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Tax Reform Framework Released, but the Road Ahead Is Long

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

Republican leaders in Washington have finally released their much-anticipated “unified framework” for tax reform. The document offers the most detailed account yet released on how Republicans would like to overhaul the tax code—but still leaves many key questions unanswered.

The document is the product of weeks of negotiations between the so-called “Big Six,” a group of Republican leaders from the White House, Senate and House of Representatives that includes Treasury Secretary Steven Mnuchin, National Economic Council Director Gary Cohn, Senate Majority Leader Mitch McConnell (R-Ky.), House Speaker Paul Ryan (R-Wis.), Senate Finance Committee Chairman Orrin Hatch (R-Ut.) and House Ways & Means Committee Chairman Kevin Brady (R-Tex.).

While Republican leaders are pushing for quick action, the substantive and political complexity of tax reform, coupled with a tight fall schedule, makes it highly unlikely that a bill will be finalized before the end of 2017. Most Washington observers believe tax reform will not be finalized until 2018—and even that is no sure thing.

As the Washington publication Politico put it succinctly, “Remember this: Six Republicans crafted the tax blueprint behind closed doors. Now 535 lawmakers with opinions will have a say in the details. And thousands of lobbyists looking to protect their carve outs will get in on the action.”

Here’s a look at some of the key elements of the plan, the details that still need to be determined, and the process for moving tax reform forward.

Key elements of the framework

The plan would cut the current seven individual tax brackets down to three: 12%, 25% and 35%. Significantly, the plan leaves wiggle room for “an additional top rate [that] may apply to the highest-income taxpayers,” but leaves that decision up to Congress. Recent reports suggested the negotiators were considering leaving the top rate at the current rate of 39.6%.

The framework also calls for roughly doubling the standard deduction, to $12,000 for individuals and $24,000 for couples. The plan would eliminate the Alternative Minimum Tax (AMT) and the estate tax.

On the business side of the tax code, the plan would reduce the corporate tax rate to 20% and cap the tax rate that would be applied to certain so-called “pass through” entities—such as sole proprietorships, partnerships and S corporations—at 25%, though there is considerable uncertainty about exactly which types of small businesses would qualify for this treatment. The proposal also offers corporations a one-time incentive to “repatriate” untaxed earnings from overseas.  

Lots of questions still to be answered

Beyond the uncertainty around the top individual tax rate, the framework document leaves unanswered a number of other key questions for investors:

  • What happens to the thousands of tax credits and deductions in the tax code? The plan says only that it “eliminates most itemized deductions, but retains tax incentives for home mortgage interest and charitable contributions.” How credits and deductions are handled will likely be one of the most controversial elements of the debate. Virtually every credit and deduction has a constituency that wants to preserve it.
  • How will investment income be taxed? The plan is silent on what the tax rates would be for dividend income and capital gains. It also makes no mention of the fate of the Net Investment Income Tax, the 3.8% surtax on investment income for wealthier taxpayers that is part of the Affordable Care Act.
  • Will there be changes to retirement savings incentives? The framework says only that it “retains tax benefits that encourage work, higher education and retirement security.” But there have been reports in Washington for months that changes may be coming to retirement savings incentives, including the idea that some or all contributions might be taxed up front, as happens today in Roth accounts.
  • How will the bill be paid for? The framework calls for an estimated $5 trillion in tax cuts—which would blow an enormous hole in the federal budget and dramatically increase the federal deficit. At least some of the tax cuts would have to be offset with provisions that raise revenue for the Treasury, but the plan is vague on those details. Those trade-offs will create winners and losers and are likely to be fiercely debated.

What’s next?

The unveiling of the framework is the first step in a long and arduous legislative process that could take many months.

First, negotiators must turn a few pages of general principles into a massive legislative proposal. The committees of jurisdiction on Capitol Hill—the Senate Finance Committee and the House Ways & Means Committee—will then have an opportunity to go through the bill section by section and line by line, changing it as they see fit. The committees can do so simultaneously, meaning that the bills that ultimately come to votes on the floors of the House and Senate are likely to be very different.

Another key hurdle to tax reform is that both chambers must first pass a budget bill known as “budget reconciliation.” This is a critical step because that bill would contain instructions that would allow Republicans to take advantage of special procedural rules in the Senate. These rules would limit debate, limit amendments and, most importantly, prohibit a filibuster, which would mean Republicans could pass tax reform with a simple majority rather than the 60-vote supermajority needed to break a filibuster (and pass most legislation in the Senate). With Republicans holding a 52-48 Senate majority, it is believed that only under these special rules would there be any chance for the Senate to approve a Republican-written tax reform bill.  

Once each chamber passes its own version of the tax reform legislation, they will come together in a “conference committee.” Members of both chambers will haggle over all the details to produce a single piece of consensus legislation. That agreement will then need to be approved by both the House and Senate before it can be sent to the president for his signature.

This process will likely take months and feature many stops, starts and unexpected changes of direction. And there’s no guarantee that Republicans will unify around a single plan. The party has spent many months trying unsuccessfully to pass health care reform legislation. Tax reform is at least as complex as health care.

In terms of timing, our expectation is that legislation will be introduced sometime in mid to late October, with committees in both chambers working through the bill in November.

That timeframe could leave lawmakers confronting another significant obstacle. The current agreement to keep the government open and operating expires on Dec. 8. At some point in November, Congress will need to turn its attention to passing an extension of government funding in order to avert a possible government shutdown on Dec. 9.

This raises significant doubts about whether Congress will be able to pass a tax reform bill into law by the end of 2017. A more realistic expectation is that this issue will be the top priority for Congress in early 2018, as Republicans will want to push to get a signature accomplishment on the books as they head into the mid-term elections next fall.

What you can do next

  • If you’ve built a solid financial plan and a well-diversified portfolio, it’s best to ignore the political noise and focus on your long-term goals. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.

  • Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.

Important Disclosures

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, business, and other conditions.

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