In the last piece, I evaluated the Tax Cuts and Jobs Act of 2017 in terms of the goals of tax reform that I wrote about last year. However, my nerdy, tax policy-oriented approach is far from the most popular way to look at this legislation. Instead, a massive amount of ink spilled over the new law was used in determining who the “winners” and “losers” are. (To prove my point, every word in this sentence is linked to a different article on that topic.) So, while the last article talked about what the tax law actually did and whether that was good from a tax policy perspective, today I’m addressing the perceived impact of the tax law and assessing the accuracy of some of the most common winner/loser assessments.
The perceptions addressed aren’t always totally wrong, but they all invite some more careful analysis which proves that the reverse-Robin Hood narrative (“tax law gives to the rich and robs from the poor”) is seriously flawed. In this article, we’ll look at this assertion in both its most direct terms and in terms of the claim that the new tax law helps corporations while hurting individuals. Come back for Part II, where we look at whether the law targets Democrats and kills charities.
Perception: This is a victory for the rich at the expense of the poor.
Correction: The tax law cuts tax rates for virtually everyone, and taxes are not a strict zero-sum game.
There are plenty of charts out there showing that the after-tax income of the richest quarter of the country will be going up the most under the new law, with the most concentrated benefit going to those just below the top 1%. So, why isn’t this proof that the rich are winning and the poor are losing? Because of two important qualifications: why the distribution looks like it does, and what we mean by “losing.”
Figuring out why the distribution is what it is takes more than looking at whose individual tax rates went down, since the bulk of that benefit is in the middle bracket. The two big reasons why tax rates dropped more for people at the top end of the spectrum are that the corporate rate came way down and the law added a new deduction for pass-through (non-corporate) business income.1 I will address the corporate rate reduction a little more with the next point, but the pass-through deduction is targeted to benefit to those making less than $207,500 ($415,000 for joint filers). While this puts those earners in the top 5-20% of all taxpayers, pass-through income goes to the owners of a company, and the people who are predominantly pulling in that sort of money as part of their ownership stake in a company tend to be part of small to mid-size partnerships, LLCs, and the like. That is, you can look at this as either a tax benefit to wealthy individuals or a benefit to small businesses. You can’t really help the latter without helping the former, so judging the tax bill should not be driven solely by feelings about rich people.
The other big assumption about the winner/loser approach in general is that it typically treats taxation as a zero-sum game. That is, if one group fails to benefit (or fails to benefit equally) from the tax bill, this equates to being harmed by it. If the rich get richer, then that must mean the poor get poorer. However, that’s not exactly how this works. As mentioned before, the new tax law cut taxes for almost everyone, which means that most families that pay taxes will take home noticeably more next year. True, the tax law did not expand the Earned Income Tax Credit or make the entire Child Tax Credit refundable, as Senator Marco Rubio pushed for, but the failure to expand social welfare programs is not the same as cutting them. Given what the government budget looks like (which I’ll get to in the last article), tax policy and spending choices clearly don’t equate on a one-to-one basis.
In other words, on an out-of-the-gate judgment, the new tax law is a windfall of varying degrees for most people, meaning that it puts extra money into the economy (the extra money in the economy is projected to end up boosting our Gross Domestic Product, or GDP, by between .4 and .6% ).2 We may argue over who’s getting how much of the economic pie, but we’re almost all getting more pie, and that’s not necessarily a loss.
Perception: This is a victory for corporations and a loss for individual taxpayers.
Correction: This is a victory for corporations and a political time-bomb that will still most likely benefit individual taxpayers.
There’s no two ways about it: the new tax law is a boon to businesses of virtually all stripes, especially corporations. Last April, I talked about how the U.S. taxes corporations differently, and I mentioned in the last article that the new tax law eliminates some disincentives and establishes new incentives for corporations to invest in the domestic economy. In addition to the rate reduction and the capital repatriation issue I’ve mentioned, there were major changes to two other big areas of incentives: depreciation and interest.
