Tax Cuts and Jobs Act

Republican-led plans to reform our tax system have now been introduced in the Senate and passed in the House.  This is trillion dollar legislation (the extra deficits alone are estimated at $1.5 trillion between 2018 and 2027), and a feeding frenzy for lobbyists trying to get new perks in the bill or protect the ones they have.

Press attention has rightfully focused on how the proposals will affect the poor and middle-class, as compared to the wealthy.  This post looks at two aspects this issue.  The first are the average impacts by income quintile, which many groups have analyzed.  The second, which has not gotten the attention I think it deserves, is how the tax plans will erode the role tax rules play in hedging large risks that individuals face with major life events -- a function the income tax system has always played, and continues to play, for corporations. 

A future post will look at the tax reform proposals and energy subsidies. 

I.  As configured, tax reform helps the poorest a little and the wealthiest a lot

According to the non-partisan Tax Policy Center, the distributional effects of the House bill aren't great:

The largest cuts, in dollars and as a percentage of after-tax income, would accrue to higher-income households. However, not all taxpayers would receive a tax cut under this proposal—at least 7 percent of taxpayers would pay higher taxes under the proposal in 2018, and at least 24 percent of taxpayers would pay more in 2027.

At lower income levels, the dollars in savings here are pretty immaterial.  For example, the lowest quintile earner in 2018 will save a whopping $60 in federal taxes.  The next two income quintiles save $310 and $830, respectively -- though savings in 2027 would be lower for all three.  Further, the raw distributional assessments of tax changes don't fully incorporate the fact that taxes are only one part of people's lives.  If the government is also stripping other programs that help these groups many people will end up way worse off than they are now.  This does seem to be what is going on:  the Congressional Budget Office expects nearly $136 billion in cuts to ancillary federal programs, many of which support the poor and middle classes.  CBO estimates roughly $25 billion will come from medicare.  That sixty bucks in tax savings isn't looking so good anymore.

Indeed, continued erosion in health care benefits and increased co-pays for most people can easily eliminate any savings well up the income quintiles -- particularly given the worsening access to medical insurance.  The proposed loss of medical expense deductions (see below) would do the same.  At lower levels of expense, the increased standard deduction helps; but if a family faces a medical emergency, the loss of medical-specific deductions will really matter.

TPC's models estimate that the top 0.1% will save nearly $175,000 per year in 2018, jumping to $320,000 annually in 2027.  In part this is because they pay more taxes overall.  But it is also because so much more of their earnings come from from partnerships (which will see a reduced tax rate at the recipient partner level) and dividends (which are likely to increase due to a lower tax rate on corporations which will leave more to pay out). 

Despite President Trump's claim that the proposal would be bad for him, his estate tax exemptions will double.  Many of the 565 private company interests he holds (the first 37 are shown in the image above) according to his June 2017 financial disclosure form will pay lower taxes.  He, and his family, will save an enormous amount of money.

Eric Toder, a co-director of the TPC remarked of the proposal to the Washington Post that “A major feature is tax collections would shift dramatically, from businesses to individuals.”  This continues a long-term trend in the US:  in the early 1940s, US corporate income taxes comprised nearly a third of federal revenues.  Since the 1970s, however, the corporate share has been less than 15% according to historical data from the US Office of Management and Budget. 

II.  Tax reform will eliminate protections to individuals from adverse life events

I'm also interested in how the changes will shift the tax system from a risk-sharing partner to an impediment for individuals grappling with life's big expenses.  The shift to standard deductions in the tax code is quite similar in structure to the push for block grants to the states as a replacement for federal cost sharing:  it works a little bit for average circumstances.  But the long-term expectation is for the grants (and cap on standard deductions) to limit federal exposure to a variety of risks, saving the Treasury money in the process. 

There may also be incentives at the state (with block grants) or family (with eliminated deductions) to deploy resources differently, but it is notable that with very few exceptions (e.g., trying to limit corporate debt and very highly compensated individuals) this "cap-and-shift" approach is not being used with corporations.  The capped policies fray quickly where underlying costs are rising sharply, or individual (states or people) are hit with adverse circumstances such as job loss or a medical emergency.

Offsetting losses and gains across years 

Here's what I mean.  Imagine a small restaurant owner who struggles to build a place that everybody wants to eat.  For the first four years of its existence, the owners borrow from friends and family; work 100 hour weeks; and max out their credit cards to stay afloat as they build their dream.  Finally they hit their stride and the tables are full.

Or consider a guy named Bezos who thought it might be possible to sell more books online at a lower price than what brick and mortar stores could do.  Others think maybe there is something there, or maybe the guy is nuts.  But he believes, and risks it all to build his platform and advertise like crazy to make this idea a reality.  And as soon as he hits his stride with books, he wants to sell everything.  He's hemorrhaging money the whole time. 

What if when these ventures finally started to make money the federal government just pretended all of those prior losses didn't exist and instead whopped them with a massive tax bill?

Luckily, it doesn't.  The federal tax system lets firms track historical losses to offset profits at such time as those profits occur.  If they never occur, too bad for the investors and owners.  But often they do, and because firms can "carry forward" losses across many years, they offset taxes due on new-found profits. 

