Robert Ricketts, a professor of taxation in the Jerry S. Rawls College of Business, says the new tax laws could have gone further and been more cohesive in their strategies.
Every year, despite the best-laid plans, individuals and businesses this time of year are racing to file their federal income tax returns, which are due on Tuesday (April 17). It is the busiest time for accountants, tax preparers and even websites that assist many Americans with the filing of their taxes.
This year's tax filing, however, has significance beyond just the normal rush to beat the deadline. Thanks to a new $1.5 trillion tax law signed by President Donald Trump shortly before Christmas, there will be many changes coming when the rush to file 2018 returns happens this time next year.
Robert Ricketts, the Frank M. Burke Chairman in Taxation in the School of Accounting at the Jerry S. Rawls College of Business at Texas Tech University, said roughly three out of four Americans in 2019 will see a reduction in their tax bill while the other quarter will see their tax liability increase. But don't go making plans to buy that summer beach house just yet.
“In the long run, the big-picture sort of view of things, probably 75 percent of the country will see relatively meaningful, but not really large, tax reductions,” Ricketts said. “Twenty-five percent of individuals will see an increase. What the next tax law really did was reduce the business tax.
“So, it depends on your circumstances on how that will affect your individual tax liability. It's fairly easy to calculate if you have this year's returns, you can go through and make those changes in just a few minutes to estimate what you will probably owe next year.”
Deductions and reductions
As far as the individual tax filer goes, someone who isn't a business owner or who simply has one job that serves as the source of income, there's good news and bad news, according to Ricketts.
For individuals, the two biggest changes to the tax law for next year will be a larger standard deduction, or the amount that can be deducted without itemizing deductions, and the elimination of the personal or dependency exemptions.
For example, Ricketts said, a family with two children this year was able to deduct $16,200 in tax-free income due to personal dependency exemptions and received another $12,700 tax-free income from the standard deduction, resulting in $28,900 in income that is not taxed if the filer did not itemize.
For the 2018 tax returns to be field next year, that same family will lose the $16,200 in personal dependency exemptions. However, the standard deduction grows to $24,000. Still, that leaves that family next year with $5,000 more taxable income. Even with that, Ricketts said, the tax rates will be lower and the child tax credits will still be in effect depending on the age of the children.
Married couples with no children who took the standard deduction will see a benefit, though not that big. Those couples earned almost $21,000 in tax-free income from the standard deduction and other deductions, which will now be covered by the $24,000 standard deduction, giving them $3,000 more in tax-free income. Their rates will also be lower, which will result in a lower tax liability in 2018.
“You can't really determine how it affects the average American, you can only figure out how it affects people in these specific circumstances,” Ricketts said. “We'll see how it plays out. I think most people are going to see a tax reduction, some will be fairly large and others not that large at all, and some will see an increase.”
Those who could see an increase include people who are self-employed or own a side business that generates income. While there is an increase in the standard deduction for those who do not itemize, those who do itemize will be unable in 2018 to claim many of the deductions they utilize to reduce their tax bill now. Most of those, Ricketts said, are what are called miscellaneous itemized deductions.
On the other hand, the self-employed will get to take advantage of a 20 percent qualified business income deduction, which Ricketts said will be the biggest benefit for individual businesses. From that perspective, the 20 percent qualified business income deduction is just a reduction in income of 20 percent.
“This deduction does not represent actual expenditures incurred by the business – those are also deductible – so this deduction really means that only 80 percent of your net business income will be taxable,” Ricketts said. “That's a pretty big deal.”
Also, those who are self-employed and use their personal vehicle for business purposes will be able to take advantage of a substantially larger depreciation tax benefit thanks to the increase in the definition of “luxury” automobiles from under $20,000 to about $45,000. Last year, the self-employed could deduct around $11,000 for a new car placed into service that year, but for 2018 that goes up to $18,000.
“That's not a gift for most people, but if you're a realtor, a sales representative or a lot of different jobs that have people in the field travelling from place to place, that will make a difference,” Ricketts said. “It will help me if I'm a car manufacturer or dealer as well.”
Charitable contributions are also affected. Under the old law, one could contribute up to 50 percent of income toward charities and it would be tax deductible. While the new law kicks that limit up to 60 percent, rarely can anyone in the U.S. afford to give away 60 percent of their income.
To help pay for these increased benefits, taxpayers are losing many deductions that were previously available, and will be available in filing your 2017 return. An example is expenses from a “hobby” where someone has income, but does not earn a net profit. Under the current law, Ricketts said, expenses are deductible up to the amount of income shown unless there is a legitimate motive to make a profit. With the new laws, that income is now taxable and the deductions are history.
Of course, the largest “give-back” under the new law is the new limitation on the deductibility of state taxes. The maximum deduction for state income or property tax expenses has been lowered to $10,000. This will affect other states more than Texas, since which has no state income tax. But Texans do pay property taxes and many of the state's residents will be impacted.
