Parsing Tax Reform Legislation
Earlier this month, Congressional Republicans unveiled the details of their much-anticipated tax reform plan. Ostensibly, their goal is to simplify the tax code by eliminating a host of loopholes, broaden the tax base, and lower average tax rates for both individuals and corporations. The premise is reasonable enough—the execution is where it gets tricky.
To begin with, today’s convoluted tax code is the product of several generations of aggressive lobbying from special interest groups, and any changes to the current law are bound to produce relative “winners” and “losers.” Revisiting our behavioral finance topic from last month, we know that individuals feel the pain of a loss about twice as severely as the satisfaction of a gain. Loss aversion explains why unraveling the Gordian knot of tax loopholes is so difficult—the benefits of concessions are typically concentrated among small groups, whereas the costs of implementing them are diffused among all taxpayers. Current beneficiaries have much to lose, and are vocally opposed to change. This inhibits political consensus—perhaps explaining why tax reform hasn’t been seriously attempted in more than a generation.
Further complicating matters this time around, the Senate version of the bill must adhere to very specific rules regarding its long-term impact on the budget deficit, in order to pass with a simple majority, party-line vote (rather than the “filibuster-proof” threshold of 60 votes). In deference to these rules, the Senate bill makes a couple of important sacrifices in order to maintain adequate fiscal headroom. First, it proposes only a temporary 10 year reduction in personal tax rates, in order to secure a permanent cut to the corporate rate (from 35% to 20%). Second, the Senate bill repeals the “individual mandate” component of the Affordable Care Act. Either proposal could upset some members of their constituency, threatening the cohesion of the GOP’s fragile majority in the Senate.
Throughout the tax reform debate, both political parties have claimed to champion the interests of the “middle class.” This objective is deceptively difficult, however, as there is no clear consensus on which Americans fall within that favored group. Statisticians would define “middle class” as the middle 50% of wage earners. However, polls commonly find that more than two-thirds of Americans consider themselves middle class. Indeed, as recently noted by the Washington Post, membership in the middle class is not purely a function of income. Moreover, the calculus of who would be helped or hurt by contemplated tax reforms depends on a number of other variables, including: filing status (single or married), home ownership, household size, type of income (wage vs. investment), and perhaps most importantly, regional differences in cost of living.
So are Bristlecone’s clients likely to be helped or hurt by the proposed tax reforms? The short answer is: it’s complicated. Both the House and Senate bills contemplate the reduction or elimination of several favored deductions—including state and local taxes (SALT) and mortgage interest—which would disproportionately impact taxpayers in high tax states with expensive real estate markets (think California & New York). At the same time, some of these negatives would be offset by lower marginal tax brackets, a doubling of the standard deduction, an expanded child tax credit, and the elimination of the estate tax. Most pertinent from our standpoint: neither bill proposes a material change to the tax treatment of investment income.
Speaking of taxes, 2017 is shaping up to be yet another strong year for global equity markets. After nearly 9 years of a bull market, it is becomingly increasingly difficult to avoid realizing capital gains. We anticipate that several of the stock funds we own will distribute capital gains this year in the range of 3% to 12% of net asset value, mostly in late December. For those clients who are taking required minimum distributions from their IRA accounts, these will also increase your taxable income for 2017. For clients who are charitably inclined, utilizing investment assets for donations can be an effective way to reduce your tax burden. We encourage you to contact us with tax-related queries as soon as possible, so that we have time to process any required paperwork before year-end.
Finally, best wishes for a wonderful Thanksgiving holiday, from all of us at Bristlecone!