Tax Reform Winners and Losers

May 26, 2019

by Steve Stofka

Φ * π Σ (y-c) / (σ ỹ)

Did your head just explode? That’s how the tax code appears to many of us. This spring, many taxpayers sat down with their tax accountants and were informed that they were among the losers created by the tax reform act that went into effect for the 2018 tax year. Among the losers were employees who claim business expenses. In the western states, many in the construction trades may take a temporary job that is located a few hours from home. Instead of driving home every day, they share hotel rooms or live in campers during the work week and travel home on weekends to be with their family. Some employers pay per-diem expenses, but many smaller employers don’t. Under the old tax laws, an employee could deduct meals, lodging and ordinary living expenses away from home. Under the new law, employee business expenses are subject to a threshold that equals 2% of gross income (Note #1).

An employee with business expenses who has a family of four has discovered that they are the losers this tax filing season, the first one under the new tax law. Under the old law, that family of four used to get $12K standard deduction and $16K in personal exemptions. Now they get a $24K standard deduction and no personal exemption (Note #2). If they have employee business expenses that meet the threshold test, it may not be enough to exceed the new higher standard deduction. Some tax accountants report that their clients are shocked when they learn how much they owe in this first tax year under the new law.

In the future, some workers may be able to negotiate higher pay on these away jobs. Some will have to turn down such jobs.   

Corporate America was a big winner in the tax reform bill. In addition to lowered tax rates, low interest rates during the past decade have helped many publicly held companies buy back their own stock. The stock buybacks have accelerated this past year, with a record 25% of companies in the SP500 buying back their own stock, according to a Wall St. Journal analysis published this week. 

Don’t companies have a better use for the money? Apparently not. When companies buy back stock, they reduce the number of shares outstanding and increase the profit per share reported. In the first quarter of 2019, these buybacks lifted per-share profits by 4%. The share buybacks have distracted investors from the fact that corporate profits have flatlined since 2012.

Corporate profits flatlined during the Reagan administration in the 1980s. Investors bid up stocks on the promise that trickle-down policies and tax reform would break the cycle. Before profits did start to rise again, stock prices shook off their speculative pricing on Black Monday in October 1987. Let’s hope we don’t have a similar phenomenon this time.  

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Notes:

  1. Workplace expense deductions
  2. Tax law winners and losers.

Rocky Tax Road

November 19, 2017

The House passed a tax cut bill this week as the Senate Finance Committee passed a separate version that must still go to the full Senate for a vote. There’s a hard road ahead for this bill to reach the President’s desk.

The Process…

The full Senate will take up the bill after Thanksgiving. If the Senate passes the bill, there are still more steps. Bills submitted by Congress must have identical language from both the House and Senate.

The House passed its tax bill first, so the Senate could adopt the House version and approve it. Highly unlikely. If the Senate passes a bill, both bills will likely go to a House-Senate conference committee to resolve differences in the two bills and produce a unified bill. The Republicans will hold a majority on that committee and do not need Democratic votes.

If the committee can produce a unified bill, it will be sent to the House and Senate for a vote. If either body rejects the bill, it can be sent back to the joint committee, but that rarely happens. The bill would be effectively dead.

Republican leaders regard passage of the bill as critical to the 2018 Senate races. After the Republican majority failed to pass a health care bill earlier this year, big dollar donors have advised party leaders that they are closing their wallets if the party cannot pass a tax bill. Fundraising for the 2018 campaigns kicks off in a month.

The Provisions…for business

Both bills cut the corporate income tax to 20%. Both bills will tax pass-through and passive income at 25% or 32%.

Pass-through income consists of profits earned by businesses that flow to the business owner as personal income. Half of all pass-through income goes to the top 1% of incomes.

Passive income can be the profits from rental property, or dividends paid by an REIT (Real Estate Investment Trust). Under current law, such income is taxed at personal rates as high as 40%.

Republican Senator Ron Johnson opposes the bill as it came out of the Finance Committee. The bill gives an estimated $1.3 trillion in tax cuts to corporations, more than three times the $362 billion in tax cuts to taxpayers with pass-through income. Each sector currently pays half of the taxes on business profits. Small businesses and farmers get 25 cents of the tax cut dollar, while big corporations get 75 cents.

With only a two-person majority, Senate Republicans cannot afford to lose more than two votes and pass this bill. Susan Collins from Maine, a state dominated by small businesses, has echoed Johnson’s objections. Rand Paul from Kentucky says he will not vote for a bill that increases the deficit, which this bill does. Unless there are some key changes made to the Senate bill during the Thanksgiving break, the bill is unlikely to pass.

