For most people, the tax filing season ended on April 15th. For many of us active tax professionals, April 15th is definitely the milestone after which things slow down to a more rational pace.
Most of my clients had some idea that big changes were afoot so getting people to start their tax preparation early came easier this year.
There has been a lot of press coverage of the lower rates, the increase in the standard deduction, and the cap on the state and local tax deduction. Under the TV journalism theory that “if it bleeds, it leads”, the press is always looking to promote losers and victims over winners.
First, let me say that most people believe there is an EA (Enrolled Agent) or CPA somewhere who has a secret book of tax deductions that would allow them to pay less or no taxes. I am both an EA and a CPA…and there is no book of secret deductions. Deductions on individual tax returns are strictly limited. The deduction flexibility is on the business return side when everything that is ordinary and necessary to the business is allowed. A much grayer area.
The December 2017 tax cut law was the longtime work of former Speaker of the House Paul Ryan and his pursuit of supply side economics - making the tax code simpler as well as lowering rates. As with most supply side economics in a world awash with Keynesian economic theory, the changes are not always obvious or immediately visible.
While the press focused on the obvious effects of the new tax law, operating behind the scenes were the following far reaching incentives:
QBI. Qualified Business Income is probably the biggest new concept in the tax code. Basically, it gave a tax deduction benefit to the owners of small businesses. This rewarded investment in small business. Since small businesses provide around 50% of the jobs in the economy, growing small business is the fastest way to increase employment. “If each small business adds just one employee” is the frequent expression.
100% Capital Asset Expensing. For years, Congress has provided faster write-offs for business investment for taxes than is provided in generally accepted accounting principles. The purpose was to incent business investment by accelerating the tax write off of business investment in equipment, furniture, and fixtures to reduce taxes. As labor is required to turn business investment into productive assets, greater business investment means greater employment. During the 2009 – 2010 recession, the government experimented with 100% tax write off of business investment to encourage investment. In the December 2017 tax law change, the speed and limits of business investment tax write off was permanently set at 100% in the first year.
SALT Limit. In Federal government budgeting parlance, a tax deduction is called a Tax Expenditure. In other words, a tax deduction to an individual is a loss of revenue to the government. On that basis, the state and local tax deduction was a major loss of tax revenue to the Federal government. Most troubling was that this revenue loss was not spread equally among all tax payers but concentrated in a few states. Since there are more elected officials from states which were not benefiting than from states that were benefiting, it was only a matter of time before the SALT exemption was going to go. The demise of SALT opened the way to lowering the individual tax rates which actually affected everyone.
Standard Deduction and Personal Exemption. The increase in the standard deduction and the elimination of the personal exemption made figuring personal taxes easier and more straightforward. Estimates are that 90 to 95% of all Federal tax returns will use the standard tax deduction going forward. Elimination of the personal exemption removes the arguments over who is a dependent for Federal tax purposes which again simplifies one of the more contentious areas of tax practice.
Miscellaneous Itemized Deductions. For the small minority of tax payers who itemized deductions this part of Schedule A was a grab bag of deductions. One of the biggest areas was “unreimbursed business expenses” which was really a subsidy to businesses that did not cover the legitimate out of pocket expenses of their employees – particularly salespeople. So rather than to continue to subsidize certain industries and occupations, the whole area was eliminated.
Mortgage Interest Deduction. This is another area where the abuse of the deduction came back to haunt taxpayers. The great housing boom of the early 2000’s encouraged people to take on excessive housing debt. Your home became your piggy bank. The mortgage interest deduction for a primary residence was always supposed to be for debt that was used to buy, build or improve the primary residence. The IRS was overwhelmed by the widespread abuse of the mortgage interest deduction for non-primary residence related activities including using home lines of credit to retire credit cards, to fund college tuition, to buy cars, or to buy vacation or rental property. So, mortgage interest on lines of credit was eliminated for all but buying, building, or improving the home and the deductible interest cap on new mortgages was lowered.
[The mortgage interest deduction is actually a very inefficient tax deduction. For a taxpayer in the 25% tax bracket, a $100 mortgage interest deduction would save the taxpayer $25. The taxpayer is effectively paying $75 in interest to get a $25 tax deduction. Not the best long-term financial strategy. Better to pay down the mortgage on the primary residence as fast as possible. Moreover, the higher standard deduction coupled with the SALT limit may mean that the mortgage interest deduction is of no tax consequence to many taxpayers at some point.]
There is a lot of angst about “tax cuts for the rich”. The QBI and 100% expensing incentivized owning and building a profitable (small) business that hires people to better utilize the invested capital. This favors small businesses not the rich. SALT and the reduced mortgage interest deduction both hit higher income tax payers by limiting two popular high-end tax deductions. The elimination of the miscellaneous itemized deductions pushes expenses back onto business that employees were having to bear. The larger standard deduction makes doing taxes simpler for everyone. Does not seem like tax cuts for the rich to me.
As we come out of the tax filing season and look back, we can begin to see the positive effects of the tax changes: business investment has skyrocketed as has employment across all the sectors of the economy. Wages at the lower end of the scale appear to be moving for the first time in many years. The SALT issue has landed squarely in the lap of the political leadership of the most offending states with well-off citizens voting with their feet to leave such states. Things are positive - in a growing economy, we can adapt and adjust to the change.
I went downstairs and asked Riley, my Golden Retriever, if she had been affected by the December 2017 tax law changes. She looked at me quizzically and then walked into the pantry and checked her water dish (full), her food dish (full), and then looked up at the new drawer where her cookie treats are now kept (full). She then walked back and lay down at my feet. Good point, Riley, some changes but things look pretty good going forward.