A lot of people in the personal finance space tune out politics and recommend that their readers do the same. I don’t agree with this approach. I follow politics closely and stay up to date on policy proposals and all sorts of nerdy wonkery.
That said, when approaching topics for this blog, I make sure that every article has a takeaway that you can use to directly improve your life. That rule helps me stay focused on helping people with my writing rather than just writing about areas of my own interest. This also means I usually don’t discuss policy proposals making their way through Congress.
In the case of the current tax overhaul, I decided that it is worth discussing here.
Everyone is affected by the tax code. This plan includes very big changes to the tax code.
This plan will change the taxes that you pay for better or for worse.
Importantly, it is also in the early stages. Republicans have indicated that in contrast to the health care bills, they plan to send the tax reform bill through the committee process. It will face hearings, amendments, and votes.
I hope that this review and analysis will help you determine which parts of the plan you like and which you don’t. You can then call your Representative and your Senators.
This plan will change based on the inputs of Representatives and Senators. The opinions and priorities of Representatives and Senators will change based on the inputs of their constituents.
Be your own lobbyist and help shape the tax code in a way that you think is most fair.
An Introduction to Comprehensive Tax Reform
The tax code is complicated.
I don’t think I’m breaking any new ground or making any sort of controversial statement in saying that. The idea of simplifying the tax code is popular.
The disagreements show up when you start proposing specifics. This is why plans for “comprehensive tax reform” tend to devolve into simply tinkering with the rates and making a couple changes around the edges.
The Trump Administration and the Republican Congress are coming back to take another swing at comprehensive tax reform. And, with control of the White House, the House of Representatives, and the Senate, they might actually get something passed.
A group of six Republicans – two from the administration, two from the House, and two from the Senate, has been working on this for months and have recently released a “Unified Framework” for overhauling the American individual and corporate tax codes.
The framework leaves a lot of details up to Congress. It is only nine pages long, which includes a cover page and a whole lot of blank space.
That said, there are a lot of changes and a lot of implications within those pages and I want to examine them with you today.
Tax Reform Goals
According to the framework, the number one goal for this tax reform is to “make the tax code simple, fair and easy to understand.”
This plan certainly makes the tax code simpler. We’re still a long way from simple, though. Whether it is “fair” is a subjective judgment that I will leave up to you.
The plan outlines eight big changes that will be made to the individual tax structure followed by eight changes to the business tax structure.
As most of you are probably more interested in the individual changes, we’ll start there.
Individual Income Tax
Standard Deduction Changes
The first big change is the elimination of the personal exemption and the increase of the standard deduction.
Under the new system, the standard deductions would be:
- $24,000 for married filing jointly
- $12,000 for single
Under the current system, the standard deductions are:
- $12,600 for married filing jointly
- $6,300 for single
- $9,300 for head of household
- Plus, a $4,050 exemption for each member of your household
Here are some examples of what this means for the deductions of families in different positions:
- Married with no kids goes from $20,700 to $24,000
- Married with two kids goes from $28,800 to $24,000
- Single with no kids goes from $10,350 to $12,000
- Single with two kids (head of household) goes from $17,400 to $12,000.
Basically, this change helps you if you have no children and hurts you if you have them. The more children you have, the bigger a tax increase you will have under the new system.
The framework explains that the elimination of the personal exemption is “fundamental to a simpler, fairer system.” Again, I’ll let you decide your own view of the fairness, but it does create a simpler system. By increasing the standard deduction (along with eliminating itemized deductions, which we will discuss later) far more people will claim the standard deduction under the new system.
For those people, the preparation of their tax returns will be easier. Whether, and how much, they’ll benefit beyond that ease will be based on how many children they have.
The current tax code includes a number of different expenses that can be considered an itemized deduction. If you add those items up and they are more than the standard deduction, you can use that number as your deduction instead of the standardized deduction.
Currently, just over 30% of households itemize. Most of that is concentrated in the higher income brackets.
The new plan keeps the same structure in place, but eliminates almost all of the actual deductions that may be included.
