The tax bill Republicans are planning to pass in the next day or two is not a good bill, and hopefully it will not pass. The fact that people have correctly identified it as a bad bill, however, has given rise to quite a bit of sloppy thinking about why, exactly the bill is so bad.
The effect of replacing the personal exemption with a larger child tax credit is genuinely ambiguous
Under current law, there are two different ways income is automatically shielded from the federal income tax: the standard deduction and the personal exemption. The standard deduction depends on your filing status, and the personal exemption depends on the number of people in your tax unit.
As a single filer with no dependents, I’m going to see a slight increase in the amount of income automatically shielded, since my standard deduction will rise from $6,300 to $12,000, a bigger increase than the loss of the $4,050 personal exemption. However, I won’t see a tax cut, since I don’t pay federal income taxes; as a sole proprietor it’s trivially easy to shield an arbitrary amount of income from taxes, and that will actually become modestly easier under the Republican tax bill due to the 20% passthrough deduction.
Now take my married brother, who has three kids. His standard deduction will also almost double, from $12,600 to $24,000, but that increase is less than the loss of his $20,250 in personal exemptions. That means he’ll have less income automatically shielded from the federal income tax. To illustrate this, assume he makes exactly $32,850 per year.
- Under current law, he owes no taxes since his income is entirely offset by the standard deduction and personal exemption.
- Under the Republican tax plan, he owes $885 in income tax.
So does he see an increase in his taxes? Not at all! That because three of his dependents are children, which allows him to claim the child tax credit. With no federal income tax owed, he’s currently entitled to a refund of $1,000 per child, or $3,000. Under the Republican tax plan, $1,400 of the new $2,000 credit is refundable, which leaves him with a $4,200 refund.
The interesting thing is what happens as his income increases. The Republican plan replaces the 15% marginal income tax bracket with a 12% bracket on up to $77,400 in taxable income. So while in 2017 my brother would owe $7,459 on $108,750 in earned income ($10,459 less the $3,000 child tax credit), in 2018 he’ll owe $3,000 on the same amount ($9,000 less the expanded $6,000 child tax credit). In other words, the lower 12% marginal tax rate on the majority of his income, and the expanded child tax credit, more than offset the fact that a larger share of his income is taxable.
Hopefully this stylized example shows why Republicans are able to say “most people” will see a tax cut in next few years compared to current law. The bill does nothing for low-income single adults, but modestly lowers taxes on middle- and high-income workers with multiple kids. These are also the provisions that are set to expire in a few years.
The effect of the state and local tax deduction cap is not ambiguous
So far we’ve only looked at stylized taxpayers with the only inputs being filing status, income, and number of dependents. Of course, what people are really talking about when they say their taxes will go up is the loss of the unlimited state and local tax deduction they enjoy today.
Under the current tax code, to the extent your state and local taxes exceeds the standard deduction, you can deduct the difference from your taxable income (technically you deduct the entire amount instead of claiming the standard deduction, but the result is the same).
Under the Republican plan, you can still deduct up to $10,000 in combined state and local taxes, but only to the extent your total itemized deductions (including the mortgage interest and charitable contribution deductions) exceed the new, higher standard deduction. That means even a joint filer that owes more than $10,000 in state and local taxes may end up actually deducting substantially less than that, if they don’t have enough mortgage interest or charitable deductions to “fill up” their standardized deduction, while under the status quo state and local taxes can be deducted in their entirety, even by taxpayers without any mortgage interest or charitable contributions
Now, it should be obvious this isn’t going to affect very many people. Property taxes are only paid by people who own real estate (renters don’t get to deduct the portion of their rent used to pay their landlord’s taxes). State and local income taxes, while less progressive on the whole than the federal income tax, are not so high that many people end up paying more than $10,000 without also having deductible mortgage interest and charitable contributions.
So we are left with the conclusion that the state and local tax deduction cap will fall almost entirely on a fairly specific group of people: high-income people who also own real estate, and fall on them it will. Your level of sympathy for high-income owners of real estate depends on your taste; I’m not here to argue with you about how sympathetic you should find such people.
However, there’s one more moving piece in the Republican tax puzzle that becomes suddenly relevant when discussing this population.
Anticipation of corporate tax cuts has inflated asset prices
Remember the point of this entire tax cut exercise: to enact an enormous permanent cut in the corporate tax rate. The ostensible reason for doing so is to spur investment in the United States. The consensus of reputable economists is that this will not, in fact, occur, which is of course one of the many reasons the bill is bad and should not be passed.
But there’s no question that it will, in fact, cut the amount of taxes owed by corporations, and given general macroeconomic stability, the anticipation of that surge in post-tax profits has inflated asset prices, with the S&P 500 rising 18.6% in the last year.
