How Wealthy Americans Are Already Trying To Game Trump"s Tax Bill

Earlier this month, Trump touted the idea that, under his tax plan, 1,000"s of Americans would be able to "file their taxes on a single, little beautiful sheet of paper."  Of course, this so-called "postcard" that Trump and Paul Ryan have referenced repeatedly over the past several months is basically nothing more than a 1040EZ shrunken down to fit on a smaller piece of paper but who are we to rain on their parade?

That said, while many Americans will enjoy an easier tax filing in 2018, or at least as easy as the 1040EZ, others, especially high-income folks living in high-tax states like New York and California, are suddenly scrambling to retain accountants to figure out how they might best game the new tax code to avoid higher rates. 

Of course, one of the key opportunities for "gaming" results from the new taxation rules for "pass-through" entities.  Unlike high-income earners filing as individuals who lost a substantial portion of their deductions, pass through entities, with the exception of certain professionals like doctors, lawyers and stockbrokers, are still eligible for a 20% deduction from their earnings.  To put that into perspective, a 20% deduction reduces Trump"s top marginal tax rate for pass-through entities to 29.6% from the 37% that will be paid by individual filers.

Not surprisingly, as CBS points out, the change has pretty much everyone suddenly plotting a post-holiday discussion with their boss to see if they can be fired and promptly re-hired as an independent contractor.

First, you convince your boss to let you quit and hire you back as a contractor after you"ve set yourself up as a sole proprietorship. Assuming you can do that and your tax treatment is better, you can offer your ex-employer the same services for less -- the company does not have to worry about giving you benefits or paying its share of your Social Security and Medicare taxes. That latter part is the iffy one for you, and the numbers would have to work out. "Do you really want to go without health care and a 401(k)?" asked online financial adviser group Betterment"s tax expert, Eric Bronnenkant.

Meanwhile, even lawyers, who are specifically excluded from the pass-through rules, could qualify by leaving their law firms and pursuing a position as an in-house counsel.

An end run works like this: A law partner, sick of the barricade to a kinder tax rate other pass-through people enjoy, moves over to be in-house counsel at an engineering firm, which is not on the ban list. "Now she"s no longer in a specified service," wrote Ari Glogower, a law professor at Ohio State University, on Vox.com. "Voila, she may qualify for the pass-through deduction."

As we pointed out earlier this week (see: Why Wall Street Is Furious At The Trump Tax Plan), for others who can"t game the pass-through system, like most of the traders earning big bucks on wall street, the best option might be to simply move from New York to a lower-taxed state like Florida or Texas.

Still others are considering a move to lower-taxed states like Florida and Texas which, as Todd Morgan, chairman of Bel Air Investment Advisors in Los Angeles notes, sounds like a great idea right to the point that you realize that actually entails uprooting your entire family and starting a whole new life in a different part of the country...something that generally doesn"t go over well with teenage kids..."If you’re already rich why would you move to another state and live a different life just to save some money on taxes?  What are you going to do with the money? Buy more clothes? Eat more food?"

Finally, the tax bill could even influence decisions on if/when people decide to get a divorce.  As Bloomberg points out, starting January 1, 2019 divorce suddenly becomes way more attractive for the recipients of alimony and punitive for payers as the payments will not longer be counted as income or allowed as a deduction.

Tax considerations are even changing for those getting a divorce.

 

Under the law, divorced taxpayers who pay alimony would no longer be able to deduct those payments from their income, and recipients of alimony would also no longer need to report the money as income. However, the provision doesn’t go into effect right away and instead applies to divorces finalized after Dec. 31, 2018. So, depending on whether you’re set to pay or receive alimony, you might want to speed up or slow down those divorce proceedings.

...which may or may not have been a clause specifically added by Melania...

Tax Bill May Spark Exodus From High-Tax States

From FinancialSense.com via ValueWalk.com,

The following is a summary of our recent podcast, “Exodus – The Major Wealth Migration,” which can be listened to on our site here on on iTunes here.

It’s looking increasingly likely that we’ll see the GOP tax bill pass in the near future. Prepped for signing by the end of this year, the bill is sure to have sweeping effects on all taxpayers, especially those in high tax states.

