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Tax Cuts Yes, Simplification a Mixed Bag

18 Monday Dec 2017

Posted by pnoetx in Taxes, Trump Administration

≈ 2 Comments

Tags

Alternative Minimum Tax, AMT, AT&T, Chris Edwards, Comcast, Fifth-Third Bank, Joint Committee on Taxation, Pass-Through Income, Peter Suderman, Reason.com, Ricardian Equivalence, SALT, Tax Cuts and Jobs Act, Tax Deductions, Tax Reform, Tax Simplification, TCJA, Territorial Taxes, Wells Fargo

President Trump signed the Tax Cuts and Jobs Act (TCJA) this morning, the GOP tax bill with an acronym that simply won’t roll off my tongue. A useful summary of the Act produced by the House -Senate conference, and the full text of the Act, appear at this link. The TCJA hews more toward the earlier Senate bill than the House version. I’ve written about both (the House bill here and both here). Here is a good summary of the Act from Peter Suderman at Reason.com.

In my earlier assessments, I relied upon the principle of tax reform and real simplification as a justification for a tax cut without revenue neutrality. There are a few reforms and partial reforms, and the bill may simplify taxes for a number of individual taxpayers. However, on the whole I’m disappointed with the progress made by the GOP in those areas.

Notwithstanding my disappointment with the overall reform effort, the TCJA cuts taxes for most Americans and is likely to have salutary effects on economic growth and the job market. In fact, one of the most remarkable things about  the Act is the claim made by its adversaries on the Democrat side of the aisle. They apparently believe that the benefits of the TCJA flow primarily or even exclusively to the rich. This is a huge mistake for them. High-income taxpayers will receive greater benefits in absolute dollars, but not proportionally. This is shown by the table above, prepared by Chris Edwards from data produced by the Joint Committee on Taxation (JCT). In fact, the TCJA will extend tax reductions to a larger share of the middle class than either of its predecessor bills would have done. You cannot meaningfully reduce the taxes generated by a steeply progressive tax system without reducing the absolute dollars paid by high-income taxpayers. And you can’t lay the groundwork for sustainable economic growth without improving the investment incentives faced by high-income taxpayers and producers.

Here are some additional additional thoughts on the bill:

Yeah, I like me some tax cuts: The Act reduces taxes for many individuals and families by doubling the standard deduction and reducing tax rates. More importantly, perhaps, it will also reduce taxes for C-corporations, providing some relief from double taxation of corporate income, as will the switch to a territorial tax system on U.S. corporations doing business abroad. The latter is a real reform, while I consider the former a partial reform. Investment incentives are improved via the corporate rate cut and elimination of the corporate Alternative Minimum Tax (AMT) — a real reform, as well as the ability to write-off spending on new equipment immediately. As I argued last month, lower corporate taxes are likely to benefit both workers and consumers. The actions of few companies (AT&T, Comcast, Wells Fargo, and Fifth-Third) seem to demonstrate that this is the case: they have announced bonuses and increases in their base wage rates in the immediate wake of the TCJA’s massage.

Pass-through tax cuts are iffy: One of the most difficult parts of the TCJA to evaluate involves the implications for pass-through business entities like sole proprietorships, partnerships and S-corporations. Some might not receive significant cuts. The Act includes a maximum 25% rate on business income, but that is dependent on the proportion of the owner’s income deemed to be business income under the new rules. It also allows a flat deduction of 20% against business income. These provisions will be of benefit to very successful and very capital-intensive pass-throughs. Owners of smaller or less profitable firms will get the benefit of lower individual tax rates and the higher standard deduction, but might not have income high enough to benefit from the 25% rate cap.

Simpler for some, but it is not simplification: The doubled standard deduction will mean fewer taxpayers claiming itemized deductions. That sounds like simplification, but many will find it reassuring to calculate their taxes both ways, so a compliance burden remains. The Act retains or partially retains a number of deductions and credits slated for elimination in earlier versions, failing a simple principle held by reformers: eliminate deductions in exchange for lower rates. Along the same lines, the individual AMT is retained, but the exemption amount is increased, so fewer taxpayers will pay the AMT. Again, simpler for some, but not real simplification.

Elimination of the corporate AMT is simplification, as are immediate expensing of equipment purchases and territorial tax treatment. However, most of the complexities of corporate taxes remain, as do certain tax breaks targeted at specific industries. What a shame. And unfortunately, taxes for pass-through entities are anything but simplified under the Act. Complex new rules would govern the division of income into business income and the owners’ wage income.

Reducing deductions and bad incentives: The mortgage interest deduction encourages over-investment in housing and subsidizes the wealthiest homebuyers. The TCJA leaves it intact for existing mortgages, but allows the deduction to be claimed on new mortgage loans of up to $750,000. So the bad incentive largely remains, though the very worst of it will be eliminated. There have been complaints that this change could reduce home prices in states with the highest real estate prices. Good — they have been inflated by the subsidy at the expense of other taxpayers.