The framework maintains the home mortgage interest deduction and the deduction for charitable contributions. It eliminates everything else, including deductions for state, local, and foreign income taxes, state and local property taxes, medical expenses, and unreimbursed business expenses.
Especially relevant to this year is the decision to eliminate the deduction for disaster and casualty losses. Under the current system, this allows you to get a break on your taxes if you have suffered major losses due to hurricanes or other disasters.
With all of these changes, along with those discussed in the previous sections, it is predicted that 84% of the households that currently itemize will switch to the standard deduction. This would mean that the vast majority of people would claim the simpler standard deduction and would not consider the more complex itemizing.
Before discussing the tax rates, I want to give a super quick explanation of marginal rates as compared to effective rates. Apologies if you already understand this, but I’ve encountered a very high number of intelligent people who don’t, so a quick refresher can’t hurt.
Last year, the 10% tax rate applied to a single person making up to $9,275, and the 15% rate applied up to $37,650. What this means is that no matter how much you made in 2016, the first $9,275 were taxed at 10%. The dollars between $9,275 and $37,650 were taxed at the 15% rate.
If you made $9,300, the 15% tax rate only applied to $25 of your income. The rest stays at the 10% rate. Crossing an income threshold and moving up to the next marginal tax rate does not make that rate apply to all of your income. Please please please do not turn down a raise because you think you’ll lose money after taxes. (I have seen this happen before. Don’t be that guy.)
Phew. Now that that is out of the way…
The framework says that we will have three marginal rates: 12%, 25%, and 35%. (It also includes a note that Congress may choose to add an additional higher rate on top, but I’m not holding my breath.)
Our current system includes rates at 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
The framework does not indicate what incomes are attached to what rates, so it difficult to draw a direct comparison between the two systems. However, the non-partisan Tax Policy Center ran the numbers by plugging in income brackets from other recent Republican tax reform proposals.
That analysis found that on average, each income quintile will see a tax cut based on these changes at first. Now, two phrases in that sentence need explanations.
First, each income group “on average” will receive a tax cut. This is because, as we discussed before, the changes hurt families with more children. The majority of people will get a tax cut, but a significant number will get an increase instead.
Next, each income group will get a tax cut “at first.” There is a key change in tax policy buried in a single sentence that most media outlets appear to be overlooking (or at least under-covering).
“The framework also envisions the use of a more accurate measure of inflation for purposes of indexing the tax brackets and other tax parameters.”
One way to make sure that your budgets, taxes, and entitlement programs can keep up with the times is by indexing them to inflation. This means that the numbers automatically increase every year to match the changing times.
In 1950, the median household income was right around $5,000. If our current income tax brackets were the same as they were back then, most of the country would be in the top bracket! This obviously defeats the purpose of a progressive tax system, so we index our brackets to inflation.
The next question is how to measure inflation. Right now we use a measure called CPI-W. Republicans have recently pushed the idea that we should move to a measure called chained-CPI, which they argue is a more accurate measure of how inflation affects regular people.
Instead of getting into the weeds on the differences here, we can cut to the chase. The important takeaway for this argument is that switching to chained-CPI would mean that our tax brackets adjust more slowly. In turn, that means that more of your money will be taxed at higher rates over time.
Because of this, what starts out as a big tax cut in 2018 becomes a tax cut of 0.5% or less for the bottom 80% of the country by 2027. It becomes a tax increase for families in the 80-95 percentile (currently around $105,000 to $200,000 household income), while staying a 5.8% cut for the top 1% and a 6.4% cut for the top 0.1%.
Child Tax Credit
The framework says that the Child Tax Credit will be increased and that it will be made available to higher-income families. However, it does not say how much of an increase to expect.
The numbers in the Tax Policy Center analysis assume that the credit will be increased from $1,000 to $1,500. This may be low, as Marco Rubio has previously proposed increasing it to $2,500.
On the other hand, the framework already massively increases the deficit with the $1,500 figure, so any increase would either need to be paid for by a tax increase elsewhere or create problems for passing the bill. (Republicans have opted to use the process of reconciliation. This would allow them to pass whatever bill they want without any Democratic votes, but requires the bill to meet a number of requirements. One of these is that it cannot increase the deficit outside of the next ten years.)
