steps in the legislative process and highlight the possible sticking points between the two bills. We conclude with a discussion of the bills' fiscal and economic impact.

We remain comfortable with our call for passage of a tax package in the first quarter of next year, with the cuts retroactive to January 2018. Our view is that the final package will rely on temporary cuts (either individual, corporate or both) and will likely end up looking more like the Senate's tax package rather than the House package.

How Does the Process Unfold from Here?

The next step in the process is for the House and Senate to vote on conferees to a joint House and Senate conference committee. This committee will be charged with reconciling the differences between the two tax bills. We expect this process to take some time given several differences between the two bills. As the negotiations unfold, we see the final bill looking more like the Senate bill than the House bill given the very tight vote margin in the Senate. Complicating matters is a deadline to fund the government by December 8. It is expected that Congress will extend funding via a continuing resolution (CR) through December 22. This short-term CR would likely eat into the time needed to clear the final tax package through both chambers, since Congress will need to again come up with another funding bill before December 22. We maintain the view that the final package will likely be passed in Q1-2018.

What Are Major Differences Between the House and Senate Bills?

Permanence of Individual Tax Cuts

One of the biggest possible sources of contention in reconciling differences will likely be the temporary nature of Senate tax cuts. In the House bill, a $300 family tax credit expires after 2022, but all other individual tax changes in the House bill are made permanent. In the Senate, however, all individual tax breaks including the larger standard deduction would expire after 2026. This expiration would also be true of the repeal of the state and local deduction (SALT). Essentially, the individual tax code would "snap back" to its current policies under the Senate bill. While this permanence issue may be a point of contention, there are few choices to work around Senate rules prohibiting a deficit impact beyond a 10-year window. Thus, the conference committee can accept the Senate's individual tax cut expiration, or it could allow some of the corporate tax cuts to expire.

Number of Individual Tax Brackets

Another key difference between the two packages is the number of tax brackets. The House bill collapses the current seven brackets into four brackets of 12, 25, 35 and 39.6 percent. The marginal rate on the top bracket is left unchanged and would kick in at income in excess of $500,000 for single filers and $1,000,000 for married filers, up from the current brackets of $418,400 and $470,700, respectively. The Senate bill leaves the number of tax brackets at seven but modifies the rates and income thresholds. The marginal rate on the top bracket is reduced to 38.5 percent and would kick in at income in excess of $500,000 for single filers and $1,000,000 for married filers. In both bills, the tax brackets would be indexed for inflation (Figure 1).

Child/Family Tax Credits

The House bill increases the child tax credit to $1,600 from $1,000, increases the income threshold for phase-out and creates a new $300 per-person family tax credit for other non-child dependents. The Senate bill has a higher child tax credit at $2,000 and increases the income threshold for phase-out to a greater extent than the House bill. The Senate bill also creates a $500 nonrefundable credit for qualifying dependents other than children.

Mortgage Interest Deduction

The House bill caps the mortgage interest deduction at $500,000 of debt (down from $1 million under current law) and eliminates the interest deduction for second homes and home equity debt. The Senate version maintains the current $1 million mortgage interest deduction cap.

Estate Tax

The House bill doubles the estate tax exemption to $10.98 million, indexed to inflation, then permanently repeals the estate tax in 2024. The Senate bill, however, preserves the estate tax but doubles the exemption to $10.98 million, indexed to inflation.

Pass-Through Income

The House bill creates a 25 percent rate for income derived from pass-through entities, which under current law is taxed through individual income tax brackets. To try and prevent abuse of the system, the bill proposes treating 70 percent of income as wage income (subject to the individual tax brackets) and 30 percent as business income (subject to the 25 percent rate). Some "specific service activities," such as income derived from financial services, law, engineering and other similar fields, are excluded from the special pass-through rate to create additional antiabuse guardrails. The Senate bill allows a deduction of 23 percent of qualified business income from total income. The Senate bill also excludes some "specific service activities" from being used to take advantage of this provision for anti-abuse reasons.

Alternative Minimum Tax

The House version eliminates both the individual and corporate Alternative Minimum Tax (AMT). The Senate bill preserves the AMT for corporations and for individuals but with a higher exemption amount.

Timeline for Implementation of Corporate Tax Cuts

Under the House bill the reduction of the corporate tax rate to 20 percent would begin in 2018. The Senate bill matches the 20 percent corporate rate but delays the implementation until 2019.

Business Expensing

Both the House and Senate bills allow for full expensing of capital investment for five years, but the Senate bill phases out the provision after five years rather than simply ending the provision as occurs in the House bill.

Deemed Repatriation

The house bill enacts a deemed repatriation of deferred foreign profits at a rate of 14 percent for cash and cash-equivalent profits and 7 percent for reinvested foreign earnings over a period of eight years. The Senate bill has differing rates of 14.5 percent for cash and cash-equivalent profits and 7.5 percent for reinvested foreign earnings.

Fiscal and Economic Impact

The Joint Committee on Taxation (JCT) serves as the official scorekeeper of the tax bills. According to the JCT's analysis, the House bill would cost $1.437 trillion over the next ten years, while the Senate bill would total $1.448 trillion over the same time period. The JCT also produces estimates of the macroeconomic impact of tax legislation. Its work found that the House bill, the only bill scored for macroeconomic effects as of this writing, would result in an economic impact of lifting the level of GDP by about "0.8 percent on average over the 10-year budget window." Since the JCT is referring to the level of GDP, and since growth compounds over time, the exercise is more involved than simply adding 0.8 percentage points to the baseline growth rate each year. While there are several possible ways to interpret this finding, on average the annual change to GDP would be roughly 0.08 percentage points, with the likely possibility of greater contributions to output in the early years of the 10-year window and somewhat smaller contributions to output in the later years. After the JCT accounts for the macroeconomic feedback of an earlier version of the Senate tax bill, the resulting budget deficit over 10-years would fall to $1.01 trillion. Given the JCT's analysis, we remain comfortable with our call for the final tax package adding roughly 0.2 percentage points to our GDP forecast in 2018 (Figure 2).

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Author: Wells Fargo SecuritiesWebsite: http://www.wellsfargo.com/
Wells Fargo Securities
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