Both bills keep the 1031 exchange clause which allows real estate owners to avoid capital gains taxes on the sale of a property when they reinvest the gains in a similar class property. Owners of equities do not enjoy this tax subsidy. An investor who sells a stock, mutual fund, or ETF must pay any capital gains even if the investor buys another equity with the gains.

The Provision…for individuals

The House bill promises to save a median income family $1182 in taxes. Not about $1200. $1182. The precision of that number indicates that it is more a selling tool than a reality. The Senate version will likely tout something similar.

Half of taxpayers will notice little change in either bill because they pay almost no income taxes. Both bills retain the Earned Income Tax Credit (EITC). Lower income taxpayers will see no relief from the bite of FICA taxes.

The standard deduction is doubled but personal exemptions are eliminated and the child tax credit is increased by $600 per child but only for five years. Have you got that? Paul Ryan, the House Majority Leader, assured us that the tax bill would be simpler. Sound simple to you?

The Senate bill includes a repeal of Obamacare penalties for not having health insurance. Oddly enough, this saves the government $332 billion over ten years. Wait, how does that happen? The Congressional Budget Office (CBO) estimates that many younger people who would be eligible for subsidies under Obamacare will simply forgo insurance if the penalty is eliminated. Republican leaders get two birds with one tax stone. Senators can register their disapproval of the most hated part of Obamacare and the savings enable the Senate bill to meet the deficit requirements under reconciliation rules.  These rules allow the Senate to pass legislation with a simple majority.

As I noted two weeks ago, both bills eliminate or reduce the current deduction for state and local taxes (SALT). High tax states like California, New York, New Jersey, Connecticut and Massachusetts have no Republican Senators. If Republican leaders lose the votes of Johnson, Collins and Paul, they would have to reinstate a full SALT deduction to have any hope of gaining one or two Democratic votes.

The Senate eliminates the SALT deduction entirely and uses the tax money to continue the deductions for medical expenses, student loans, mortgage interest and charitable donations. The House bill eliminated these deductions but allowed some SALT deduction in order to appease Republican House members from high tax states.

The House bill simplifies the tax brackets from the current seven to four. The Senate version has seven brackets.

The Conclusion…

Imagine a rough dirt road after a lot of rain. The tax bill has just turned off the paved highway and onto the dirt road. Expect a lot of muttered cursing, pushing and digging to move a tax bill to its final destination, the desk of President Trump.

 

Numbers and Feelings

November 5, 2017

How do numbers feel to us? Numbers are hard like rocks. Feelings are squishy. Numbers are left-brained. Feelings are right-brained. Deep in the vaults of our brains, tiny elves translate one into another. Here’s an example.

This past week, House Republicans released an initial proposal of tax reform. A feature of the plan is the limitation of state and local tax deductions (SALT) to $10,000. Under current tax law, taxpayers have been able to deduct state and local taxes without limit.

This will hurt taxpayers in high-tax blue states which are overwhelmingly Democratic. Wisconsin, a purple state, is the lone exception among the top ten states (Forbes ranking of state tax burden).

Expecting no votes from Democrats in passing a tax reform/cut bill, Republicans included few provisions in the bill that would pacify voters in Blue Democratic states. Republican congresspersons in those states are faced with a dilemma. One Republican congressperson in New Jersey, one of the top high tax states, claimed that the average SALT deduction in his district was $21,000, more than double the allowance in the tax reform proposal.

Knowing that the SALT limitation will hurt their constituents, do Republican House members vote with their party or in the interests of their constituents? Numbers can make politicians anxious.

For some taxpayers in those states, the feeling is anger. “I don’t want to pay taxes on my taxes,” one New Jersey resident growled.

That same N.J. congressperson claimed that incomes less than $200,000 were middle-class. According to this calculator based on the Census Bureau’s Current Population Survey, an income of $200K is in the 97th percentile of all incomes. Less than 3% of households have incomes greater than $200K. Hardly middle-class.

What is middle class? Some studies use the 25th – 75th percentile. Some use the 30th – 80th percentile. Using the latter definition, 2016 incomes from $24,000 to $75,000 were considered middle-class. These classifications use national data. Many coastal states have far higher incomes and living costs.

People living in some east and west coastal states feel middle class even though the income numbers do not classify them as such. Take for example, a household in Silicon Valley, where the median household income is almost $100K,  $40K more than the national median. They are rich, right?

Not so fast. The median price of a home in Santa Clara County (San Jose) is almost $1.2 million (See here ). Spending $40,000 annually for housing on an income of $95,000 feels middle class. The percentage of housing cost to income, 42%, is far higher than the 30% HUD guideline, and is more typical of poor working-class families.