It also appears that after meeting with Ivanka Trump who has been pushing for child care tax credits to be included in the process, they have decided that the Child Tax Credit will be sufficient and that no child care costs will be tax deductible or covered by credits.
This will be an important number to watch. A very high Child Tax Credit could make up for the loss of the personal exemption and give large families the tax cut that childless families are already going to get. On the other hand, the larger this credit gets, the more taxes need to be raised elsewhere.
Work, Education, and Retirement
“The framework retains tax benefits that encourage work, higher education and retirement security. The committees are encouraged to simplify these benefits to improve their efficiency and effectiveness. Tax reform will aim to maintain or raise retirement plan participation of workers and the resources available for retirement.”
That’s the whole section. Retain and simplify.
This is pretty loose language and not much to go on. I honestly don’t know what direction Congress will take this. They may just leave all of the work, education, and retirement components of the tax code alone.
Or they may not.
One suggestion that is making the rounds is to switch the tax benefits on 401(k)s from contribution to withdrawal. What this means is that every 401(k) would become a Roth 401(k). Everyone would pay taxes on their income as they put it into their account and then take it out tax-free rather than getting a deduction on their taxes when they contribute and paying taxes when they withdraw as we do now.
This helps Congress because it increases tax revenue in the short term. This gives them a better CBO score, makes the plan look more fiscally responsible, and makes it easier to pass through reconciliation as discussed above.
They could argue that this change would still retain a tax benefit that encourages retirement security because you still get the tax relief on the back-end. Whether they pursue this route or not is still an unknown, but it is an option that has been bandied about.
Other Provisions Affecting Individuals
“Numerous other exemptions, deductions and credits for individuals riddle the tax code. The framework envisions the repeal of these provisions to make the system simpler and fairer for all families and individuals, and allow for lower tax rates.”
Again, this is the entire section.
Clearly the goal is to eliminate as many exemptions, deductions, and credits as possible. We do not know how strongly or weakly Congress will enforce this goal.
However, if you’re looking to eliminate exemptions, deductions, and credits for individuals, the place with the most is probably the Schedule E, which applies to supplemental income.
If you have income from rental real estate, this may be the time to start calling your members of Congress and begging. Right now there are all sorts of deductions that make rental real estate a great deal from a tax perspective. The committees could take a hatchet to that.
Alternative Minimum Tax
The Alternative Minimum Tax is basically a tool to make sure that people with high incomes don’t get to avoid paying taxes by stacking deduction on deduction on deduction. If you have a high income and a lot of deductions, you need to run the numbers under the regular tax rules and the AMT tax rules and then pay whichever tax is higher.
This is an unpopular system and a pretty roundabout way to make sure people are paying enough in taxes. Still, it only affects a very small number of households, and most of those are towards the top of the income spectrum.
In 2016, the share of households that paid the AMT is as follows:
- Under $75,000 – 0%
- $75,000 to $100,000 – 0.3%
- $100,000 to $200,000 – 1.9%
- $200,000 to $500,000 – 30.3%
- $500,000 to $1 million – 62.9%
- Over $1 million – 20.5%
We famously do not know much about Trump’s taxes. All we have seen is two pages from his 2005 return.
However, those two pages showed that Trump got hit with a massive AMT bill that year. Without the AMT he would have paid around $7 million in taxes. With it he paid $38 million.
This plan completely eliminates the AMT without putting a different system in place.
Once again, this is a change that makes the tax system simpler, but maybe not more fair.
Speaking of completely eliminating a tax provision: the estate tax is completely eliminated.
Under current law, very large estates are taxed as the money passes from the deceased to the heirs. The tax rate is 40%, but the first $5.49 million for an individual, or $10.98 million for a couple, is exempted from this tax.
This means that if a couple passes away and leaves $11 million dollars to their kids, they will pay $8,000 in taxes. (40% of $20,000.) If that same family left $10,980,000 to their kids and $20,000 to charity, then no tax would be owed.
