Wednesday, January 17, 2018

What Exactly Does The New Tax Law Do?

What exactly will the new tax law do?  We'll have to wait and see, I'm afraid.

A reader writes:
Anyway, I've seen you reference the new tax plan a couple of times in your writing, stating (and I'm paraphrasing) that it will just benefit the rich and encourage businesses to move out of the US. From all my research it does the exact opposite, providing the biggest relief to the middle class and encouraging businesses to stay in the US with a very competitive corporate tax rate compared to before. And that's not even mentioning the repatriation rate that encourages businesses to bring cash back from overseas. 
Everyone has blind spots of course, but just wondering if you can expand on that if you have something to add, as maybe I'm missing something.
(UPDATE 2021:  Well, the new tax law went into effect and all that cash repatriated from overseas went to.... buying back stock shares.  When CEOs are paid in stock options, it ain't hard to see why this is.  They didn't move factories back from China or create jobs, they just created more wealth for themselves.)

He has some good points.  If you listened to the Republicans, Donald Trump, and Fox News, the new tax law will put a chicken in every pot and a new car in every garage.   We will all be rich as Nazis, and factories will work overtime to make all the products that Americans will buy with all their newfound money.

Or maybe not.  Law have effects, both intentional and unintentional.  And already we are seeing some of these unintended effects.

The law has a lot of different features.  There is the corporate tax cut, the change in marginal rates, the change in the standard deduction, the cap in SALT deductions, the elimination of the Obamacare "penalty" and the proposed elimination of the so-called "death tax" or Gift and Estates tax, as it is properly called (which was dropped at the last minute).  So there are a lot of features, and some that are so minuscule that people aren't even aware of them - but they may affect certain people and groups of people.  And these effects may be intentional or unintentional, as we shall see.

The problem with our tax code is that it is complicated and uncomplicated at the same time.   We have a system of tiered marginal rates which apply to different income levels.  On top of this, we have exemptions (or had them, anyway), deductions (itemized), a standard deduction, and of course tax credits.  And then we have capital gains, which are taxed at different rates than "ordinary income" and taxed at two separate rates - long-term and short-term.

If you want to know what your tax bill will be for $50,000 of income, compared to $100,000 or $150,000, it isn't as easy as saying, "10%, 20%, and 30%, respectively" but rather you have to sit down and actually go through all the tax forms to calculate the tax due.   Simplification of the tax code has thus been a goal for many.   But there are many interest groups that want to keep special perks for certain behaviors and events - which may or may not make sense.   Tesla wants to keep a fat tax credit for their cars - as it sells more cars.   Others argue that these credits help develop an industry which may someday be predominate, and that it is in the nation's interest to insure it thrives.

Other consequences are harder to foresee.   For example, non-profit companies that donate "all proceeds to charity" as is written on the labels of Newman's Own products, may face hefty tax bills if they continue to donate all proceeds to charity after the owner dies.  This is an unintended consequence of a law designed to prevent people from using non-profit entities to skirt taxes in the long term.

So where do we begin?   Let's start with the Corporate tax cut.   Now, all you pony-tail and man-bun hippies holding signs saying "Corporations are evil, man!" can just go away now.  We are trying to analyze this rationally, and with as little political bias as possible.  And as we shall see, both Democrats and Republicans wanted a corporate tax cut - the only difference being how much.   And this tax cut is creating and will create unintended consequences as well.

To begin with, tax cuts are not a Republican thing.   Democrats have been in favor of tax cuts, including the granddaddy of them all, the Kennedy Tax cut of the early 1960's.  Back then, marginal rates were well over 50% and many argued (correctly) that this was a disincentive to working.  Why bother working an extra hour, when all it would profit you, after Federal, State, and local taxes, is a few bucks?   Coming off the 1958 recession, the Kennedy tax cut stimulated the economy and the 1960's were swinging as a result.   Well, until the oil embargo of 1973, anyway.

