Revisiting the 2017 Tax Cuts and Jobs Act
It has been two years since the 2017 Tax Cuts and Jobs Act was signed into law. The goal of the bill was to simplify the tax code and curb special deductions. The most contentious piece of the bill was the $10,000 cap on state and local tax deductions. Champions of the bill, mainly conservatives, continue to assert that the cap is a way of assuring that state and local governments don’t raise taxes too much; and opponents of the cap, mainly progressives, continue to argue that the cap will bring negative impacts to the nation’s economic engines, like CA and NY, and their middle-class residents.
Last year was the first tax year where residents and states could determine the impact the changes made to their personal finance. But no one has done a real assessment of the numbers. Until then the debate continues to be re-litigated.
Proposals to work around the tax
At the end of 2019 the Democratic-controlled House passed a Restoring Tax Fairness for States and Localities Act that would do away with the $10,000 limit on the itemized deduction for state and local taxes in 2020 and 2021. There is no chance of the Senate passing the bill anytime soon. In New Jersey Governor Phil Murphy signed legislation recently that gives small businesses in the Garden State a workaround for the $10,000 cap on state and local tax deductions. The Pass-Through Business Alternative Income Tax Act permits flow-through businesses in NJ, such as sub-S corporations, partnerships, LLCs and sole proprietorships, to elect to pay income taxes at the entity level instead of at the personal income tax level. The law is estimated to save New Jersey business owners $200 to $400 million annually on their federal tax bills.
Other states like New York, attempted to create state-run charitable funds that taxpayers could contribute to as a way of paying their state taxes and receiving tax credits in return. Other ideas focused on a new payroll system that employers could use to reduce their taxes. However, the U.S. Treasury Department and the Internal Revenue Service issued regulations last year that effectively prevented these changes. The tax workarounds for businesses have not been barred as yet.
What CA is up to
The CA legislature has entertained a few ideas, but there has been zero progress on any. CA Governor Newsom recently proposed a $100 million initiative that grants a first year exemption for the $800 minimum tax paid by limited liability companies, limited partnerships, and limited liability partnerships. If this survives the budget process in June 2020 it may prove to be one helpful resource to the growing number of Californians who are setting up LLCs following the passage of AB 5, which pushes more employers to categorize contract workers as employees. The high cost of doing so has led many contractors to begin setting up their own companies, which could benefit from the Governor’s credit. Though the real impediment to entrepreneurial growth is the astronomical costs associated with paying for health insurance on the open market.
SALT impact on CA
In 2018 the CA Franchise Tax Board estimated that the potential impact of the SALT cap based on 2015 tax year filings. They showed that 5.9 million CA resident taxpayers (~ 35 percent of all filers) reported itemized deductions on federal individual income tax returns. Approximately 2.6 million, of those taxpayers, reported more than the $10,000 limit.
The average SALT deduction claimed was $20,451 and the CA percentage of those taking the deduction grew as incomes grew. Those with adjusted gross incomes between $25,000 and $50,000 had the deduction on 18.9 percent of returns and those with incomes of $100,000 to $200,000 had the deduction on 83.4 percent of returns, and returns with incomes above $200,000 took the deduction at least 98 percent of the time. The total amount of itemized deductions reported was $213B and of this total, $110B in deductions were for state and local taxes assumed (for this estimate) to be affected by the new federal limit on SALT deductions.
They estimated that ~ 1.5 million taxpayers would have a lower federal liability under the new law, and about 100,000 taxpayers would have approximately the same federal tax liability, and about 1 million taxpayers would have an increase in federal liability. If the cap was eliminated, and other parts of the new law remained in place, this last group’s liability would be reduced by ~ $12B. FTB also estimated that about 500 thousand CA taxpayers would switch to the standard deduction under the new law and about 400 thousand CA taxpayers would choose the standard deduction under the new law even if the SALT cap were eliminated.
