No kidding – the new Trump Tax plan is going to be huge, especially if it really happens. What is contemplated is nothing less than a shift from an income-based tax to a consumption-based tax, the kind widely preferred by economists. When finalized, it will combine business + individual + estate taxes into a ball and roll it right down the National Mall towards Congress.
Now known as the Brady plan, it is a work in progress dating back to the Bush administration and before. I will not bother addressing the corporate tax part here, since I don’t understand it. Let’s focus on the important part: you and me.
Not everyone loves a consumption tax, though
Boston Tea PartyIndividual Taxes
The big news is radical simplification to three tax brackets: 12%, 25%, and 33%. Add to this a large standard deduction ($24,000) and personal exemption/child credit ($1,500) and many fewer people need to bother with Schedule A. The mortgage interest deduction remains, as does the one for charitable donations. In the strictest edition, all other deductions are toast, including, controversially, state and local taxes. Also, begin the begone for the Alternative Minimum Tax (A.M.T.).
Now get this: interest, dividends, and capital gains would all be taxed the same, which would be ½ your labor income marginal tax rate. A top bracket investor would pay 33% on income and 16.5% on interest, dividends, and gains. This is especially helpful, as many Americans know how to divide by two. The 3.8% Obamacare surtax and the 1.2% Pease surtax on dividends and capital gains are history. Interest income benefits the most, as it is currently taxed the same as labor income. That means twice as much of the 0.01% the bank pays me on my cash deposits is going to stay in my pocket, allowing me to save up for that stick of gum I’ve been dreaming of.
This is radical tax simplification. The current rococo income tax system will be junked and sold to Parker Brothers for a board game. But how is this a consumption tax?
Here’s how. The magic formula is Consumption = Income minus change in Savings.
If you save your income, there’s no tax. Earn $100,000 and save $25,000, you only pay tax on $75,000. Earn $100,000 and spend $125,000, you pay tax on $125,000 worth of income. Since there is no tax on invested capital, it is a pro-growth policy.
In other words, it is as if you would be given a special new IRA-like account with no limits on cash flows in or out. Money you save inside it remains untaxed for as long as you save it. But as soon as you spend it, it is taxed at your marginal rate. You readily can see how this would promote saving and investment while discouraging consumption.
This is a better mousetrap than the Euro-style Value-Added Tax (V.A.T.), which notoriously promotes contempt for the law as merchants and consumers are tempted to cheat using tax-avoiding under-the-counter cash transactions.
Lest you get too excited and need to take a pill, many issues remain. Like how existing capital would be taxed when used as a source of consumption, for one. Some of these issues have to do with the transition to the new regime, and others with the interaction between corporate and individual taxes. In one blood-curdling variant, we could end up having to pay a marked-to-market or imputed capital gains tax on our investments every year. Wouldn’t that be special? Or, considering that we already have been taxed on our existing savings, some of us sensitive souls would prefer to be not taxed on them a second time when we turn the piggy bank upside down to spend them. It won’t all be peaches and herb.
Estate Taxes
This one’s easy. The death tax is repealed. Unless you have over ~$11 million in your estate, you weren’t going to be paying it anyway.
There is one wrinkle that could make the new law more taxing for your estate, though. That would occur if you had a large cache of unrealized capital gains. Under current law, you might have $10 million in capital gains, and they can go to your heirs with a step-up in basis. Your heirs can sell the securities, pay no taxes, and start over. Voila! No estate tax, no capital gains tax. Life is good.
What if they eliminate the capital gains step-up? Then your heirs would pay no estate taxes, as before, but the $10 million in capital gains would be taxed at half their marginal rates (say, 16.5% or $1,650,000 payable to U.S. Treasury). There would be an effective new estate tax where there was none before. Many people would end up worse off under the new system, which would impose a de facto estate tax on the little people in the name of eliminating it for the ultra high net worth.
In Sum
The Trump tax plan is not carved in stone; it’s carved in oatmeal. Bold proposals are often floated to crank up on the Congressional lobbying ATM, which is the primary side-purpose of the tax code anyway. Stay tuned for further developments on this work-in-progress. One thing’s for sure: we aren’t in Kansas anymore.
In the meantime, if you want to read a more detailed analysis, see the one by U Chicago’s David Weisbach here.
