Near the end of 2017, we saw a large tax reform signed into law that will have some significant changes and effects.
The primary focus of the law was the corporate tax side, so I’ll start there. These tax changes are “permanent,” meaning it will take a new congressional law to change them. The theory is that corporate changes take time, and that corporations wouldn’t make a decision to relocate to the US or invest in more production here.
Here are some of the biggest changes:
– A single 21% flat tax on corporate earnings replaces the previous progressive tax with the 35% top rate.
– Capital investments can now be expensed immediately instead of over a 5-year period
– Foreign earnings are no longer subject to tax in the future, and a system is in place to tax commonly used methods (such as profit sharing) used to repatriate domestic earnings as foreign tax liabilities.
-Foreign earnings (currently on the balance sheet) can be re-patriated at an 8% rate if classified as investments or a 15.5% rate if cash equivalents.
These changes are designed to encourage foreign registered corporations to re-register under the US banner, and discourage US companies from registering in foreign countries. As such, expect that other countries will react with their own tax reforms and complain at the UN.
Tax receipts are likely to go up the first year as one-time tax charges to repatriate incomes at lower rates are taken. Much of this money will be classified as investments, freeing up domestic earnings for stock buybacks. Expect significant stock market support from stock buybacks next year.
Much of the capital investments in the US will be in various forms of automation- requiring less workers for higher production. This is a good thing long term, as productivity per person is essential to supporting per-capita income growth which can increase standards of living. In the short-term it can also lead to increased income inequality, but this will inevitably be addressed at some point because we have a functioning Democracy which allows for election upsets and votes for change.
It is likely that many S-Corporations will redesignate as C-corporations to take advantage of the lower corporate tax rates. Similarly, individuals with high earnings will try to shift some tax liability to the corporate side. This will cause “average” individual incomes to come down significantly as they are reclassified in the system. A change in taxes for S-Corporations was made to somewhat mitigate this.
Politically, Trump will crow about higher tax receipts and a rising stock market while Democrats crow about corporate incomes rising while private incomes fall. Both are red herrings; neither argument will reflect real or permanent changes to the system.
I’d like to mention one positive change, not big but a force in the right direction. A major side-effect of current low interest rate policies is to encourage way too much corporate leverage, as large amounts of debt are created for stock buybacks and companies or hedge funds use leveraged buyouts to pile debt onto otherwise solvent companies. That has lead to many large bankruptcies. Now, not only do lower corporate rates reduce the value of the interest payment deduction, but the law caps corporate interest deductions to discourage this shift from equity to debt that has been going on.
The only way to really fix this problem in my view is to make stock buybacks illegal again (made legal under Reagan in 1986), to better regulate leveraged buy-outs so that the SEC will not allow them if the underlying company ends up with too much debt, and to make one-time dividends illegal for a period of time (say 5 years) after any leveraged buyout occurs.
Note that unlike the corporate tax changes, the individual changes are mainly set to expire in 2025. The inflation rate, which adjusts certain deductions, will calculated in a new way to make it lower, so that individuals will see an increase in 2017 tax levels after expiration.
The reason these individual tax changes are temporary is to game the system so that the tax changes seem more revenue-neutral. In reality, everyone expects them to be extended as a sharp increase would be unpopular.
– There are 7 tax brackets, which all go down except for the lowest at 10% and the second-highest at 35%. Middle class earners will notice the 3% reduction in each of the second and third brackets.
– The personal deduction goes away, and the standard deduction is doubled. This will cause a significant shift as the middle class homeowner will no longer itemize taxes; the mortgage interest deduction will effectively only apply to the most expensive homes. This will be a noticeable benefit to renters while homeowners won’t see their taxes increase, so it is one of the few progressive measures of the tax bill. At the same time, the real estate lobby will fight it, so expect to hear a lot of quacking on it next year.
– The child tax credit increases to $2000 (up to $1400 refundable for low incomes). The child must be under 18. A $500 non-child dependent is also created. This is another progressive change as it helps young families, and making the benefit a credit means it keeps its value for low earners. I hope this survives the 2025 expiration because it actually helps young families.
—Other noteable changes
Some of these are individual tax changes, but the consequences wont be noticed by middle class households or were unique in ways that deemed separation. I’ll start with one of the latter.
– The tax penalty of the “Affordable Care Act” reduces to zero starting in 2018. This will have an unknown effect on insurance premiums. Big insurance companies like to claim that healthy people will drop coverage which will increase rates. However, I like to think insurance premiums will stabilize or drop because the companies will once again have to “sell” their plans again instead of merely dictating what people have to pay. Time will tell, though their is significant political will on both sides to overhaul the ACA anyways. I see this as a temporary reprieve for squeezed middle to lower-middle class families who will no longer be forced to pay a large portion of their take home pay in health premiums for high deductible plans that don’t help them much anyway.
– The estate tax exemption is raised. This only helps the newly wealthy really, as too many loopholes exist to keep dynastic wealth intact while the vast majority will never hit the old exemption amount.
– State tax deductions are limited to $10,000. This only affects high earners in high tax states directly. Indirectly, it is an added incentive for high earners to relocate from high tax states to lower tax states. While arguably a mixed bag, I tend to hope it helps to counteract the disturbing trend for jobs to leave the countryside and crowd into the big cities. People can only live where the jobs are, and it would be nice for people to be able to aspire to home ownership instead of being stuck in a tiny apartment in an overcrowded city while paying crazy high rents.
– Much of the arctic wildlife refuge in Alaska has been opened up for oil & gas drilling. This will have the typical groups fighting, but most people won’t notice the change.
Perhaps I should mention the affect on the national debt. Many will talk about it in the news and political circles, but it’s not something that will cause a quick change we can usefully analyze. Our country will not go bankrupt, as the Federal Reserve can simply purchase all of it the way the Bank of Japan does.
The wealth divide is very real, and the tax plan primarily helps the top. However, the trickle-down monetary policy during the Obama years created far more wealth disparity than trickle-down tax cuts will.
This plan isn’t the end of the world or the savior of the country, it has its pluses and minuses like anything else and we’ll continue to muddle through. In my view the real way to fix the county and rebuild the middle class is to use the SEC to break up companies that have gotten way too big while lowering barriers to entry for small business formation, and we don’t see any interest there from the leadership of either of the two major parties. Monopolies are simply bad economic policy which leads to stagnant growth and rising inequality. I don’t mean to get sidetracked. Our country still has a good system going overall, I just don’t want to be dragged in to the pro- or anti- Trump camps in the wave of relentless over-politicization.