With regard to the corporate tax cut, people on both sides of the aisle have been in favor of this for years.  Obama proposed a cut to 28%, but it went nowhere with the do-nothing Congress who was more concerned with not letting Obama "win" than with getting something done.   As I have noted before, people have long argued that the corporate tax rates were too high and in effect, double-taxation.

If a corporation "played it straight" (as few do) and paid out all its profits as corporate dividends, it would have to pay taxes - at 35% on those dividends.   Individual shareholders could end up paying well over 30% in income tax, if they were in the higher brackets.  The net effect was an effective tax rate of 70% or more.   As a result, many companies were shunting excess money overseas and parking it in Treasury bills or corporate bonds.  Some say one unintended effect of the new bill could be a sell-off in bonds.

Trump proposed lowering the tax rate to 20% but a compromise was reached at 21%, to limit the amount of additional deficit in spending.   And here's the first unintended consequence of the tax code - increasing the national debt.   Or you could argue it was an intended effect as legislators knew all along what would happen.

Remember the debt clock?   Like clockwork (sorry) Republicans would drag this out whenever a Democrat was in power, and make ominous warnings about how the national debt was increasing at an alarming rate.  For some odd reason, when Republicans are in power, they don't talk much about the debt clock - and for good reason, too.   Turns out that Republicans love to spend as much as Democrats do.   But instead of "tax and spend" they are "deficit and spend" which could be really the same thing.

Just as companies can pay shareholders in a number of ways - by paying dividends, retaining earnings, or buying back stock - countries can tax their citizens in a number of ways.  You can tax income, sales, land, cars, possessions, capital gains, dividends, or whatever - at the Federal, State, or local levels.  And there are also "user fees" and other charges that act as taxes.

Or you can print more money.   Talk to anyone in Venezuela today about this.  If you print more money to meet your financial obligations, you create inflation.   Inflation decreases the value of every dollar (or bolivar or whatever) and as a result takes a little away from everyone - or a lot in some cases.   Wiemar Germany, after World War II printed money like mad to pay off foreign debts from the Versailles treaty.   People's savings were wiped out in a matter of months.  Similar events have happened in Chile and elsewhere.

So this is a real concern for me - or anyone else hoping to retire on their savings.   Inflation could wipe out our carefully laid plans, and so far, it appears that interest rates will be going up shortly (after artificially propping up the market for years) and inflation will follow suit.

But unintended consequences don't end there.  As I noted in an earlier posting, it was projected that the new tax law would reduce the value of corporate deductions, as well as corporate taxes, and some big banks, still deducting losses from the 2008 meltdown (remember that?) will show lower profits.  And today, Bank of America is showing just thatSo is Goldman.  Whether this is a one-time deal or something more pronounced, remains to be seen.  Some are saying it will affect BoA for one quarter but other banks, such as Citibank, far longer.

Others are saying that the plan - which ostensibly will allow corporations to "repatriate" money they have squirreled overseas - will do just the opposite.   21% sounds good, but it is still more than the 12.5% in Ireland, or even less than other jurisdictions.   What's more, a one-time "repatriation tax" may be a roadblock to this money flooding back into the States anytime soon.  What will actually happen?  We'll just have to wait and see.

But Bob, I heard that Wal-Mart is already handing out bonus checks of $1000 to each employee from the tax savings of this plan!   That is an interesting stunt on the part of Wal-Mart, but since they have yet to see these savings, they are really not handing them out.   What they are doing is a stunt, designed to get employees (and citizens in general) to connect some concrete event with the tax plan and thus be in favor of it.

That is the problem with tax policy.  The effects are so nuanced that few people see any difference in their paycheck from month to month.   It is only when you do your taxes at the end of the year that you really figure out what you owe, and even then, your life situation and income may have changed from year to year, so you really don't understand whether you've paid more or not.