Californians have counties with the highest incomes in the U.S. – and some of the poorest. The state has a median household income that is 12% higher than the national average.

CalUSHouseholdIncComp

But that’s not how it feels. That extra income is eaten up by higher housing costs, high car insurance premiums, and higher taxes at all levels. California sends about 12% more taxes to Washington than it gets back in various national programs. The additional federal taxes paid by higher income coastal states helps pay for benefits to those in lower income states, particularly those in southern states. Blue states subsidize Red states.

The Red states control the national agenda in Washington. The Republican tax proposal in its current form takes tax pebbles from the Red scale and puts them on the Blue scale. That feels spiteful.  Voters in those Blue states feel angry.

Interest groups around the country feel angry. The National Association of Home Builders claims that the SALT limit will lower home valuations, particularly in coastal states. They have promised a considerable effort and expense to defeat this version of the tax proposal.

When I recalculated my family’s 2016 taxes using the new proposal, we saved $752, a bit less than the $1200 average savings for a family of four. The monthly tax savings – the numbers – are relatively small. I feel neither angry or joyful. Those of us who are little affected by the proposal are unlikely to raise our voices in protest or support.

Angry people act. They call, they shout, they organize.

Joyful people – the CEOs of large corporations who will benefit greatly from this proposal – are not shouting. They calmly make claims that lower taxes will create more jobs, although the evidence is rather weak. They are organizing. They are calling talk shows. But most of all they are donating.

Political donations can speak more loudly than the shouts of angry people. In the political game of Rock, Scissors, Paper, cash covers a rock thrown in anger. Angry people must take up the more precise and patient tool of the scissors if they hope to best cash in a contest.

Lastly, this tax proposal further divides earners into groups. Income earners above the median will learn that this $1 is not the same as that $1 to the taxman.  According to an analysis done for the Wall St. Journal,
The $1 earned in wages and salary will be taxed more than
The $1 earned by the small manufacturer, which will be taxed more than
The $1 earned by the real estate investor, which will be taxed more than
The $1 earned by a stock or bond investor, which will be taxed more than
The $1 paid to an inheritor, who will pay $0.

Republicans criticize the identity politics practiced by Democrats. With this tax proposal, Republicans have stamped identities on the very $$$$ we earn. Those numbers don’t feel good.

 

 

Sacred Cow

October 22, 2017

Moo. One of the sacred cows of tax law has been the mortgage interest deduction. There is talk that the proposed Tax Reform law will erase this deduction. Who benefits from the deduction? Before I look at that, here’s some groundwork.

Two months ago the IRS released aggregated income tax data for 2015. Pew Research analyzed the data and produced this  chart of who pays how much in individual income taxes.   I took the liberty of marking up  their chart.

TaxAnalysis2015Pew

The Tax Reform bill that is being tortured to death in the back rooms of Congress proposes to double the standard deduction, making the first $50K that a couple earns tax-free. About 50% of tax returns will pay little or no federal income tax. That leaves the other half to pick up the tab for the 5% of taxes paid by the lower half of incomes. 1% of tax returns paid 40% of taxes in 2015 and they will argue that they are already paying their fair share.

As the Congress tries to craft a Tax Reform bill, one of the hot button topics is the mortgage interest deduction. According to IRS analysis of 2015 tax data, 33 million returns, about 20% of total returns, took the mortgage interest deduction totaling $304 billion, averaging over $9000, or $770 a month. The annual cost to the Treasury is about $70 billion in taxes not paid.

The bulk of this tax giveaway goes to wealthy families, but the program is popular among middle class families in expensive housing markets, particularly on the east and west coasts. The Tax Reform package proposes to double the standard deduction.  For many married couples, this would exclude another $25K of their income. This $25K is far more than the $9K average mortgage interest deduction.  However, there will be about 8 million returns, mostly wealthier Americans, who will pay more.  Those 8 million will certainly raise a campaign of alarm and outrage as they try to convince the vast majority of Americans that this reform is so un-American. Those in the real estate sector will claim that this will cripple a recovering homebuilding sector and prevent many American families from owning a home.  It won’t.  Each sector of the economy wants to preserve their tax carve outs because their business model has come to depend on it.

Notice that the analysis included effective, not marginal, tax rates. What is the difference? The effective rate is the net tax divided by adjusted gross income. It is the average tax paid for all the income received. For those who use tax preparation software, the program calculates the effective rate and prints it out on the summary page.

