Doylestown Wealth Management - LPL

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October 2017 Monthly Budget Commentary

“It is mathematically impossible to make significant changes to the tax code without either reducing revenues or shafting the upper-middle class.”

—September 2017 Monthly Budget Review

Last month this commentary suggested that a new, more fiscally-lax attitude was beginning to sprout on the banks of the Potomac.  The administration’s recent tax change outline does significantly reduce revenue thanks to cuts in corporate income taxes and individual taxes on high incomes.  Unfortunately, the Gang of Six did not stop there but instead included several provisions which are designed to shift the tax burden to the upper-middle class (defined here as households with annual incomes between $100,000 and $300,000.)    While some of the bad news, such as eliminating the personal exemption and the deduction for state and local taxes are explicitly stated in the proposal, the plan as currently structured would also effectively get rid of other widespread deductions for interest on home mortgages and charitable contributions for most taxpayers.  Since more than 80% of $100,000 to $300,000 income earners itemize their deductions, the administration’s proposed overhaul would likely result in a substantial increase in their income taxes.

To understand how the tax proposals would affect upper-middle income taxpayers, we must first review how the current system works.  In essence, each filer comes up with an adjusted gross income (AGI) and then subtracts both exemptions and either a standard or itemized deductions from it to reach a “taxable income.”  This taxable income is the basis for determining taxes owed although there are other ancillary credits and taxes which can adjusted it further.

The “personal” exemption, which amounted to $4050 in 2016, is allowed for the taxpayer, his/her spouse (if filing jointly), and any eligible children—generally those under 18 or in college full-time under 24.  Thus, a family of four would have been able to subtract $16,200 from their AGI.  (Note: this exemption is phased out starting at $311,300 AGI.).  In addition, taxpayers are able to subtract either the standard deduction ($12,600 for married couples filing jointly in 2016) or the itemized deductions on their Schedule A—whichever is greater.

Schedule A includes several types of deductions, but the largest are the deduction for state and local taxes, for interest on a home mortgage, and for charitable donations, which together accounted for 90% of the $1.2 trillion in itemized deductions in 2015 (the latest data available from the IRS.)  Much of this amount went to working Americans in the upper-middle class, since they usually live in larger houses with bigger mortgages and higher property taxes, as well as paying more state and local income taxes.  For a majority of filers with household incomes over $100,000, the sum of their deductions exceeds the standard amount, often by a substantial margin.  While this is particularly true of so-called “high-tax” states, it is definitely not confined to them.

Let’s compare the current tax code with the effect that the proposed changes would have on a family of four with a household AGI of $150,000, a combined state and local income tax rate of 4% who live in a $500,000 house with a $350,000 mortgage (annual interest about $12,000) and property taxes of $6,000 per year.

As you can see, doubling the standard deduction, a provision loudly touted by the administration, does nothing for this household.  In fact, it does little for even filers who currently use the standard deduction since exemptions would be eliminated at the same time.  Announcing that the plan benefits “middle-class” Americans seems well off the mark.

Some commentators have taken solace in the notion that the tax increases in the plan would fall largely on taxpayers in states with “high taxes. What this analysis fails to see is that getting rid of the state and local tax deduction would be tantamount to eliminating the home mortgage interest and charitable deductions as well.  This is because very few taxpayers would have enough payments in these areas to exceed the increased standard deduction.  Eliminating the mortgage interest deduction would presumably have a damaging effect on house prices, since it would effectively raise the net interest rate on mortgages—an argument which the real estate lobby has made for many years.  And while many Americans might continue to contribute to charities without the benefit of a tax deduction, the proposed changes would likely reduce the amount of giving.

In summary, we can see that the proposed changes would increase the taxable income for a majority of American households making more than $100,000.  Since the administration has not yet stated where the cutoffs for the various tax brackets would fall, it is impossible to say precisely what the final effect would be.  However, given the misleading hyperbole and general sense of chicanery which ooze from the outline of the “reform” proposal, this commentator has little hope that the final version would not shaft upper-middle class taxpayers.  I’m hoping to be proven wrong, but I doubt that I will be.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  

Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Doylestown Wealth Management, Inc. are separate entities from LPL Financial.