Richard Rubin makes some major errors in his summation of burgeoning tax bill. He uses a scenario of five people and goes through how they would be affected by the current proposed legislation. However, he does not get his calculations correct. He’s comparing apples and oranges. He’s also not looking at the reasons for the tax law changes and if the changes make the tax law fairer. He’s only looking blindly at how the tax law changes affect the current tax burden of the people. Rubin should have run his article by a real tax accountant before he published his account. From the article, under the GOP plan: “The executive would pay $868,000 in taxes. The manufacturer pays $704,400, but might be able to argue her way into a lower bill. The passive business owner pays $576,000. The dividend-earning investor pays $476,000. The heir to the estate pays nothing. The manufacturer, the estate and the passive owner all get big tax cuts from the GOP plan. The investor and the wage earner generally don’t.”
Now, in this scenario, Rubin doesn’t explain that the the first person — the executive — would remain unchanged; His tax rate is 43.4%, which is a 39.6% rate + 3.8% medicare tax. The manufacturer’s lower tax bill has to do with how flow-through businesses do things, because they are not a corporation. The passive business owner is changed because he pays a new 25% tax rate + the 3.8% medicare tax. The dividend investor pay the $476,000 because he pays 23.8%. It’s a dividend tax. However, what Rubin does not explain is that the dividend investor already paid another tax, a corporate tax, before the dividend was issued. That part of the tax law remains unchanged, and the investor remains unchanged.
The heir to the estate doesn’t pay any taxes because it is not income. Never has an heir paid an estate tax, because it has already been paid.
Rubin is essentially trying to be provocative here by using a $2 million base figure as a means to show a great difference in numbers, when really, this random list of five people makes no sense. The comparisons don’t really compare, such as including some things that are not income items. Rubin needs to be more careful with his writing.
The GOP Senate released its own version of a tax reform plan with a few differences from the House version. The most notable example is a one-year delay on cutting the corporate tax rate from 35% to 20% — meaning that the tax change would not take affect until 2019.
Their rationale is that the cost of the marginal cut would save $100 billion in costs. One drawback, however, is that companies would likely just sit and wait to make major changes and business decisions. This would certainly delay economic recovery.
In another departure from the House, the Senate bill would eliminate the deduction for state and local taxes (SALT), a move that is positive, yet affects states with high taxes. This was originally in the House bill, but after pushback from places such as New York, California, and other high-tax states, the House modified the deduction to allow a cap of $10,000. This full elimination is really what needs to happen; it puts all taxpayers around the country on a level playing field, especially if it helps to reduce federal tax rates across the board.
The House and Senate also differ in the estate tax. While the House has a plan to repeal the estate tax entirely by 2024, the Senate plan does not. Instead, it will only target a select few taxpayers, by doubling the size of estates that are exempt from being taxed. The estate tax is a punitive tax and really should be eliminated; the House form is much better.
Finally, the Senate bill would lower the top marginal rate by 1%, to 38.5%. While a slight reduction is better than none, neither bill version goes far enough. The final tax reform plan must include a return to at least the Bush tax cut rates (35%) if Congress is serious about really jump-starting the economy.
It will be interesting to see what the final form takes. A true tax reform bill, like the IRC code reforms of 1986, are long overdue. The taxpayer deserves a cleaner, more streamlined tax code.
The Wall Street Journal has done a nice roundup of the October Jobs Report released a few days ago. U.S. employers hired at strong rate in October, reflecting a sharp bounce back from September, when payroll growth slowed in the wake of hurricanes striking the southern U.S. Meanwhile, the unemployment rate fell to a new low for this expansion. Here are some of the key figures from Friday’s Labor Department report.
UNEMPLOYMENT RATE
4.1%
The jobless rate last month edged down to 4.1%, the lowest reading since December 2000. That low rate, however, reflects that fewer Americans were working or seeking work during the month. The labor-force participation rate slipped to 62.7% from 63.1% in September. The prior month’s reading was the highest in years—and the participation rate slipped in October back to a level recorded this spring.