Consider Dan White at Moody’s: Taxation Shift Spells Trouble for Underfunded States

“(Eliminating the state and local tax deduction) could help on the margins to drive people from those states to lower tax states because their burdens are going to increase significantly,” White said.

 

“What’s more, it’s going to make it more difficult during the next recession for states to increase taxes without being burdensome to the underlying economy.”

Many of the Rich Will Pay Under New Tax Plan

If we take the example of a high-net-worth individual living in California and making $1 million a year, that person’s state taxes amount to $102,000. If that person owns a $1.5 million home, property taxes would be around $27,000. As the new plan eliminates mortgage interest deduction above $500,000, this person would lose the ability to deduct roughly $20,000 in interest expenses.

In total, this person would lose roughly $150,000 in deductions. At a 40 percent tax rate, this person would end up paying around $60,000 more in taxes under the GOP plan.

“The idea that this is a tax giveaway to the rich just doesn’t hold true,” Financial Sense’s Jim Puplava said.

 

“It may help somebody that lives in Florida, who doesn’t have to worry about state tax deductions, because there’s no state income tax. And it does help out corporations by lowering their tax rate… but as far as individuals who lose their itemized deductions, this is going to, in effect, be a tax increase.”

Millionaire Migration Patterns

Generally, high-net-worth individuals don’t tend to move state-to-state very often, but that’s probably about to change.

One notable example occurred last year when billionaire hedge fund manager David Tepper relocated from high income tax New Jersey to Florida, which doesn’t have a state income tax. This not only saved Tepper millions of dollars, but also cost New Jersey as well.

If the GOP plan goes through, high tax states may have to rethink their tax strategy.

“I think we’re going to see a big migration,” Jim Puplava told listeners this week.

 

“We’re already losing almost 100,000 taxpayers per year in California. … If this tax bill goes through, this is really going to force a lot of people out. This is going to have a major impact on those high-tax states, and this is going to be a revenue drain.”

Ramifications Down the Road

With the deductibility of state and property taxes under threat, where every dollar paid saves 40 cents in federal taxes, we could see the effective tax rate spike.

Also, historically, when the federal government has eliminated deductions in exchange for lower tax rates, it has a habit of hiking those rates back up in short order. This happened in 1986 under Ronald Reagan’s tax reform where we saw President Bush Sr. and President Clinton hike rates up to the current 39.6 percent rate on the high end.

“This is a major game changer,” Puplava said.

 

“Now that it looks like we have a greater likelihood of this tax bill getting passed, we’re going to see a demographic migration.”

Listen to all our daily interviews with leading guest experts by clicking here.

Corporate Tax Cuts: "The Seen & The Unseen"

Authored by 720Global"s Michael Lebowitz via RealInvestmentAdvice.com,

Since Donald Trump was elected President, the S&P 500 has rallied over 21% or nearly 500 points. In our opinion, a good portion of the gain is attributable to his promise, as well as congressional efforts, to reform the tax code. In particular, the proposed sharp reduction in the corporate tax rate has the equity market’s attention. At first blush, the simple logic driving equity investors appears reasonable.

Appearances, however, can be deceiving, and history is littered with failed investors that banked on a faulty thesis. As such, instead of tripping head first into that same category, we decided to assume nothing and look at the proposed reduction in the corporate tax rate and historical data to better understand how the legislation might affect the economy and corporate earnings.

Corporate Tax Rates

The graph below highlights the statutory and effective corporate tax rates since 1947.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The statutory tax rate is the legally mandated rate at which corporate profits are taxed. As shown above, the rate has been consistent over the last 75 years except for one significant change as a result of the Tax Reform Act of 1986.

The effective corporate tax rate is the actual tax rate companies’ pay. One can think of the statutory rate as similar to the MSRP sticker price on a new car. It provides guidance on cost but consumers always pay something less. The effective tax rate, like the “discounted” price one pays for a car, is the actual percentage of profits that corporations remitted to the government. This rate is calculated by dividing a company’s tax payments by their pre-tax profit. Deductions of all sorts reduce the pre-tax profit, thus creating a difference between the statutory and effective tax base and therefore the amount paid. For purposes of this article, we aggregate corporate tax receipts and corporate profits to calculate an effective rate for all corporations.

From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.

