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A Tax Story, Less Radical Than Expected

Now that most Americans have filed their first tax returns under the law’s latest revamp, it is becoming clear that for the great majority there was less to this story than first met the eye.

There was also less to the story than the media suggested. Remember all those stories from early this year about how the average taxpayer’s refund was down by as much as 16% from last year? While not fake, that news was certainly premature. Internal Revenue Service statistics for the filing season through April 5 show an average individual refund of $2,833, which was just $31 – or 1.1% – lower than a year ago. Even that decline was mainly due to new withholding tables that took effect in 2018, which took out less in federal income taxes for each paycheck. Taxpayers had more money to spend sooner, at the cost of a little less of a forced savings account with Uncle Sam.

It will be quite a few months before we can measure the effects of the new tax law in full. This is because, while most citizens and businesses have already reported their 2018 taxes, the taxpayers with the biggest incomes and most complex business interests seek automatic extensions of time to file at much higher rates than everyone else. Our firm handles exactly those types of returns, for high-income individuals and the trusts and closely held businesses intertwined with their finances. This year, 45% of the returns we prepare will be filed after April 15.

For taxpayers in these complex situations – who account for a vastly disproportionate share of total taxes collected at both federal and state levels – everything they have paid thus far is only an estimate.

Because of the radical changes the new law made in limiting itemized deductions, while providing a special 20% deduction for income from many noncorporate businesses, there is a much wider than usual variation in how this round of tax reform affected individual taxes. On balance, most Americans received a tax cut, but that cut was not especially dramatic for typical wage earners.

The standard deduction increased from $6,350 to $12,000 for an individual, and double those figures for married couples filing jointly. But the new law eliminated a personal exemption that was worth $4,050 in 2017, so the net effect was to exclude or deduct from taxable income only an additional $1,600 per individual at most income levels. Probably more significantly, the new law both cut tax rates and expanded the brackets in which the new rates apply. A single filer with taxable income around $150,000 was in a 28% marginal tax bracket in 2017; for 2018, that marginal tax rate fell to 24%. And this is before considering the pass-through exemption for noncorporate business owners.

Articles such as a New York Times news analysis from January also jumped the gun in reporting that the tax cuts under the new law failed to pay for themselves as some advocates had contended they would. In this case, the prematurity is probably more measurable in years than in months.

First and most obviously, tax revenues actually collected in 2018 reflected a combination of balances due on taxes generated under the prior law, the newly reduced income tax withholdings, and estimated taxes paid by partners and self-employed business owners. The accuracy of those estimates will not be tested until all of this season’s returns are complete, including the high-dollar filings currently on extension.

Also, of course, the economic growth that took place during 2018 does not immediately translate into taxable income that taxpayers received in the same year. The law of compound interest also applies. An economy growing at 2% annually for 10 years will be 22% larger when the decade is over. One that grows at 3% will be 35% larger; at a 4% growth rate, the compounded increase is 49%. Economists of varying persuasions will endlessly debate the extent to which the new law did or did not contribute to increased growth over an extended period of time. I am confident that where each economist comes out on that question will be governed largely by the biases that particular economist carried into the exercise.

Of course, averages are only averages. When it comes to government finance, averages are not necessarily what matters most. States like New York depend heavily on the taxes paid by an exceedingly small share of their population. Citing Congressional Budget Office statistics, the Empire Center for Public Policy reported that in 2016, the top 1% of New York earners (households with an income of about $5 million or more) accounted for about 35.5% of the state’s adjusted gross income on federal tax returns, but paid 51% of state income taxes and 43% of New York City income taxes.

These are the earners most affected by the new law’s $10,000 cap on itemized deductions for state and local taxes. In New York, this not only means combined state and city income tax rates that can exceed 12%, but also some of the highest property and sales tax rates in the country. We have seen preliminary figures for some of our clients who fall into this category, and they are not pretty. It is no wonder that New York Gov. Andrew Cuomo and his peers in other high-tax state are enraged at the new tax regime, even though it adds to the tax burden on the people they are quickest to tax. They fear too many of those people will relocate to more favorable tax climes in places like income-tax-free Texas and Florida.

I can’t say that this fear is premature or unfounded, but it will take some time to see the extent to which it ultimately plays out – assuming federal law does not change again in a way more favorable to top earners and property owners in high-tax states.

In the meantime, the tax world continues spinning on its axis, and most of us are adjusting to the new regime. If you are like most people, this year’s tax filings probably were not quite as big a deal as you may have been led to believe.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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