JOBS
261,000
U.S. employers added 261,000 jobs to payrolls in September—the best pace of monthly pace of hiring in more than a year. Employment rose sharply in food services and drinking places, mostly offsetting a decline in September that largely reflected the impact of hurricanes Irma and Harvey, the Labor Department said. Hiring last month also improved in business services, manufacturing and health care.
WAGES
-1 Cent
Average hourly earnings slipped by a penny to $26.53 in October. It was disappointing showing for wages, which had appeared to break out the prior month. From a year earlier, hourly pay rose a lackluster 2.4% in October. Many economists are waiting to see wages rise at a faster pace given the historically low unemployment rate.
UPWARD REVISIONS
90,000
Payroll growth was significantly stronger than previously estimated in recent months. Upward revisions showed 90,000 more jobs were added to payrolls in August and September than previously reported. September hiring was revised to a gain of 18,000 from an initial estimate of down 33,000. That keeps intact the longest stretch of consistent job creation on Labor Department record.
UNDEREMPLOYMENT
7.9%
A broad measure of unemployment and underemployment known as the U-6, which includes people stuck in part-time jobs and others, was 7.9% in October. That was the lowest monthly reading since 2006.The rate has been declining this year in concert with the narrower unemployment rate, known to government statisticians as the U-3.
With President Trump proposing to eliminate the Federal tax deductions for state and local taxes, there has been an outcry from states that allow this deduction currently. The biggest criticism is that it creates “double taxation” because it forces individuals to pay two separate taxes – federal and State – on the same income- without giving any relief against the federal tax in recognition of the tax paid to the State. Without the deduction, Lawmakers warn that tax bills will rise substantially for their citizens. However, the truth is that these attacks are nothing more than an attempt to shift the focus away from affected states (like New York, New Jersey, and California) who are failing their fiduciary responsibility to its taxpayers. They currently levy a very high level of taxation upon its citizens. The deduction is simply a subsidy that masks the egregious overspending of the state which creates the situation in which high taxation is necessary to feed the body politic. Why should the federal government have to subsidize some states at all? If the residents of these states think that high (some would say ludicrously wasteful) government spending paid for by very high taxes is the right way to run a state, it is certainly their right. But these residents also have no right to ask taxpayers of other states to subsidize them. And that is exactly what happens when the federal tax code enables some states to reduce their federal tax — via the state and local tax deduction — simply because they pay high taxes to their states. So yes, although the proposal will hurt some citizens, it is essentially and simply a reform that puts all taxpayers around the country on a level playing field, especially if it helps to reduce federal tax rates across the board. If lawmakers are so concerned with their affected taxpayers, they should aim to reduce the scope and size of their state governments and the wildly out of control spending that created it, instead of expecting other citizens to subsidize their irresponsibility.
Capital gains are unusual in that the taxpayer has the ultimate decision as to whether and when to sell his asset (stock, his business, a work of art, etc.) The higher the tax rate, the less likely he is to sell, seeing as he will only be able to enjoy or reinvest what is left of the proceeds after tax. History has borne this out – capital gains tax collections go down in the periods after increases, and go up in the years after decreases. The actual impact of raising the capital gains rate by the Obama administration was devastating to the economy. By discouraging the sale of assets, there was reduced capital available for new projects and opportunities, reducing job creation and wages, and resulting in lower revenue collection. Furthermore, with higher capital gain rates, the expected after tax rate of return on new projects went down, assuring that fewer of them went forward. Additionally, there were a number of localities, like the state of California and New York City, which have tax rates of 12% or more and also a large concentration of wealthy people and high performing businesses. The Obama federal capital gains increase brought total capital gains rates of more than 37%. A capital gains rate this high virtually brought elective capital to a standstill. This amounted to a rate of almost 60% higher than the rate during the Bush Administration (15%) – when growth and the economy were very strong. The higher capital gains rate put a stranglehold on risk taking and available capital. Why sell an asset to fund further investment and opportunity when the government takes a large share of the gain with the loss remaining all yours? It makes virtually no economic sense to do so, and the result meant an already anemic economy continued to struggle. Lowering the capital gains rate as part of the Trump Tax Reform package is a positive game-changer for the economy.
