Republicans still don't understand why their plan raises taxes on many middle-class families

AP

Bloomberg reports President Donald Trump was angry to learn his tax plan would raise taxes on some middle-class families, and that Republicans will look to address Trump's anger by revisiting their proposal to repeal the deduction for state and local taxes.

Trump is right to be concerned, but he apparently still doesn't fully understand the problem.

The Tax Policy Center estimates that 12% of taxpayers would pay more tax under the Republican plan than under current law if it were imposed this year, and that the bite would get worse over time, with 25% facing a tax increase relative to current law by 2026.

Some people with truly moderate incomes would see their taxes go up, but upper-middle income taxpayers would be the most likely to face a tax increase. And as Barack Obama learned, you will not like what happens when upper-middle income voters think you are coming for their tax breaks.

But the main culprit behind the tax increases on middle- and upper-middle income families is not the proposal to raise $1.3 trillion by abolishing the state and local tax deduction.

The main issue is the plan's abolition of personal exemptions, a change that would raise $1.6 trillion, according to the Tax Policy Center.

The most important tax break you barely notice

Almost everybody benefits from the personal exemption, even though it's not a tax provision people think about very often. The personal exemption means you get to exclude $4,050 of your income from tax, simply for existing and breathing. You get to exclude another $4,050 for your spouse, and $4,050 more for every dependent you have.

Crucially, you get to do this even if you also take itemized deductions. Look back at Ann and Bob and their two kids, the theoretical family of four whose taxes I wrote about last month.

Because of their mortgage and their property taxes and their charitable giving and their state income taxes, Ann and Bob take $21,056 in itemized deductions. They also take $16,200 in personal exemptions, which knocks their income of $120,000 down to a taxable income of $82,744.

Under Trump's plan, the standard deduction is increased to $24,000 for a family, but there are no personal exemptions. So even though the new standard deduction is larger than the itemized deductions Ann and Bob used to take, they end up paying tax on much more of their income — $96,000 of it.

This leads to a tax increase for Ann and Bob of $587, assuming Republicans set the terms of their (as yet unspecified) child tax credit increase in line with Paul Ryan's most recent prior proposal, which would have increased the credit by $500 per child.

Skye Gould/Business Insider

Even if you currently take the state tax deduction, leaving it in place may not help you

If Republicans changed their tax proposal to leave the state and local deduction in place and otherwise made no changes, Ann and Bob would face exactly the same tax increase as under the current proposal.

Ann and Bob make a good living, but they don't pay enough state and local taxes to get their total deductions over $24,000. So, even if the state and local tax deduction was left in place after tax reform, it wouldn't make sense for them to claim it anymore. Their tax increase under the Trump plan is entirely attributable to the abolition of the personal exemptions they used to take on top of their itemized deductions.

Of course, this won't be true for every single taxpayer. There will be some families — generally, richer families than Ann and Bob's — whose Trump tax hike is partly or wholly attributable to the loss of the state and local tax deduction.

Because the value of the state and local tax deduction rises in line with the amount of state and local tax you pay — and therefore with your income — its abolition will disproportionately hit high-earning households.

The personal exemption is also more valuable to higher-income households, at least up to incomes in the mid-six figures where the right to the exemption phases out under current law. But the trend is much less steep — multiplying your income by 10 does not increase the value of the exemption by anywhere close to 10.

Abolishing personal exemptions is a revenue-raising option that hits middle-income families unusually hard.

Thomson Reuters

This tax plan can be fixed, in theory

To be clear, while I'm laying out the problems the Republican plan as currently described would create for many families, there is a sound policy argument for many of the structural ideas about taxes in the plan.

Repealing personal exemptions, making it harder to take itemized deductions, and then offering higher standard deduction and higher tax credits for dependents could be the foundation of a good plan to reform the individual tax code that treated the middle class well, if you got the numbers right.

Tax credits are a more progressive alternative to the personal exemption — a $500 credit is worth the same $500 to a low-income taxpayer or a high-income taxpayer, while the tax savings from each personal exemption claimed equals $4,050 times your marginal tax rate, meaning high-income taxpayers benefit more.

A shift toward a larger standard deduction would have the benefit of making many people's taxes simpler. And many tax deductions create inefficient economic distortions, for example encouraging people to put more mortgage debt on their homes than they otherwise would.

To make this shift without screwing over regular people, you just have to set rates and amounts and thresholds in the new tax plan so benefits flow toward the middle class, unlike the current Republican plan which saves 80% of its tax cuts for the top 1% and raises taxes on many middle-income families.

You can see the problem just by looking at the macro numbers on what the tax plan's provisions raise or cost.

Abolishing the personal exemption would raise $1.6 trillion over 10 years. The measures designed to offset that change — the larger standard deduction and dependent credits — would only reduce taxes by $1.1 trillion, meaning a net tax hike of $500 billion aimed largely at the middle and upper-middle class.

Thomson Reuters

Here's what Republicans could do to make their tax plan work for working families

They could use a combination of these options:

• Increase the standard deduction by even more than they have currently proposed.
• Increase their proposed "non-child dependent" tax credit from $500, and raise the existing child tax credit by more than $500.
• Make these new and expanded tax credits refundable, or deductible against payroll tax, so low-income families would benefit from them even if their incomes are too low to owe income tax.
• Set a bottom tax rate of 10% instead of 12%.
• Extend this lowest tax bracket to cover more income.

All of these options would cost money, and the tax plan already has too many tax cuts to fit within the budget vehicle Republicans plan to use to pass it, so they'd have to offset these changes by making the plan less generous elsewhere, perhaps to rich people.

As tax reporter Richard Rubin of the Wall Street Journal noted, Republicans have already laid out some to-be-described-later options to shrink the size of their proposed tax cut, whose effects would be progressive:

• A limit on business interest expense deductions.
• A minimum tax on the global income of US-based multinational firms.
• Some sort of rules to prevent individuals from abusing their proposed "small business" tax break to recharacterize their labor income as tax-preferred business income.
• The "mystery bracket," an additional bracket above 35% that they might impose on very high incomes.

In my view, the whole small-business tax preference idea is wrongheaded and Republicans should scrap it. The proposal as they have designed it is going to be ripe for abuse, and despite the "small-business" name, all of its benefits would go to high-income taxpayers.

My expectation is that Republicans will not be willing to make the major changes they'd need to make to their tax plan for it to be fair to the middle class, and they will have to go to the voters defending their proposal to raise taxes on many middle-income families while raising the deficit and giving a windfall to the rich.

But that's not their only option.

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