Of course, relatively few people own the overwhelming majority of financial assets in the United States. However, those exact same people also earn the highest incomes and own the most valuable real estate.
Economists pretend to believe marginal effects matter the most
When you read “heartbreaking” stories about wealthy suburbs of New York City, you see people complaining that their inability to fully deduct their property taxes will cause them to up stakes and head to a lower-tax jurisdiction, or perhaps lead to a tax revolt against high property taxes they now have to pay with after-tax income.
That’s because they’ve been convinced that it is marginal effects (tax rates in this case) that govern people’s behavior. Each decision in every aspect of a person’s life is supposed to be made by optimizing its marginal cost and benefit, resulting in an equilibrium that maximizes their total well-being. If property taxes become more expensive, the model has to be re-run and a new, lower-tax equilibrium has to emerge.
There is no reason to believe anything like this is true. Economists pretend to believe it because it makes it easier to develop models of “rational” human behavior. But you can just ignore them.
Your corporate tax cut is just as real as your property tax increase
Look: I get it. You’re a responsible investor. You max out your 401(k) contributions, your HSA, your 529, and your IRA. You invest in a sensible target retirement date fund. You save every raise so you don’t suffer from lifestyle inflation. You don’t speculate in bitcoin. And as your reward, you’ve seen your net worth reliably increase over the last 8 years. Those are your investments.
And now you find yourself shocked to discover that due to the cap on the state and local tax deduction, your federal income taxes are going to go up by tens of thousands of dollars. You’re being punished for working hard, for homeownership, for living in a good school district, for loving your family too much and wanting to keep them too safe.
But your federal income taxes are going up to pay for a cut to the tax rate on your investments! I understand perfectly well the psychological disconnect. One of them shows up as a quarterly bill you have to pay out of pocket, and the other doesn’t seem to show up at all. You’re responsibly reinvesting your dividends, after all, so you won’t even notice when Apple pays out an enormous special dividend with its repatriated profits; it’ll be plowed right back into your target date fund.
But the tax cut, the special dividend, and the rise in asset prices are still there. So if you’re having trouble finding the cash to pay your higher federal income taxes, it’s sitting right in front of you.
nice summary, now I don’t have to try to understand the bill!!
“Under the Republican bill, you can only deduct state and local taxes to the extent they exceed the new, higher standard deduction by $10,000 or less. That means state and local taxes in excess of $22,000 for a single filer or $34,000 for joint filers aren’t deductible from federal income taxes.”
So If I have $6500 in State Income Tax and $6700 in Property tax I can still deduct the full $13,200 even though combine these are over the $10000 cap? I have been trying to figure this out a while but cant find the information you have anywhere else. Any links would be helpful! Much appreciated
http://money.cnn.com/2017/12/18/pf/taxes/tax-bill-effects-2018/index.html
(Removed info not needed)
Single person in Queens, N.Y.
— $120,000 income
— Itemized deductions totaling $22,500 ($10,000 state/local income tax; $5,000 property tax; $6,000 mortgage interest; $1,500 charitable contributions)
…, the GOP bill caps her state and local tax deduction (income + property) at $10,000, which is $5,000 less than she currently takes. She would still continue to itemize under the bill because even with the $10,000 cap, her deductions combined would exceed the nearly doubled standard deduction of $12,000 for single filers.
This goes against what you are saying above.
Tony,
I apologize, in my effort to be as precise as possible, I unintentionally introduced new ambiguity! My point was to say that up to $10,000 in state and local taxes remain deductible, but you can only deduct them if you have additional itemized deductions such that your total itemized deductions exceed the new, higher standard deduction. I will rework that paragraph.
—Indy
Your point about SALT deduction & personal exemption loss being offset by lower rates/AMT exemption increase/investment gains is correct for a subset of affluent salaried folks making about $150-$450k in NY/NJ/CA. However, that just lines them up with the other plebes getting a few crumbs.
As per the most recent Tax Policy Center distributional analysis, most of the benefits go to the 0.1%ers, who benefit most directly by owning the most corporate equity, and pass through businesses including real estate, and are able to structure their own very large labor income as business income for tax purposes. Not to mention all their pre-existing loopholes like preferential treatment of capital over labor through cap gain rates and regressive payroll taxes and industry carve outs.
That’s the main reason this is bad policy. Adding govt debt to further advantage an extremely advantaged super minority, and increasing the burden on the rest of us. And probably using the increased debt load as an argument for reducing spending on the rest of us too (SS/Medicare), while refusing to touch spending that benefits the super minority (defense, tax subsidies for ag/real estate).
