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Tax-Reform Losers Are Mostly Wealthy Individuals With Big Bills

Tax-Reform Losers Are Mostly Wealthy Individuals With Big Bills
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Monday, 06 November 2017 01:03 PM Current | Bio | Archive

Tax Reform I: Sausage Factory. House Republicans released their massive tax reform bill last Thursday. It is 429 pages long. The new bill, known as the “Tax Cuts and Jobs Act“ (TCJA), proposes a radical overhaul of the tax system. Now comes the hard part. Getting it passed through both houses of Congress will be challenging, especially in the Senate.

To get it passed, Republicans may have to alter it in significant ways, which makes it hard to predict what the ultimate bill will look like. Of course, it might not pass.

Consider the following:

(1) Losers. As currently proposed, the TCJA hits wealthy individuals in states with high income and property taxes the hardest. That’s because the plan eliminates the itemized deduction for state and local income or sales taxes (SALT) for individuals and caps the real property tax deduction at $10,000. (Currently, there is no cap on the SALT deduction.) It also caps the amount of deductible mortgage interest expense on new loans that are no larger than $500,000. (The current limit is for loans up to $1 million.) That may be too much simplification for wealthy people to bear without putting up a political fight, given that their top marginal tax rate won’t be cut and might actually go up.

The top rate stays at 39.6% for both joint and single filers. However, it would apply to fewer people—joint filers with annual incomes of $1 million or more rather than $470,701 as now and single filers with annual incomes of $500,001 or more rather than $418,401 or more. For joint filers, incomes between $260,001 and up to $1 million would have a marginal tax rate of 35%, combining the 33% and 35% rates that previously applied to income in this bracket. For single filers, the 35% applies to incomes between $200,001 and up to $500,000. (For more, see Business Insider’s helpful chart found in an 11/2 article.)

In an 11/2 article, Politico discussed a hidden 46% tax bracket in the November bill. It noted: “[A] little-noticed provision effectively creates a new band in which income is taxed at over 45 percent. Thanks to a quirky proposed surcharge, Americans who earn more than $1 million in taxable income would trigger an extra 6 percent tax on the next $200,000 they earn—a complicated change that effectively creates a new, unannounced tax bracket of 45.6 percent.” That means that “the top marginal tax rate would rise above 40 percent for the first time since 1986.”

The new code could be bad news for real estate values, especially for large homes since the mortgage interest deduction has been cut in half. It’s bad news for states with high income taxes like California, Connecticut, Illinois, New Jersey, and New York. They’ve been seeing net population outflows to states with no income taxes like Florida, Tennessee, and Texas. The new tax plan will only exacerbate these outflows from SALT to SALT-free states. That would depress real estate prices in the SALT states too, and force them to raise property taxes and/or cut spending.

Now that there is a detailed bill with specific measures, the special interest groups are marshalling their resources and lobbyists to fight the measures they don’t like. The housing-related special interest groups are already up in arms. Republican senators from the high-tax states are threatening not to support the bill.

(2) Winners. The big winners are corporations. They are projected to get a tax cut of $1.5 trillion over the next 10 years from lower corporate rates alone (which is somewhat offset by other reforms). The corporate statutory tax falls from up to 35% to a flat 20% rate starting next year. (A different rate applies to personal service corporations.)

Interestingly, the effective tax rate during Q2-2017 for all corporations was down to 21.3%, according to National Income & Product Accounts data (Fig. 1). For the S&P 500 (LargeCaps), the effective tax rate was 26.4% during 2016 (Fig. 2). Part of the reason that those rates are lower than the 35% top statutory rate is because of offsetting deductions. Additionally, corporate tax rates are currently based on a rate schedule, so some smaller corporations do not incur the 35% statutory rate; accordingly, lowering the statutory rate to 20% may not matter that much to them.

Since Election Day (November 8, 2016), S&P 500/400/600 are up 21.0%, 21.3%, and 24.1% partly on expectations of lower corporate tax rates (Fig. 3).

