Fiscal Policy Part 2 – A Primer on Tariffs

If you haven’t been living under a rock for the past half year or so, you likely saw some variation of this headline on the news:

“Trade war heating up with China and/or the EU and/or Canada and/or Mexico!”

“Trump administration pressures Beijing to make trade fair”

“Business owners uncertain about their future after most recent tariffs”

“Business owners optimism showing after most recent tariffs”

If you noticed that these headlines seem to contradict each other, you would be correct! Tariffs are trade actions are all over the news, and don’t seem to be showing any signs of slowing down. What exactly this means for U.S. and Global commerce, like all specific things in economics, is evidence-based and remains to be seen. However, in this post, I will discuss the basics of tariffs; why they exist as a tool of fiscal policy, some applications of tariffs and quotas in the past (both good and bad), and some general economic application of this kind of policy in today’s context. And, as a bonus, I’ll also talk a little about a political theory that has application with this topic, Dependency Theory, and why it matters in the environment that is most suited for tariffs to take place.


Let’s start with the basics. What are tariffs?

Tariffs are essentially a way for a domestic government to make the prices of foreign goods more expensive, to achieve the goal of protecting domestic industry from foreign competition. When you hear the word “Protectionism”, tariffs should immediately come to mind. Tariffs are most often used to prop up domestic industry that cannot yet support itself financially when faced with much larger global competitors. Think of a nascent company in a mature industry, such as Tesla competing with Toyota or GM, or Venezuela’s oil company competing with Saudi Arabia’s. These are perfect examples of companies that are tapping into a big, rich marketplace, but are new and lack the capital or reach to compete effectively.

The way tariffs work is relatively straightforward. The domestic government will see that domestic industry needs to charge higher prices than foreign competitors, and will tack on an additional tax (the actual tariff) to those foreign companies when they want to sell their goods to the domestic economy. In theory, this raises the price of foreign goods up to or just below the price of the domestic goods. Since prices are now equal in the domestic market, consumers have less incentive to not buy domestic, and producers and governments can appeal to consumers’ patriotism to make them buy more out of the domestic market. In theory, this props up domestic employment and reduces exports.


Sounds good, right? Don’t get set on the idea just yet. For all the upside, there’s a whole lot more downside. The following series of paragraphs will address some of the problems with tariffs, from multiple points of view, followed by criticism of each paragraph. I apologize for the dryness in advance, but it’s interesting stuff, and if you understand both the good and bad sides, you will know more than many in government today.

First, there exists in macroeconomics a concept called “Crowding Out”. This is most commonly used to chastise government spending as a way of stimulating demand. Raising government spending levels necessitates more government borrowing, which raises interest rates as more bonds are issued. Since big governments like the U.S. can essentially spend as much money as they want, and their bonds are seen as ‘safer’ investments, huge demand for government bonds is created when interest rates rise. Money that would otherwise go toward more productive assets, such as corporate bonds or common stocks, instead goes toward government bonds, where it is theoretically safer, but does not contribute as much to private sector activity. In other words, private sector investment is “Crowded Out” by government investment. Many people think this is a leading contributor to the slowdown of western economies’ GDP in recent decades.

Now, let’s apply the concept of Crowding Out to tariffs, in the context of the modern United States. Ours is an economy with an enormous amount of Demand, coming from a multi-million-person population with a high amount of disposable income relative to other countries. But as wages stagnate, the demand of the U.S. will shrink as fewer and fewer people have access to more disposable income. Considering this macro issue, let’s assume that Demand in the U.S. is flat, and while it is high, will not rise unless acted on by a massive force. Consumers naturally try to access the highest quality product for the lowest cost, so they will buy more foreign goods while they are cheaper, and more domestic goods from companies that can compete on price. If prices of goods rise enough, then consumers will have to adapt while their income is stagnant. I would think this adaptation means simply buying less stuff, both foreign and domestic. In this way, even though tariffs are meant to stimulate demand for domestic products, that demand is Crowded Out by consumers’ need to save their money.


Second, tariffs fly in the face of fundamental concepts of free trade, such as Competitive Advantage. Competitive Advantage is the flip side to the consumer demand trend shown above, where economies will specialize in industry where they have an advantage relative to their peers. We see examples of this everywhere, all the time, from Software Technology hubs in the U.S. (due to our world-class university system and earning power) to Oil Drilling in the Middle East (due to their overabundance of natural resources) to Call Centers and Textile Manufacturing in India and Bangladesh (due to their dual characteristics of a massive population that is relatively poor and can perform cheap labor), all the way to exports of Chocolate from Ghana (actually, cocoa from Ghana is a primary source of world famous Swiss chocolate). When Opportunity Cost is lower for an area of industry, economies will naturally take advantage and specialize. Because of this, goods and services will increasingly come from places where cost is lowest, and as long as a country has an advantage in one measure of industry, they will gain market share against their peers. This is Competitive Advantage in a nutshell.

