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“Yeah, I’m The Taxman” Redux.

December 14, 2017

With the current tax reform/tax cut bills in conference it is looking increasingly likely we will be seeing new tax legislation this year. While I had originally intended to do a lengthy blog to discuss the positives and negatives of all the various changes House/Senate bill, the busy-ness of the Christmas holidays and completion of grading my OSU students this week has made that impossible. So instead I provide a short synopsis of the bills’ positives and negatives and a little bit of economic commentary. Per usual in this blog, I will be dealing only with facts and numbers and analysis not political hyperbole that seems to have been the main reaction of the press, social media and our political leaders to the tax reform/cut effort, ranging from it will be “terrible” to it will be “incredible”.

Earlier this year I blogged about the change needed to make the tax system more efficient, truly fair, to reward savers, to discourage excess consumption, to make the tax code simple and reduce the hundreds of billions in losses in productivity to our economy from a tax code that is hopelessly complex with myriads of subsidies. My conclusion is that the Fair Tax (see FairTax.org ) is by far and away the best system of taxation we could have in this country. However, sadly it is politically unrealistic so I won’t repeat my plea here again. Nonetheless, I have attached my April 2017 blog which goes thru the arguments and points out what principles in taxation make sense and why. (An economist can dream!)

So what is one to make of the current efforts and likely final passage of something resembling the Senate or House Tax Reform Bill? Herewith is my thumbnail review/analysis and my own takeaways:

Summary – The tax reform bills are focused on three main areas of taxation (1) Personal Income Taxes and (2) Corporate Income Taxes and (3) Estate Taxes 

Key Changes

  • Corporate Taxes Reduced (1) Corporate Rate for Domestic “C” Corporations reduced from 35% to 20% (Senate Bill changes this beginning in 2019/House Bill 2018)- as of today it could be 21% in the final bill (2) Foreign Earning Tax Treatment Changed providing an incentive to repatriate past earnings (currently about $2 trillion ) making them subject to a low US rate (3)Domestic Corporations CAPEX for new and used investments – Can now be expensed immediately rather than depreciated (in House Bill), (4) Interest Expense No longer deductible
  • Individual Income Taxes Cut/Reformed – (1) Marginal Tax Rates Generally Reduced to 12% (from 15%), 25% (from 28 and 33%) and 35% (from 39.6%) (2) Top Marginal Rate of 39.6% Retained — but now only for individuals earning more than $500,000 and couples earning more than $1 million (Senate Bill reduces this rate to 38.5%). Final Bill has apparently reduced this to 37% (3) Standard Deduction roughly doubled (to $24,200 for couples) though Personal Exemption eliminated –Net effect is a greater “net” standard deduction except for families with 4 or more children  (4) Major Itemized Deductions Eliminated (e.g. state and local income taxes) or Capped (e.g. property taxes limited to $10,000 deduction). Looks like the final bill will cap state and local income tax deductions at $10,000
  • Estate Tax Cuts—Approximately doubles the estate tax exemption from $5.49 Million to $11.2 Million. House bill repeals estate tax altogether by 2025.

Macroeconomic Impacts

Most of the changes in the tax reform bills will have a positive economic impact. My assessment below is based on my own economic analysis, supported by a number of the economic models that have been used to assess the national impacts:

  • POSITIVE — Reduction in the Top Corporate Rate from 35 to flat 20%/Expensing of New Investments – This will make US corporations much more competitive with foreign companies. (Currently the US has one of the highest corporate tax rates –which includes state corporate taxes– among OECD countries). It will reduce the use of foreign subsidiaries and increase the use of domestic offices. It will also make it more likely that foreign companies may headquarter or have operations in the US. It will lower the effective marginal cost of capital, increase profits, increase wages and employment, and also result in lower prices and higher volume of goods sold.
  • Slightly NEGATIVE Interest Expense No Longer Deductible  – This will likely raise the after-tax cost of debt financing, raising in turn the costs of goods sold. However, in today’s low-interest rate environment, many companies have become too leveraged and this tax change should help discourage excess debt financing and increase use of equity instead which will offset some of the negatives.
  • POSITIVE Individual Marginal Tax Rate Cuts/Increase in Standard Deduction/Major Itemized Deductions Eliminated or Capped– The cuts in the tax rates will lead to more disposable income and savings for most taxpayers. This will be offset somewhat  for higher income taxpayers with the reduction in itemized deductions. (In high tax states, the advantage for high income taxpayers may be more than offset by the elimination of itemized deductions).  The removal/limitation of itemized deductions will have a positive impact on the economy overall as it removes or limits the amount of effective subsidies for homes and properties and frees up more capital to be spent on more productive uses. On balance, these changes should be positive for the economy.
  •  NEUTRAL Estate Tax Cuts –  Because there are relatively few taxpayers affected by the changes in the estate tax and most of the very wealthy have created foundations which shelter much of their income, the economic impacts of the estate tax cuts or its elimination (in the House Bill) are relatively small.

 

Federal Deficit Impacts

The impact on the deficit varies depending on the model and economic assumptions used. I generally subscribe to those models that actually indicate what their underlying macroeconomic assumptions and are “dynamic” reflecting the impact of the tax changes on investment/savings and consumption . For the Senate Bill I have seen estimates from the Joint Committee on Taxation (JCT) staff (which is bipartisan) which suggests a $1 trillion cumulative deficit impact over the next ten years ($1.4 trillion loss in “static” terms somewhat offset by $0.4 trillion gain due to the “dynamic” effects on GDP and hence tax revenues). The House Bill generally shows a somewhat lower deficit estimate. Notably, the Tax Foundation has pointed out that the dynamic scoring of the bill used by JCT substantially understates the positive impact on the economy for a variety of reasons (See “JCT’s Dynamic Scoring is Positive but Underestimates Economic Benefits” from their website). To be sure, the Tax Foundation has some biases in favor of tax cuts ( just like the Brookings Institution has a bias against tax cuts). Nonetheless, their economic arguments seem compelling to me, though I am not convinced that we won’t have some added debt as a result of the plan.

Some estimates that have been published are “static” (e.g. CBO), meaning they don’t consider the effect of behavior changes by firms and individuals to the tax changes. I would caution anyone from giving these estimates any credence as they are just plain wrong.

In short, we are probably looking at approximately a $1 trillion deficit from the ultimate tax law with the possibility that more optimistic assumptions about growth might result in a nearly neutral deficit impact. As a deficit hawk, I am not happy  with $1 trillion more debt but its important to put this in perspective. For all those who are now screaming about this, where we’re you when we more than doubled our debt from about $8 to $18 trillion during the Obama years? While some of this occurred due to the recession, most of this happened due to a one-time (but really permanent) $800 billion increase in spending due to the 2009 Stimulus Act. So the deficit impacts of $1 trillion really pales in comparison to the roughly $5 trillion increase in debt due to the stimulus ( a policy which by the way did not work all that well). And all else being equal, I would much rather put more money in the hands of individuals and corporations thru a tax cut and cut government spending (which we need to do in a very BIG way in the long run), than the other way around.

Distributional Impacts

The most important effect (or rather the one most people care about!) is who wins or loses with the changes in the individual tax code. After running a few numbers on the House Tax Bill version , I got the following results for married couples (no kids) :

  • $50,000 Income (Std. Deduction)— Current Law Income Tax: $3428  House Bill: $3072 Net Savings: $356 or 10%
  • $75,000 Income (Std. Deduction) — Current Law Income Tax: $7178   House Bill: $6072  Net Savings: $1106 or 15%
  • $100,000 Income (Std. Deduction)–Current Law Income Tax: $11483  House Bill: $9072  Net Savings:   $2411 or 21%
  • $100,000 Income (Item. Ded. $25,000)—-Current Law Tax: $9308      House Bill: $9072  Net Savings:  $236 or 2%
  • $150,000 Income (Item. Ded. $20,000)—-Current Law Tax: $22158    House Bill: $19700 Net Savings: $2458 or 11%
  • $150, 000 Income  (Item. Ded. $30,000) –Current Law Tax: $19658   House Bill: $19700 Net Loss: $-43 or -0.1%
  • $500,000 Income (Item. Ded. $40,000) —Current Law Tax:$127602   House Bill: $128,760 Net Loss: $-1159 or -1%
  • $500, 000  Income   (Item. Ded. $80,000) —-Current Law Tax: $113,701 House Bill: $128,760 Net Loss: $-15,059 or -13%