I’ll dip slightly into the weeds to explain this, so if that’s intimidating, just skip the next two paragraphs with the knowledge that the changes incentivize more capital investment and less debt-financing.
Now, into the weeds. Businesses are generally taxed on profits, which means they can deduct their expenses against their revenues in figuring out their tax bills. When a company buys, say, a new truck, this expense would therefore offset a good chunk of revenue. Depreciation rules prevent a company from deducting all of that expense in one year and instead spread that deduction out over the useful life of the purchase. The new tax law allows much faster depreciation, even allowing a large number of purchases to be depreciated entirely in the first year.3 This essentially allows a company to expense many of its costs up front, which is a massive incentive to invest in business infrastructure.
The other big incentive tweak is the way that interest payments are handled under the new law. Under the old system, there have long been a number of powerful incentives in favor of choosing to finance big new purchases and corporate acquisitions by borrowing money. For one, taking out a loan creates a liability that offsets the money received, so there’s no tax associated with getting that money on hand right now (because there’s no profit). Secondly, the owners of the company might prefer to use debt over equity (that is, issuing new shares), because debt won’t dilute the ownership shares of the existing shareholders. Lastly, and very importantly, the interest payments a company makes on the debt it carries are generally deductible as ordinary business expenses. This means that there are corporations who have value on the market because they have a lot of high-interest loans which can help shelter the profits of any company that acquires them. It also means that the tax system itself favors debt over equity, which creates a distortion in the economy in favor of debt and, consequently, risk. The new law sharply reduces the deductibility of interest payments to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA), then reduces them to an even smaller calculation in 2022. This, along with the lower overall tax rate, is an important step to reining in excessive debt-financing in a way that could have important stabilizing effects for the whole economy.
For those of you who skipped our little excursion into the weeds, welcome back! For everyone, the upshot of this is that the new tax law is clearly a victory for corporations, but the low rate that corporations wanted comes with incentives to move overseas cash back to America, the possibility of investing in new improvements to company infrastructure, and a disincentive to deepen Corporate America’s love affair with using debt to buy things. These are not just good things for corporations, but should be healthy changes for the American economy overall.
Lastly, the real lynchpin to the reverse-Robin Hood tagline is tied to the fact that the lowering of the individual income tax rate is temporary. In order to push through the new tax changes as a budget reconciliation item that needed only a majority to pass the Senate without a Democratic filibuster, the Republicans set a number of provisions of the new tax law to expire in 2025. Virtually all assessments that have “individual taxpayers” in the loser column are doing so on the assumption that the individual tax cuts will expire. Of course, Republicans are banking on the fact that allowing individual tax rates to jump back up will look like political suicide to future lawmakers, and the cuts will in fact be extended.
Now, nothing is certain, but if 2012 is instructive, then it’s a reasonably safe bet that these changes will be made permanent. Further, the Republicans seem to have learned from the 2012 fiscal cliff debate by setting only the hottest of political potatoes to expire: rather than see the estate tax or higher corporate rates come back, the political debate in the future will be about hitting middle class families with higher taxes. I’ll address the political gamesmanship involved in this process in the last piece, but, for our purposes here, it’s somewhat ignorant (or, more likely, disingenuous) of realpolitik to assume that the tax cuts to individuals will expire, and, with those in place, the overall bill is far less of a giveaway than it is sometimes claimed to be.
Perception: This is a victory for Red States over Blue States.
Correction: The changes to the individual income tax are better for people who will claim the standard deduction and are more likely to mean less to people in high tax/high-cost states.
The biggest reason why many winner/loser tallies put blue states in the loser column is that Democrat-leaning states are more likely to have both a high cost of living and a high tax burden on residents. This is not universally true, but it is certainly true of states like California and New York, which lean so solidly left that Donald Trump wrote off California nearly entirely in his presidential bid. It’s also not unreasonable to come to this reading based on the lingering open hostility between the President and the governing officials of California. However, the fit is not exact, and, if we look at the three factors that cause analysts to judge blue states as losers in the new law, we can have a better appreciation of what the target really is.