What does this have to do with tariffs? Remember the definition I gave to tariffs, and how they are mostly used to protect nascent industry from bigger foreign competitors. This reason can be perverted easily, and stretched to mean the protection of any industry the domestic government sees fit to protect, even at the long term expense of its economy. The context of the 2018 world economy is a perfect example of where tariffs are neither necessary nor appropriate. The Trump administration levied a 25% tariff on foreign steel because it sees the preservation of U.S. steel manufacturing as a national security priority. It even went as far as to call steel imports from our strongest allies (Canada, the EU) a national security risk. Tariffs are unnecessary here because they drive up costs wastefully and without reason. Canada and the U.S. enjoy the largest peaceful border in world history, and have not been at war since the War of 1812. You would be hard pressed to find a more allied set of two individual nations, as evidenced by our cultural and athletic rivalries that could not be friendlier. If the U.S. can secure reliable steel imports from Canada at cheaper prices than in the U.S., then why would we want to raise those prices and increase expenses of every U.S. company that uses steel as a raw material? Would it not make more sense, from both a consumer standpoint and a long-term producer standpoint, to keep the inputs of manufactured goods as cheap as we can reasonably make them, and foster better relations with Canada so they keep reliably exporting to us? I digress. The point of this example is to illustrate that Canada is able to produce steel at less cost, so they have a Competitive Advantage in steel production. Instead of propping up our own steel industry, and possibly sacrificing a portion of our workforce that can be more productive elsewhere, we should instead rely on the cheaper good from a close and loyal ally, and use that savings to advance industries where we have advantage of our own (notable examples are Tech, Movies & Entertainment, and Military/Defense).


Third, in a world of ever-increasing globalization and competing world economies, tariffs do more harm than good. In the era of tariffs’ heyday, when the world was comprised of many individual countries that dealt with each other one on one, as opposed to in a group, hostile fiscal policy made more sense because it was used as a cudgel for a stronger economy to make a weaker economy do what it wanted. In case you didn’t know which era I’m talking about, it is the 1600’s – 1800’s. The great economies at that time, England, France, Holland, and Spain, all used economic hostility just as frequently as they used military hostility, to further their mercantilist goals of colonization and resource extraction. You may be aware that this era was comprised of many, many wars, and very few alliances or friendly relations. This was due in no small part to all the hostility between nations, in its various forms. Nowadays, the world is decidedly not that. The past 70+ years have seen rise to international and multilateral institutions previously unseen and unimagined, facilitating international development, financing, cooperation, and security. The effectiveness of these organizations is up to your personal interpretation, of course, but the world in general has taken great pains to make a world order than is without a doubt, one hundred percent not bilateral.

Why am I explaining all this? To drive the point home that bilateral economic relations is mostly a thing of the past, and attempts to further one nation’s agenda at the expense of a second nation will assuredly spill over and have negative effects with a third nation. To put it in a middle school context, other nations will talk behind our backs! If we slap a bunch of tariffs on China, for example, that drives the Chinese economy further from us. But if we also push away the Canadian economy, there is no rule saying Canada will be forced to deal with us and no other nation, regardless of how we treat them. Quite the contrary! China suddenly has more incentive to do business with Canada, since their economies are both further away from ours, and thus closer to each other. Who’s to say they won’t both levy tariffs of their own on U.S. exports, pushing up the world price of goods even further?


There have been a few notable examples of tariffs throughout American history, and the vast majority have been met with negative results on net. The most popular example is the Smoot-Hawley Tariff Act of 1930, meant to protect the profits of farmers suffering from the Dust Bowl. The Act set tariffs on foreign imports of agricultural products as high as 19%, pushing up domestic production and employment of agriculture in the short term. But US tariffs were already high at this time, and the additional tariff contributed to other countries’ rapid and substantial declines in global commerce. Obviously due to the Great Depression, the exact effects of the tariff were unclear, but the consensus is that Smoot-Hawley exacerbated its effects. Some notable statistics having to do with tariffs are, however, well documented. U.S. exports decreased 61% from 1929 to 1933 and Gross National Product fell 27% from 1929 to 1931. You don’t need me to tell you that the Great Depression was the worst economic event in modern history, but the tariffs certainly did not help, as foreign imports were discouraged in the U.S., which led to U.S. exports being discouraged in foreign countries.

Another example of tariffs in history is the Tariff of Abominations, enacted by Andrew Jackson in 1828. This tariff was a fixed 38% rate set on almost all foreign imports of products produced by the Northern states, so that they could compete with their British competitors. Again, this tariff produced more net negative than positive. By raising the prices of foreign goods to match domestic goods, the Northern states could compete on a level playing field in the domestic economy. However, the Southern states, which were not manufacturing states and relied on agrarian exports with cheaper foreign tools, suffered immensely due to a two-pronged effect. Their costs rose dramatically, while foreign countries they normally exported to would not accept as much of their exports due to perceived isolationism and unfair treatment. South Carolina in particular was hit so badly by this tariff, that in 1832, the state assembly approved a nullification measure, essentially saying that the states could choose to nullify any federal law they did not agree with. The ensuing clash over states’ rights and North vs South economies contributed in no small part to tension between the two sides of America, eventually leading to the civil war.