Because of this very high exemption, only 0.2% of estates have to pay any tax at all. However, the repeal of the estate tax will cost the government just under $240 billion of revenue.
Before discussing the small business tax rates, I first want to establish the definition of “small business.”
Under the framework, small businesses are defined as “small and family-owned business conducted as sole proprietorships, partnerships and S corporations.”
The short-hand for this is a “pass-through” company, which is a company where the owners pay individual tax rates instead of corporate tax rates.
This definition includes 95% of businesses in America, including the Trump Organization.
Because these businesses now pay taxes under the individual tax rates, the rates are progressive and range from 10% to 39.5%. This plan would cap those taxes at 25%.
The majority of small businesses are already paying under 25%, so this change would not affect most people. However, it would be a sizable tax cut to “small businesses” like the Trump Organization and other closely held businesses that have high profits.
The US has one of the highest corporate tax rates in the world. However, we also have a lot of deductions, credits, and exemptions that corporations can employ. What this ends up meaning is that the tax that US companies actually pay is above average, but roughly comparable to other developed nations.
There has long been agreement that we should lower the rate and eliminate deductions. This could simplify our tax structure, align ourselves more closely to the rest of the developed world, and avoid losing the revenue that would result from cutting the rates without ending deductions.
This plan takes a swing at that. Sort of.
First, the rates.
The framework cuts the corporate tax rate from 35% to 20% and eliminates the corporate Alternative Minimum Tax.
Next, it tackles ending deductions. By identifying one deduction.
While it states that “numerous other special exclusions and deductions will be repealed or restricted,” the only one that the framework identifies is the domestic production deduction, which provides a tax incentive for companies to produce the majority of their goods in the US rather than overseas.
Without deductions identified, this becomes by far the most massive tax cut in the entire proposal, amounting to just under $2 trillion in lost revenue over the next ten years. (For reference, the entire program cuts government revenue by just over $2.4 trillion.)
Right now, any money earned by American companies overseas is taxed when it is brought back to the US. This has led some companies to keep lots of money overseas that they otherwise may have brought back and invested in the US.
The framework addresses this by taxing all cash that is currently overseas at a one-time discounted rate and then completely eliminating the tax on foreign income by US companies for the future.
On the positive side, this would be a simplification of the tax code and would bring us more in line with other developed nations. On the negative, it completely eliminates a stream of income from the government’s toolbox.
Summary of Outcomes
There are still a lot of details to be worked out here, so consider these numbers to be preliminary. However, don’t dismiss them out of hand.
These are the numbers from the first draft of a tax reform bill that has a good chance of actually becoming law. If you don’t like the numbers, then call your Representative and call your Senators. If you don’t participate, you can’t complain about the results.
On to the numbers!
Over the first ten years, this plan would add $2.4 trillion to the deficit. This would grow to $3.2 trillion for the following ten years.
The plan basically consists of a giant tax cut for businesses and a small tax increase for individuals. Tax revenue from businesses shrinks by $2.6 trillion in the first decade and $4.1 trillion in the second. Tax revenue from individual income tax grows by $470 billion in the first decade and by $1.4 trillion in the second.
The reason that individual taxes go up so much in that second decade is because of switching to chained-CPI as a measure of inflation. It will cause taxes to go up gradually, but significantly, over time.
The biggest income generating tools other than switching the inflation numbers come from eliminating personal exemptions followed closely by state and local tax deductions. This means that the biggest losers from this tax plan will be people with children and people that pay higher state income tax or property tax.
As far as income brackets, this plan is worst for families making between $150,000 to $300,000. About a third of those families will see their taxes go up next year under this plan and by the end of the first decade, over 60% will be paying higher taxes under the new system than they would have under the current system.
The biggest winners from this plan will be the top 1% (those making more than $730,000 per year), who would see their after-tax income increase by 8.5%.
If you’re more into charts and numbers than words and paragraphs, I highly recommend checking out the charts in the appendix of the Tax Policy Center analysis, which I found really helpful and interesting.
I put out a call for questions over the last couple days on Twitter and in the Rockstar Finance forums. It was met with a combination of serious and, well, less serious questions. I attempt to answer them all below.
