The manufactured “kiddie tax” crisis, explained

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There’s a simple rule I like to remind people of whenever a business or finance story emerges from the business section of the paper into the news section or into public consciousness: business journalists are the laziest people in the country. I would call business journalism “stenography,” except for the serious injustice that would do the patient, skilled, and honorable work hard-working stenographers do every day.

Business journalism is far worse than stenography: it’s fiction. Today’s entry in the genre is the manufactured “kiddie tax” crisis that snuck its way into the “Politics” section of the New York Times.

What is the “kiddie tax?”

Formally the “Tax for Certain Children Who Have Unearned Income,” the kiddie tax is a section of the tax code that applies to unearned income received by certain children, specifically children:

• who do not file a joint return;
• who have a living parent;
• who are under the age of 18;
  • or who are between 18 and 24 and are full-time students and receive less than half their “support” through earned income.

The kiddie tax is reported on Form 8615, which only needs to be completed for a certain child if that child’s unearned income exceeds $2,100.

Note one thing here: the test above is not whether a child is claimed as a dependent, but the stricter standard of whether a child may be claimed as a dependent, so the kiddie tax can’t be avoided simply by having a full-time student file their own tax return (unless they meet the 50%-earned-income support test).

How and why did Republicans change the kiddie tax?

Until the 2018 tax year, Form 8615 required a complicated calculation based on their parents’ tax rates, with special rules for divorced and separated parents. Republicans changed that calculation so that all children subject to the kiddie tax pay trust-and-estate rates on their unearned income in excess of $2,100.

This somewhat simplified the calculation by not requiring reference to the parents’ income, although as the Journal of Accountancy helpfully explains, “While many complexities of the old kiddie tax were eliminated, new complexities were introduced.”

But obviously simplifying the tax code wasn’t the point of the change, since the Republican law made the tax code vastly more complicated, introducing as it did 6 new schedules to replicate information that used to be provided on Form 1040. The reason the change was made is that the budget authorizing the law to be passed through the reconciliation process only permitted Republicans to raise the federal deficit by $1.5 trillion over 10 years. Since they wanted to cut a far bigger hole in the federal budget than that, they needed to find offsetting revenue anywhere they could, including the much more famous changes to the standard deduction and the cap on the state and local tax and mortgage interest deductions.

And it turns out, now they want to call backsies.

Policymaking by anecdote: students-and-orphans edition

That brings us to today’s news, that the Republican authors of the tax reform bill, with control of both chambers of Congress and the White House, “accidentally” raised taxes on certain sympathetic populations, and want “to correct drafting errors and other technical issues on a bipartisan basis.” Let’s take a look under the hood.

Financial aid for post-secondary students is treated by the tax code in distinct ways based on a number of factors:

• grants (including merit-based, need-based, and discretionary awards) are completely tax-free up to the amount of mandatory tuition and fees charged by the institution, plus books, supplies, and equipment required for courses;
• student loan interest is deductible from income in the year it’s paid, whether or not you otherwise itemize deductions;
• work-study income is taxable as earned income but exempt from FICA taxes during the school year (FICA taxes apply if you continue to work over the summer, for instance);
• grants in excess of mandatory tuition, fees, and expenses are taxed as unearned income.

This treatment of “excess grants” as taxable income is one reason virtually no institutions provide scholarships covering room and board: a dollar of tax-free scholarship spending goes further than a dollar of taxed scholarship spending, so institutions naturally prefer to “fill up” the bucket of untaxed scholarships before they start issuing taxable ones. Student loans, work-study awards, and family contributions are expected to make up the difference in the cost of attendance.

I want to draw special attention to one piece of sleight of hand the Times’ journalists dutifully copied down from whichever lobbyist fed them this story:

“In the past, a student from a household with a joint income of $50,000 who was awarded a scholarship that covered $11,500 in room and board would be taxed at their parents’ rate of 12 percent. Under the new law, that money would be taxed up to 35 percent.”

Did you catch it? Reread the paragraph one more time, I’ll wait here.

“In the past” there was no 12 percent income tax bracket!

In 2017, a married couple with one dependent making $50,000 would have owed $2,840 in income tax on $25,150 in taxable income, and the $9,400 in unearned income in excess of $2,100 would have been taxed at the parent’s marginal income tax rate of 15%, for a “kiddie tax” of $1,410, and a total tax bill of $4,250.

In 2018, the same couple would owe $2,739 on $26,000 in taxable income and $1,927 in kiddie tax, for a total of $4,666. In other words, the catastrophic mistake Republicans are rushing back to fix cost this family a grand total of $416 per year, raising their average tax rate from 8.5% to 9.33% during the years their child is enrolled.

But of course even this overstates the consequences for the family because they’ll continue to enjoy the Republicans’ lower income tax rates after their child leaves school (and increased child tax credit in the years prior to that, if applicable). Assuming their income remains the same for the 10 years the personal income tax cuts are in effect, the changes to the kiddie tax will cost them a total of $1,664 while the lower personal income tax rates will save them $1,001, meaning the total cost to this family over 10 years is $663 on $500,000 in income, or 0.13% of the total.

The point is, Republicans needed to find additional sources of revenue in order to make the numbers work on their enormous deficit-financed tax cut. Complaining about the new sources of revenue in isolation without taking into account the enormous tax cut is always going to make it look like taxes went up, instead of down, because you’re only looking at one half of the equation.

Conclusion: politics ain’t beanbag

Making predictions is hard — especially about the future. If you ask me honestly what I think will happen to this provision, I’ll tell you I think Democrats are going to get rolled on it, because Republicans are better at this than Democrats are. There’s going to be a steady stream of these stories planted in the business press, where the laziest journalists in America take in press releases, process them, and uncritically pass them along to the public. Long lines of sobbing athletes, scholarship students, widows, and orphans will parade past television cameras until Democrats cave and shovel another billion dollars into the furnace.

And look: I don’t care one way or the other if room and board scholarships are taxed as unearned income, earned income, or are completely untaxed. My point is that in a world with a competent financial press, Democrats would be in a much better position to extract concessions from the people who single-handedly created this manufactured crisis before throwing them a lifeline to get out of it.

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