Yes, there are some folks out there who look at their taxes in terms of their "refund check".   If the refund check is larger, then they think they paid less taxes.   But of course, the refund check only represents the difference between what was withheld and what was paid in taxes, and if you withheld more, you get more back, if taxes stay the same.   It illustrates how most people have no clue how taxes work and indeed, don't know what a marginal rate is, or what the difference between a tax credit and a tax deduction is.   And yes, a lot of people think you can deduct your way to wealth  - particularly people in brackets so low, they end up paying little or no taxes anyway, and deductions are of no use to them.

New RateNew Income Bracket|Old RateOld Income Bracket
10%Up to $19,050|10%Up to $19,050
As you can see, in the lowest tax bracket, there is no real tax cut.   But then again, people in this bracket end up paying little or no tax anyway, what with the standard deduction and exemptions of yesteryear.

Folks like me in the old 15% bracket might see a small break, but then again, I really pay little taxes these days, other than self-employment (social security and medicare) taxes, which I will pay for the last time in April of 2018.   So there isn't much in terms of savings for me.   It doesn't even really pay to itemize in this class, and in fact, with the new standard deduction, itemizing is going to be a thing of the past for a lot of middle-to-lower-income people.

Now, if you go up the chart, you see the juicy parts are where the higher incomes are.  Not only are rates dropped (except for the 35% bracket) the income levels are much higher now.   The stated goal of reducing the number of brackets went by the wayside in the sausage-making, apparently.

It is interesting how they did this, as they can claim, with a straight face that the largest cuts are in the lower brackets (dropping from 28% to 24% in one case).   But since the income numbers are also jiggered, it hides the effect on higher income people.

Taking deductions, credits, and other things aside,  if you made $1,000,000 in 2017 and 2018 (which is doing fantastically well, by the way - about 20 times the median income) your gross taxes in 2017 (before deductions, etc.) would be $340,144.20 - calculating marginal rates for each stage of income and adding them up.   Your gross taxes in 2018 (before deductions, etc.) would be $310,879.

So you can see, there is a huge savings - over 10% in fact - for people in the higher brackets.  And most of this is because the cutoff has been raised to $600,000 for the highest bracket while simultaneously lowering the marginal rate.  Marginal rates alone don't tell the story.

If we break out how much tax you pay in each step of the calculation, it looks weird.  The big savings is in the top bracket, but the 35% bracket expands so much in size, that you end up paying more in that range.  The main thing you see, though, is that folks making $50K a year aren't going to see much in the way of savings - while people making a million are going to see huge savings.

Tax paid for each marginal bracket, married couple, taxable income of $1,000,000
New RateNew Tax|Old RateOld Tax
By the way, these individual tax rate cuts expire in a decade, but the corporate tax cut is permanent.

But of course, this presupposes that someone making a million dollars a year doesn't have some sort of tax dodge.  And the oldest one in the books was to create a subchapter-S "pass-through" corporation and then try to pay yourself in capital gains - the so-called Romney rate of 25% or less - sometimes far less.

In the past you had to be a big Whale to do this - be able to afford an army of attorneys and accountants to file your taxes and end up in perpetual audit.   This is why Trump's claim of "I'm being audited" as an excuse not to release his taxes is so bogus.   Guys like him are pretty much audited every year.  His accountants play games and then they see what they can get away with at the IRS.

I noted before how my brother-in-law followed advice of an accountant and paid himself exclusively in dividends from his Subchapter-S corporation, rather than paying the 18% self-employment tax (which is on top of the marginal rates shown above).  His accountant ended up going to jail, and my brother-in-law realized too late that he didn't have the 40 quarters of income necessary to qualify for social security.  He scrambled to do this, before he retired, and will receive the minimum benefit under the law as a result.

Under the new law, people who own a subchapter-S corp - well, certain people, anyway - can report a portion (20% from what I hear) of their income as a return on capital, and thus get a lower capital gains tax rate.  This may favor some small businesses, but not others (some service providers may be exempt).   It is an interesting incidental feature of the law, one that Johnny Lunchbucket will not benefit from.

One thing that will change for us little people is the change in the standard deduction, exemptions, and the SALT deductions for State And Local income and property Taxes.   This could complicate things for many people, simplify them for others, and cause tax hikes for people in blue states and tax cuts in red ones.