Finally, what about Dependency Theory? I’m no political scientist, but as I understand it, Dependency Theory is the emerging theory of international development that essentially splits the world into two types of nations. There are strong, sustainable nations, typically in the West and Europe, and smaller, weaker nations, typically found in Africa and East Asia. The growing inequality present in today’s rendition of capitalism causes the rich nations to grow richer on their own, and the poor nations to need the rich nations in order to get richer as well. So, the richer nations will turn this need into a predatory relationship, buying up natural resources and raw materials found in poorer nations for far cheaper than they would have had to pay to other richer nations. Since they pay the poorer nations far less than the resources are ‘worth’, poor nations only gain a small amount of wealth while rich nations keep the vast majority of their wealth. Tell me if this sounds familiar to you, because it should. This theory basically describes a modern version of Mercantilism, with poorer nations subject to ‘colonization’ by companies of richer nations, not unlike the East India Trading Company or the Hudson Bay Company belonging to England in the 1600’s.

The reason this theory comes to mind when talking about tariffs is because it gives a very good reason for tariffs to exist. If developing countries cannot sustain their own necessary industry, why would they allow themselves to be taken over by foreign developers and companies? Sure sounds good in theory, but again, it suffers the same fundamental negatives that we discussed already. Competitive Advantage is the cure for this. When I talked about Competitive Advantage above, I briefly brought up cocoa exports from Ghana, a small, developing African country. Despite having little in the way of manufacturing, a pegged currency, and a small population, cocoa exports from Ghana are the second largest exports of chocolate products in the world! Ghana happens to have several regions where rainfall is very heavy, and conducive to increased farming and production of cocoa and other chocolate products. As I mentioned, they export to famous chocolate producers like Switzerland, but they also export to and have beneficial trading relationships with the U.K. and Singapore. More facts about the cocoa exports of Ghana can be found here: https://www.cocobod.gh/

I’m not saying that Ghana’s cocoa exports are a perfect example of a country using competitive advantage to gain an edge in industry, but it is an example of how developing countries can effectively use this concept to compete with their foreign peers without limiting other industry. Countries like Ghana would do well to become friendlier with their neighbors, to pool resources for the common defense, and to promote commerce that is mutually beneficial and plays to all countries’ forms of advantage. In Ghana’s case, the African Union is a rapidly growing player in global trading blocs, and in a few decades, could become as important as the Association of South East Asian Nations (ASEAN) or even the European Union.


In summary, though I have not expressed my own opinion on whether tariffs are good or bad, I hope I have shown you that on the whole, tariffs are more negative than positive in a globalized, integrated economy like that of today. As with all things in economics, circumstances are never the same and everything should be taken with evidence. What’s important is that you make up your own mind using information readily available, and use your influence to make policy that better suits not only the U.S. population, but the population of the entire world. As always, thank you for reading, feel free to leave a comment or message me with any questions or concerns you have, and be sure to look out for more!

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Analysis of the Tax Cuts and Jobs Act of 2017: Businesses

Welcome to Part Two of my analysis of the Tax Cuts and Jobs Act of 2017. The first post on this new tax law focused on individual changes, and this post will focus of business-side changes. There are way too many changes to the code to go over in this post, and we will include a few of the major changes as well as some that have passed under the radar. We will conclude with my thoughts of this law. Overall, I believe that businesses will be able to save a significant amount of their profits under this law, with each type of entity and industry affected to a various degree.

First, we need to go over the different business entities, because the type of entity carries a significant impact on the tax paid, under both the current tax laws and the new one. 

  • C Corporation – This is the type of entity you think of when you hear the word corporation. The most easily recognizable, this entity has two levels. The corporation is its own ‘level’ subject to the corporate tax rate (currently 35%), and shareholders are the second ‘level’ subject to personal capital gains taxes for dividend payments and sale of stock.
  • Partnership – This entity is the most common ‘pass-through’ entity, meaning subject to only one level of taxation. Owners of a partnership, the partners, take complete ownership of the partnership’s profits, and those profits ‘pass through’ to those partners’ individual tax returns on a K-1 form, subject to their own individual rates only. Since those partners originally contributed capital to create the partnership, any distributions back to the partners are nontaxable (this is separate from end-of-year earnings).
  • S Corporation – This is a hybrid entity that has characteristics of both C corps and Partnerships. For tax purposes, however, it has the most to do with a Partnership. Subject to a few restrictions, the shareholders of this entity take ownership of the business income and it ‘passes through’ to their individual tax returns as well.

I will refer to C Corporations in this post as Corps, and the other two entities as Passthroughs. Now that we have an understanding of that, let’s go over some of the major changes to the business side of the tax code.


 

First and foremost, there is a change in the tax rate for Corps. Under the current system, corporate income is taxed progressively with a top marginal rate of 35%. Under the new law, this would be changed to a flat tax of 21%. This represents a tax cut of 40%, though most corporations did not pay the top marginal rate of 35%.

Some business deductions are repealed, the most popular being the Interest Expense deduction. Businesses like this deduction because it lowers the cost of issuing debt (bonds). Under the current system, interest paid on that debt is deductible on a business tax return. The new law would limit this deduction to 30% of a business’s Earnings Before Interest and Taxes (EBIT). Exception – Real Estate Companies.