The concept of an American President (Obama) going after people making a lot of money and paying a relatively low tax rate on it was particularly naïve; it displayed an absolute lack of familiarity with how people get wealthy. As a CPA, I can attest to the fact that the most common way people accumulate massive wealth is either by a huge amount of hard work (creating a successful business) or selling an asset (an invention, real estate, etc).
Many people who file tax returns with large amounts of income, such as selling a business for $10 million, will have a multi-million capital gains amount. It’s not that the higher income earners have some sort of capital gains loophole, but it’s really that the wealthy have done something well to attain the American Dream. And when they do strike it rich through their effort, part of their wealth is treated as a capital gain and it gives those earners a chance to keep a part of it. Knowing that there is a low capital gains rate is an extra incentive to work hard and be successful. Many of my clients are wealthy, and I have experienced time and again that they will come to me and ask the question: if they are successful, can they keep the majority of their money?” This is because they know that government wants to take more from the highest income earners who have proven their success, while at the same time, the government is quite happy to let them lose on their own on their particular endeavor. Most in the top echelon get there from a one-time income-producing significant event. To punish such success by having a high capital gains tax only served to drive a deeper wedge between the have- and have-nots in an attempt to level the economic playing field. Trump would do well to lower the capital gains rate and and restore a sense of trust with those who work hard, contribute to the economy, and attain the American Dream.
Entitlement reform is necessary for the fiscal health of this country, but it is something that no one wants to talk about, much less tackle. How can we begin? How can we open up the conversation and the possibility to reform and improve our social security system? One step in the right direction would be to treat Social Security as a true retirement plan, and not as a wealth transfer system that it currently is. This could begin with reclassifying the payroll tax. The majority (6.2% out of 7.65%) of the payroll tax covers Social Security retirement benefits. If we actually used it (or at least most of it) for that individual’s social security retirement, everyone’s perception would change. Instead of being viewed as a hated tax (just ask any young person who has received their first paycheck), it would be viewed as a desirable saving for their future! Let’s make another incremental change. The employer and employee contribute equally to the Social Security Tax. If the individual’s part went towards his personal retirement, the other part could go towards defraying the past obligations that are coming due. If we had done such a thing 20 years ago, the entire system would have been fixed. Unfortunately, the present situation would probably require some portion of the individual’s portion to also go towards paying the ever growing obligation for past unfunded promises. It’s that dire! And every year that we do not fix it, it gets worse. We must stop treating Social Security like welfare or wealth transfers and start treating it like a retirement system. It’s our money anyway, even though the government wants to act like it is being generous when it gives us back our money. This would lessen the loose-and-fast accounting gimmicks that contribute to the fiscal mismanagement of Social Security anyway — and may move it away from its impending insolvency.
Forbes has published a continuation of John Mauldin’s essay from September 16. He reiterates that “the coming pension and unfunded government liabilities storm is so big that many of us simply can’t get out of the way, at least not without great difficulty. This holds true not just for the U.S. but for almost all of the developed world.” Read his essay below:
Getting back to the topic, we’re all trapped on small, vulnerable islands. Multiple storms are coming, and evacuation is not an option. All we can do is prepare and then ride them out.
And we all have some very important choices to make.
It Will Be Every Man for Himself
Although I’m known far and wide as “the Muddle Through Guy,” the state and local pension crisis is one that we can’t just muddle through. It’s a solid wall that we’re going to run smack into.
Pleasing both those groups is not going to be possible in this universe.
So what will happen?
It’s impossible to say, just as we don’t know in advance where a hurricane will make landfall: We just know enough to say the storm will be bad for whoever is caught in its path. But here’s the twist: This financial storm won’t just strike those who live on the economic margins; all of us supposedly well-protected “inland” folk are vulnerable, too.
The damage won’t be random, but neither will it be orderly or logical or just. It will be a mess.
Imagine local elections that pit police officers and teachers against once-wealthy homeowners whose property values are plummeting. All will want maximum protection for themselves, at minimum risk and cost.
