Performing a Reality Check on the Tax Reform Law
The tax reform bill has now been signed into law by President Trump. It was all congratulations and excitement yesterday as the Republican members of Congress joined members of the Trump Administration to celebrate the passage of the bill and the delivery of a major part of their mandate - tax relief for American households and businesses and the provision of incentives believed will lead to jobs and income growth over time. Congressional Democrats on the other hand were all glum, continuing to raise the specter of how the bill, by heavily favoring the wealthy, will hurt the American people and in particular the middle class. In this blog post I perform my own reality check on the new law, to ascertain where the truth or semblance thereof lies.
Key measures in the Tax Reform Law
Corporation tax rates cut from 35% to 21%.
Pass-through businesses get a deduction of 20% (with income caps of $315,000 for married couples, and $175,000 for single filers). Expires in 2025.
Full and immediate expensing of qualified business purchases with increased cap to $1million. Expires in 2023.
15.5% one time repatriation tax on corporation foreign profits (8% for reinvested foreign earnings).
Move to a territorial tax system for multinational corporations.
Marginal tax rates cut and income brackets expanded (Expires in 2025).
Standard deduction expanded considerably to $12,000 for single filers, and $24,000 for married joint filers (Expires in 2025).
Child tax credit expanded to $2000 (phaseout begins with AGI over $200,000 and $400,000 for married joint filers). Expires in 2025.
The Estate Tax exemption doubled (Expires in 2025).
Repeal of the Individual Mandate penalty under Obamacare effective 2019.
I focus on these because these are arguably the most important aspects of the tax reform plan in which there are both perceptions of benefits to be gained for the American people. In what follows I provide a summary analysis of potential implications/ impacts from these.
The first five bullet points above are directed at businesses. The benefits they provide are direct and permanent for corporations. Against these there are minuscule costs in the tax reform bill: some business credits and deductions under the now old law are eliminated or curbed. The trivial impact of these for businesses is reflected in the fact that none of these even comes up as newsworthy in the media and no corporation appears to be complaining.
Corporations receive a 14% tax rate reduction beginning in 2018. Prior year profits that should have been taxed at the 35% rate, nested abroad, can be repatriated at a one time rate that represents a 19.5% tax rate reduction. One dimension of this analysis worth keeping in mind is that first most of these corporations do not pay taxes at the statutory rate because of existing loopholes which reduces their effective tax rate. According to the Congressional Budget Office (CBO), the average effective corporation tax rate is 18.6% (including both federal and average state and local taxes). This move therefore potentially reduces the effective tax rates to a much lower rate despite the repealing of some of the deductions and credits under the current law, such as the domestic production activities deduction and the limits put on net interest deductibility.
The move to a territorial tax system is intended to encourage multinational corporations to increase investments in foreign projects and endeavors by lowering their costs as their foreign profits will not be subject to taxes, for the most part. This allows them to be competitive in foreign markets and make them all the more profitable as a result. The ancillary benefit from this to individuals is the presumption that those foreign investments will generate a need for increased demand for workers in the US to support the expanded foreign investments. An argument somewhat similar to how free trade in the aggregate benefits all parties.
Other businesses that are treated as passthroughs typically pay taxes at the owners' marginal tax rates, so under the old law, it is possible to pay taxes at the highest income tax bracket for a passthrough business. The provision in the new law, effective in 2018, still has this pattern in place but adds a fairly generous deduction which effectively reduces the top rate to about 29.6%. So this is a tax rate reduction of 10%. This is also a direct benefit against which there are no costs to be traded off. The businesses here who gain the most are those providing products or services that perhaps do not compete directly with corporations which now face a lower tax rate (21%), and an even much lower effective tax rate. There is an income phaseout for this deduction though but this simply allows businesses to determine whether to reorganize as corporations for tax purposes to take advantage of the lower tax rate or if on the whole they do better by retaining their status as passthroughs.
Businesses are allowed to deduct immediately the full value of short lived capital investments up to $1 million which is double that under current law. This allows larger businesses not just small businesses to potentially take advantage of this to further reduce their tax liabilty.
Add to all of this the repeal of the corporation AMT and it is immediately clear that there is no downside whatsoever for businesses in general and for corporations there is only an upside. Tax Reform DOES unequivocally benefit businesses.
For American households it is the trio of the reduced marginal rates along with the expansion of the income brackets, the higher standard deduction , and the increased child tax credit that provide the overall net benefits for Americans compared to the old law. The elimination of the personal exemptions therefore is fully addressed by this trio of benefits.