Other deductions that are repealed for individuals are kept for businesses. Some of these are the State & Local tax deduction and the Property tax deduction, not being limited to $10,000 a year like they are with individuals. Whether or not the deductions not applicable to individuals would be able to ‘pass through’ from a Passthrough return to their own is uncertain.

So, Corps get a big tax cut, but what about Passthroughs? They don’t get hit with a corporate tax. Under the current system, the top Corps rate of 35% with average capital gains rate of 15% gave a total shareholder tax of 50%. Comparatively, the top individual rate of 39.6% is not exactly close to parity. Under the new system, the corporate rate of 21% adds to the same capital gains rate for a total tax of 36%. The top individual rate of 37% on Passthroughs is very close to parity. However, Passthroughs can deduct up to 20% of their business income, subject to:

  • 50% of wages paid to their labor
  • 25% of wages paid to labor + 2.5% of total adjusted basis (cost at acquisition) of any depreciable property. Advantage: Real Estate Companies.

This Passthrough deduction does not apply to most Personal Service Businesses (such as lawyers and accountants) but real estate companies are included. This would bring the Passthrough tax rate down to 29.5%, which is a whole lot better than the Corps rate when looked at from the shareholder level (which is the level you should be looking at it from). Believe it or not, the vast majority of businesses in America are Passthroughs that will take advantage of this lower rate. In many cases, the owners of these Passthroughs have all their income from them, bringing all their income taxes down even more significantly than the Rich taxpayer in my last post.

Another big change in the tax code is the depreciable lives of most assets. When economists talk about ‘business investment’, they refer to either hiring more workers or buying more Equipment & Plant assets. Think of these assets as income-producing, meaning they are used over many years to boost company growth, like new computer systems or upgraded farm machinery. Instead of being written off completely in the year they are bought, these assets are ‘depreciated’ from their cost to zero over a period of years. Expensing these assets all in one year would allow corporations to hide a huge amount of their income when they buy these assets, so depreciation makes it so these costs are spread out and profits per year are higher.

The biggest changes to asset depreciation are new Farming equipment being shortened from 7 year lives to 5 years, and new Real Estate Property being shortened from 39 years to 15 years.


 

This is only half the picture. Policymakers have also radically changed how the US looks at worldwide income from a taxation standpoint. Currently, there is a ‘worldwide’ system, where multinational corporations headquartered in the US must pay the US Corps tax on their worldwide income, in addition to the foreign countries’ taxes, with a foreign tax credit to offset. This results in a tax of 35% paid on all income foreign and domestic. Under the new law, we would transition to a ‘territorial’ system where those multinationals would have to pay the US Corps tax on their domestic income, but all foreign income would be exempted from US tax.

The purpose of all this is to bring foreign profits back to the US. Companies like Apple, Pfizer, and others that have significant foreign operations currently are taxed on the worldwide basis only if their foreign profits come back to their domestic headquarters, so they keep that money offshore to avoid the tax. The new plan would work in two ways. First, there would be a ‘deemed repatriation tax’ of all post-1986 foreign profits (since the last tax reform) that have not come back to the US, in the form of 15.5% for cash and 8% for capital assets. That would be paid over 8 years, and all future foreign profits would be treated as described in the above paragraph.

As I said above, the purpose of this is to incentivize companies to invest back in the US. To do this, policymakers have provided for 5 years of 100% depreciation (full expensing) of depreciable property bought in the US from 2018-2022.


 

What do I think?

I’ll start easy. If you look through the statements of fact above, you will notice the bold font whenever Real Estate companies receive preferential treatment. Real Estate companies are exempted from the interest deduction limitation, have their depreciable asset lives cut in half, and since they are primarily S Corporations, can take advantage of the 20% Passthrough tax reduction. Real Estate companies make out like kings with this new tax law. It doesn’t take mathematics to figure out that their taxable income will be offset significantly by the doubling of depreciation expense with their assets (and Real Estate companies, by nature, have a lot of them) and an additional 20% tax cut using the basis of those assets.

Passthroughs will seek to take full advantage of this 20% tax cut across the board. Personal service companies that cannot take the cut will have an easy choice. A law firm that owns their building can create a separate real estate company and place the law firm under its ownership, and the real estate company can take the cut. If the law firm rents their building, they should consider buying that building. Passthrough shareholders will see a gigantic tax decrease due to this law, resulting in significantly less revenue going to the government.

Multinational corporations also stand to do very well due to this law. I believe it will have the opposite effect as policymakers desire, namely, it will incentivize US corporations to push more of their operations overseas rather than bring them home. Why is that? I look at this from a conceptual level. Many people see the ‘worldwide’ tax system as unfair, and punishing corporations for doing business overseas, and that if we reduced their taxes, they would want to do more business in the US. Because these people somehow think of corporations as having their own thoughts and consciences. Corporations are in the business of making the most money, and they are shifting their operations overseas because by and large, the cost of doing business is cheapest in developing countries with cheap labor. I personally do not think tax policy factors much into this kind of corporate decision making, and if anything, the ‘worldwide’ system only serves to level the playing field and ensure that when corporations lay off US workers and leave our shores, they are still paying the tax they would have paid if they had continued to do business here. The problem arises when they simply hide their offshore profits, but this law does not solve that problem very well either.