They can’t all win. Compromises will be the only solution—but reaching those unhappy compromises will be unbelievably ugly. In the next few paragraphs I will illustrate the enormity of the situation with a few more details, some of which were supplied this week by readers.
The Problem Is Reaching a Critical Point
Let’s look at a few more hard facts. Pension costs already consume more than 15% of some big-city budgets, and they will be a much larger percentage in the future. That liability crowds out development and infrastructure improvement, not to mention basic services. It forces city leaders to raise taxes and impose “fees.” Let me quote from the always informative 13d letter (their emphasis):
Consider the City of Los Angeles, which Paul Hatfield, writing for City Watch L.A., recently characterized as being in a state of “virtual bankruptcy.” After a period of stability going back to 2010, violent crime grew 38% over the two-year period ending in December 2016. Citywide robberies have increased 14% since 2015. One possible reason for this uptick: the city’s population has grown while its police department has shrunk. As Hatfield explains:
The LAPD ranks have fallen below the 10,000 achieved in 2013. But the city requires a force of 12,500 to perform effectively… A key factor which limits how much can be budgeted for police services is the city’s share of pensions costs. They consume 20% of the general fund budget, up from 5% in 2002… It is difficult to increase the level of service while lugging that much baggage.
What about subway service in New York City? The system is fraying under record ridership, and trains are breaking down more frequently. There are now more than 70,000 delays every month, up from about 28,000 per month five years ago. The city’s soaring pension costs are a big factor here as well. According to a Manhattan Institute report by E.J. McMahon and Josh McGee issued in July, the city is spending over 11% of its budget on pensions. This means that since 2014, New York City has spent more on pensions that it has building and repairing schools, parks, bridges and subways, combined.
There are many large, older cities where there are more police and teachers on the pension payroll than are now working for the city. That problem is compounding, as those workers will live longer, and the pensioners typically have inflation and other escalation clauses to keep their benefits going up.
Further, most cities do not account for increases in healthcare costs (unfunded liabilities) that they will face in addition to the pensions. Candidly, this is just another “a trillion here, a trillion there” problem. Except for the fact that the trillion dollars must be dug out of state and local budgets that total only $2.5 trillion in aggregate.
While reading the New York Times’ assessment of the upcoming tax cut bill, a sentence popped out at me: “Wary of any tax legislation that benefits the rich, Democrats have taken a firm stance against Republican policies that would add to the deficit and said they will not support a bill that does not pay for itself.” (“Senate Republicans Embrace Plan For $1.5 Trillion Tax Cut,” NYT: Sept 19, 2017). This is laughable! Did the Democrats take a “firm stance” at any time during the Obama Administration against policies that added to the deficit? Of course not.
Indeed, most of the article was an attempt to paint the Republicans as hypocrites for trying to pass a tax cut plan that may or may not add to the federal debt after 10 years — while staying utterly silent about the fact that federal debt doubled during the Obama Administration, and each fiscal year ended in a deficit! The sudden interest in some sort of fiscal responsibility from the Democrats rings hollow.
John Maudlin writes a compelling piece this week on what he coins “the bubble in government promises.” He claims it “is arguably the biggest bubble in human history. Elected officials at all levels have promised workers they will receive pension benefits without taking the hard steps necessary to deliver on those promises. This situation will end badly and hurt many people. Unfortunately, massive snafus like this rarely hurt the politicians who made those overly optimistic promises, often years ago.”
This is a theme I have been focusing on for years. His essay below is a must-read in its entirety:
This time is different are the four most dangerous words any economist or money manager can utter. We learn new things and invent new technologies. Players come and go. But in the big picture, this time is usually not fundamentally different, because fallible humans are still in charge. (Ken Rogoff and Carmen Reinhart wrote an important book called This Time Is Different on the 260-odd times that governments have defaulted on their debts; and on each occasion, up until the moment of collapse, investors kept telling themselves “This time is different.” It never was.)
Nevertheless, I uttered those four words in last week’s letter. I stand by them, too. In the next 20 years, we’re going to see changes that humanity has never seen before, and in some cases never even imagined, and we’re going to have to change. I truly believe this. We have unleashed economic and technological forces we can observe but not entirely control.