The marginal rate is the highest tax rate paid on the last dollar. When we hear someone complain that they are in the 33% tax bracket, for example, we think that the person pays 33% on all their income. They don’t. A two-earner family making $130K, filing jointly, two deductions, would be in the 25% bracket in 2017, but their effective tax rate is 12.89%, almost half of the marginal rate. (Dinky Town calculator)

Why is this important? Let’s return to the difference between effective and marginal tax rates. Let’s say our hypothetical couple making $130K wants to buy a new house for $300K. After $60K down, they will pay about $7800 per year in interest for the first 20 years of a 30-year mortgage (Zillow mortgage calculator). What they tell themselves is that they are “saving” over $160 per month, almost $2000 per year, because they are in the 25% tax bracket.

What is the fallacy? The couple assumes that the first dollars they earn buy the groceries, buy clothes for the kids, or make the car payment. It’s the last money earned, the money that is taxed at a 25% rate, that they will use to pay the mortgage. It’s sounds silly, but it’s effectively what we do when we use the marginal rate to analyze costs. Real estate salespeople sometimes use this technique to upsell a couple into a more expensive house, one that earns the salesperson a higher commission. If our couple uses the effective tax rate of less than 13%, the savings on that monthly mortgage payment is only $83. Many financial decisions are made “at the margin” but this is not one of them.

Also on the cutting board is a reduction in the amount of pre-tax contributions a person can make to a 401K retirement program.  Higher income earners would be trading in that tax break for lower tax rates, but the finance industry is sure to balk.  They make billions of dollars in administrative and trading fees for these retirement programs. In addition to the taxpayers who receive the benefits directly, tax breaks have protectors who benefit indirectly from the break. Together, this minority fights for their interests.

Soon after the last tax reform was passed in 1986, members of Congress began adding tax exclusions. Republicans may be able to pass a reform bill under a Budget Reconciliation rule in the Senate, which requires only a 50-vote threshold. Their slim majority in the Senate and a lack of cooperation from Democrats means that passage of a reform bill is vulnerable to just a few Republican defections. This is how health care repeal or reform was defeated earlier.  It can happen again.

Avoidable Taxes

April 19, 2015

Taxes

Some call them loopholes, tax breaks, or giveaways but the official name for them are tax expenditures.  In August of last year, the Joint (House and Senate) Committee on Taxation detailed  the many gimmes in the tax code.  The Pew Research Center graphed out the largest expenditures including the big banana, tax free employer paid health insurance premiums. (They forgot to include the $38 billion in Sec. 125 cafeteria plans.) That program started during World War 2 when wage increases were frozen by law.  That war ended 70 years ago but the “temporary” tax break goes on and on.

The list of giveaways runs for 12 pages. Those with incomes above $100,000 get 80% of the mortgage interest deduction (page 37), 90% of real estate tax write-offs (page 38),  60% of the child care credits (page 39), and claim 86% of the charitable contributions (page 38).  Reduced rates on dividends and capital gains cost almost $100 billion in 2014.

28 million low income families qualify for the earned income tax credit but the $68 billion cost for that is less than half the cost of tax free health insurance premiums.  Almost 37 million families claim a child tax credit for $57 billion dollars (page 41).

Seniors get $60 billion of gimmes in tax free Medicare benefits (page 32).  In 2015, tax breaks for all types of medical spending will total almost 1/4 trillion dollars in foregone tax revenue.   As spring arrives, let’s lobby for tax deductions for gardening expenses.  Gardening is therapeutic, a genuine medical expense.

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CWPI

As expected, the composite Purchasing Managers Index (PMI) in the manufacturing and service sectors declined further but remains strong. We may see a slight decline for one more month before the cycle upwards starts again.

New orders and employment in the service sectors is strong and growing, offsetting some weakness in the manufacturing sector.

March’s retail sales gain of almost 1% was a bit heartening after the winter slump.  Excluding auto sales, year over year gains have dropped sharply since November and the trend continued in March as the yearly gain was only 1/4%.

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Labor Market Conditions Index

The Federal Reserve takes about a week after the release of the monthly labor report to compile their Labor Market Conditions Index (LMCI), a comprehensive snapshot of the many facets of the labor market.  For the first time in three years, the index turned negative in March.  It barely crossed below 0 but is sure to give some pause, a watch and wait when the FOMC meets at the end of this month.  While some of the FOMC members have been making a more aggressive case for raising interest rates, chair Janet Yellen is sure to point out that the economy is below target in both employment and inflation.

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Mortgage Banking

In an April 8th article, the Wall St. Journal reported that loans backed by bank deposits fell from 44% in 1980 to 20% in 2008.  Since 2012, the big banks have fled the mortgage business and now account for only a third of new federally guaranteed mortgages.  Small finance companies, which avoid much of the oversight and regulation in Dodd-Frank, now account for more than half of new mortgages.

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