December 22, 2017
No one should have any doubt about the main impact of the Republican tax cuts. These tax cuts are about giving more money to the richest people in the country. After four decades of the largest upward redistribution in the history of the world, the Republican tax cuts give even more money to the big winners.
In TrumpWorld, that makes sense. Instead of spending money to rebuild our infrastructure, reduce greenhouse gas emissions, provide quality child care or affordable college, we’re going to hand more money to Donald Trump and his family and friends.
However, even in the cesspool known as the “Tax Cuts and Jobs Act,” there are some changes for the better. These are worth noting and expanding upon when saner creatures gain power.
Doubling the Standard Deduction
The first and perhaps most important item on this list is the doubling of the standard deduction. This is really a good thing; it means that the vast majority of people will have no reason to itemize their deductions. We will spend over $27 billion this year (an average of almost $200 per household) on fees associated with filing taxes. In addition, many people waste hours of their time preparing documents and then worrying about making mistakes. Anything we can do to make this process simpler and cheaper is for the good.
In fact, we should look to take this another step forward. In many European countries, it has long been the practice that the tax agency prepares people’s returns for them. This is relatively easy if they are taking the standard deduction. People are sent the returns, along with a refund or invoice for additional payments. If they believe the form is mistaken, they compile their documents and make their case. Otherwise, they are done. Their taxes have been calculated for them and they can spend their time and money on better things.
Limiting the Mortgage Interest Deduction
The second item on my list is reducing the limit on mortgage principal for which interest is deductible. Since this has caused a great deal of confusion, it is worth pointing out exactly what was done in this tax bill.
Under the old law, people could deduct interest on up to $1 million in mortgage debt on both their primary and secondary homes. It is important to realize that this is not a limit on the size of the mortgage for which interest could be deducted. If someone has a mortgage of $1.1 million, under the old law they could deduct interest on $1 million but would be excluded from deducting the interest on the last $100,000.
This bill lowers this limit to $750,000. The impact of this reduction will be zero for the vast majority of homes in the country. Even in relatively high-cost areas like New York City and Washington, the impact will be limited. If a home sells for $900,000, it’s likely that the mortgage is not going to be much larger than $800,000, which means that the vast majority of the mortgage interest will still be deductible.[1]
For homes that cost well over $1 million, where the owner is likely to have a mortgage of more than $1 million, this change means that the interest on $250,000 less of the mortgage can be deducted. Assuming a 4.0 percent interest rate, this costs the homeowner $10,000 in deductions on their returns. If they are in the new 37 percent top tax bracket, this means an increase in their tax bill of $3,700 a year.
The change that likely has more impact for the mortgage interest deduction is the doubling of the standard deduction. This means that it will make sense for a much smaller percentage of homeowners to itemize even if they could deduct all their mortgage interest. The total of people’s itemized deductions is unlikely to exceed their standard deduction and even if they do, the margin will often be small.
For example, if the sum of a couple’s itemized deductions, such as state and local property taxes, charitable contributions, and mortgage interest, comes to $25,000, this is just $1,000 more than their $24,000 standard deduction. If they are in the 24 percent bracket, their deductions collectively save them $240 a year on their taxes.
The loss of mortgage interest deduction is overwhelmingly positive. While there is an argument that the government should be helping moderate-income families to become homeowners as a way to build wealth, the overwhelming majority of the benefit from the mortgage interest deduction went to relatively affluent families. In effect, the deduction was subsidizing people who would already be homeowners so that they could buy bigger, more expensive, homes. It is very hard to see the public purpose served by that policy.
Limiting the Deduction for Business Interest
Another positive item in the tax bill was a limit on the amount of interest that businesses can deduct from their profits for tax purposes. The bill puts a cap on interest deductions at 30 percent of profits, with the notable exception of the real estate industry. (Yes, we know who is in the real estate industry.)