The ‘deemed repatriation tax’ does stand to bring in hundreds of billions of dollars in tax revenues over the next few years, but what after that? If you believe that tax policy is a defining point in the corporate decision making process, then you must acknowledge that we have effectively brought our tax rate on foreign profits to zero, and now, the only area in the world that companies would owe US tax on is in the US. Given that we are a second mover in the ‘tax rate war’, bringing our rate down to match other countries, why should we expect those other countries to keep their rates where they are, instead of bringing them down another few percentage points to once again become better than ours? And why would US corporations bring business back to the US when those other countries have the first-mover advantage? This ‘tax rate war’ is becoming a race to the bottom, where the country that has the lowest rate will get all the business. But I digress, you get the point, I hope.

As an aside on the rationale for why this tax cut was deemed necessary in the first place, I ask you to once again approach this from a conceptual level, and please pardon me if I seem some level of cynical. In capitalism, the means of production are Land, Labor, and Capital. From a corporate standpoint, Land is the building the corporation is in, Labor is the workforce that makes it run, and Capital is everything else, from the machinery and property to the shareholders owning the company stock. Corporations pay income taxes, but corporations are owned by people, so those people, the Capital means of production, do bear the brunt of corporate taxes. A popular Classical Economic talking point is that corporate tax cuts would free up the Capital side and let the corporation keep more of its money to reinvest or grow its business. But what does this really mean? When a corporation pays its tax, I as a shareholder could feel punished that the corporation had to pay out money that belonged to me, or I could feel nothing at all, knowing that the tax rate is a necessary thing. I personally feel the latter. If I seriously lent myself to worry about a corporation I bought stock in having to pay a tax, if I really cared about how that corporation does business and wanted it to employ the most people possible, then there are a lot of other things I could do than gripe about taxes. I could advocate for higher wages paid by that corporation (which are fully tax deductible under both the current and new laws) or I could use my voting power to steer the corporation into higher growth industries with bigger workforces. If the purpose of corporate tax cuts is to free up Capital production, then logically, the first benefits would go to the Capital side, namely the stockholders. Executives holding lots of stock would see big bonuses, noncorporate shareholders would receive more dividends, outstanding stock would be bought back to raise the price of other shares, and maybe some additional investment would occur, but I believe that events happening in any other order would go against the economic principles of the means of production themselves.

So concludes my analysis of the Tax Cuts and Jobs Act of 2017. I certainly hope I kept things sufficiently brief, but with a level of detail that you would not get from most media sources. As always, feel free to message me or comment with any questions or comments, and most of all, keep learning!

Source: Detailed breakdown of the tax code changes

https://docs.google.com/document/d/1pcOIQOQ_G4eM7DAib61eLNBMIZdUiAQ9EN-Ueaorw68/edit?usp=sharing

Source: Business changes in new tax laws

https://docs.google.com/document/d/11E-YaRXwhyIVsMe47GerkPnXmFjyoOyUvf6F4urbuyc/edit?usp=sharing

Source: Foreign changes in tax laws

https://docs.google.com/document/d/1xtUgvJFsdizIiBuq5jes13HSPjmmw9Cdym2ZNpo0SIU/edit?usp=sharing

Source: Tax Cuts and Jobs Act of 2017

http://www.wsj.com/public/resources/documents/JointExplanatoryStatement121517.pdf

Analysis of the Tax Cuts and Jobs Act of 2017: Individuals

The Tax Cuts and Jobs Act of 2017 is a sweeping tax overhaul that is set to enact dramatic changes to individuals on every part of the societal scale in the United States. Much has been said about this giant piece of legislation, and much of what has been said has been exaggerated or is plain wrong. I am a tax accountant, and I have been waiting for the final version of the bill to be released before I released my analysis. However, rather than putting yet another partisan spin on this monster bill, which I am sure you are quite weary of, I want to approach this another way.

Each partisan side has their own cherry-picked changes in this bill, some good and some bad. This blog will show an objective, nonpartisan analysis of the bill. I have created five hypothetical individual taxpayers spanning from poverty to near-extreme wealth, and have included some pertinent information about their hypothetical lives that will be changed by the new tax legislation. The taxpayers are as follows:

  1. Poor – He is single, works 2 jobs, makes $8.46/hr at McDonalds ($17,596.80 a year) and works at church. His income totals $30,000. He has no other streams of income, and pays $695 as an ACA penalty for not affording health insurance. He also rents a 1-bedroom apartment for $930/month.

 

  1. Lower Middle – He is married with 1 child, makes $13/hr at a retail sales job ($26k a year) and $9/hr in fast food part time ($40k total income a year) and his wife makes $20k in retail, giving them $60,000 a year in income. He contributes 5% to his 401(k) plan, has an ACA silver plan for his family for $700/month. He also has student loans of $45,000 at 4% interest, and pays $400 a month in loan payments with interest included of $81 a month.