Personal exemptions were designed to eliminate from the tax calculation, money you spend on supporting yourself and your kids and other dependents - that was the theory, anyway.   The new law eliminates these.   As a result, if you have ten children, you may see your taxes go up, as you lose this $4000+ deduction from your income (for each child/dependent, yourself and spouse!).

But at the same time, the standard deduction goes from $12,700 to $24,000 (married couple filing jointly) which means that for a lot of people, itemizing mortgage interest may no longer be worthwhile.   This may help offset the loss of the personal exemption, provided you were claiming fewer than three kids.   For many people, particularly those who itemized before, it may be a wash.

The law also caps SALT deductions at $10,000, which for folks living in places like New Jersey or New York, means a huge increase in taxable income.   People in some areas there are paying well over $1000 a month in property taxes, sometimes $2000 - plus State and local income taxes of up up 5%.   If these are capped at $10,000, some middle-to-upper income people may see an effective tax rise as well.

The law also abolishes the AMT - Alternative Minimum Tax which may have mixed and unintended consequences.   Some argue this will help the "blue state" high earners who have high tax bills.  The elimination of the AMT will also help upper income people.  The AMT was designed to prevent people from deducting their way to tax-freedom, by claiming so many deductions and credits as to make their declared income look tiny.   So I would have to label this one as a sop to the rich.

Some things the Republicans wanted didn't pass, apparently.  The elimination of the Gifts and Estate tax did not go through.  The GOP has been using this as a "talking point" for years now, convincing people who live in trailer parks that they will have to pay a "death tax" when they die.   The reality is, of course, there is  a $5M exemption from the gifts and estate tax, and certain exemptions for farmers and the like.   There are a number of ways around this tax (trusts, etc.) and only the very, very rich have to worry about paying it.

Another "minor" effect of this bill was to eliminate the Obamacare "penalty" tax for not having health insurance - or not having an Obamacare-compliant plan.   This will have a far greater effect than many expect.   As I noted before, Obamacare has a lot of problems, one being that folks in certain brackets get nailed for the full cost of Obamacare - with a rather sudden cutoff.   It is an unintended consequence of a law that was not well-thought-out and rushed through.  So you see why I am skeptical of a rushed GOP tax law - it will likely do similar things.

People making over $100,000 a year are faced with huge costs for health insurance.  My premiums, if not subsidized, would be over $20,000 a year.  I have to hope my income stays low, otherwise I would have to pay this.  For example, a small inheritance I received last year had some capital gains associated with it (from a trust).  Will this put me over the edge, cause me to lose my subsidy, and thus force me to not only pay tax on the inheritance, but also $20K for Obamacare?  If so, ouch.

Non-compliant health insurance plans are available - ones that do not allow for pre-existing conditions, for example (usually exempting claims for one year for pre-existing conditions).  This is basically what we had before Obamacare.  Now that the "fine" has been repealed, many healthy families may shop around for such lower-cost plans, leaving the sicker folks on Obamacare, which in turn will increase premiums even more dramatically.   This could lead to a collapse of the whole system, as people can no longer afford the premiums, and the government can no longer afford the subsidies.  Again, wait and see.

So, what do we conclude from all of this?  Beats the heck out of me.   We will have to see the dust settle before we know the intended and unintended effects of this bill.   My gut reaction is that the GOP tried to do too much, too quickly.  Sudden dramatic changes to our tax code are not healthy for the economy as it makes it hard to plan ahead, both for individuals and for corporations.

But the overall conclusion is that this helps the rich more than the middle class, is kind of inescapable.   But then again, when things go up or down by flat rate, across the board, the rich make out better than the poor.   If the richest man in town makes $100,000 a year and the poorest makes $10,000 a year, and everyone gets a 10% raise, the richest man makes 10 times more in his raise than the poorest.   What's more the "income inequality gap" goes from $90,000 to $99,000 - which illustrates why, in part, income inequality will always be on the rise, unless punishing taxes are enacted (and I am not promoting that idea!).

