The good, bad, and most indefensible parts of the tax overhaul

Erik McGregor | Pacific Press | LightRocket | Getty Images.

By David Nelson, CFA

Late Friday we got the final details on the $1.5 trillion GOP tax overhaul. Last minute endorsements from Senators Marco Rubio and Bob Corker pushed the bill a step closer to a vote and the president’s desk. Like everything in Washington, the passions on both sides of the debate are intense. Some like Senate minority leader Chuck Schumer say the GOP “will rue the day they pass this.” On the other side Representative Kevin Brady says; “we’re on the one yard line and intend to punch it in….”

I’m going to take a walk through the highlights, admittedly through the lens of an investment strategist and portfolio manager. Here’s my take on what’s good, bad and ugly.

The good

The headline that jumps off the page is of course the corporate tax rate slashed from 35% down to 21%. Critics will point to this as corporate welfare and a Wall Street giveaway benefiting only the rich and contend that the current code is working just fine.

I’ll repeat what I’ve posted several times. If the current code is so star-spangled awesome how come U.S. corporations have been leaving for years moving to lower tax countries? 21% will make us far more competitive and creates a code that doesn’t encourage industry to off-shore their cash, manufacturing and sometimes the whole company. Estimates suggest there is $1.9 trillion to $3 trillion of corporate cash trying to make its way back to the United States. Apple (AAPL) alone has close to $250 billion parked outside of the country. The media loves to suggest the marginal rate for most corporations isn’t the high 35% but below 30%. I doubt that analysis includes the thousands of high-taxed companies that have already left.

Pass-Through — For those running their own business, proposed changes to pass-through income or S corporations are a big deal. Currently pass-through income is taxed at the individual rate. The proposed bill has a 20% income reduction and according to the Wall Street Journal has some language letting pass-through firms qualify for a tax break on capital investment. There’s a lot that concerns me about the pass-through portion of the bill but I’ll cover that in the bad below.

SALT — The original version of this legislation would have eliminated the State & Local Tax deduction but the final bill provides some relief for those living in high tax states. I’ve long believed states like Connecticut, New York and of course California have been on a suicidal path forcing some of their most productive residents to lower tax states or even worse out of the country. I live in Connecticut and have watched in disbelief as taxes continued to climb — forcing industry out, taking jobs and workers with it.

Wealth is portable. If we continue to push the wealth of the country out whether at the corporate or personal level, you destroy the tax base. The good news for residents of these states, unlike previous versions of the bill, is that some of the state and local tax deductions remain. If you itemize you will be able to deduct up to $10,000.

All of the above is part of a plan to break GDP out of a decade long slump. We’ve been preached to for years by left-leaning economists like Nobel Laureate Paul Krugman that it was economic arrogance to expect anything approaching 3.5% growth. Of course it was Mr. Krugman who predicted the markets would never recover following the election and Trump victory last year. Nearly 6,400 DOW points later I’d say that estimate is off by just a little.

Medical Expenses Protected — For those who itemize, currently you can deduct expenses above 10% of income. Under the proposed bill it drops to 7.5%.

Standard Deduction nearly doubles for married, single and head of household to $24,000, $12,000 & $18,000 respectively. However, the personal exemption disappears.

We now have 7 brackets from 0% – 37% as laid out below. (WSJ)

The Bad

This isn’t tax reform. There are all sorts of names you can give this bill — tax cut, tax overhaul — but tax reform it is not. True tax reform would look a lot different, refusing to buckle under to lobbyists protecting tax breaks, loopholes and giveaways. Money still controls Washington and for every loophole you eliminate two more that pop up.

From the beginning, this tax bill was supposed to make the process simpler — advertising that we would be able to fill out our taxes on a post card. I suspect that accountants and tax attorneys have nothing to worry about regarding job security. Anyone who itemizes or runs a business is going to need all the help they can get.

Real Tax Reform would be closer to a flat tax with a zero rate up to some multiple of the poverty line. It’s not likely to happen in my lifetime so I’ll leave that alone for now. At the beginning of this process an army of lobbyists descended on Washington like locusts each fighting for a different loophole or tax break. Unfortunately for those of us embracing real change and reform, too many of them succeeded.

Alimony – Honey I want a divorce 

Expect divorce rates to skyrocket next year. If you’re thinking about getting a divorce, get in touch with your lawyer today. If I’m reading correctly, the alimony deduction for the payer is gone after 2018.

Deficit — We started off on a path of revenue-neutral but of course that fell by the wayside long ago. Growth solves a lot of problems and even without dynamic scoring I believe we will be lower than the headline number. However, the direction is wrong.

Pass-through complexity — At least at first reading there’s potential for abuse and a likely boom for accountants and tax attorneys looking to get some portion of wealthy client income closer to the corporate rate. We were told early on guard rails would be put in place to protect from abuse.

Mortgage interest deduction largely stands although the size of the loan drops to $750,000 from $1 million. You’re probably wondering why I have this in the bad column. Not because of the drop in the loan size but as a renter I’m tired of subsidizing home ownership. In any event probably bad news for homebuilders like Lennar (LEN), Pulte (PHM) and Toll Brothers (TOL).

The ugly

Perhaps the most appalling indefensible line item is that carried interest survives. President Trump ran on a platform of eliminating this giveaway but has been largely silent throughout the process. Private equity and hedge fund managers still have the ability to have some of their income taxed at the capital gains rate rather than the higher personal income tax. Coming from the financial industry I find it an embarrassment believing this borders on the criminal. Lobbyists scored big here pointing out that many of their private equity clients are big political donors. Money talks and in the end the number one job of every politician is to get elected.

Maybe the ugliest observation is the process itself. Thirty years ago the party with a slim majority would have reached out for support from the other side of the aisle. In a polarized Washington, bipartisanship is a distant memory and unfortunately Washington is little more than a reflection of your home town.

See also:

Here’s what you can expect from the stock market in 2018

Net neutrality is on death row — we should let it die

Warren Buffett is sending the wrong message on Wells Fargo

Amazon: The benevolent dictator