 

  1. Middle – He is married with 2 children, makes a $35,000 salary as a pharmacy technician. His wife makes $30,000 as a teacher, giving them $65,000 in income. He has a mortgage of $350,000 at 3.75% interest, with a monthly payment of $1,655 and average interest included of $682. He pays $5,000 in property taxes per year, and he has the same student loan situation as #2 above. He has health insurance through work, with a $250/month family plan premium. He also has a $400/month alimony payment. Finally, he lives in Oregon, which has a 9.9% state income tax.

 

  1. Upper Middle – He is married with 3 children, he makes $100,000 as a lawyer his wife makes $50,000 as a nurse, giving them $150,000 in annual income. He has a mortgage of $550,000 at 3.75% interest, making monthly payments of $2,786 with $1,258 of average interest. He lives in California, paying 13.3% in state income taxes and $10,000 in property taxes. He has family health insurance for $300 a month, and the same student loan situation as the previous two individuals. He also has a home equity line of credit (HELOC) of $50,000 with 4.5% interest, with monthly payments of $518 and interest included of $187. He donates $5,000 every year.

 

  1. Rich – He is married with 2 children, with a net worth of $11 million. He works at a Private Equity firm making $350,000 a year base salary, plus 2% carried interest on acquired companies. His wife does not work, and he has paid off his mortgage and his student loans. He lives in New York, paying 8.82% state income tax and $12,000 property taxes. He is a shareholder of an S-Corporation that buys and sells residential real estate that nets him $50,000 a year in capital gain income, and he donates $50,000 every year. He has free health insurance through his executive compensation, has Incentive Stock Options through his firm and pays $3,000 for a CPA to prepare his taxes.

 

Due to the size of this tax bill, this post will focus on the individual side, and the business and foreign side will be covered in a separate post.

The individual income tax rates under the current tax code and the new tax code are compared in the source documents below.


What’s In the New Plan

The new plan takes out many deductions, in order to ‘broaden the base’ of taxable income. To compensate for this, the seven marginal rates are taken down a few percentage points. The full list of individual changes are shown in the source document below, but I will highlight a few major ones that will affect our analysis.

The Standard Deduction, the deduction taxpayers automatically take if they do not itemize, is nearly doubled. The original deduction is $6,350 for single filers and $12,700 for married filers. The new deduction is $12,000 for a single filer and $24,000 for married filers.

The personal exemption, a dollar amount exempted from taxable income for every person on a return, is suspended. The exemption amount under the current system is $4,050 a person, now it is $0.

Above-the-line deductions, like student loan interest, alimony payments, and teaching expenses, are fully deductible under the current plan, meaning you can reduce your gross income by the amount paid on these items. These items will go away under the new plan.

Most itemized deductions will go away under the new plan. A taxpayer can itemize their deductions if they total more than the standard deduction. These deductions include medical expenses, charitable contributions, State & Local Taxes (SALT), Property Taxes, Mortgage & other loan interest, as well as miscellaneous expenses like Tax Prep Fees and Theft losses. These are subject to various income limitations, with the lowest being 2% of Adjusted Gross Income (meaning if these deductions are less than 2% of your AGI, you cannot take them). Under the new plan, most of these deductions are completely repealed, but you can claim a reduced mortgage interest deduction, a combined deduction of SALT and Property taxes to a maximum of $10,000, and the full charitable contribution deduction. But bear in mind that the standard deduction is doubled, so many less taxpayers will be itemizing.


The Comparison

  1. Poor taxpayer does not have many taxable events. Under the current tax system, his $35,000 of income is taxed as follows:

 

$35,000 adjusted gross income

$6,350 standard deduction          –

$4,050 personal exemption         –

$24,600 taxable income

 

(10% x 9,525) + (15% x 15,075) = $3,213 in tax paid. Add the $695 ACA penalty, Poor owes a tax of $3,908.75.

 

Under the new tax system, his same $35,000 of income is taxed as follows:

 

$35,000 adjusted gross income

$12,000 standard deduction     –

$23,000 taxable income

 

(10% x $9.525) + (12% x $13.475) = $2,569.50 in tax paid. There is no ACA penalty, so this is his total.

 

Poor does indeed get a substantial tax cut in the new plan, of $1,339.25.

 

  1. Lower Middle taxpayer has a few more taxable events, including some deductions both above-the-line and below-the-line (meaning deductions taken both before and after calculating adjusted gross income). His $60,000 in income is taxed as follows:

 

$60,000 income

$972 student loan interest deduction ($81 x 12)               –

$59,028 adjusted gross income

$12,700 standard deduction ($6,350 x 2)                            –

$12,150 personal exemptions ($4,050 x 3)                          –

$34,178 taxable income

 

(10% x 19,050) + (15% x $15,128) = $4,174.20 in tax paid. There is no ACA penalty from this point forward, so no additional taxes are owed because of this.

 

Under the new plan, his same $60,000 of income is taxed as follows:

 

$60,000 adjusted gross income

$24,000 standard deduction ($12,000 x 2)                            –

$36,000 taxable income

 

(10% x $19,050) + (12% x $16,950) = $3,939 in taxes paid. Lower Middle does get a tax cut under this plan as well, but a much smaller one, of about $235.