This is a big deal for the private equity industry. The industry has thrived by loading up companies with debt, with the idea that if the company survives the leverage allows them to make a huge profit. If they go bankrupt, most of the losses are shifted on to creditors. Some of these creditors, like suppliers and workers with pensions, were not intentional creditors, but get stuck holding the bag anyhow. (For more on private equity, see the book by my colleague Eileen Appelbaum and Rose Batt, Private Equity at Work: When Wall Street Manages Main Street.)
Private equity is a mixed story at best, but there is no reason that the government should be subsidizing businesses to take on excessive leverage. This 30 percent cap on deductibility is a big step in the right direction.
Capping the Deduction for CEO Pay at $1 Million
Part of the story of inequality of the last four decades is the explosion of CEO pay. In the 1960s and 1970s, CEOs earned on average 20 to 30 times what a typical worker made. These days, they earn 200 to 300 times the pay of ordinary workers. It’s common for the pay of a CEO of a major company to run into the tens of millions annually.
While there may be an argument that some CEOs are actually worth this sort of money in terms of what they do for returns to their shareholders, it is hard to believe that this is true for most of them. Take for example John Stumpf, the Wells Fargo CEO who was forced to resign due to the fake account scandal. He ended up walking away with over $130 million. This was even after having to sacrifice $40 million of his pay as a result of the scandal.
Did Wells Fargo really have to pay this sort of money to attract someone with Mr. Stumpf’s talents? Wasn’t there someone else in the financial industry who would be willing to come up with a similar scam for $2 million or $3 million a year?
Excessive CEO pay matters not only for the high pay going to one individual. It affects pay structures throughout corporate America and spills over to other sectors. It’s now common to see the presidents of major universities and charities drawing salaries well over $1 million a year. And more for those at the top means less for everyone else.
So it’s good to see the tax bill make a modest effort to rein in excessive pay by ending the deduction for amounts in excess of $1 million.[2] It’s not clear this will have too much impact on CEO pay (in effect it imposes a 21 percent tax on CEO pay in excess of $1 million), but it is a step in the right direction.
My view is that we have to change power relations in the corporation to make it easier for shareholders to rein in the pay of top executives. (If CEOs are not worth their money, they are effectively ripping off shareholders.) As it stands, the folks who immediately determine CEO pay are the corporate boards of directors. The directors essentially owe their jobs to the CEOs (more than 99 percent of management supported directors are re-elected) so they have little incentive to look to cut CEO pay.
My preferred reform would be to attach a stick to the non-binding “say on pay” votes of shareholders on CEO compensation that are taken every three years. Suppose the directors lost their salaries if a say on pay vote went down? That might give them some incentive to ask whether they could get away with paying their CEO less. (This and other mechanisms are discussed in chapter six of my [free] book Rigged: How Globalization and the Rules of the Modern Economy Were Structured to Make the Rich Richer.)
Imposing a 21 Percent Penalty on CEO Pay at Non-Profits In Excess of $1 Million
This is the same story but applied to non-profits. This is both appropriate in trying to put some downward pressure on high-end pay and also useful in calling attention to the fact that non-profits are drawing a big subsidy from taxpayers. Under current law, taxpayers are effectively paying 40 cents of every dollar that some rich person chooses to give to a university, art museum, or other charity. When we’re talking about contributions that can be in the hundreds of millions or even billions, that is a big chunk of change.
It is reasonable to put some conditions on organizations that receive such large subsidies from the government. Personally, I would put the pay cap much lower ($400,000 is what the President of the United States makes) and make the penalty much steeper. (How about you lose tax-exempt status?) I know the cry of the non-profits: they won’t be able to get qualified people for these sorts of salaries. My response is that if you can’t attract good people for $400,000 a year, then maybe your non-profit is not the sort of organization that deserves the taxpayers’ support. (For folks interested in trying this at home, measures to limit pay at non-profits can also be done at the state and local level; see Chapter 6 of Rigged.)