Consider four typical scenarios (I use Ohio but it should not be different for most of the country):
Scenario 1: A married couple in Ohio, who own a home worth $500,000, with combined income of $250,000 (wages are $100,000 and business income from a partnership is $150,000), filing jointly and itemizing deductions worth $41,000 (with state and local taxes being approximately $17,850).
Scenario 2: The same married couple in scenario 1 with similar situation but their income comes alone from wages and sums also to $250,000.
Scenario 3: A single mother in Ohio with 3 kids earning $30,000 and living in a rented apartment. She claims the standard deduction.
Scenario 4: A married couple in Ohio, who own a home worth $100,000, earn combined income of $80,000 and have two kids. They claim the standard deduction.
I provide slightly more detailed analysis for these scenarios here. The results however show that compared to filing under the old law, the Tax Reform law reduces their tax liabilities, or, as in scenario #3, while the filer faces no tax liability under the old and new laws, the filer still gets a refund from the government under the new law. In all those cases above with no kids, if kids were added to the families they gain even more under the Tax Reform law compared to under the old law.
For most scenarios the tax liability with the tax reform bill in place reduces tax liability for most households compared with the old law.
There are however some observed patterns and scenarios where the tax reform will lead to a higher tax liability than would have been with the old law:
Mostly for single filers with low incomes and no kids who would have itemized under the current law, and for married joint filers with slightly higher incomes but also with no kids and who would also have itemized under current law. Also for some low income earners who may have had unique situations where they had to move for job reasons and would have claimed an above the line deduction for moving expenses. There are also some high income married earners with no kids who have very high itemized deductions, particularly for state and local and property taxes. With the cap on these deductions under the Tax Reform Law, they appear to be worse off compared to the old law.
For all of these itemizing scenarios described above, the likelihood of being worse off increases with the need to itemize higher medical bill expenses as that is one itemization that could potentially increase without limit. I present five new scenarios that show some particular households who lose from the Tax Reform Law:
Scenario 5: Helen a single filer living in Ohio with an AGI of $25,000. She has a home worth about $80,000 and would itemize up to $9,000 worth of qualified deductions under the old law.
Scenario 6: John also a single filer living in Ohio with an AGI of $40,000. He also has a home worth $100,000. He would itemize his deductions worth $12,000.
Scenario 7: Anne and Phil, a married couple with no kids also living in Ohio and with a combined AGI of $50,000. They own their own home worth $100,000 and their combined itemization summed to $18,000 which they would itemize under the old law.
Scenario 8: Consider the same couple in scenario 3 and same situation but now their combined AGI is $60,000 and the sum of their itemizations is exactly $20,000.
Scenario 9: Consider Dwayne and Takeesha a married couple, who own a new home worth $500,000 and have joint income from wages of $250,000. They itemize their deductions, a total of $47,000 inclusive of state and local and property tax deductions that total $27,650.
For all these scenarios I provide a little more detailed analysis here as well. In all these cases, the households are worse off having higher tax liabilities with the Tax Reform law in place compared to their tax liability under the now old law. It is important to emphasize that these situations may be rare when one takes into account I have focused say on Ohio and IRS data for 2015 show only 26% of filers itemized. Further, while most claim the deductions illustrated above, only 3.2% claimed medical expense deductions. So this is a pattern that suggests that those adversely affected may be a small portion of Ohioans and more generally of Americans.
Finally, the amount of the gains that households receive from Tax Reform, for those who gain, tends to also increase with incomes. Thus the wealthier households receive a greater share of the benefits that American households get from the tax reform. When this is combined with the doubling of the estate tax exemption, which under the old law affected only about 2% of estates, but will now affect a much smaller percent only, the wealthiest households enjoy even more benefits from tax reform compared to the middle class and lower income households.
Repealing the Individual Mandate
Now stack all of these varied benefits against the implication of eliminating the individual mandate under the Affordable Healthcare Act.
A November report from the Congressional Budget Office (CBO) looked into the implication for repealing the health insurance mandate and concluded that this would both lead to a reduction in the deficit by $338 billion between 2018 and 2027, and would see a reduction in the number of people with health insurance by 4 million in 2019 and by 13 million in 2027. Also average premiums in the non-group market would increase by about 10 percent in most years of the decade. They caveat their report by stating that their analysis was based on what was current law.
From an intuitive point of view the deficit reduction number is in large part why this option was included in the Tax Reform bill as a way of curbing costs - this arises because of the expectation that the Federal Government would no longer need to provide subsidies to those who will now choose not to be insured as there is no penalty for that. This however means that because fewer people are enrolled (who will likely be those who are relatively healthier), risk sharing in the non-group market, and throughout the insurance market as a whole is reduced. The particular market becomes too costly for insurance providers who will either have to raise prices in this market (or spread them across other markets) or cease to provide coverage in that market. Further because preventive care will also decline, when people get sick, the costs of treatment will be more expensive. The question therefore is this. How will the impact of the repeal affect American families?
