There has been a lot of talk about ‘Tax Reform’ and how it’s going to be a huge windfall for the ‘rich.’ Although this may be true in some instances it’s not the entire truth. In reality the ‘rich’ will be taxed more or less depending on how they earned their income. That’s because the proposed tax reform has less to do with tax breaks and more to do with economic policy. This article will detail why some ‘rich’ taxpayers will receive massive tax cuts while other ‘rich’ taxpayers will see massive tax hikes.
Most Taxpayers See No Change
For most, tax reform isn’t really tax reform – it’s more like tax simplification. According to the Tax Foundation, 30% of taxpayers chose to itemize their deductions instead of claiming the standard deduction. This means that 70% of taxpayers are virtually unaffected by the elimination of some, if not all, itemized deductions.
True, there is an increased standard deduction but it’s almost equivalent to the elimination of the personal exemption. The true tax savings comes in the form of reduced rates but the reduction in rates only saves taxpayers a few hundred dollars in the short run. A few hundred dollars is nothing to scoff at but the tax cut is not intentional – it’s merely a selling point to make the bill more palpable.
But there are hidden tax increases within the bill that all but eliminates these breaks in the long run. For example, the proposed increased child tax credit expires within the decade and a portion of the credit is non-refundable. This means that those who would benefit the most from this credit won’t see any change as compared to the current tax regime.
Another stealthy tax increase is the introduction of the chained CPI. This is a lower rate of inflation than the traditional CPI which means tax brackets and deductions will increase at a slower rate. In essence, taxes will be increased over several years without taxpayers being fully aware.
Stealing From the Rich and Giving to the Wealthy
The key policy proposal in tax reform is a reduction in the corporate tax rate. If you start there then you’ll realize that everything else surrounding tax reform is built on paying for a massive corporate tax cut. So here are the guidelines:
- Cut the corporate tax rate to 20%
- Leave most middle class taxpayers unaffected
- Have a total cost less than $1.5 trillion over the next decade
How is this accomplished? Well it’s simple, go after the largest deductions to pay for a massive corporate tax cut. Couple this with an increased standard deduction and lower rates so that most taxpayers will either pay a little less, a little more, or relatively the same.
But those that benefit from these tax cuts are the ‘rich’ – the top 1%. These are households earning in excess of $400,000 per year. Are they ‘rich?’ You bet. Do they benefit the most from these tax breaks? You’d be correct. However, those earning several million dollars per year (the top .01%) are largely unaffected by the elimination of itemized deductions. Why? Well, when you make several million dollars annually, your itemized deductions are most likely capped and they don’t make a huge impact on your overall tax liability.
If you make several million each year you’d benefit more from a tax rate cut then you would from deduction from your income. “Keep your lousy deductions and give me a tax rate cut” – and that’s exactly what tax reform would do.
Incentivizing Passive Investment
The US tax code already has a massive incentives for passive investors. Although there are limitations on passive income losses, there are several tax incentives if you make the majority of your income from interest, dividends, capital gains, and pass-through entities. Not only do you avoid employment taxes on investment income you also get a lower rate for qualified investment income.
The proposed legislation only exacerbates those incentives by lowering the corporate tax rate and proposing a lower rate on pass-through entities. So, if you own several businesses, hold several real estate investments, get a substantial amount of income from interest, dividends, and capital gains, then your tax rate will be substantially lower than someone who actively works for their money.
If you own and operate your own business and make a substantial amount of income, then that income will be taxed as high as 39.6%. If you are a passive investor in that same business and don’t actively participate in the day-to-day operations then your tax rate could be as low as 25% if the House proposal remains in the final bill.
Putting It All Together
When you really get into the details of the proposed legislation you quickly realize what’s happening. The bill is littered with budgetary gimmicks and tricks to squeeze the total cost under $1.5 trillion. The big-ticket item is the reduction in the corporate tax rate partially paid for by the elimination of several corporate and personal deductions.
The reasoning behind this “reform” is to incentivize capital investment from domestic and foreign investors. This will lead to economic growth and that increased growth will pay for the $1.5 trillion in tax cuts. Or the proposed legislation will just exacerbate income inequality by redistributing income through tax policy. Either way the rich will be taxed and the wealthy will reap massive benefits.