David R. Henderson  

Cowen on the Republican Tax Cut Bill

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Tyler Cowen has written a mainly excellent piece on the Republican tax cut bill. I want to add to part of his analysis and challenge him on one of his numbers.

But first some highlights.

Tyler leads with this paragraph:

The tax plan released by the House last week limits deductions for a variety of expenses, including tuition debt, mortgage interest, alimony, medical expenses, state and local taxes, gambling losses, tax-preparation expenses, and moving expenses. The details are likely to change in the Senate, but the important point for long run is that the deductions are being challenged. Many of the changes -- in particular, mortgage interest, medical expenses, and state and local taxes -- are taking on powerful lobbies and constituencies. Several months ago I would not have thought the Republicans would be so bold.

That's mainly description, but, like Tyler, I didn't expect them to be so bold and I am heartened by it, along with, of course, my favorite part, the cut in the corporate tax rate. Another one he doesn't mention: getting rid of the expensive gift to people who buy electric cars: the $7,500 tax credit.

Tyler points out some interesting political dynamics:

If the bill succeeds in limiting these deductions, a logic is set in motion for future tax reforms. Let's say the Republicans eliminate tax deductions for new mortgages above $500,000. That would become a sign that the homeowner and real-estate lobbies are not as strong as we might have thought. The next time tax reform comes around, legislators will consider lowering the value of the deduction further yet. After all, the anti-deduction forces won before and, in the new battle, those who expect to have future mortgages above $500,000 don't have a stake anymore [sic].

I would also point out something that is, I'm sure, obvious to him, but not obvious to many of his readers. Limiting the deductibility of mortgage interest to interest on the first $500K means that even most people with mortgages well above $500K will still benefit a lot from the deduction. Take my co-blogger Bryan Caplan, who mildly laments this loss of tax deductibility for his own mortgage. I would be surprised if Bryan's mortgage is much above $600K. Let's say it's $600K and assume that his mortgage interest rate is 4.25%. So he will lose deductibility on 4.25% of $100K, or $4,250. Assuming he and his wife are in the 33% bracket, his extra federal taxes in a year will be only 0.33 * $4,250, or $1,400. Substantial? Yes. But not huge.

One correction. Tyler writes:

There even seems to be a rate of 45.6 percent on some earners, in the range of $1.2 million to $1.6 million a year. That is a far cry from Jeb Bush's call in the Republican presidential primaries for a 28 percent top marginal rate, in the tradition of President Ronald Reagan. Some well-off Californians could possibly face a total marginal rate, all taxes considered, of over 62 percent.

Actually, the top rate, as co-blogger Scott Sumner has pointed out numerous times, is 43.4 percent (the 39.6 + the 3.8% tax rate on "net investment income".) So the phaseout for high-income people of the benefit of a 12% tax rate on the first dollars of income will add 6 percentage points (which is what Tyler had in mind) to the 43.4% for some taxpayers. Some high-income people, therefore, will pay a top rate of 43.4% + 6% = 49.4%. In California, people with an income of over $1 million pay a top rate of 13.3%. So, with deductibility of income taxes gone, the top tax rate (state + federal) for some very high-income Californians with substantial net investment income will be 62.7%.

Update: Vivian Darkbloom has pointed out that I did the math wrong. It is now corrected above.

P.S. I posted some years ago on high marginal income tax rates in California. See here and here.

Comments and Sharing

CATEGORIES: Tax Reform , Taxation

COMMENTS (4 to date)
Thaomas writes:

Subject to the caveat that limiting the tax subsidy on favored kind of consumption would be done better and more fairly with partial tax credits rather than caps on deductions, I'm all in favor of the limitations on mortgage interest expend and medical expense (which should have no minimum or the application of the partial credit).

I fail to see much rationale for limiting the deductability of S&LG taxes (except as a way of increasing tax progressivivity), as these are not consumption at all but really are more like "income not received."

If we are trying to move toward taxation of consumption rather than "income" we should raise rather than lower the amounts that people can save "for retirement" (for whatever).

The big drawback of the proposal is that it fails to pay for the reduction in business taxes by raising taxes on personal income (or better, consumption). There is no reason to increase the structural deficit; indeed we should be reducing it.

Vivian Darkbloom writes:

If you are going to include the 3.8 percent medicare surtax on net investment income in the marignal rate, I would think the marginal rate "in the bubble" for *ordinary* net investment income would be 39.6 + 3.8 + 6 = 49.4%*. If you take Tyler's rate of 45.6 that already includes the 6 percent phaseout but it omits the 3.8 percent (i.e, 45.6 + 3.8 also equals 49.4%). By working from Tyler's number you are counting 6 percent twice, but omitting 3.8 percent.

That rate would not apply to qualified dividends or LTCG's which, while subject to the 3.8 net investment tax, are subject to a special lower income tax rate of 20 percent. The above-mentioned rate of 49.4 percent should apply only to interest income and short-term capital gains, non-qualified dividends, royalties and other ordinary investment income. My reading of the phaseout rule is that it applies to unmodified AGI. Thus, dividends and LTCG's appear to trigger the phaseout for AGI above $1/1.2 million. Thus, the rate for these types of income should be 20 + 3.8 + 6 = 29.8%.

The rate in the bubble for employment income should be 39.6 + 2.9 regular medicare (employee and employer) + 0.9 medicare surcharge + 6 = 49.4%

Bottom line: It's complicated. Too complicated.

David R Henderson writes:

@Vivian Darkbloom,
Thanks. Correction made.

adam writes:

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