Is Trump’s current tax reform legislation here to stay? Lanhee J. Chen, Ph.D., David and Diane Steffy Research Fellow, Hoover Institution and Director of Domestic Policy Studies in Public Policy at Stanford University, analyses the political trends in the U.S. and provides his insights on how changes in the legislation could affect the private equity industry.
Policy experts are divided over whether tax reform legislation signed into law last year by President Donald Trump constitutes a “win” for private equity. Some have argued that the lower corporate tax rates and relatively insignificant change to the treatment of carried interest are reasons for investors to believe they have made it out well. Still others note, in contrast, that significant changes to interest expense deductibility will require fundamental changes — for the first time in thirty years — to the way the private equity industry does business.
The more likely answer is that such facile conclusions missed the mark. The continuing political polarisation in the U.S., coupled with the recent (and troubling) trend of lawmakers re-litigating major pieces of public policy means that the final chapters on the tax reform law of 2017 have yet to be written.
For this reason, investors should certainly take steps to respond to current law but hold onto those intentions loosely – for possible changes and amendments to the law may be just around the corner.
Future tax reform efforts are likely to take more direct aim at increasing rates of taxation on carried interest.
That doesn’t mean that all of the provisions in the law are created equal. Indeed, there are a few of the changes made by the 2017 reforms that are likely to remain with us, primarily because undoing them would result in significant turmoil in the economy and dramatic impacts on the deployment of capital in the United States. Or, more notably, such potential changes would cause political difficulties for their advocates.
The three changes that are here to stay
1. The reduction of U.S. corporate tax rate
The reduction of the U.S. corporate tax rate to a flat rate of 21% for tax years beginning after December 31, 2017, is likely here to stay. Republicans absorbed significant political heat for making the corporate tax rate reductions in the reform law permanent, while sunsetting individual tax relief after a decade. But many economists believed that these reductions were long-overdue and will create a more stable environment for economic growth and investment going forward. For these reasons, a reversal of these reductions is unlikely, and even more so the longer that they remain in effect.
2. The treatment of carried interest income
The relatively modest change to the treatment of carried interest income (applying the higher ordinary income tax rate to carry from investments held for less than three years) is likely to remain. If anything, future tax reform efforts are likely to take more direct aim at increasing rates of taxation on carried interest. This has been a politically sensitive issue that members of Congress from both parties have vowed to tackle. Even President Trump has suggested in the past that he would be willing to consider more aggressive taxation of carried interest income.
3. The ability to fully expense capital expenditures
It’s unlikely that there will be changes to the tax reform law’s provision allowing companies to fully expense capital expenditures through 2022, with a phase out of allowable expensing through 2026 (when it decreases to 20 percent). There is some potential that a future Congress considers an extension of full expensing because this provision is both politically popular and has a positive impact on short-run economic growth. But a reversal of full expensing, or reduction in expensing permissible after 2022, is not likely.
Future Congresses (and presidents) will surely revisit the tax reform law, if for no other reason than to clarify or revise any provisions that prove difficult to implement. Whether those changes benefit or hurt investors remains to be seen. But if we’ve learned anything from the constant debate over the fate of major pieces of legislation such as the Affordable Care Act (ACA) and the Dodd-Frank financial services reform, it’s that no significant public policy is safe from debate and potentially path-breaking change – even more so during an era of massive political polarisation such as one Americans find themselves in today.