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.