Data from the Kaiser Family Foundation for 2013 show average monthly premiums per person in the individual market in the US is $235.27. In Ohio it is slightly lower at $221.52. A 10 percent increase in this over a year provides an additional cost of $265 for an Ohioan who remains in the market. Comparing this with various scenarios for those who would not qualify for a subsidy to see how if this increase is offset by any tax reform benefits for individuals shows a similar pattern as before. For single filers who would have itemized and even for higher incomes up to $60,000 assuming itemized deductions worth $15,000, the gain from tax reform is a little over $100, such that it does not offset this increase in premium
Again, these are possibly rare situations. More generally Tax Reform for most households especially those with kids provide larger benefits compared to the status quo. It is however also possible that insurance for families would have higher premiums than the ones I used from the Kaiser Family Foundation website, so there is still the possibility that more households are worse off when the impact of the Individual Mandate penalty repeal is included in determining the impact of Tax Reform on households.
The longer time frame - post 2025
The Tax Reform bill in order to meet Senate rules and keep the deficit in check over the requisite 10-year period, sunsets the various provisions for individuals - tax rates, deductions, and credits in 2025, while it has the changes that apply to corporations as permanent. This means corporations should continue to enjoy tax benefits compared to the status quo into the future, whereas we should expect individuals to have higher tax liabilities in the future.
Perversely, according to the distributional effects of the tax bill analysis carried out by the Joint Committee on Taxation (JCT), by 2021, incomes in the range of $10,000 to $30,000 should see their average tax rates increase under the tax reform plan compared to under the old law. By 2022 that also includes those with incomes less than $10,000; and by 2027 it will include all incomes less than $75,000 in which the tax reform bill will impose higher average tax rates on than under the the old law.
The political expectation is that the future Congress will not have incentives to allow these changes to take place and will likely extend them for political reasons. If this is the case then the projected cost of the tax reform in terms of the mounting deficits will be a lot larger than was worked out in order for the bill to meet Senate rules. If the future Congress allows them to expire then the tax relief for American households especially the low income and lower middle class households would have been transient and been only self serving to Congressional Republicans.
This was an attempt at looking beyond the fog of political promises to see whether the Tax Reform law holds the promise Republicans are touting it to, and to investigate the contrary position Democrats have about this law. The following are summary results that have followed.
First, the Tax Reform law does provide tax relief both to Americans and American businesses as promised. This is almost universally true for all businesses and true for most households with the exceptions I illustrated.
Second, the Tax Reform law is lopsided providing unapologetically the largest benefits to the wealthier segments in society - corporations are favored compared to small businesses; and wealthier individuals are favored to lower income and lower middle class earners. The corporation tax rate is lowered to 21%, whereas for other businesses that may also be competing with some of these corporations they may end up with higher tax rates in spite of the 20% deduction, and only temporarily.
Similarly looking at the JCT report on the distributional effects of the bill, in 2019, low income households' average tax rates go down by only 0.5%, compared with the high income households that go down by up to 3.1% for very wealthy income earners making over $500,000 with the tax reform compared to the now old law. This lopsided pattern continues through subsequent years and even in years when average tax rates go up for low income households, the high income households continue to see decreases, compared to the old law.
Third, the impact from the repeal of the Individual Mandate penalty may have far reaching consequences in terms of reversing any benefits from the tax reform for some households who may see their health insurance premiums go up as a result. These are again likely to be low or lower middle income households who may not qualify for the Federal subsidies for healthcare.
Fourth, the temporary nature of the tax changes for households takes the credibility of genuine tax reform to task. In any case should these indeed expire, the question remains as to what exactly tax reform has accomplished other than perhaps having hoodwinked an undiscerning electorate into applauding a feat that is at best fleeting.
Finally, there is yet another perhaps equally important part of this analysis that I have not particularly touched on. That is, the economic growth implication of this law. I have already addressed this in a different blog post, "Tax Reform and the Supply Side Promise". Some notable corporations, in reaction to the passing of the bill, have already promised generous benefits to their employees and plans to create jobs. The Tax Foundation's Taxes and Growth model demonstrates strong growth effects coming from these supply side policies, in particular the corporation tax cuts, and expects this to drive the 1.7% increase in long run GDP, the 1.5% higher wages, and the creation of 339,000 full time equivalent while adding $600 billion in additional revenues all over the next 10 years, its model predicts. For reasons I have discussed in that post, there is plausible reason to be skeptical.