In other words, the individual tax reform bill is more of an “across the board” tax cut than a “middle class” tax cut. It is generally on the order of a 10 -20% tax cut for most middle to upper-middle income tax payers (e.g. $50,000 to $150000 income). However, if you live in a high tax state (e.g. New York, New Jersey, California) and make more than $100,000 and have a home mortgage, your tax cut will be largely offset by the loss of your itemized deductions and in some cases you may end up paying more in taxes. At higher income levels, there is even a greater difference between the high tax states/homeowners vs. individuals in low tax states. For example, my quick calculations suggested a relatively wide difference between taxpayers earning $500000 with a lot of net itemized deduction (e.g. $80,000) vs those in lower tax states that don’t have large mortgages (e.g. $40000). In the latter case, these taxpayers would pay about $1159 or 1% more in taxes. In the former case, these taxpayers would be paying 13% more in taxes or an additional $15059.

Overall, of course, most of the “dollar” tax cuts go to individuals in higher tax brackets. This is not surprising because these people pay the vast majority of federal income taxes today. Consider the following statistics from the most recent year (2014) available:

  • In 2014, 139.6 million taxpayers reported earning $9.71 trillion in adjusted gross income and paid $1.37 trillion in individual income taxes.
  • The share of income earned by the top 1 percent of taxpayers rose to 20.6 percent in 2014. Their share of federal individual income taxes also rose, to 39.5 percent.
  • The top 50 percent of all taxpayers paid 97.3 percent of all individual income taxes while the bottom 50 percent paid the remaining 2.7 percent.
  • The top 1 percent paid a greater share of individual income taxes (39.5 percent) than the bottom 90 percent combined (29.1 percent).
  • The top 1 percent of taxpayers paid a 27.1 percent individual income tax rate, which is more than seven times higher than taxpayers in the bottom 50 percent (3.5 percent).

 

Missed Opportunities

  • Keep The Estate Tax as is – The estate tax cuts and  ultimate repeal in the House Bill make no sense to me. Most economists believe they will only mildly improve the economy. And they benefit ONLY the heirs of the very wealthy. I realize that estate taxes reflect triple taxation (once when earned, once when gains are made and once after death) and arguably that is very unfair. However, it is not worth reducing overall tax revenue to benefit a very few.
  • Lower SSN Payroll Tax rates – One way to help out the working poor would be to lower payroll tax rates for Social Security while raising the income subject to the tax.  This could be done to keep neutral the amount of $ collected by the payroll tax, while significantly cutting into the amount of taxes that the working poor pay. (Note the FairTax goes even further and eliminates the Social Security and Medicare taxes completely!). I understand why no one wants to touch the third rail of Social Security Reform quite yet, but making a “neutral-revenue” rate cut would be welcome for those most needing the help.
  • Eliminate Home Mortgage Interest Deduction/Property Tax Deduction – By retaining the mortgage interest deduction (and in the case of the Senate expanding it) as well as keeping, albeit a capped, property tax deduction, an opportunity was lost to get rid of deductions which will only help upper-middle and upper income taxpayers (those that will itemize because they will have more than $24,200 in itemized deductions for couples) making more than $100,000 a year. I know the real estate lobby is fierce BUT this would have been an opportunity to increase tax revenues while simultaneously making the tax code more efficient.
  • Keep a Line-Item Deduction for Charitable Donations – Even though both bills left in deductions for charity, with a much larger number of taxpayers taking the standard deduction with the tax law changes, many taxpayers may reduce their charitable deductions. The new tax law should create a special line item which much like Health Savings Accounts directly reduces AGI (adjusted gross income) so that this deduction can be taken in addition to the standard deduction.
  • Limit Business Income Deductions Further – The further limitation or even outright removal of the deductibility of business entertainment (e.g. luxury suites, meals, parties etc.) would be a good step. Why should a business be able to deduct such activities for tax purposes? Maybe it would help reduce the ridiculous salaries and profits made by sports teams and players. It certainly would help raise some needed tax revenue to offset some of the tax rate cuts. See the recent WSJ op-ed on this.