 

  1. As we get to the Middle income taxpayer, the situation becomes even more complex, with more deductions and additional taxes to consider. Under the original tax plan, Middle’s $65,000 of income is taxed as follows:

 

$65,000 income

$972 student loan interest deduction                                     –

$4,800 alimony exclusion                                                          –

$59,228 adjusted gross income

$16,200 personal exemptions ($4,050 x 4)                           –

$8,184 mortgage interest deduction ($682 x 12)                 –

$5,000 property tax deduction                                                –

$4,558 state tax deduction (9.9% x taxable income)           –

$25,286 taxable income

 

(10% x $19,050) + (15% x $6,236) = $2,840.4 of taxes paid

 

Under the new tax plan, his same $65,000 is taxed as follows:

 

$65,000 adjusted taxable income

$24,000 standard deduction                                                   –

$41,000 taxable income

 

(10% x $19,050) + (12% x $21,950) = $4,539 in tax paid.

 

Middle was able to take advantage of a few deductions under the old code, but most go away under the new one. As a result, his income taxes nearly double, increasing by $1,698.60.

 

  1. Upper Middle has perhaps the most complex tax situation of them all, with even more items to consider: Under the original plan, his $150,000 is taxed as follows:

 

$150,000 income

$972 student loan deduction                                                         –

$149,028 adjusted gross income

$20,250 personal exemptions ($4,050 x 5)                                 –

$15,096 mortgage interest deduction ($1,258 x 12)                 –

$10,000 property tax deduction                                                   –

$2,244 HELOC interest deduction ($187 x 12)                            –

$5,000 charitable contribution deduction                                  –

$12,826 state income tax deduction                                            –

$83,112 taxable income

 

(10% x $19,050) + (15% x $58,350) + (25% x $5,712) = $12,085.50 in taxes paid.

 

Under the new tax plan, the same $150,000 of income is taxed as follows:

 

$150,00 adjusted gross income

$10,000 combined SALT and Property limitation                     –

$5,000 charitable contribution deduction                                 –

$15,096 mortgage interest deduction                                        –

$119,094 taxable income

,

(10% x $19,050) + (12% x $58,350) + (22% x $42,504) = $18,257.88 in taxes paid

 

If you aren’t seeing the pattern forming here, the more deductions you currently take under the current plan, the more your taxable income will increase under the new plan. The lower rates are not enough to compensate for your increased taxable income, and in the case of Upper Middle, his taxes increase by $6,172.38.

 

  1. Rich taxpayer is on a level unlike the previous four. He does not have as many deductions, but he has more streams of income, and that gets him preferential tax treatment under some provisions in the new law. Under the current law, his exemptions begin to phase out after $145,000 of income, and he has none remaining. His income is taxed as follows:

 

$350,000 adjusted gross income

$12,000 property tax deduction                                                –

$3,000 Tax Prep Fee deduction                                                 –

$50,000 charitable contribution deduction                            –

$25,137 state income tax deduction                                        –

$256,863 taxable income

 

(10% x $19,050) + (15% x $58,350) + (25% x $78,750) + (28% x $81,850) + (33% x $21,863) = $60,463.79 in ordinary taxes paid, and (15% x $50,000) = $7,500 in capital gains taxes paid, netting a total of $67,963.79 in total taxes paid.

 

Under the new system, his income is taxed as follows:

 

$350,000 adjusted gross income

$10,000 SALT & property tax deduction limitation              –

$50,000 charitable contribution deduction                           –

$290,000 taxable income

 

(10% x $19,050) + (12% x $58,350) + (22% x $87,600) + (24% x $125,000) = $58,179 in ordinary taxes paid, and (15% x $50,000) = $7,500 in capital gains taxes paid, netting a total of $65,679 in total taxes paid.

 

Rich taxpayer has deduction limitations under both plans, but his top rates are significantly lower than the top rates of the three middle income taxpayers, giving him a significantly more favorable overall tax, and a savings of $2,284.79. The higher in income you go, the more you will be able to save through the lower top marginal rates.

 

As you can see, the results of the new tax plan’s changes are varied, and do not fall neatly within one particular set of political talking points. The working poor will see a tax cut under this plan, as will the very rich. Those in the middle, the taxpayers who can use the most deductions and who all of us consider the Middle Class, would see their taxes go up, significantly in some cases. Obviously this depends on the particular circumstances of each taxpayer, but that seems to be the trend. We will cover the rest of the changes in the next post, but hopefully this analysis will help us understand exactly what changes we can expect.

 

Sources:

 

Individual changes write up: https://docs.google.com/document/d/1StjeoOmJdLPyZDbxQMHuMYGSD1VrxQAPbFz0yveX24E/edit?usp=sharing

 

Joint Explanatory Statement (Final version of Tax Plan): http://www.wsj.com/public/resources/documents/JointExplanatoryStatement121517.pdf

Fiscal Policy Part 1: Do Tax Cuts Pay for Themselves?