Tax Reform II: The Byrd Rule. Any changes that are made to TCJA risk violating the Byrd Rule. Passed in 1985, it requires any bill going through the budget reconciliation process not to contain any “extraneous matter” or something “merely incidental” to the federal budget. The budget-reconciliation maneuver through which the GOP hopes to move the TCJA allows a bill that adjusts the federal budget to pass through the Senate with a simple 50-vote majority to avoid a filibuster. Any other legislation needs 60 votes to avoid a filibuster.

One of the provisions of the Byrd Rule is that any bill going through the reconciliation process can't add to the federal deficit outside of 10 years, which is the length of a budget resolution. According to an 11/3 Business Insider analysis: “The most likely way leaders could cut down on the deficit increase in the second decade would be to make its planned corporate tax cut temporary.”

The key will be whether dynamic scoring, i.e., factoring in faster economic growth from tax reform, will boost revenues enough to satisfy another provision of the fast-track reconciliation process: “Procedurally, the economic impact is important—because under the reconciliation rules, it can only add $1.5 trillion to deficit over 10 years. If the economic growth projection slips, however, this could change, putting it outside of that $1.5 trillion window.”

The bottom line is that the bill might change a lot to achieve enactment, or it might die.

Tax Reform III: Favoring Business. The TCJA is weighted more toward benefiting corporations and small businesses than individuals. To demonstrate this, it is helpful to step away from the minutia of the specific tax changes. Here are the major bottom lines based on the Joint Committee on Taxation’s (JCT) table of the estimated revenue effects of the tax bill:

(1) On balance, revenue effects seem equally split between individuals and businesses. JCT estimates that the net effects of the proposed tax changes will result in a $1.5 trillion overall tax cut from 2018 through 2027. According to the JCT breakdown, that is composed of cuts of $929.2 billion for individuals and $846.5 billion for businesses. To arrive at the balance, there are offsetting increases for tax changes for foreign income and foreign persons of $285.4 billion and $3.2 billion for exempt organizations. So on the surface, according to the JCT, it appears that the cuts are more or less balanced for individuals and businesses.

(2) Pass-through businesses are businesses. Notice, however, that the JCT version includes the treatment of pass-through business income in the total of the section for “individuals.” Many pass-through businesses will enjoy a reduced tax rate under the bill, which is estimated to result in tax cuts of $448 billion. If we simply shift that to the business side of the ledger from the individual side, it’s obvious that the bill favors businesses.

We aren’t the only ones who think this classification makes sense. When the Tax Policy Center (TPC) analyzed the Trump administration’s September preliminary tax framework that preceded the November bill, the analysts included the treatment of pass-through business income as a provision for businesses (see Table 1 on page 7 of the TPC’s preliminary analysis of the framework). Further, the policy highlights for the November bill from the House Ways & Means committee don’t discuss pass-through provisions under “individuals and families” but under “job creators of all sizes.”

(3) The bottom lines. Even without pass-throughs, corporate cuts are bigger than individual cuts. The rate reductions for individuals are expected to result in cuts of $1.1 trillion, offset by other adjustments that will increase tax revenues by $608 billion, for a net effect of $481 billion in cuts. Lower corporate tax rates are estimated to result in tax cuts of $1.5 trillion offset by increases from other reforms of $616 billion, for a net effect of $846 billion in cuts. (For more details on the bill, see the House Ways & Means committee’s section-by-section summary of the “Tax Cuts and Job Act.”)

Tax Reform IV: Good for Stocks. Politically speaking, the Trump administration never would blatantly admit that the goal of tax reform is to benefit the stock market. However, Steve Mnuchin did recently indicate as much. In a mid-October interview with Politico, Mnuchin said: “To the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done you’re going to see a reversal of a significant amount.”