The tax write-off for state and local taxes (SALT) will be limited to $10,000 a year under the TCJA, though it adds some flexibility by allowing that sum to be met by any combination of state or local income, sales or property taxes. This change will reduce the subsidies from federal taxpayers residents of high-tax states, and should make leaders in those states more circumspect about the size of government.

The TCJA preserves and even expands a number of individual deductions and credits, subsidizing families with children, medical expenses, student loans, graduate students, educational saving, retirement saving, and the working poor. The interests benefiting from these breaks will be relieved, but this is not simplification.

Yet another case of “simpler for some” is the estate tax: it remains, but the exemption amounts are doubled. The estate tax does not produce much revenue, but it is fundamentally unjust: it ensnares the families of deceased property owners, farmers and small businesses; planning for it is costly; and it often forces survivors to sell assets quickly, sustaining losses, in order to meet a tax liability. The TCJA will significantly reduce this burden, but the tax framework will remain in place and will be an ongoing temptation to ravenous sponsors of future tax legislation.

Individual cuts are temporary: The corporate tax changes in the TCJA are permanent. They won’t have to be revisited (though they might be), and permanence is a desirable feature for sustaining the impact of positive incentives. The individual cuts and reforms, however, all expire within eight to ten years. The sun-setting of these provisions is, as some have said, a gimmick to reduce the revenue impact of the Act, but sunsetting means another politically fractious battle down the road. It is also a device to ensure compliance with the Byrd Act, which limits the deficit effects of legislation under Senate reconciliation rules. Eight years is a fairly long “temporary” tax cut, as those things go; for now, the impermanence of the cuts might not weaken the influence on spending. However, that influence is likely to wane as the cuts approach expiration.

Deficit Effects: The TCJA’s impact on the deficit and federal borrowing is likely to be somewhere north of $500 billion, possibly as much as $1.4 trillion. Deficits must be funded by government debt, which competes with private debt for the available pool of savings and must be serviced, repaid via future taxes or inflated away. In the latter sense, government borrowing is not really different from current taxes, a proposition known as Ricardian equivalence.

Nonetheless, the incentives, complexities and compliance costs of our current tax code are damaging, and the TCJA at least accomplishes some measure of reform. Moreover, the incremental debt is small relative to the impact of prior estimates of government borrowing over the next decade, with or without extension of the individual tax cuts. The most fundamental problem that remains is excessive government spending and its competing demands for, and absorption of, resources, with no market guidance as to the value of those uses.

Stumbling Through Pass-Through Tax Reform

22 Wednesday Nov 2017

Posted by pnoetx in Taxes

≈ 2 Comments

Tags

GOP Tax Reform, National Federation of Independent Business, Pass Through Business, Personal Service Business, Profits, Small Business Taxes, Tax Reform, Tax Simplification, Wage and Salary Payments

Small_tax

The GOP tax reform bill passed by the House of Representatives last week contains a reduced tax rate for “pass-through” business income. The discussion of this provision in my post of November 9 was accurate as far as it went, with one qualification: the highest marginal federal tax rate on pass-through profit income would be 25% under the bill, down from 39.6% currently. However, the bill contains complex rules for defining pass-through profit that qualifies for the lower rate, and my earlier treatment was woefully inadequate with regard to those rules.

The House bill seeks to address concerns that owners of personal-service businesses would be tempted to classify an “excessive” share of their income as profit rather than wages and salary. Profit would qualify for the new rate, but the wages and salary paid to the owner would not. Currently, all pass-through income is treated the same. Therefore, “safeguards” were inserted in the bill to prevent the presumed “abuse” that could occur under the bill (or see here or here). First, pass-throughs would be subject to a 70/30 rule: 70% of pass-through income would be treated as wage and salary payments; 30% would be treated as profit. That’s the simplest option. But it means that the true marginal rate on a dollar of income for an owner in the top bracket would be roughly 35.2% (0.7×39.6% + 0.3×25%). That’s much less favorable than my earlier post implied. It’s also less favorable than the corporate rate cut.

Alternatively, a business owner could use a schedule based on invested capital to determine a percentage of income qualifying for the 25% rate. This might benefit a physician invested in costly medical equipment, for example. However, other personal-service businesses are specifically assigned a percentage of zero. This list includes accountants, lawyers, financial advisors, and performers. Imagine that: the House approved a benefit for which lawyers cannot not qualify!!

Another important point is that many small businesses people do not earn enough to benefit from the 25% pass-through rate. Yes, they would see reductions in their marginal rates in lower brackets (and there would be fewer brackets), but in some cases the loss of deductions for items like state and local taxes would be more than offsetting. So it’s not clear how many pass-through business owners would actually benefit from the plan.