Steve, from Think Save Retire: “The only question I really care about: Does the plan make it easier for us to keep more of our hard-earned money?”
Maybe? For most families this is a moderate tax cut next year that shrinks to a very small tax cut by 2027 and a tax increase shortly thereafter. As some of the biggest losers in the short term end up being folks that were paying big property tax and state income tax bills, I’d imagine that families traveling the country in an Airstream should come out ahead.
Guy on FIRE asks: “Do real estate investors like myself get screwed with the mortgage interest deduction chatter?”
Probably, but the extent depends on the details that Congress supplies. Economists are predicting that the mass exodus from itemized deductions to standard deductions will hurt home values. That’s obviously not great for real estate investors, but may not be too painful if you are a buy and hold investor. I don’t see any reason why this would severely impact the price point or demand for rentals.
On the other hand, the framework recommends cutting a lot of deductions from the individual income tax, and the Schedule E is chock-full of deductions. Depending on how Congress approaches this, you could end up anywhere on the spectrum from no real change to the tax treatment of rental properties to almost no tax benefits at all for rental properties.
ChasesFIsh asked: Why is the home mortgage deduction staying but state income tax isn’t? Should they both be eliminated for lower rates?
If the goal was to lower rates as much as possible, then absolutely. All of the deductions should have been eliminated. My honest answer is that I would imagine that the home mortgage interest deduction had stronger support from lobbying than the state tax deduction.
Plus, when ranked by state income tax, eight of the top ten states are solidly blue states. It might just be fun to poke the other side in the eye. (Joking. Maybe.)
I believe that the argument that you would hear from Republican lawmakers would be something along these lines: It is a valuable service for government to encourage home ownership because it contributes to stable communities. It is not a valuable service for the federal government to subsidize people that choose to live in high tax states. If you don’t like your tax bill in New York, then move to South Dakota.
Or something like that.
NatPhorU added: “So many questions. I think the most succinct one is why is this being considered a plan? This isn’t a plan. This is floating an idea, an abstract at best. I’ve written more comprehensive plans for moving data from one server to another, a simpler task by any measure.”
Fair! This is clearly not a workable change to the tax code as it is. The framework is nine pages. One is a cover page, and the rest is so broadly spaced that you could pretty easily cut out another two and half pages without harming readability at all.
The fact that this team of six Republicans could not agree on more details does not bode well for the ability of the 535 person Congress to fill it in. That said, this is already more thoroughly considered than a couple of healthcare bills that were only a vote or two from becoming law recently. I’ve learned to assume that anything can happen.
Oh, this could be fun. I am going to interpret this as asking (a) which part will the Democrats freak out about unnecessarily, and (b) which parts will Republicans totally overvalue. I will base this on which responses will be (in my opinion) most out of proportion. There are things that Democrats will hate in the proper proportion and things that Republicans will justifiably be happy with.
I expect that Democrats will freak out about the elimination of the AMT and the ceiling on taxes for pass-through companies, but I think those complaints are justified. Instead, my money is on the elimination of the deduction for state and local tax. Based on the way Democrats have worked thus far in 2017, I anticipate the introduction of an awkward and not very catchy slogan for this. Maybe the “Tax on Blue States” or the “Hillary Voter Tax Increase.” Something that will sound convincing to lawmakers, but will not connect with voters at all.
On the Republican side, I think they are already over-hyping the increased standard deduction. The number of times policymakers have touted “almost doubling the standard deduction!” is hitting Despacito levels of annoying.
What they don’t acknowledge is that eliminating the personal exemption eliminates the benefit of this for a huge number of families. Go ahead and brag about simplifying the tax code, but you can’t also brag about the new standard deduction cutting taxes when it raises taxes on every family with kids.
If you made it this far: thanks for sticking with me! I hope that you have learned something and I hope that you will reach out to your Representative and Senator to let them know where you stand.
In the meantime, I would love to chat with you in the comments below. Let me know what you think about the proposed changes. Also feel free to let me know if you think I messed up or missed anything or if you have any questions.