The three factors that led some to conclude that this law targets Democrat-leaning states are the changes to the Mortgage Interest Deduction, the limit on state and local tax deduction, and the distributive effects of doubling the standard deduction.
As I mentioned before, the new tax law significantly alters the way that the Mortgage Interest Deduction is calculated. It does so in two major ways: first, by reducing the cap on how much of a new mortgage (pre-2018 mortgages are grandfathered) is deductible down from $1 million to $750,000, and, second, by doing away with a deduction for home equity loans which are not spent to improve an eligible home.
These changes will definitely impact people in high-cost locales like San Francisco, but it’s inaccurate to think of these changes as targeting Democrat voters. First, while there are definitely a few cities and some states that have a median sale price nearing or exceeding that number, it’s far less prevalent than a strict partisan analysis would suggest. Second, one of the defining features of a high-cost area is that more people rent homes, because the average person, Democrat or not, still can’t afford a $1 million house.
In other words, if the law is targeting Democrats, it’s going after the rich ones. Lastly, dropping the deductibility of cashing out a home equity loan has nothing at all to do with partisan politics.4 None of this even takes into account that economists on both sides of the aisle generally hate the Mortgage Interest Deduction as a regressive5 tax policy which only becomes more so with the doubling of the standard deduction. In other words, the primary effect of the changes to the Mortgage Interest Deduction is to make the law less of a handout to the rich, not to punish Democrats.
The new tax law also reduces the total deduction available for state and local taxes (SALT) to a cap of $10,000. The logic of the targeting theory is that the cap on this deduction will disproportionately affect states with higher tax burdens, and that the states with higher taxes lean Democrat. Interestingly enough, this isn’t totally true. Based on information about the percentage of taxpayers who claimed the SALT deduction in 2014, we can see that several solid red states, like Utah and Georgia, had more than 30% of their residents claiming the deduction. When looking at the size of the average deduction claimed, solid blue states do top the list, but many swing states are not far off. Really, the better unifying logic about the cap on the SALT deduction is that it impacts the wealthy, who are the major benefactors of this strongly regressive tax benefit.
In other words, like the Mortgage Interest Deduction, the primary target of the SALT deduction limitation is again the wealthy, not specifically Democrats.
The last potential argument for why the new tax law is a loss for blue state residents is really derived from all the things we’ve talked about so far. Doubling the standard deduction means that many more taxpayers will be claiming that instead of itemizing in 2018. By the Tax Policy Center’s projections, the total number of itemizers may drop by almost 60%, to as low as 11% of all taxpayers. As a result, many of the 26 million or so people who switch from itemizing to taking the standard deduction will see less of a drop in their tax bill than people who previously claimed the standard deduction. However, the distribution of itemizers who will see this lesser benefit is even less defined by partisan divides than the previous two issues.
Overall, the reality is that over 75% of Americans will see lower taxes under the new law, while only about 9% (progressively distributed) will see increases. Just like I mentioned when addressing the reverse-Robin Hood narrative, if the pie is after-tax income, almost everyone is getting more pie, and it’s not necessarily losing to get more pie. Based on the factors we’ve discussed, it’s more likely that individuals in high tax or high-cost states will receive less of a benefit, but the specific changes have largely progressive effects.
I guess if you’re dead-set on saying that the new law targets Democrats, it’s targeting relatively wealthy ones, but aren’t those the people who say they can afford to pay more taxes anyway?
Perception: This is a big loss for charities.
Correction: Charitable giving may slightly decrease under the new tax law, but most people don’t really choose to give based on the tax treatment of their donations.
The last big perception that I’ll address is the concern that the changes to the tax law will result in less charitable giving. The roots of this concern lie in the large reduction in the number of people itemizing deductions, since you can only claim a deduction for giving if you itemize. Further, the reduction in overall tax rates means that the marginal tax value of each dollar donated is reduced. Lastly, the exemption from the gift and estate tax was doubled from $5 million to $10 million, meaning that only estates exceeding that amount (roughly 2,000 in the U.S.) are subject to taxation. The net effect of these changes is to remove or weaken a number of tax incentives that favor donating money to a charity, and the fear is that weakened incentives mean less giving and thus “devastation” for America’s charitable organizations.