My Bottom Line Takeaways

Reform of corporate taxes in the US was long overdue and cutting the marginal tax rate to 20% (or 21%) is a positive move for the US economy and US citizens. While reform of individual taxes was only partially accomplished, the removal and capping of most itemized deductions (in exchange for generally lower tax rates across all income levels ) is a step in the right direction. On the other  hand, the bill should have reigned in more deductions and tax shelters in the corporate and individual so that it was unequivocably revenue neutral. It should have provided more tax cuts (in the payroll tax) to help lower-income workers. The tax bill certainly isn’t perfect and it certainly isn’t my idea of true tax reform, but at least it was an improvement over the current system.

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“Yeah, I’m the Taxman” (Post from April 19th)

With this years official tax due date of  April 18th just behind us, it is time for my annual tax blog. But as I purveyed my past blogs around tax time, I realized that I haven’t written an “annual” post in three years. So for now what is my “triennial” post on taxes, I will focus on with the multitude of problems with the current system and why we must change it pretty radically. I am not naive on tax policy however, and the chances that anything close to the type of changes I am suggesting are minimal at best. Nonetheless, sometimes I like to dream.

The federal government collects money largely thru a system of personal income taxes and to a lesser extent corporate income taxes. In 2016, the government collected $3.3 Trillion in Taxes –almost $1.6 trillion thru personal income taxes,  $1.1 trillion thru payroll taxes (i.e. medicare and social security paid by employees and companies) and about $0.3 Trillion thru corporate income taxes with the balance of $0.3 trillion collected thru federal excise taxes and other taxes.

I won’t be focusing on corporate taxes as that is the most likely area to be reformed by Congress this year and frankly is not a major part (only about 10%) of our current tax picture. However, my main focus will be on personal income and payroll taxes which account for more than 80% of the total taxes collected by the government. However, the changes I am suggesting would replace all corporate taxes and personal taxes currently collected by the US government.

Why is our personal income tax system a problem?