The 1.4 Percent Tax on College Endowments In Excess of $500,000 per Student
There has been an explosion in the size of college endowments in the last three decades. This has been due to both some generous gifts from the very wealthy and also the enormous run-up in stock prices. Harvard’s endowment leads the pack at more than $37 billion. With 22,000 students, this comes to almost $1.7 million per student.
Endowments of this size are effectively enormous slush funds. In the case of Harvard’s endowment, it can be expected to give real returns of at least $1.4 billion a year, even assuming no extraordinary finance whizzes or insider trading. It is certainly reasonable for the government to either take some cut of this income or to require that the money go to some public purpose, such as paying the tuition of low- and moderate-income children.
I worry that the endowment tax can be easily gamed. For example, the university can spin off large piles of money into various independent funds that are designated for specific purposes, thereby getting under the taxable limit. But the idea of taxing these huge pots of money is a good one.
Reducing the Size of the Orphan Drug Tax Credit from 50 Percent to 25 Percent
The cost of the orphan drug tax credit has exploded in recent years. This credit had the government pick up half the costs of clinical testing for drugs that met the definition of being designed to treat a disease that affects fewer than 200,000 people. The generosity of the benefit gave drug companies enormous incentive to pursue drugs that fit this categorization. More than 40 percent of the drugs approved by the Food and Drug Administration last year were designated as orphan drugs.
There is nothing wrong with the government paying for the clinical testing. In fact, I have argued for exactly this policy (see Rigged, Chapter 5). But the idea is that the government pays for the testing and then makes the drugs freely available as generics. In this scenario, the next great cancer drug sells for a few hundred dollars instead of a few hundred thousand dollars.
By contrast, the orphan drug tax credit effectively has the taxpayers pay for a drug twice. First, we pay half the cost of the clinical testing (and also often for much of the pre-clinical research through the National Institutes of Health) and then we pay again by giving the drug company a patent monopoly that allows it to sell the drug at a markup of several thousand percent above its free market price.
There is a huge amount of money at stake in these monopolies. We will spend more than $450 billion in 2017 on prescription drugs. These drugs would likely sell for less than $80 billion in a free market without patent monopolies or related protections. The difference of $370 billion a year is roughly twice as much money as is at stake with the Republican tax cut. And, this is just the amount associated with prescription drugs. If we added in the costs associated with patent and copyright protection in medical equipment, software, and other areas it would easily be twice as high.
It speaks to the bankruptcy of our policy debate that the prospect of relatively modest increases to the government deficit or debt can be all-consuming on the national stage, but much larger amounts of future spending that the government commits through these monopolies draw essentially no attention. Anyhow, cutting the size of the orphan drug tax credit is reducing a pointless give away to the pharmaceutical industry. It would be great if it were the beginning of a serious discussion of the best mechanisms for financing prescription drug research.
Conclusion: The Tax Cuts and Jobs Act Is Still a Rip-off
To call attention to some of the positive items in the tax bill is not to say that it is in any way good policy. There is little dispute about the distributional impact of this tax bill, the bulk of the tax cuts go to the richest people in the country, exactly the people who have been the big winners in the economy over the last four decades.
The bill also creates a potpourri of potential loopholes by taxing income from different sources at different rates. This is 180 degrees at odds with the idea of simplification. In fact, it goes in the exact opposite direction of the 1986 tax reform, which tried as much as possible to tax income at the same rate regardless of the source. (That bill was passed with a huge bipartisan majority after years of public hearings and debate.)
But there are some items in this bill that can provide a basis for constructive reform in the future. These can be built upon at a time when we have a Congress interested in serious reform.
[1] Also, since the principal is paid down over time, after a few years the outstanding principal on a $800,000 mortgage will be less than $750,000, which means the interest will again be fully deductible.
[2] The Clinton tax bill had limited the deduction on pay not related to performance to $1 million, but companies quickly restructured their contracts so virtually all CEO pay could be defined as “performance-related.”
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