So far, the market has reacted positively to the release of the detailed tax bill on 11/2. The S&P 500 has risen 0.3% since 11/1 and 3.2% since the White House released an outline of the plan on 9/27. So it held the gains since late September despite the news that the tax bill would result in a lower dollar amount of tax cuts than preliminary estimates suggested. Based on the September framework, the TPC estimated the net effect of the tax cuts would be $2.4 trillion versus the JCT’s recent $1.5 trillion estimate. Nevertheless, the market’s upbeat reaction could simply demonstrate that the investors are starting to believe more in the tax cuts now than they did before, even though the effects might not be as great.

Tax Reform V: Reagan’s Cuts Favored the Wealthy. Unlike TCJA, President Ronald Reagan’s tax cuts significantly favored reducing taxes for individuals over those for corporations. Corporate rates were consolidated and reduced, but corporate deductions were reduced too, as discussed in a 1986 NYT article “The Tax Bill of 1986: Lower Corporate Rate, But Fewer Deductions; Numerous Changes Would Raise Burden on Business.”

The 1990 Budget of the United States Government includes a table on page 4-4 that shows the net effect on tax receipts of major enacted legislation during the 1980s. At the bottom of the table, an addendum breaks the effects down by source. For all periods shown, the largest reduction in tax receipts by far is for individuals.

For example, the net effect of tax receipts expected for the farthest year out shown, 1992, is a reduction of $258.3 billion. Included in that figure, individual tax reductions totaled a whopping $326.9 billion, while corporate income taxes and social insurance taxes and contributions were among the offsetting increases totaling $43.7 billion and $27.8 billion. (Increases to excise taxes and reductions to estate and gift taxes as well as miscellaneous receipts made up the difference to arrive at the overall net tax cut.)

Pre-Reagan, the top tax rate was 70%, which was slashed to 28% by the time Reagan was done, according to a record of tax facts found in a 2006 US Department of Treasury analysis. The current top tax rate stands at 39.5% and could rise to 45.6% for some high-income taxpayers, as noted above.

Tax Reform VI: Raising Taxes to Cut Taxes. The GOP tax reform plan is likely to reduce the percentage of Americans paying income taxes, placing a greater burden on wealthy individuals. Nothing in it is likely to broaden the tax base, in our opinion, other than the faith-based notion that the plan will boost growth enough to create more wealthy people, who will pay more taxes.

The key concept of the plan seems to be to raise taxes on the wealthy to pay for some tax cuts for the middle class and a big cut for business owners, with a key assumption being that they will pay their workers more and spend on capital to boost productivity.

Just for the record, IRS data available for 2014 show that 35.0% of income tax return filers paid no taxes (Fig. 4). The IRS reports that during 2014, there were around 400,000 millionaires. Collectively, they accounted for 17.2% of total taxable income and paid 27.6% of all income taxes (Fig. 5).

The media has actually hyped the opposite: that wealthy taxpayers stand to get a windfall from the tax cuts. That’s because the owners of pass-through entities, which are essentially small businesses that file through individual tax returns, mostly fall into the higher income tax brackets. However, the catch is that it all depends on how that income is earned, i.e., either actively or passively.

There are strict guidelines via a formula that’s intended to prevent the new lower rates on pass-throughs from being applied to personal labor income. So, for example, accountants, lawyers, and doctors who do their work through their own practices might not get much of a benefit. The rule is intended as a “give” for small business owners who are creating lots of jobs, rather than those who are practicing their trade solo through pass-through entities. While many might not like it, it’s an important rule because it should help to prevent taxpayers from fraudulently shifting personal income to pass-through income. Such fraud was a key concern that came out of the previous framework, which had assumed more aggressive rate cuts for pass-throughs than the latest bill.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
House Republicans released their massive tax reform bill last Thursday. It is 429 pages long. The new bill, known as the “Tax Cuts and Jobs Act“ (TCJA), proposes a radical overhaul of the tax system. Now comes the hard part.
tax, reform, losers, wealthy, bills, trump
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2017-03-06
Monday, 06 November 2017 01:03 PM
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