The Senate bill takes an entirely different approach. It reduces tax rates in lower brackets, but it would also allow pass-throughs to deduct a flat 17.4% from taxable income, effectively reducing the top marginal rate from 39.6% to 32.7%. Effective rates in all lower brackets would be reduced by the same percentage. There is no distinction in the Senate bill between wage and salary payments versus profits.

The post linked in the first paragraph left the impression that the House tax bill offered more relief for small businesses than the Senate bill, and that’s probably not true, at least for the most successful small businesses. However, the National Federation of Independent Business estimates that at least 85% of small business would not qualify for the 25% rate. Some businesses won’t qualify simply because they are too small to pay a rate exceeding 25%. And when a business qualifies, only 30% of its income will qualify for the reduced rate. Other pass-through businesses won’t qualify due to the nature of their services, another example of different tax treatment of different sources of income. The rules governing qualification for the 25% rate are distortionary and are hardly a simplification. The Senate bill, on the whole, probably does more for small business owners in lower brackets and probably many in higher brackets as well.

Step-Up, Pay-Up & Shut-Up

23 Friday Jan 2015

Posted by pnoetx in Taxes

≈ 4 Comments

Tags

Capital Gains Tax, dependency, economic growth, Estate Tax, Income Tax, IRS, President Obama, Stepped-Up Tax Basis, Tax Policy, Tax Simplification

obama-harry-potter-tax-increases-political-cartoon

Predicting support among relatively affluent leftists for President Obama’s proposed elimination of the step-up in tax basis at death is probably a simple matter of knowing whether they have a surviving parent or whether they have a bequest motive of their own. Perhaps I’m too cynical: it probably depends on age as well (as that may influence awareness of the tax provision). Still, I’ll bet my predictions would be highly accurate for “affluent leftists of a certain age”.

A technical digression: the cost basis of an asset is the price originally paid. The tax basis is the same until the owner’s death. When the asset is ultimately sold, the gain over and above the tax basis is taxed at the capital gains tax rate, now 20% (plus a 3.8% Medicare surtax for incomes greater than $200,000). However, under current law, when an asset is held until death, an heir’s tax basis is “stepped-up” from cost to the asset’s value at that time. No income tax is owed at the time of the inheritance even if the asset is sold immediately. The estate tax still applies to the asset’s value (depending on the size of the estate and whether there is a surviving spouse), but there is no capital gains tax liability until an heir sells the asset at a price greater than the stepped-up tax basis.

Our rhetorically-inclined president calls this feature of the income tax code a “loophole,” despite the fact that it is a legal feature of our ridiculously-complicated income tax and that inherited assets are still subject to the estate tax.

Obama’s proposal would eliminate the stepped-up basis at death. The increase in value would be subject to the capital gains tax at the time of inheritance (even if the asset is not sold) and subject to the estate tax (40%) if the size of the estate exceeds a threshold (about $5.4 million per individual). In addition, the President wants to increase the capital gains tax rate to 24.2% (plus 3.8% yields the oft-quoted 28%). These points are generally unaffected by whether the asset is held in trust for the full benefit of the heir. There are some exemptions in Obama’s proposal to eliminate stepped-up tax basis for small, family-owned businesses and for gains on primary residences. Also, gains would be taxed only after the first $100,000 per individual and only at the time of the second death for a couple.

The double taxation of capital gains in large estates might not evoke much sympathy, but it would ultimately have negative consequences for the economy. It would bleed capital out of productive, employment-generating private investments to feed a resource-hungry Leviathan, notwithstanding Obama’s high-minded pretensions. Perhaps worse is the impact on smaller estates held by conscientious middle-class savers who have understood the magic of compound growth. The aggrieved children of many such savers would find themselves in the grips of a significant income tax liability, which might require a fire-sale of assets in order to make payments to the IRS.

Complex features like the stepped-up basis are not hallmarks of a well-designed tax system. They tend to be promulgated as a way of offsetting other features of the tax code that would otherwise be punitive. If anything, this web of features is an impediment to efficient revenue generation. A simple tax code would minimize compliance costs and eliminate the many provisions that distort economic decisions. But complexity lends itself to political manipulation, which is the subtext for President Obama’s failure to propose any sort off meaningful tax simplification. Instead, he proposes even more complexity to be administered by that most trusted of institutions: the IRS. Fortunately, the president’s tax package stands no chance of becoming law, but it is illustrative of his statist agenda and his economic ignorance.

This post at Reason critiques this and other aspects of the President’s tax plan. This note in Forbes gives more detail about the proposal but is just a bit too optimistic about its potential to benefit the middle class. For a variety of reasons, the middle class is unlikely to benefit in the long-run. Slower economic growth will take its toll, and the sad truth is that Obama is seeking to increase middle-class dependence on the state.

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