With the House of Representatives set to pass the final version of the Republican tax bill on Tuesday, and a vote in the Senate expected later in the week, here is a prediction: no matter which party controls Congress after next year’s midterms, lawmakers will be forced to revise this tax bill substantially. This legislation simply isn’t workable in the long run. Unless it is fixed, it could end up crippling the tax system.
At this stage, the unfairness and ideological bent of the proposal are widely recognized, as is its corrupt nature. Giveaways to the wealthy and large corporations have been at the heart of the bill all along, while last-minute changes made to the final bill, unveiled on Friday, included goodies for a number of groups, including architects, engineers, and the owners of a particular sort of commercial real-estate entity—the kind that Donald Trump, Senator Bob Corker, and certain other members of Congress just so happen to own. (On Monday afternoon, Senator Orrin Hatch, the chairman of the Senate Finance Committee, admitted that he was responsible for inserting the offending provision. The real-estate industry has long been a big donor to his campaigns.)
What isn’t yet fully appreciated is how porous and potentially unstable the rest of the tax code will be after the bill is passed. With a corporate rate of just twenty per cent, and a big new break for proprietors of unincorporated businesses and certain types of partnerships, the new code will contain enormous incentives for tax-driven restructurings, creative accounting, and outright fraud. Every tax adviser and scammer in the country will be looking for ways to reclassify regular salary income as favored types of business income.
For tax accountants, the first step will be to see how many of their well-to-do clients could feasibly convert themselves into corporations. “Taxpayers will be able to shield their labor income from tax by simply setting up a corporation and having their income accrue in the form of corporate profits. . . . Income that would have been taxed at the high individual rates is instead taxed at the low corporate rate,” an updated report from a group of tax experts at New York University, the University of Chicago, and other places noted on Monday. Investment income is also taxed at the lower rate. “There is really no downside to this game,” the report said.
For some high earners, another alternative will be to go freelance and set up their own businesses, reporting their profits as “pass through” income on their personal tax returns. If they do this, many of them will be able write off twenty per cent of their taxable income, thus reducing the new top rate from thirty-seven per cent to 29.6 per cent, and the new second-top rate from thirty-five per cent to twenty-eight per cent. This “game is clear,” the report said. “Don’t be John Doe, employee. Be John Doe, independent contractor (or partner in an LLC, receiving a profit share rather than wages).”
But not all unincorporated businesses will be treated equally under the new code. Law partners will be excluded from the twenty-per-cent write-off, as will doctors who co-own medical practices. The owners of other firms that provide a “specified service” whose principal asset is their “reputation or skill” won’t be eligible, either. At least, they won’t be until they start engaging in some restructuring shenanigans.
Take a mid-sized medical practice that owns its premises. Victor Fleischer, a tax professor at the University of San Diego, has suggested that it would make sense for such a practice to set up real-estate-investment trust, which would then charge the doctors and nurses a very high rent. The medical practice’s profits would suffer, but the real-estate company would make out well, and, because of Hatch’s last-minute changes, it would also be able to claim the twenty-per-cent pass-through deduction. In a similar vein, it might well make sense for law firms to set up different companies to handle their accounting, computer systems, and other routine services. Here again, the trick would be to overcharge the main business and generate profits in entities that are eligible for the pass-through deduction.
In many instances, this sort of reorganization would be perfectly legal. In other cases, in which the rules are ambiguous, the I.R.S. would doubtless try to crack down. But the I.R.S. is reeling after years of budget restrictions—it has lost about a fifth of its workforce since 2010—and the scale of the problems introduced by this new tax bill could very quickly overwhelm the tax agency. The shortfall in tax revenues could be enormous.
Perhaps that is what Republicans want to happen. Undoubtedly, there are some in the Party who would like to see the tax base decimated, the I.R.S. crippled, and the federal government forced to slash spending on domestic programs, particularly entitlement programs. But, for anybody who believes in a properly functioning government, a rational, clearly defined tax system is essential. The Republican reform doesn’t meet that standard. In the words of the report, the “haphazard lines” that the legislation creates are “fundamentally unfair and inefficient,” and, taken as a whole, it represents “a substantial blow to the basic integrity of the income tax.” It won’t survive in its current form.