Wednesday, March 21, 2018

The Republican Tax Reform: Part 13 — The Increase In the Standard Deduction

The dynamic of tax systems is that they tend to get more complex slowly and continuously. Occasionally this is punctuated by widespread reforms.

On personal income taxes, a large source of complexity is Schedule A of Form 1040, which is used for itemizing deductions. Form 1040 is the main form for individuals and couples. It has several variations. About 30% of returns include Schedule A. So, any move towards personal income tax simplification probably needs to either reduce the complexity of Schedule A, or reduce the number of filers who use it.

We need one quick note on how taxes are filed. Filers are not the same as people. Filers are usually the only ones in an entire household filing personal income tax forms, so this is something like a third to half the overall population. Dependents are those who do not file.  Filers can be 1) singles, couples, or heads of household (who have dependents who may not be directly related to them). Couples have the choice of filing jointly (more common) or as individuals.

Increasing the size of exemptions and/or standard deductions has been a policy proposal floating around D.C. for a generation. Most flat tax proposals made by Republicans included this. Alternatively, guaranteed income proposals made by Democrats can be shown to be equivalent to a combination of a larger exemption and/or deduction combined with extending a subsidy if one's adjusted gross income is negative (we already sorta’ do that too, with the Earned Income Tax Credit).

In review, personal income is subject to adjustments, exemptions, and deductions prior to the calculation of tax. Adjustments are items that added or subtracted from income. Exemptions are amounts that are subtracted from income, usually per individual/dependent, to reduce taxes owed (and completely exempt those at very low incomes). Deductions are per filer, but otherwise work in a similar way.

Filers have two choices: take the standard deduction, or itemize deductions on Schedule A. Taking the standard deduction is similar to a large exemption that is the same for all filers. Alternatively, if one itemizes, you may be able to deduct more, at the expense of doing more paperwork (and a larger audit probability).

Expenses that can be itemized include SALT, out-of-pocket healthcare expenses, investment interest expenses (including mortgage interest and points), charitable contributions, and casualty and theft losses. A portion of the last major tax reform in 1986 was targeted at reducing the number of filers who itemized, by making it tougher to claims expenses (on your personal income tax) on business activity done in your home.

The idea of the standard deduction is twofold: 1) many filers have expenses that would be close to the standard amount if itemized, so why bother making them do the paperwork,  and 2) if they don't have that many itemizable expenses the standard deduction amounts to a tax break.

This gives us a clue about who those 30% of filers are. One group would be taxpayers in states with high income taxes, and/or localities with high property taxes. These filers are primarily rich and/or in the Northeast. Since the old and the poor have most healthcare expenses covered by Medicare or Medicaid, those who itemize due to healthcare expenses tend to be working, ill, and underinsured. These filers are most commonly found in the West where health insurance is both less common and more often seen as less economical. Mortgage expenses tend to be most heavily deducted by the young (with bigger payments), those with larger homes, or those in areas where real estate is more expensive (primarily the Northeast and Pacific Coast). Other investment interest is actually not that common a source of itemization, since many do this through corporate structures (with different forms) to limit their liability. Charitable contributions are quite common, but are often not terribly large because of the paperwork involved in documenting fair value. An exception to that is tithing, which is most common in the South and also Utah. In short, the 30% of filers who itemize is fairly diverse, with some lumpiness, across income, wealth, age, and geographic location.

Prior to this year, the standard deduction was around $12,000 for couples filing jointly. The Republican tax reform increased this to $24,000. It changed for other types of filers too, but I’ll stick to this most common case.

To understand the economic issues involved, recognize that this change divides the population of filers into three groups.

The largest group is those who did not itemize before the change. The change gives them no reason to change. Roughly, these are "the poor" even though this group also includes most of the middle class, so the increase in the deduction amounts to a tax cut equal to their marginal rate times the $12K difference. Also note that this reform effectively increases the width of the income bracket subject to a marginal rate of zero, increasing the number of the poor who go from paying a small amount of income tax to none at all.

So this reform should absolutely be regarded as a tax cut for the poor and middle class. However, as pointed out in other posts, many of the people don’t pay much tax to begin with, so the absolute size of the cut may not be very large.

The second group is those with deductions that are so large that they itemized before and will continue to after the change. Roughly, these are "the rich", and the increase in the standard deduction leaves their situation unchanged. They didn’t use it.

So, this particular reform should not be labeled as benefitting the rich at all.

The third group are those who did itemize before the change, but will claim the larger standard deduction after the change. (Personal note: my household is in this group during most years). For those near the lower end the change amounts to a tax cut, less so for those at the top end. For both groups the reform is a tax simplification.

In sum, from a Keynesian perspective, this reform is going to lead to a modest decline in revenue, since it largely affects those who don't pay much in taxes to begin with. From a supply side perspective, this is a simplification of the tax code, but not a terribly large one since it does not affect that may filers. Both are viewed as expansionary policies.

No comments:

Post a Comment