This conclusion is wrong for two major reasons: effect size, and underlying assumptions. The first leg of the “devastation” narrative is rooted in predictions by the Council on Foundations that the new tax law will cut charitable giving by $16-24 billion a year. This is a huge number, but it’s only 4-6% of the $390 billion Americans are estimated to have given to charities in the past year. That’s not an insignificant drop, but it won’t be evenly distributed among charities, so an organization should first look to its donor base and determine whether they represent a class of people likely to alter their giving as a result of the tax changes. Looking to the underlying assumptions made in concluding that people will stop giving, it becomes clear that the affected class is likely to be rather small.
The devastation perception makes the glaring assumption here that people give because it gives them a tax benefit, but there are good reasons to doubt this assumption—based on both who is affected and why anyone gives.
First, the primary tax incentive only exists for those who itemize. Around 20% of the money given to charities comes from people who already claim the standard deduction, so that group is unaffected by the change. With respect to the rest, it is really individuals who make more than $500,000 a year who are most significantly impacted by tax changes. However, the number of these taxpayers likely to stop itemizing is far, far smaller than the drop in overall itemizers. Second, the wealthiest individuals are also more likely to give a larger portion of their wealth away as they become increasingly wealthy, so the reduction in tax rate is partially offset by greater wealth. Lastly, the estate tax incentives already apply to a vanishingly small group, and giving as part of estate planning is a very small part of the overall giving that Americans do.
In other words, the tax changes may not affect the deductibility equation for most givers.
Even for the givers potentially affected by the new law, the assumption of reduced giving rests on the assumption that people who receive a tax benefit are motivated by that benefit. Of those making less than $500,000 a year, economic analysis suggests that these givers are much less motivated by tax incentives. This makes sense when 47% of charitable giving in the United States is directed to religious and educational institutions. In both of those cases, one would fully expect that spiritual incentives, institutional loyalty, or other personal motivators would far eclipse tax considerations in the decision of whether or not to donate. As I mentioned before, a 4-6% drop in giving won’t be across the board, so there are many reasons not to buy the devastation narrative, especially for churches and schools.
Overall, the impact of the new tax law, judged independently, is not as dire as many public perceptions cast it. In fact, many, if not most, will probably benefit from it in immediate and tangible ways. I graded the law itself at a B-, which—at least in the era before grade inflation—was a mildly positive rating. And from the perspective of its direct impact, I think it’s fair to maintain that conclusion.
However, this was not a law passed in a vacuum, and there are a number of factors in the broader political context of the Tax Cuts and Jobs Act of 2017 that I find far more sobering if not downright scary. We’ll turn to those issues in the last piece of this series.
- This is a deduction for income that comes through so-called “pass through” entities, like partnerships, which are not subject to the corporate income tax.
- This may not seem like much, but remember that we’re talking about stupidly large numbers here, so that equates to well over $100 billion higher.
- If you really want to dive into the weeds on this, try here.
- Instead, this change is actually a fix for a loophole created the last time we did tax reform. Prior to 1986, credit card interest was deductible. This was an undesirable incentive toward debt which was eliminated; however, the equity loan deduction that was added allowed for a workaround to the old system that let a taxpayer cash out a home equity loan and still enjoy deductibility of debt incurred to buy the same sorts of things.
- The benefit of the deduction is overwhelmingly for the wealthy and unclaimed by nearly 75% of Americans.
This post was originally published as two parts for In All Things on April 11, 2018 and April 12, 2018, and is cross-posted with permission. The original versions of this post can be found here:
Part 1: https://inallthings.org/fact-checking-claims-about-winners-and-losers-with-new-tax-reform-part-i/
Part 2: https://inallthings.org/fact-checking-claims-about-winners-and-losers-with-new-tax-reform-part-ii/