  1. Federal income/payroll taxes provides a disincentive to “work” and for employers to hire U.S. workers – By taxing income, we are taxing the hundreds of millions of Americans who are working. This is particularly problematic for the lower-income worker who is often making only a bit more than welfare plus food stamps benefits because it discourages employment. (A single person making only $20,000 per year will pay about $2500 in taxes largely because of the mandatory FICA taxes of 7.65%). Studies abound about the importance of having a job to an individuals self-worth and the positive effects it can have on the family. But our current system actually financially discourages work which is obviously a big problem. More pernicious is that the payroll tax is also paid by the employer which discourages hiring and encourages more automation or outsourcing.
  2. Our Federal income tax system tax “savings” but not consumption – As a society one of the most important things we want to encourage is individuals saving for their retirements or for unexpected rainy days. More importantly, savings are the bedrock of capital that businesses need to expand and invest creating economic growth and jobs. However, our current system taxes savings by taxing interest, dividends and capital gains earned as well as eventually taxing all earnings in deferred tax accounts (e.g. IRA, 401K etc.). More importantly, we encourage consumption now because we don’t tax it at all. Partially as a result of this, we now are a nation of consumers and NOT savers with average savings of only about $40000 for those approaching retirement and only $9000 for all families. In contrast to our savings, our national debt has soared with total personal debt of $18.3 trillion almost as large as our US government debt. This personal debt burden is now more than double our personal debt burden in 2000 and TEN times our personal debt burden in 1980.
  3. Federal income and payroll taxes fail to tax the underground economy –  It is pretty obvious that income and payroll taxes miss the underground economy of illegal drugs, gambling and prostitution as well as legal professions such as maid, cleaning and other services which are often paid in cash and go undeclared. This underground economy is estimated to be not paying some $300-500 billion in taxes per year. In addition, the massive complexity of the tax code means that there are many knowing and more commonly unknowing tax cheats which cost the federal government significant tax revenues.
  4. Federal  tax deductions encourage home purchases and borrowing – The notion of home ownership is strong in the US and has a long history and individual home ownership is generally a good thing. However, by allowing deductions for property taxes and mortgage interest we significantly subsidize the cost of home ownership for many taxpayers. This has two negative effects: (1) it often encourages greater borrowing and the overconsumption of housing ( e.g. a bigger house than is truly affordable) and (2) it results in over-investment in the housing sector to the detriment of areas of our economy where investment would be more efficient (i.e. result in more economic growth and more jobs).
  5. Federal tax deductions for state and local taxes and tax-free interest for state and local governments encourage overspending by state and local governments –The largest itemized tax deductions for many tax payers are deductions for state and local taxes (both income and property). Also, state and municipal governments benefit from interest paid on their bonds being federal tax-free. The effect of these subsidies is to significantly subsidize state and local government spending and more state borrowing. Total state and local debt outstanding now totals $3.1 trillion some 10 times the amount of debt in 1980.
  6. High Marginal Tax Rates Discourage Small Business and Entrepreneurship  – Not surprisingly most small businesses and proprietorships pay individual taxes and with about a 50% marginal tax rate (when local and state taxes are factored in), it is not surprising that businesses are discouraged from expanding or for that matter even starting businesses since the venture or other capital needed is hampered by a low after-tax return on investment. Another effect of high marginal tax rates is to encourage tax deferred investment (401Ks and IRAs) and deferred income for the wealthiest tax payers. This actually reduces tax collections in the short run.
  7. The Current Tax Code is So Complicated that it Results in Much Wasted Spending –  According to the Tax Foundation the current federal tax code now totals MORE THAN 70,000 pages!!! The IRS estimates that the average individual tax payer spends about $120 per year to file taxes or a total of more than $18 billion per year across 175 million individual tax returns. Each individual taxpayer also spends about 8 hours on average preparing taxes. This is also a tremendous economic waste almost 1.3 billion hours (155 million tax filers x 8 hours) could have been spent on productive work, volunteering or leisure activities , were it not for our absurdly complex tax code. Valuing these foregone activities at a conservatively low $50 per hour (and arguably the number is higher as most of the tax preparation hours are spent by those in upper income brackets) means that there is an additional loss of almost $80 billion per year to the economy. In other words, just the costs of filing  for individual tax payers costs the US economy almost  $100 billion per year in wasted activity. And this doesn’t even include our corporate tax filing costs which are nearly as  significant.

The Trump Administration and Republicans in Congress promise to reform taxes. I believe that this will happen with respect to corporate income taxes, but it is lot less likely to happen with personal income taxes. Even if they do succeed, my fear is that it will only affect matters marginally. Certainly, reducing all the tax rates some will help (particularly IF deductions are phased out for the wealthy or capped to pay for the tax rate reductions). However, something much more fundamental is needed. We simply can’t afford as a nation to continue to operate with a tax code that is costing our economy hundreds of billions $ and maybe even trillions$ per year.

My favorite tax reform proposal to rectify these serious problems is something called the Fair Tax. See FairTax.org. I blogged about this proposal five years ago, but it seems more important than ever today. So with apologies to those who actually read my first blog post on taxes :), the remaining section is largely from that post in 2012.

The Fair Tax proposal represents a simple and effective way of raising tax revenues and having a system which is fair and positive for the economy.  To quote the website: “The FairTax is a national sales tax that treats every person equally and allows American businesses to thrive, while generating the same tax revenue as the current four-million-word-plus tax code. Under the FairTax, every person living in the United States pays a sales tax on purchases of new goods and services, excluding necessities due to the prebate”. Of particular note:

  •  Simplicity– The FairTax is a 23% national retail sales tax on all goods and services plus a prebate to offset the 23% tax rate on consumption up to the poverty level. This  eliminates ALL federal personal income, corporate income, gift, estate, capital gains, dividends, alternative minimum, Social Security, Medicare and self employment taxes. It is very simple and straightforward to collect and eliminates the incredibly complicated federal tax system we have in place today.
  • Revenue Neutral – The Fair Tax is estimated to be revenue neutral relative to the current set of federal taxes. However, with the economic benefits that it would unleash, it probably will result in even more tax revenue for the federal government being raised.
  • Efficiency—Compliance with the FairTax would be far better than under the current tax system due to its simplicity and its collection at the point of sale. (Something most states already do). In fact, even the $1-$2 trillion underground economy and others that don’t pay enough taxes (either knowingly or unknowingly) would be taxed fully as they would still consume goods and services. The costs of personal and corporate tax accountants, tax lawyers, HR Block, Turbo Tax and the IRS would disappear entirely and filling out your tax forms would no longer be necessary.
  • Great for the Economy and Jobs–By eliminating the large amount of unproductive activity associated the current tax code, resources are freed up to produce more goods and services more efficiently across the economy. In addition, the elimination of subsidies and penalties in the current tax code, will eliminate overconsumption which is also inefficient, and encourage savings and investment which are badly needed in our debt laden economy.  Net retail price increases in the first year of the tax should be relatively small because the 23% tax on prices will be mostly offset by the elimination in corporate and other business taxes (which are estimated by economists to account for about 20%+ of  retail prices today). The US will become the mecca for foreign investment and US companies will no longer produce as much offshore given the elimination of these embedded taxes on exports. This will mean many more jobs in the US and better paying jobs as well.
  • Fair and Progressive—The system provides a prebate in the form of monthly check equal to the national sales taxes paid on consumption at the poverty level for each family. This means that  the first approximately $30000 of spending for a family of four is completely tax-free and the effective tax rate for those that spend at or below the poverty level is zero. In addition, all used goods (e.g. used cars, used appliances, used furniture, used clothing, etc..) are completely tax exempt under the proposal. This means that many necessities to live are NOT taxed while discretionary items are taxed. Also, those who are frugal and save more, get taxed even less. This is very different from the system today where the working poor pay significantly more federal taxes (when payroll taxes are included) than under the FairTax.  Studies also demonstrate that spending on goods and services are generally proportional to income (e.g. someone earning twice as much usually spends twice as much) . Thus, the tax is progressive ( a higher effective rate is paid for those who earn and spend more).

In short, the FairTax would broaden the tax base, aid the economy, create more US jobs and help us out of our budget and debt crisis. In addition, it can be easily modified to make it even more progressive by increasing the prebate and overall tax rate to account for the lost revenues, if that it is ultimately what US taxpayers want.

The biggest problem with the FairTax is POLITICAL. The benefits of the proposal is to the US population and economy collectively. However,  the benefits of the current tax system are to a multitude of special interests ranging from higher education, wind and solar power manufacturers, oil and gas drillers, public employee unions, state and local governments, the medical industry, real estate brokers as well as lawyers and accountants that thrive on the current hopelessly complex system. Any attempt to change the current system, let alone completely eviscerate it will be met with strong resistance. Also, there will be many who won’t feel that the Fair Tax is progressive enough particularly when it comes to the very wealthy.

Accordingly, I would add either one of two provisions (or both) to the Fair Tax IF NEEDED to get consensus around the proposal. The first would be additional federal excise taxes on “bads” including all tobacco, alcohol content and sugar content. See my Post from 2012  “No Sugar Tonight” for the value of doing this on sugar. This could be used to supplement tax revenues and allow for a higher income for which there would be no effective taxes (by raising the probate) AND/OR to lower the fair tax rate of 23%.  Second, if it would help  would be a 10% earned income tax on joint filers with earned income of say over $400,000 per year (or whatever income level is deemed necessary for high income earners). This would be simple addition which would tax salary over this threshold and only require a relatively small number of filers.

I know the obstacles are considerable and I am clearly dreaming. But it doesn’t hurt to try. It’s a good idea whose time has come. It’s about time we changed a federal tax system that was born in the early 20th century and clearly has outlived its usefulness.

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