Tax Reform: Part Deux November 3, 2017Finally; a Tax Reform Bill. Or is it really reform? Politicians (primarily, Republicans unfortunately since they presently are driving this train) have demagogued for years on a couple of very powerful but ultimately misleading arguments for tax reform. For years they have proposed a “flat tax”, and more recently, they propose the simplification of tax law such that a tax return can be “submitted on a post card”. While the “talking points” play very well to the uninformed, there are a host of reasons why each of these is grossly inequitable in application, largely impractical in execution, and misleading as descriptions of the bill. This is going to be a long and in some respects complex discussion. There’s no way to do it briefly. This is a big part of the problem. Your representatives are trying to force-feed a very complex tax bill through the legislature without giving an adequate opportunity for even the legislature, much less the voters to understand and weigh in on it. Forewarned is forearmed. Let’s start with a very basic understanding of the purposes and use of the income tax itself. If the purpose of an income tax were simply to collect revenues to fund the government, then a simple tax code, and a flat rate structure might make sense. But revenue generation has never been the only, and some would suggest not even the most important purpose for the income tax code. The economy of any country must be managed to achieve any and all desirable outcomes, and to avoid other undesirable results. However attractive in concept a Libertarian, hand’s off, capitalistic philosophy may be, most economists and philosophers (even those of the conservative capitalistic persuasion) recognize that such an approach would be inequitable in the extreme, and ultimately in no-one’s best interests with regard to outcomes. In America, we have divided the responsibility for managing the economy between the Federal Reserve Board (the “Fed”), who are responsible for “monetary” policy, and the congress with respect to “fiscal” policy. Ideally the two should work in concert and coordination with one another to achieve synergistic goals. Were it only so.Monetary policy has to do with managing the money supply in order to control inflation and to encourage full employment. Theoretically, (and at a very basic level) adding “liquidity” (i.e., access to capital) to the economy stimulates business activity, creates jobs, and boosts economic growth. Unfortunately too much growth creates (again theoretically) inflation, too much of which is damaging to the economy, and potentially to the currency. Inflation is controlled by “contractionary” monetary policy, essentially withdrawing or increasing the cost of capital. The Fed’s primary tool is interest rate policy.Fiscal policy is affected by encouraging and subsidizing in the private sector, or actually undertaking by the government, activities to bring about positive and desirable economic growth, and to discourage ineffective or negative (usually but not necessarily always economic) behavior by the private sector. One traditional example of this is infrastructure spending – building roads and bridges for example, creates jobs during the construction phase, but ultimately also makes the economy more efficient, so there are long-term benefits as well. This kind of activity is the specific purview of the congress (the federal reserve cannot, and the private sector will not do so on it’s own). The tax code is a primary tool the congress uses to achieve these responsibilities, not just for tangible growth, but to alternately encourage and discourage other activities which it perceives as either beneficial or contrary to public policy. For example, tax benefits are allowed to charitable organizations in recognition of the fact that charities provide benefits to the common good which, were the charitable organization non-existent, to the degree their services are essential, would fall to the public coffers. Tax benefits are offered for retirement savings to encourage the public to save for their own retirement and relieve the need for welfare as the population ages. Tax benefits are offered for life insurance, again to encourage and subsidize the common man to provide for his own family. On the other hand, behaviors which are perceived as not in the best interests of society are discouraged. An example is the cigarette tax. The goal to keep this a “basic” discussion has perhaps been compromised, but let me say at this point that, I hope you recognize that there is much more to our tax code than just collecting revenues. One always worries about “unintended consequences” in any complex legislation, but in this case, I suspect there is much in the way of outcomes and results that are entirely intended but not publicly proclaimed, and which, if they were acknowledged, would be totally unacceptable to a fully informed and engaged electorate. I suggested in a previous newsletter that if my typical client really understood the tax bill being proposed, that they wouldn’t like it. I am convinced at this point that this is the case. There are a number of concepts that come up in the tax reform discussion. Two subjects frequently heard are “deficit neutrality” and “pay-fors”, essentially the argument usually by Tea Party affiliates, that any reduction in taxes must be offset either by reductions in spending or identifiable revenue increases. A common alternative is the “supply-size” theory which I addressed in a previous newsletter, essentially the idea that reductions in taxes would result in increased economic activity which will lead not only to business improvements and profitability but also more and better paying jobs, both of which would bring increased tax revenues even at lower rates (See https://www.dfs-advisors.com/tax-reform.) One very basic result of the deficit neutrality philosophy if one does not subscribe to the supply-side argument is that the only way you can ever have an actual tax reduction is to, at the same time, identify offsetting spending reductions. But if we set aside the elimination or limitation of deductions, we have heard absolutely nothing about any spending reductions in this bill. The inescapable conclusion is that this is not really a tax reduction bill; it’s a tax reallocation bill. For every dollar you save (and I’ve done the math, I’m not saving anything) someone else will have to pay an extra dollar. There really is no deficit-neutral alternative to this very basic fact. All tax reductions are paid for with offsetting tax increases. Moving on. There are multiple absolutely idiotic aspects of the tax reform bill, as is currently proposed. In the interest of brevity I am only going to address one. I select this one because I see it as potentially affecting every single one of us in one way or another. Medical expenses will not be deductible. This one has to be at the top of any list of hair-brained proposals. No increase in the standard deduction will offset the loss of this deduction for anyone who currently is using it. Everyone recognizes that the cost of health care is potentially the single most devastating expense any of us are exposed to. For everyone insurance premiums are increasing exponentially. The reason insurance costs are exploding is because the cost of treatment and services – simply keeping people alive in many cases – is accelerating. To take away the ability to deduct