Some preliminary data
For extension returns for the 2018 tax year preliminary data is suggesting that the number of taxpayers taking the standard deduction for federal, but itemizing for state, has more than doubled. This supports claims by proponents of the tax bill that the overall tax changes in the bill were broad enough to more than offset the impact of the cap.
Trends show that the size and role of federal, state and local governments will only continue to grow in the future. As will the demand to fund their activities. The federal government can print money. State and local governments have to increase taxes, borrow or increase fees to meet the needs of growing populations and the challenges they bring.
State and Local Growth
- Governor Jerry Brown’s first CA budget proposal in 1975 was $17 billion (today’s dollars: ~82B) for 20 million people. Governor Newsom’s second budget proposal for 2020-2021 is $220 billion for 40 million people. And the state now employs more then 220,000 employees.
- In L.A. County, the GDP is more than $700 billion, which represents almost 30 percent of California’s GDP.
- In the L.A. region, the public sector spend represents almost 13 percent of the region’s GDP and nearly 13 percent of the region’s overall workforce of 5 million.
- The two dominant spenders are L.A. County, whose annual budget is $31B and L.A. City, whose annual budget is $10.6B.
- In 1929, federal spending as a percentage of gross domestic product (GDP) was 3 percent versus 22 percent in 2016.
- The United States federal budget deficit jumped 26 percent in the 2019 fiscal year to $984 billion, reaching its highest level in seven years as the government was forced to borrow more money to pay increased spending and the 2017 tax bill.
- The deficit has now swelled nearly 50 percent since 2016 and it is projected to top $1 trillion in 2020. Annual budget deficits have now increased for four consecutive years, the first such run since the early 1980s.
- The rising levels of red ink have come despite a period of sustained economic growth, when budget deficits typically fall as households earn more money, corporations make higher profits and fewer people use safety net programs like unemployment benefits and food stamps.
- The deficit, which is the gap between what the government takes in through taxes and other sources of revenue and what it spends, now sits at 4.6 percent of gross domestic product, up from 3.8 percent of G.D.P.
Trends – that impact government – to watch
- Americans are getting older, which calls for greater spending on retirees. The ratio of elderly Americans – those expected to be in the last 15 years of their lives – to all other Americans will rise about 50 percent from 2010 to 2030.
- As inequality increases, the call for more taxes or spending increases.
- Labor-intensive services, like education and medical care, have become more expensive, and they also tend to be the areas where the government spends money. (L.A. County spends close to $1 billion a year, alone, caring for and managing homeless people, with a majority of the money going to their health needs.)
- American military spending has not kept up recently with the spending by our main rivals, including China, Iran and Russia. (Since 2000 defense spending has skyrocketed to pay for multiple long-term wars.
The big things to watch
- SALT impact on home ownership rates and charitable contributions: Of the 5.9 million taxpayers who reported itemized deductions on federal income taxes in 2015, 2.1 million made between $100,000 and $250,000 and this group claimed $11 billion in real estate tax deductions, more than any other group. Congress also indirectly diluted the tax incentives for building affordable housing — a change that’s predicted to result in a quarter of a million fewer units.
- How will rising populations in states like Florida, Texas and Nevada, that have no state income taxes or minimal local taxes, cope with citizen’s demands for more services and programs: The SALT deduction was historically a way for the federal government to incent state and local governments to raise a reasonable amount of revenue from taxing local residents. Proponents of the cap think it will curb excessive taxation. Hopefully it will in some ways, but in the end will it limit the other states mentioned above from raising revenues when their time comes to support their growing economies. They have been lucky up until this point because CA’s taxpayers have paid more in federal income taxes – $1.12 trillion from 2008-2014 – than any other state in the U.S., year after year; and more recent data shows it to be about $227 billion annually. In return we do not get our fair share of federal dollars back, which means the federal government is using these extra funds to disproportionately subsidize a number of states with no or low-income state and local income taxes, like Texas, Florida and Nevada.