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What's Next for Tax Reform?

There are some important differences that need to be ironed out between the House and Senate bills, but Morningstar's Aron Szapiro thinks it is likely to be done by the end of the year.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Now that the Senate has passed their version of the tax bill, we're starting to get a clearer picture of what the final legislation may look like. I'm here today with Aron Szapiro. He's our director of policy research, for his take.

Aron, thanks for joining me.

Aron Szapiro: Thanks for having me.

Glaser: Let's start with the Senate bill, then we can look at some of the differences with the House version and what you think is going to happen there. Big picture, anything surprising change in the Senate bill from when we discussed it last until when it was passed early on Saturday?

Szapiro: Not really. There was just some tweaking around the edges. I guess the biggest surprise is probably a change to 529 accounts, a lot of our viewers are probably familiar with those, that would allow you to use that money to pay for K-12 education. That really is a substantial change in the tax treatment of 529s and a pretty big change in how we've subsidized people or paid for public and private education.

Glaser: One of the things we had talked about before was the potential for this bill to change capital gains or maybe increase capital gains payouts because of the way that the tax laws would work. But there was some clarification on that, that that would not apply directly to mutual funds themselves.

Szapiro: Right, they wouldn't apply to the mutual funds themselves. That's clarification that came out of the Senate Finance Committee staff, but it would apply to investors in those mutual funds, if that makes any sense. The idea is that investors wouldn't be able to use alternative ways of calculating their capital gains and losses but rather, they'd have to use first in, first out.

This really seems to me to be aimed at the expansion or democratization of tax law's harvesting strategies. I think it's important to remind people that these were always strategies for tax deferral, not really tax avoidance permanently. I'm not sure how strong an impact they'll really have. In any case, that provision is still in the Senate bill, is not in the House bill.

Glaser: Let's take a look at the differences then as the bills head to conference to try to get one piece of legislation here. What are some of the biggest differences that are going to have to be hammered out?

Szapiro: The biggest difference is the difference in the tax rates for individuals. The House bill has four brackets as opposed to the seven brackets in the Senate bill. Obviously, that needs to be reconciled. There are differences in the tax credit for families for children. That needs to be changed as well. Those are two pretty big differences.

Then I think the other really big difference, both the House and the Senate agree that there should be different tax rates for people who own pass-through businesses. These are businesses that are not organized as corporations but rather pass through all of their profits to their owners, which had traditionally been taxed at individual tax rates.

Both the House and Senate bill have breaks, but they're quite different from each other. The House has a very complicated formula that phases in the break for certain kinds of businesses. The Senate bill, after some negotiating, is just a 20% deduction applied to anybody who is paid through a pass-through business. I shouldn't say anybody. There are a lot of exceptions and exemptions. Frankly, it's going to take a while to figure out what it all means and who it applies to. The accountants and lawyers will figure out how they can use the rules to the best of their clients' advantages.

Glaser: Let's talk about the mortgage interest deduction. This has been a hot topic of conversation. Looking across the two bills, are there huge differences there, or do you think that the value of that mortgage interest deduction is going to be diminished?

Szapiro: I'll continue to say that I actually don't think--there is a difference on paper, which is that in the House bill, only up to the first $500,000 of a mortgage, only that basis can apply for the mortgage interest deduction. The Senate retains the current cap, which is $1 million. The Senate does some other things, gets rid of a tax preference for home equity lines of credit.

I actually don't think that this difference is all that big a deal, because both bills double the standard deduction. They pay for it by getting rid of the personal exemption. By doubling the standard deduction, they make it so most people will be unable to itemize. If you can't itemize, you can't the benefit of the mortgage interest deduction, or the charitable deduction, for that matter.

That's actually something that tax wonks on both sides of the aisle have long thought, that this subsidy for mortgage interest is priced fully into the market and maybe isn't a great use of tax expenditure. But in any case, by doubling the standard deduction, it really equalizes the treatment of your taxes as a renter to your taxes as a buyer for many, many, many people. Not all people, but many people.

I think that is a really significant change. In fact, there's been quite a bit of focus on this $500,000 cap or $1 million cap. That will matter to some people, but it won't matter to a lot of people who just won't itemize anymore because of that doubling of the standard deduction, and because you won't be able to itemize your state and local income taxes. 

There's actually pretty broad agreement, and it seems very likely that will be in the final package, given that we see that language in both the House and the Senate bills.

Glaser: Big picture, do you think that there's enough common ground here that they will be able to move quickly and get this done by the end of the year?

Szapiro: Yeah, it seems very likely. There's obviously a lot of pressure to get this done, to hand the president a legislative achievement. I think also, and this is not necessarily meant as a knock on the bill, but major reforms often make people nervous. They're often pretty unpopular. This bill does not poll very well. I think there's going to be a lot of pressure to just get it done and move on. The longer that they wait, the more easy it will be for opponents to mobilize against it.

I actually think it's moving very quickly. Again, because there's broad agreements on the corporate tax rate, broad agreements there should be some change through pass-through, broad agreements on limiting the number of people who can itemize on the personal income tax side. I think the other stuff, and there are big details that need to get sorted out, but I think they probably will.

Glaser: Aron, thanks for your take on this. We'll be sure to keep talking to you as we get a better sense of what that final piece looks like.

Szapiro: Yeah, thanks so much.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.