I will defend this bold claim at greater length in my forthcoming book, The Age of Transformation.
Today we will zero in on one of those forces, which last week I called “the bubble in government promises,” which I think is arguably the biggest bubble in human history. Elected officials at all levels have promised workers they will receive pension benefits without taking the hard steps necessary to deliver on those promises. This situation will end badly and hurt many people. Unfortunately, massive snafus like this rarely hurt the politicians who made those overly optimistic promises, often years ago.
Earlier this year I called the pension mess “The Crisis We Can’t Muddle Through.” Reflecting since then, I think I was too optimistic. Simply waiting for the floodwaters to drop down to muddle-through depth won’t be enough. We face an entire new ocean, deeper and wider than we can ever cross unaided.
Storms from Nowhere?
This year marks the first time on record that two Category 4 hurricanes have struck the US mainland in the same year. Worse, Harvey and Irma landed directly on some of our most valuable and vulnerable coastal areas. So now, in addition to all the problems that existed a month ago, the US economy has to absorb cleanup and rebuilding costs for large parts of Texas and Florida, as well as our Puerto Rico and US Virgin Islands territories.
Now then, people who live in coastal areas know full well that hurricanes happen – they know the risk, just not which hurricane season might launch a devastating storm in their direction. In a note to me about Harvey, fellow Rice University graduate Gary Haubold (1980) noted just how flawed the city’s assumptions actually were regarding what constitutes adequate preparedness. He cited this excerpt from a recent Los Angeles Times article:
The storm was unprecedented, but the city has been deceiving itself for decades about its vulnerability to flooding, said Robert Bea, a member of the National Academy of Engineering and UC Berkeley emeritus civil engineering professor who has studied hurricane risks along the Gulf Coast.
The city’s flood system is supposed to protect the public from a 100-year storm, but Bea calls that “a 100-year lie” because it is based on a rainfall total of 13 inches in 24 hours.
“That has happened more than eight times in the last 27 years,” Bea said. “It is wrong on two counts. It isn’t accurate about the past risk and it doesn’t reflect what will happen in the next 100 years.”
Anybody who lives in Houston can tell you that 13 inches in 24 hours is not all that unusual. But how do Robert Bea’s points apply to today’s topic, public pensions? Both pension plan shortfalls and hurricanes are known risks for which state and local governments must prepare. And in both instances, too much optimism and too little preparation ultimately have devastating results.
Admittedly, public pension liabilities don’t come out of nowhere the way hurricanes seem to – we know exactly where they will strike. In many cases, we know approximately when they’ll strike, too. Yet we still let our elected officials make impossible-to-fulfill promises on our behalf. The rest of us are not so different from those who built beach homes and didn’t buy hurricane or storm surge insurance. We just face a different kind of storm.
Worse, we let our government officials use predictions about future returns that are every bit as unrealistic as calling a 13-inch rain in Houston a 100-year event. And while some of us have called pension officials out, they just keep telling lies – and probably will until we reach the breaking point.
Puerto Rico is a good example. The Commonwealth was already in deep debt before Irma blew in – $123 billion worth of it. There’s simply no way the island can repay such a massive debt. Creditors can fight in the courts, but in the end you can’t squeeze money out of plantains or pineapples. Not enough money, anyway. Now add Irma damages, and the creditors have even less hope of recovering their principal, let alone interest.
Puerto Rico is presently in a new form of bankruptcy that Congress authorized last year. Court proceedings will probably drag on for years, but the final outcome isn’t in doubt. Creditors will get some scraps – at best perhaps $0.30 on the dollar, my sources say – and then move on. We’re going to find out how strong those credit insurance guarantees really are.
“That’s just Puerto Rico,” you may say if you’re a US citizen in one of the 50 states. Be very careful. Your state is probably not so much better off. In 10 years, your state may well be in the same place where Puerto Rico is now. I’d say the odds are better than even.
Are your elected leaders doing anything about this huge issue, or even talking about it? Probably not.