Based on this simple analysis thus far, it is easy to understand why equity investors are giddy over a sizeable reduction in the corporate tax rate. If the statutory rate is reduced to 20% as proposed, and the effective rate remains 10% lower, the amount of money corporations pay in taxes will be reduced sharply. Based solely on this assumption, corporate after-tax profits, in year one alone, should increase by almost $200 billion while federal corporate tax receipts will be reduced by the same amount. Such a boost in corporate earnings would increase the forecasted internal rate of return (IRR) on the S&P 500 by approximately .90%.  Holding everything else constant this equates to a price increase of 285 points for the S&P 500 or an 11% gain from today’s level. It is impossible to assess how much of the gain since the election is due to tax reform expectations and how much is due to other factors, but we wager a good portion of it has been based on the promise of tax reform.

History

While the math and logic above seem sound, we can turn to historical data to understand the relationship between taxes and economic growth and profits. In doing this, we can better forecast the actual effects that lower corporate taxes might have on economic growth and corporate profits.

The graph below compares the effective corporate tax rate to the running three-year average GDP growth rate. The dotted trend lines smooth the data to allow for a clearer comparison.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As is clearly observable, GDP has trended lower at a very similar pace as the effective corporate tax rate. The graph below puts the data in a scatter plot format to evaluate the statistical relationship between corporate tax rates and economic growth rates.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The R² shown above (.3552), a statistical measure of correlation, is far from perfect, but there is a reason to believe that lower effective tax rates may partially explain the weakening trend in GDP growth.  Based on statistical regression, every 1% decrease in the effective tax rate should diminish GDP growth by 0.12%. 

The President, his economic team, and lawmakers are selling the tax bill with claims that a reduction in corporate taxes will boost economic growth. Based on data from the last 75 years, that has never been the case. In fact, the average annualized GDP growth rate in the five years before the major statutory tax reduction in 1986 was 3.90%. In the five years following the tax cut, the average annualized growth was reduced by more than half to 1.93%.

Next, we show a scatter plot comparing effective tax rates to corporate profits.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As measured by a R² of .051, the graph above shows that over the last 75 years, there has been no measurable relationship between effective corporate tax rates and corporate profit growth.

Who Pays

The historical evidence above tells a different story than the bill of goods being sold to citizens and investors.

 Corporate tax rates are positively correlated with economic growth which means that lower corporate tax rates equate to slower economic growth. Further, there is strong evidence that corporate profits are largely unaffected by tax rates.

Investors buying based on the benefits of the tax proposal appear shortsighted. They value the benefits of corporate tax cuts, but they are grossly negligent in recognizing how the tax cuts will be funded.  

The tax bill, as it is currently proposed, will increase the deficit by $1.5 trillion over ten years. As such, the government will borrow an additional $1.5 trillion on top of current projections of approximately $1 trillion per year.

When the government borrows money to fund a fiscal deficit they effectively crowd out investment that could have funded the real economy. Said differently, the money required to fund the government’s deficit cannot be invested in the pursuit of innovation, improving workers skills, or other investments that pay economic dividends in the future. As we have discussed on numerous occasions, productivity growth drives economic growth over the longer term. Therefore, a lack productivity growth slows economic growth and ultimately weighs on corporate earnings.

A second consideration is that the long-term trend lower in the effective corporate tax has also been funded in part with personal tax receipts. In 1947, total personal taxes receipts were about twice that of corporate tax receipts. Currently, they are about four times larger. The current tax reform bill continues this trend as individuals in aggregate will pay more in taxes.

As personal taxes increase, consumers who account for approximately 70% of economic activity, have less money to spend.

Summary

As is often the case in economics and investing, there is a “seen” and an “unseen.” The “seen” is widely visible and, right or wrong, generally represents a consensus agreement about reality. The “unseen,” while equally important, largely goes under-appreciated. In time, it is the “unseen” that will affect economic growth rates and corporate earnings. It is the “unseen” that investors must grasp if they are to be successful. In this case, the “unseen” is the massive federal deficit. Its burden on the economy prevents traditional forms of stimulus from having their desired effects.

Given the historical evidence regarding the implications of corporate tax cuts, we are left questioning the so-called “Trump bump.” We would argue that a market rally based on that premise is incoherent, and the market should be discounting prices and valuations due to the tax cuts not inflating them.