The economic news of the day is centered on the Republicans’ tax reform bills becoming law, and what their effects will be. Rather than debate over political lines about the pros and cons of this particular piece of policy, I want to take this opportunity to address certain aspects of Fiscal Policy as a whole. As a reminder, Monetary Policy refers to policy from the Federal Reserve, such as changing the supply of money, bank reserves, and interest rates. Fiscal Policy, on the other hand, comes from the Federal Government, in the form of the tax code and government spending/borrowing. This set of posts will focus on the latter, starting with the backbone of tax plans: do they pay for themselves?

The chief argument for cutting individual taxes is thus: The Federal Government is inefficient and takes money out of the private sector that people could use to benefit themselves if they were allowed to hold on to it. If people were allowed to keep more of their earned income, they could spend it on additional goods and services, or invest it and be more financially stable. The argument for cutting corporate taxes is roughly the same, that if businesses were allowed to keep more money that they earned, they could invest it in better equipment or more workers, boosting nationwide GDP. This boosted GDP would in turn create more tax revenue because of the broader ‘base’ of taxpayers (additional corporate entities, more individuals in the workforce) and would offset the initial loss of revenue created by the cuts.

To its credit, this theory does come from sound economics. In the Keynesian business cycle, the economy digs itself from out of a recession by deficit spending, and a way to do that is by cutting taxes and giving people more money to spend. Spending more money on goods and services incentivises businesses to produce and hire more, and the growth that comes from that would restore the economy to normal levels.

On a static basis, the answer to our question is a resounding No. Cutting taxes does not lead to additional tax revenue. Pretty self explanatory really. But proponents of this kind of Fiscal Policy would prefer it be judged on a dynamic basis, that is, a basis that takes into account the effects of additional growth.

I should tell you now that, if you’ve read my last write up on the business cycle, you would know that I do not think producers have as significant an effect on spending as consumers do. By extension, I do not think that cutting business taxes stimulates higher economic growth. But facts are more important than opinions, and there is data we can look at to see how our original question can be answered. Logically, the only way a revenue-negative tax plan can pay for itself is through more taxes taken in from additional economic activity.

I have provided some data links at the bottom of this page that show GDP growth for certain years at certain corporate tax rates. A common political talking point is that GDP growth used to be a lot higher than it is now, and that we can get back to those levels if we cut taxes. Looking at the data, we see that GDP growth was highest when we had higher tax rates, with tax rates in the 80s and 90s, and the change in GDP has generally gotten smaller over time. A longer, future article will delve into this trend in much more detail, but suffice it to say for now that GDP growth is not and should not be the end all measurement for economic performance as it relates to tax policy, as it is influenced by many different factors having nothing to do with taxes, and that the downward trend of GDP growth is part of a larger theory on developed nation performance and is looked at too negatively.

The data still does show that at a higher marginal tax rate, especially for businesses, GDP does tend to gain higher. Surely that could not be the case, if those businesses were better handlers of their money than the government and could stimulate growth in a better way? Again, a further article will explore another growing trend, but in recent decades, higher corporate profits have translated into stock buybacks and higher management compensation more so than higher wages and increased investment.

Having established that GDP growth is on a low and predictable decline (for several good reasons), the only way for tax cuts to pay for themselves would be through similar cuts in government spending. Without getting bogged down in the political weeds, I will simply say that the government ran a $676 billion deficit last year, and the national debt recently crossed $20.5 trillion this year. The most recent tax cut plan will assume just over $1.4 trillion in additional debt over 10 years, so $140 billion a year. Democrats and Republicans both have spending items they want to see shrunk and spending items tbey want to see expanded, and I do not see this number shrinking too much in the near future. Additionally, as tax revenues shrink and spending does not, the government will need to borrow more, and issuing more government bonds will raise the effective interest rate on those bonds. The government will have to pay more in interest as a consequence. If you want to track where the debt is, I have included the website on the bottom of this page.

But doesn’t tax policy have any effect on GDP? The answer is yes, through not as much as proponents of cuts would have you believe. Taxation takes money away from the Consumption function of GDP, shown as 1-T = C. The bigger T is, in theory, the smaller C can be. However, the corollary theory would show that making T smaller does not necessarily increase C by a proportional amount. This is the Marginal Propensity to Consume function, defined as MPC = N, where N is a number between zero and one. If N is 0.5, then for every additional dollar a consumer earns, he will only spend 50 cents. Every consumer’s MPC is different, and it is nearly impossible to map a constant MPC for an entire population, but the point of this function is to show that an additional dollar saved does not equate to an additional dollar spent. As wages continue to flatten and costs continue to rise, I expect to see most consumers increase their propensity to save, and decrease their propensity to consume.

These are just a few of the things that need to be looked at if policymakers want to make sure that cutting taxes leads to increased tax revenue. I think, based on the information I have gone over, that the answer is no, they do not. This page is the first of a series on Fiscal Policy, and you can expect more soon!

Sources:

https://www.cbpp.org/research/tax-cuts-myths-and-realities

http://www.usdebtclock.org

http://politicsthatwork.com/graphs/top-gdp-and-tax-rate