It is hard for me to understand how the republicans think they can do this without losing voter base. Is it just that the impact on the 99.9%will be small enough, up or down, that it won’t be noticed if the rest of world goes on reasonably intact?
@mom
Your theory is partly correct. Most don’t pay much attention, and have a hard time connecting the slow moving effects (inflation, lower income to labor vs capital) to the bad policy and the people pushing that policy. Those who do make the connections already vote Democratic.
However, due to distribution of GOP voters, gerrymandering, low voting rates by Dem leaning constituencies like the young and racial minorities, voter suppression, the Electoral College and the 2 senators per state regardless of population, the GOP only needs about 45% of the vote to maintain control of the White House/Senate/House. The GOP has successfully leveraged racial factors to get about 33% of voters on their side no matter what, with a further 10-15% leaning their way on economic advantage or social conservatism. Their lower to middle income voters are basically impervious to information that they are being screwed by their elected GOP reps. Ironically, their higher income college educated voters tend to be most sensitive to occasional scandals like Moore in Alabama and don’t turn out, or Charlottesville in Virginia and swing to Dems.
As in the most recent general elections, the balance of power currently rests on where that last 10-15% ends up. If Dem constituencies hit Obama presidential year levels or college educated whites don’t turn out or swing Dem, its around 10% and Dems are in good shape. Other way around, its 12-15%, and GOP takes over,
Jig,
I agree this is bad policy and continue to hope a way will be found to stop it from passing. The idea of passing an enormous deficit-financed corporate tax cut while raising individual taxes and complicating, rather than simplifying, the individual tax code, is so inexplicable on policy or economic grounds that the only reasonable explanation is that the Republican party has written off the future of the country and has fully embraced a smash and grab politics on behalf of their donors.
But if we’re going to have to live under the effects of this bill, I’m still going to try to explain it to my readers.
—Indy
I understand the point you were trying to make (high SALT paying affluent but still 99% member homeowners have offsets to their increased taxes and aren’t going to flee their locales), but that kind of discussion is very small potatoes to the larger picture (massive burden shift by GOP from billionaires to 99%, with more to come through ‘entitlement reform’).
Digging around in these details of whether individuals within the 99% win or lose by a few hundred dollars (which is basically the result for everyone excluding people with $50 million or more) is missing the forest for the trees. Which is what the GOP wants. My opinion is any discussion of the impact of this legislation should at least lead with a very quick summary of that big picture.
Jig,
I see, in that case your point is well taken.
This post was meant as a targeted response to the criticisms I have seen most commonly reported in the news media, where wealthy homeowners interview other wealthy homeowners about how upset they are about their income taxes increasing. I find those criticisms misplaced for exactly the reasons you describe and which I describe in the post, so I meant this post to silence those criticisms so people can properly focus on the actual devastating consequences of the bill on the deficit and Republican plans for repeal of the welfare state in 2018. But I could have made that argument more clearly at the top of the post.
—Indy
Do you have a post floating around on shielding income via sole prop? I’d love to know more.
Ken,
You can start with my posts tagged “self-employment” and let me know if you have any more questions: https://saverocity.com/independentlyfinanced/topics/self-employment/
I have a pretty simple strategy that basically consists of contributing to retirement accounts until my AGI gets down to $18,500, then the Retirement Savings Contribution Credit wipes out any remaining tax liability. At lower incomes you can also take advantage of the (refundable!) Earned Income Credit.
—Indy
Property taxes in NJ are hugh in General but maybe this will help a citizens revolt against rising taxes. My town has a around average of 15k per year per house. So yea moving to a lower tax state aka FL would be a huge gain Saving on No local taxes no state taxes wow that’s another 7 % property tax for similar house like 4K.
That’s 16k alone min. Savings on my first 100k hmmmm maybe I should move.
Ny Nj Ct Ca will have a lot of people in 2018 or 2019 making a move
It has been outlined in one of the tax papers that the SALT tax collectors “easily” can set up tax-deductible charitable funds you donate to but decrease your tax liability dollar-for-dollar. So you would claim SALT up to the tax threshold and run the rest through donations.
If a state raises more money they have more money to spend on services. Usually in places with high property taxes schools are better; places with high state taxes might have better universities; etc. Granted you can go to a no-tax state and pay for services yourself (e.g. private school, private security, etc.) but it’s tough to come out ahead that way. Just saying…
I see this tax bill a little differently. To me, it’s a semi-ingenious (i.e. evil) plan by Republicans to offer very small tax cuts to *most* Americans, in hopes of distracting them from the massive tax cut they are extending to the rich. A pox on them all, I say.