I have been reviewing the new Republican tax plan framework, and noticed that my family pretty much defines the profile of households that would see a tax increase: upper middle-class families in a high-tax state that itemize deductions. Following the assumptions of the Tax Policy Center, I used my 2016 tax return to calculate the potential change for my family and received quite an unpleasant shock from what the President calls the largest tax cut in history.
The big change in the proposal for households would be to eliminate exemptions and deductions for state and local taxes, while increasing the standard deduction and child tax credit.
Currently, my family takes $16,200 in exemptions (family of 4) and we had $38,000 in itemized deductions last year (of which about $20,000 were state/local income/property taxes, and the rest mortgage interest and charitable giving). The exemptions and itemized deductions resulted in our taxable income being $54,000 less than our gross income.
Under the Trump Plan, we would no longer itemize deductions because we would lose the state/local tax deduction and the remaining interest/charity deduction of $18,000 would be less than the new standard deduction of $24,000. We would also lose the exemptions, so our taxable income would be $30,000 more since the total of our exemptions and deductions would be reduced from $54,000 to $24,000. This additional $30,000 in taxable income under the Trump Plan would have a 25% federal tax rate, and thus would raise our taxes by $7,500 per year.
However, we would get some offsetting tax reductions under the Trump/Republican plan. It would eliminate the Alternative Minimum Tax, so I would avoid $450 in AMT from last year. My kids are dependents between the ages of 16 and 25, too old for the child tax credit, but we might get up to a $500 tax credit for each one under the new non-child dependent tax credit (depending on an income phase out). Finally, the tax rates are a little bit lower, our marginal rate would be 25% instead of 28%, the exact dividing lines for the brackets is uncertain but the lower rates look to save us about $2,000. So I estimate $2,500 to $3,500 in offsetting tax reductions.
Put it all together, and our family is a clear loser, as our federal income tax bill will go up at least $4,000 and possibly by $5,000 depending on assumptions. Most households would receive some level of tax cut, as only 30% of households itemize deductions that are most likely to trigger an increased tax bill.
One of the interesting economic questions is whether this will change the behavior of households like mine. Losing the state and local tax deduction makes paying California taxes more painful, not enough to make us move, but it could affect a few decisions of whether to move in or out of the state. Perhaps most importantly, it will make it harder to pass state and local income and property tax increases in the future. The real estate market and charitable giving could also be affected. This indirect loss of the mortgage interest deduction increases our cost of home ownership right now, but it has no effect on our past home buying decision. But losing this mortgage subsidy will affect how much we are willing/able to spend on a home if/when we move again, and considering many households in the same situation, this should somewhat reduce demand for owner-occupied housing in heavily impacted state's like California. Charities probably won't feel too much of an impact, but some could indirectly if they depend on middle/upper-middle class households who stop itemizing.
In theory, lower marginal tax rates will give us more incentive to work and earn income. I teach my students some core tenants of tax efficiency (low rates on large base) and this structure of eliminating deductions with lower rates would seem to fit the bill. However, this is eliminating a deduction that subsidizes my state income tax rate, so it doesn't do much to lower our combined marginal tax rate. Here is some math to illustrate: How much tax will my family pay on an additional $10,000 in income? Under current law, we pay 9.3% state tax, then deduct this from federal income before applying a 28% rate. State tax on $10,000 is $930, federal tax = .28*$9,070= $2539.60 for total tax of $3469.60 or 34.7% of $10,000. Under this proposal, we can't deduct the state tax, but pay federal taxes at 25%. Our state tax is the same, but the federal bill is .25*$10,000 = $2,500 for a total tax of $3,430 or 34.3% of $10,000 in income. So while it seems like the Trump tax plan would lower our marginal tax rate by 3 percentage points, it only reduces the combined rate by 0.4 percentage points from 34.7% to 34.3%. That's barely a change at all, and thus does little to impact incentives for work and investment for those who itemize deductions in California or any state with a significant income tax.
Not everyone in my extended family will get a tax increase, as most people who don't itemize deductions will see a small cut. For example, my parents do not itemize and do not take exemptions for kids, and are in the 15% bracket. They will do better with the new $24,000 standard deduction than their current exemption/st. deduction of $18,600, and will be paying 12% at the margin instead of 15%. So my parents will probably save about $1,000 under this plan. Maybe that will buy them some plane tickets to come visit us, because tickets for my kids to visit their grandparents could be one of the things we have to cut to pay for our new taxes.
All of this could change and Congress is being lobbied heavily to not eliminate state/local tax deductions (especially California republicans) and to not eliminate exemptions. And Trump has had a very hard time getting things through Congress. Thus, my guess is our taxes will not really go up by this much. But I have more personally at stake in this debate than I realized - and maybe you do too if you are a Californian who itemizes deductions like most homeowners with a mortgage.
It's not necessarily bad tax policy just because my taxes would increase, and I admit that it is hard to be an objective analyst when you are one of the few looking at a steep tax increase in the context of a very large overall tax cut. There is a case for eliminating the state/local tax deduction and even reducing exemptions. However, I thought something like this would come with much larger offsetting cuts to individual marginal tax rates, but the Trump/Republican plan is reserving the large cuts in marginal rates for corporate taxes.
November 2: See my update as new details have been released.
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