This process of loss carryforwards doesn't just buffer start-ups:  existing companies can go through severe market cycles as products or consumer tastes change; the broader economy is in recession; or commodity cycles wrench at their margins.  Losses from the  lean years help offset the gains during the good years:  the government is effectively sharing risk with the private firms.  

It is a very useful function of the tax system, and one that can be seen clearly in the extract from the federal receipts below, covering the period just before and after the credit crisis and recession we went through starting in 2008.  The corporate share of federal receipts began dropping even in 2008, and halved in 2009.  Profits were down sharply, so this isn't surprising.  But the rebound in corporate tax contributions has been slow, muted by the use of tax loss carryforwards in subsequent years. 

Tax Loss Carryforwards Helped Corporations Weather the Downturn
Share of total federal receipts by sector

Some tax policy for corporations goes even further.  Refundable investment tax credits, as were available for a time for wind power investments, allowed firms with no profits to claim tax refunds anyway.  In other cases, as is being proposed for the nuclear power production tax credit, credits earned by non-taxed entities can be used or sold to taxable entities to claim.  Both are examples of more active risk-taking in private ventures by the federal government via the tax code.

Buffering of income and losses on the individual side has been less generous

This type of offsetting losses seen for companies exists to a much lesser extent for individuals.  True:  losses on the sale of stocks or bonds may be used to offset similar gains, and carried forward year-to-year if there are not enough gains to offset in any single year.  However, wealthier individuals own the vast majority of stocks (80% of stocks are owned by the richest 10%).  As a result, this buffering is of limited value to the lower income quintiles who earn nearly all of their money through wages.

The trouble is that if the expense side of the ledger for individuals surges in a year, the taxes on wages are adjusted only through itemized deductions of those expenses.  And the tax proposals now under consideration strip away the vast majority of those deductions.  Here are some examples:

Health problems.  Unfortunately, health problems are a reality for many families in the United States.  However, healthcare is in many ways a dysfunctional market:  surging prices year-after-year, insurers who provide expensive policies under which it is often difficult to tell what is being covered, and individual purchasers who can rarely see prices let alone shop them.  Medical expenses are also often unpredictable, going from fairly low to levels that can bankrupt a family should an adverse event occur.  Indeed, they are a major cause of personal bankruptcy. 

While current law does treat unreimbursed medical costs as a deductible expense, this benefit only kicks in if a taxpayer is spending more than 10% of their income on those costs (up from 7.5% a few years ago).  Further, the IRS has a very detailed list of what items count and what don't.   Both provisions help target the deduction to families that really need it.  The tax bill that passed the House of Representatives eliminates medical expense deductions entirely -- as well as medical savings accounts that were developed as a way to boost private savings to cover medical cost surges in order to reduce reliance on government.

Of the less than 6% of filers claimed the itemized medical expense deduction in 2015, nearly half who did had income levels of less than $50,000; and nearly 70% had income less than $75,000.  These are lower- and middle-class people, often dealing with very challenging medical expenses in their family.  One aspect of this deduction I was hoping to find data on, though couldn't, was the degree to which the 6% claiming the deduction changes year-to-year.  For many families, there is an acute medical issue hitting a loved one and driving costs up -- but the surge may last only a couple of years either because the medical intervention stabilizes the situation, or because the person dies.

Dealing with family or employment challenges.  In addition to medical costs, other financial challenges to building a family can arise - such as infertility or having to care for disabled relatives.  The House bill eliminates the elderly and disabled credit, the credit for adoption expenses, the exclusion of employer benefits on dependent care programs from gross income, the deductibility of moving costs incurred to take a new job, and a slew of costs often required of employees for them to take or keep a job (e.g., buying a uniform, or malpractice insurance if a doctor).  In many cases the revenue impacts of these changes aren't that large on a national basis, but as with medical costs, they can be more significant for specific individuals.  A business is routinely allowed to deduct the costs of earning income; but these tax bills make it much harder for individuals to do so.   

Tax preparation fees.  Perhaps the most ironic aspect of the House bill is the removal of tax preparation expenses as a deductible expense.  Here's a massive new change to tax laws that no layperson in their right mind and can figure out; yet if one needs to hire a tax preparer to ensure ones taxes are properly calculated, this is no longer viewed as an eligible offset to ones taxable income.  As with so many of these provisions, the exact same practice within a corporate form remains deductible. 

Owning a home.  There are large proposed changes to the tax treatment of home ownership.  This includes eliminating the tax deductibility of mortgage interest on second homes (which I think is a good idea); on home equity loans (more mixed); and halving the eligible size of a loan that can get that benefit even on first homes.  There is also a proposed cap on the ability to deduct local property taxes paid from federal tax bills.  These policies will greatly affect real estate markets and could have unintended side effects even if some of the changes make sense.  This includes a downturn in home sales, and a shift towards rental housing.

It is also notable that the tax reform proposals don't seem to be stripping away tax subsidies to rental housing -- the tax-exemption for publicly-traded real estate partnerships called real estate investment trusts (REITs), for example.  Indeed, the effective tax rate on these will drop, since REITs are pass-through entities and income from pass-throughs in both proposals will see a new, lower top tax rate. 

It is also notable that when the really wealthy own really large real estates, they often own it within a corporation -- so will be able to continue to deduct all of the expenses that are being limited for individuals.  Yes, there is a pattern here...