these expenses is for many of us a substantial tax increase, regardless of what happens to the rate structure. Now, if you think your employer is footing the bill, let me disabuse you of that notion. First, more and more employers are doing away with this benefit altogether, or as a minimum, reducing coverage and/or instituting cost sharing measures. And the trend will continue. Secondly, if you don’t recognize the impact health insurance benefits costs have on your salary and retirement benefits, you are either uninformed or you have your head in the sand. But the greatest travesty is for those facing long-term-care expenses. I have several clients who are experiencing costs exceeding $150K per year in nursing home or home health care expenses. The ability to deduct these costs is absolutely essential to their ability to pay them. Once again, if this is not of immediate concern to you, this is no assurance that it will not be in the future. Losing this deduction is unacceptable. And then there is one which has been and perhaps still is under consideration … the deductibility of Retirement plan contributions: To understand the societal impact of this proposal (remember the “fiscal” policy discussion and the reason retirement savings are subsidized by tax policy) you only have to recognize that (1) many people only contribute to their retirement plans because of the tax benefits of doing so, (2) some are only able to contribute because of the tax savings, and (3) to the extent that we as a society do not prepare for our own retirement, we will increase the costs to the society of caring for one another in our old age. Add to this the societal economic benefits – the multiplier effect and velocity of money considerations – of investment in the economy simply for the sake of investment. These savings are not stashed under a mattress or buried in a mason jar, they, along with the tax savings, are invested in businesses – more commonly American businesses, which create more jobs and other economic activity. So let’s go back to the opening demagogery discussion – the “flat tax”, the post card tax return, et. al. The Flat Tax: Obviously (at least to my way of thinking) a truly flat tax is not fair. There should be some degree of progressiveness to our tax system, some recognition of differences in circumstances, opportunity, and ability to pay. One of the public (fiscal) policy imperatives is some degree of reallocation of wealth. I understand that many of my readers may not agree in principal to this idea, but there are aspects of the concept with which most of us would agree are desirable if not imperative. A true flat tax would not achieve this end in any respect. The “post card” tax return again to my way of thinking, follow’s this precept. Deductions and exemptions, tax credits and yes, even penalties, are for example, entirely appropriate ways of recognizing that, while a single man with no dependents in Jackson, MS benefits from American Citizenship in most of the same ways that a family with five kids in Newark, NJ, their respective costs of living are very different. If each of these citizens make the same income, to charge them both the same tax (or even at the same rate) is inequitable. A simplified tax return system does not offer any opportunity for the tax system itself to recognize the ways these two tax payers should be treated equally, and the ways in which their situational differences should be recognized. At the end of the day, as I have said previously, the more basic the tax reporting system is, the more inequitable it is ultimately likely to be, and the more taxes you are likely to pay if you use it. And one more “demagogue issue” … you’ve all heard it: “We’re eliminating the Alternative Minimum Tax”. BALD-FACED LIE …what they’ve actually done is to make the AMT universal. Get this. The single most common reason why one falls victim to the AMT is the level of state and local taxes – income and property taxes. Both are deductible for the regular income tax but not for the AMT. So by eliminating the state and local tax deduction, they have essentially extended the AMT to everyone who itemizes deductions. The increase in the standard deduction does not compensate. As a matter of fact, The increase in the standard deduction is another red herring. Not only does the change not offset the loss in itemized deductions for many, but rather transfers additional deductions to many who are not currently eligible from those who are. And the elimination of personal exemptions, for many offsets the increase to the standard deduction. It’s all balderdash! Tax increases in the name of simplification. I fear that this article may be perceived by someone who does not know me well to be an indictment of the Republican leadership. Most of you know well enough where I stand on the issues that you would not be surprised if you knew how I voted in a normal election. The fact is the Republicans are currently in charge. I’m sure I would have issues with any plan put forth under a Democratic administration as well. The problem is not simply that the proposals and the solutions are entirely based on a single-party philosophy, but also that they are based on what’s achievable politically simply to “get a win”. The result is much demagoguery with talking points that tickle the ears but do not accurately reflect the ultimate results of the bill. Worse, many of the legislators themselves do not understand the very important nuts and bolts of tax policy, much less the impact of this legislation. You need to make an effort to understand the ultimate impact of this plan on your finances and on your financial health. And then you need to get on the phone to your congressman – the Republican ones – and let them know they need to go back to the drawing board. We do need tax reform. But this is not tax reform. This is just plain bad law. Jim Denton An aside here, but important consideration … the congress, again under Republican leadership, has left the Fed to act entirely on its own over the past few years when stimulative activities would have been especially beneficial to the economy. Now, when the economy is starting to perform more effectively, (in fact it is surprising we are not seeing more threat of inflation) the congress is considering – for entirely political reasons – a potentially stimulative tax law which may very well fuel the inflationary fires, pushing the Fed into an exactly opposite policy imperative, at a time when their tools are limited from previous policy acts.  An example – The original “Obamacare” legislation was flawed, I believe intentionally by its writers, such that the ultimate outcome would be unsustainable, the ultimate result of which will be a single-payer national health care system. As we are learning, it is impossible to go back to the preexisting system. As the Affordable Care Act collapses under its own weight, the only alternative is an increasingly socialized health care system. The observations and opinions expressed in this commentary are those of the author and do not necessarily reflect the views of LPL Financial. This commentary is for general information only and is not intended to provide specific advice or recommendations for any individual. Income Tax services provided by DFS Advisors, LLC are conducted as an outside business activity separate and distinct from our relationship with LPL. LPL Financial does not provide tax advice or services.