The Irreverent Economist

Perspectives on Tax Reform

This week, Republicans in the US House and Senate are working on parallel versions of a tax bill that they hope to pass before year-end.  Two distinct proposals have emerged from their respective committees.  The House version has already passed the full chamber, and a vote is scheduled in the Senate for later this week.  If and when that passes, the two proposals will go through a reconciliation process, before a unified bill heads to the President for his signature.

Given significant differences between the two chambers’ proposals, the reconciliation could be difficult and time consuming.  As we saw with attempts to repeal/replace Obamacare, efforts to woo one group of legislators have a tendency to alienate others.  The challenges are greatest in the Senate, where at least six Senators have expressed concern over different aspects of the bill.  Since their concerns do not align, finding a compromise that satisfies them all could be difficult.  Therefore, everything that follows should be taken with a grain (or shaker!) of salt.

I do expect something to be passed before year-end, because that is a political imperative of the Republican party.  However, it may disappoint expectations and will probably do little to support the economy. Wealth will be transferred from those who spend relatively more of their income to those who spend less, which includes most KPF Global clients.

Here are the ways in which clients will likely benefit (depending on which provisions make it through the reconciliation process):

  • Lower tax rates on pass-through entities (to 25%) will help small business owners, although benefits are restricted for those in “service” professions for whom pass-through income is equivalent to salary
  • Lower tax rates on large corporations (to 20%), immediate write-off of capital investments, and a 12% tax on repatriated offshore income will increase corporate profitability and spur stock buybacks.  All else equal, this will boost stock prices, although much of this is already priced into markets.  As savvy investors say:  buy the rumor, sell the fact
  • Elimination of the AMT and a reduction/simplification of brackets will reduce personal income tax liability for most payers in the short run, but (per the Senate bill) goes away in 2027
  • The increase in the estate tax threshold to $10m in 2018, followed by its eventual phase-out, will save an enormous amount of money for wealthy families

And here are the ways in which it could hurt:

  • Elimination (under the Senate bill) or capping (under the House bill) of the state & local income tax deduction will increase taxes for those in high-tax states (NY, NJ, CT, MA, IL, CA, etc.)
  • The cap on property tax deductions (under the House bill) of $10k will limit this benefit for those with substantial real estate assets (keep in mind that some of these deductions were not available to those subject to AMT)
  • The cap (under the House bill) on the deductibility of mortgage interest on new loans to below a $500k threshold will hurt those with expensive homes who seek to buy, refinance or relocate
  • The switch after 2023 from the CPI to the chained CPI adjustment of tax brackets will reinstate “bracket creep,” pushing effective tax rates higher for most payers.  We anticipated this in our spring 2016 quarterly letter to clients
  • Elimination of the deductions for student loan interest, alimony, tax preparation & financial advisor fees, moving expenses, theft & losses, and medical expenses (in the House bill) will affect taxpayers with specific reliance on those benefits.

It is probably obvious but worth remembering that neither bill has the support of a single Democratic member of Congress.  In the Senate, the Byrd rule requires that any new legislation not increase the deficit by more than $1.5 trillion over ten years (and nothing beyond that) without requiring a 60-vote majority.  Since Republicans don’t have that majority, they’ve contorted their bill to create the appearance that it meets these requirements.  Whether or not it passes, these contortions doom the bill from a public relations standpoint—not just in the eyes of policy wonks and historians.  The legislation does little to increase the efficiency and transparency of the tax system, does not enjoy bipartisan support, will not be revenue-neutral (the growth effects of the legislation are unquestionably overstated) and is quite regressive.  For these reasons, it cannot legitimately be called “reform.”  Nor can it be considered “permanent,” since tax laws change with each swing of the political pendulum.

The most notorious of the Byrd-inspired charades in the Senate bill is the expiration of personal income tax cuts in 2027.  Per the Center on Budget & Policy Priorities/Joint Committee on Taxation, the 10-year phase-out is expected to raise personal income taxes relative to current levels on anyone earning less than $75k.  The promised offset to these payers from the stronger growth that will supposedly be triggered by corporate tax cuts is laughable.  Per the US Treasury, effective corporate tax rates, which reflect various expense deductions, are already fairly low—around 22%.  Maintaining the deductibility of interest while allowing capital investments to be written off immediately will further lower effective rates, pushing them below other OECD countries.  This will certainly boost corporate profitability; whether this will help the economy is another matter.  Corporate profits are already at historically high levels, and have been for two decades.  The surge in profitability did little to promote hiring or capital spending; on the contrary, it was the result of restraining spending and hiring.  Rather than reinvesting earnings to build sustainable, long-term businesses, publicly-owned firms have used profits to finance stock buybacks.  Why? Because they are unsure of future demand for their products and services.  Absent measures to support the precarious financial position of most households, corporate tax cuts will end up in the pockets of investors who are, disproportionately, wealthy people.

Much has been written about the benefits to small business, who historically have created the lion’s share of new jobs.  It’s certainly true that lower taxes would benefit their owners.  However, apart from professional service firms (which may not benefit from the pass-through provisions) these businesses typically do not generate a lot of taxable income.  Besides, surveys show that taxes are not a primary consideration in small businesses’ hiring and expansion plans.

Analysts who have studied these proposals believe that, on balance, the legislation will put money back into the private economy (thus the projected $1.5tr rise in the deficit).  However, most benefits will go to the wealthiest taxpayers since, for these families, the effects of the personal & corporate tax reductions, and the estate tax elimination, will be only partially offset by the reduced deductibility of income and/or property taxes, mortgage interest, medical expenses and other items.  For others, especially after 2027, taxes will go up.

Which brings us to the issue of permanence (or lack thereof) of major policy changes.  Economists believe that only tax and spending changes that are believed to be permanent can have a stimulative effect on the economy. This legislation is explicitly temporary.  Wild swings in estate tax policy over the past decade have made it very difficult for our clients to make tax-efficient plans for the disposition of their estates—and expensive even to try.  So don’t be too quick to spend your windfall—it may not last!

Finally, a personal reflection.  Although, as a small business person and asset owner, I stand to benefit from this legislation, I think it’s bad for the country.  For one thing, it tries to perpetuate the illusion that deficits don’t matter—that we can have something for nothing, forever.  Fewer and fewer people are drinking that Kool Aid.  These proposals create a fairly blatant zero-sum game, building class conflicts that will only worsen with time.  This political moment calls into question the whole purpose of government and this is, in many respects, a healthy debate.  I am anything but a fan of our overreaching Federal bureaucracy.  However, while we are getting more honest about what’s at stake,  and what really matters to each of us, representative democracy is failing.  Worse, promises upon which people have relied in planning for their futures are shown to be unreliable, at best.  It seems only fair that certain benefits should be phased out slowly, or grandfathered for those with lower incomes and fewer resources to fall back on.  Separately, missing from this “reform” is any effort to limit the tax deductibility of corporate interest expense—which creates strong incentives for debt-funded stock buybacks, distorts the capital structure, and is expensive in terms of foregone taxes.  It is an understatement to say that a casualty of this legislation is the  reputation of Republican fiscal restraint.  For all of these reasons, I hope the legislation does not pass in its current form.  If it does, I will be donating whatever savings I receive to others who need the money more than I.

 

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