This humorous story illustrates the effect of tax cuts "across the board":
Suppose that every day, ten men go out for lunch and the bill for all ten comes to $100.

If they paid their bill the way we pay our taxes, it would go something like this:
  • The first four men (the poorest) would pay nothing.
  • The fifth would pay $1.
  • The sixth would pay $3.
  • The seventh would pay $7.
  • The eighth would pay $12.
  • The ninth would pay $18.
  • The tenth man (the richest) would pay $59.
So, that's what they decided to do.
The ten men ate lunch in the restaurant every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve ball.  "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily lunch by $20.00." So lunch for the ten men would now cost just $80.
The group still wanted to pay their bill the way we pay our taxes. So the first four men were unaffected. They would still eat for free. But what about the other six men? How could they divide the $20 windfall so that everyone would get his fair share?  They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to eat his lunch.

So the bar owner suggested that it would be fair to reduce each man's bill by a higher percentage the poorer he was, to follow the principle of the tax system they had been using, and he proceeded to work out the amounts he suggested that each should now pay.
  • And so the fifth man, like the first four, now paid nothing (100% off).
  • The sixth now paid $2 instead of $3 (33% off).
  • The seventh now paid $5 instead of $7 (28% off).
  • The eighth now paid $9 instead of $12 (25% off).
  • The ninth now paid $14 instead of $18 (22% off).
  • The tenth now paid $49 instead of $59 (16% off).
Each of the six was better off than before. And the first four continued to eat lunch for free. But, once outside the bar, the men began to compare the amount they got off. 
The sixth man said, "I only got $1 off out of the $20 while the tenth man got $10 off!" 
"Yeah, that's right," exclaimed the fifth man. "I only got $1 off, too. It's unfair that he got ten times more benefit than me!" 
"That's true!" shouted the seventh man. "Why should he get $10 off, when I got only $2? The wealthy get all the breaks!" 
"Wait a minute," yelled the first four men in unison, "we didn't get anything at all. This new tax system exploits the poor!" 
The nine men surrounded the tenth and told him they they were angry that he got so much off while they each got very little. 
The next day the tenth man didn't show up for lunch, so the nine sat down and had their lunches without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money amongst all of them for even half of the bill! 
And that is how our tax system works. The people who already pay the highest taxes will naturally get the largest benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start eating overseas, where the atmosphere is somewhat friendlier.
There are some flaws in the story, of course.   Tax cuts are rarely "across the board" even, as the new GOP tax law illustrates.   But even if they were "even Steven" the largest breaks do always go to the richest, as they pay more in taxes (except for the very, very rich) and as a result, see the biggest savings.  (UPDATE:  The idea of being paid to eat lunch is, of course, real.  You can actually get tax credits to the point where you get more money back than you paid in).

I think the biggest concern for me, personally, is that inflation will wipe out any benefit of this tax cut.   The idea that we need to throw viagra at the raging boner of the current economy is somewhat flawed - it could end up exploding.   In times of financial hardship, a tax break or stimulus makes sense - much as Obama cut the Social Security tax during his tenure.  Even the people who passed this bill admit that it will not expand the economy to the point where tax collection will offset cuts in rates.  So increased deficits - and accelerating deficits - will be the result.

This in turn will lead to rising interest rates (which are already rising from essentially zero) and increased inflation over time.   Ultimately, this will be the higher "tax" that the little people will have to pay - and they will have to pay it.

When I was 18, inflation was running at 10% or more.  Mortgage rates were in the low teens.  Unemployment was double-digit.   High inflation  and "stagflation" are something you don't want to live through, let me tell you.   And the problem with inflation and the deficit, is that it has a snowball effect.   When interest rates skyrocket, the government has to pay more to service its debts as treasury rates go up.   This leads to more deficits and more debt and higher interest payments.

I approach 2018 cautiously optimistic.   We'll just have to see where it goes.  But in terms of a "huge tax cut" I will not personally benefit much from the new law.