Also, the deduction for state and local sales taxes has been repealed except for such taxes paid in connection with a trade or business activity. Far fewer Texans will itemize deductions due to the increased standard deduction, but for many of those who do, these limitations will be significant.
“The next test will be what happens when these things are schedule to expire – will they be allowed to expire or will they be extended?” Ricketts noted.
That's right. As good as all the new deductions and eliminations of certain taxes might sound, for individuals at least, there is a downside. In order to make it appear as though it would not affect the budget deficit – though many economists and experts have argued since the bill was announced that it would drive the deficit up – most of the new tax laws are set to expire in 2023-24.
The last time this happened, there was a big fight between the Obama administration and Congress. Most of the 2001-03 tax laws put into place by George W. Bush were phased out between 2011 and 2013, with both sides going back and forth about whether to extend the tax cuts in 2012. Though they were set to expire, the Obama administration was characterized as wanting to raise taxes on Americans, even though the lower tax rates were ultimately allowed to expire only for those making $400,000 or more.
The key issue for these new tax cuts will be whether the government can still bring in sufficient revenue, and whether doing so will mean undertaking what would surely be a huge political fight – cutting Social Security and Medicare, something President Trump vowed during the 2016 campaign he would not do.
“We'll see what happens in a few years from now, because the debt picture already, very quickly, has gotten much larger,” Ricketts said. “At some point we're going to have to have a philosophical reckoning to decide what is important. Cutting Social Security, Medicare or defense spending seems unlikely to have much political support and not very much broad support in the electorate. Those are the three biggest federal expenditures. So it's hard to imagine these tax benefits being permanent, but it could be that we just decide to run even higher debt financing for a while.”
The last time cuts had to be made to make up for revenue shortage, defense spending was cut. But President Trump announced in January that his 2019 budget would request $716 billion in defense spending, an increase of 7 percent over 2018 and 13 percent from 2017.
That leaves other areas vulnerable to being cut in order to make up for the revenue shortage expected under the new tax laws, and with an aging population, Medicare and Medicaid may be too hot for the administration to touch if it is already thinking about the 2020 election.
“I, personally, don't think they will do it,” Ricketts said. “But that's the gamble right now.”
More could be done
While Ricketts said there are mainly good things in the law for the individual taxpayer, it could have been better.
One tax he would like to have seen changed is the estate tax, or the tax levied on the net value of the estate of a deceased person before distribution to the heirs. Republicans nicknamed it the “Death Tax.” Ricketts said there's some confusion about what the estate tax really is, and he wishes the new law would have made it a bit heavier.
“The estate tax sort of claws back some of the wealth that, in some cases, is not clear that it was legitimately earned,” Ricketts said. “For example, if you're a corporate executive, there's a lot of gamesmanship that goes on with stock options and things like that. You don't want to make stock options illegal, because who am I to say what is a fair stock option for some multinational company? On the other hand, someone needs to have input there.
“The estate tax works to at least get back some of the excess compensation that is taken out by executives. It's not going to really hit farmers or ranchers unless it's someone, maybe, of the size of the 6666 Ranch. There certainly are taxes that are easier to justify than others.”
One of those “replacement taxes” that could be hard to sell is a value-added tax at the national level, essentially a sophisticated sales tax. Raising revenues that are lost under the new tax laws could lead to discussions about this option, but there's been little talk of it at the moment, Ricketts said.
“Right now, we're not able to have a legitimate conversation about revenue,” Ricketts said. “Not enough people have that data to really comprehend how vast some of these differences are. It's hard to blame people for not voting to increase their own taxes, but if you're not paying taxes, it's also unrealistic to expect someone to not vote to cut spending because it doesn't cost the individual voter anything. To me, that's the most interesting issue we're going to have to address as a country.”
Ricketts pointed to the fact that the U.S. has never cut taxes during a war. Taxes are always raised to help pay for the war to make sure the whole population makes some contribution to the effort and feels a little bit of the cost of fighting the war. But since the Sept. 11 terrorist attacks in 2001, it's been a tiny majority of Americans off fighting various wars while everyone at home gets tax cuts, so the sacrifice is not being shared equally.
“That's very unusual and probably not a healthy trend for democracy,” Ricketts said.
Ricketts recognized from all the various changes in deductions and tax tables that much thought and work went into specific elements of the tax law.
But it is apparent, he said, there was no communication between the various interest groups that had input on the law regarding how all those proposals would work together in a cohesive way.
“As a whole, none of these things were considered in the aggregate, no one thought about ‘this is going to do this much to revenue, and this is going to do this much, so how are they going to interact?'” Ricketts said. “We don't really have a simpler system, we've got a more complicated system. There are goals you have to have for your tax system, but nobody thinks about those things anymore. It's just cut, cut, cut. There were a lot of things in this bill that could have been cut that they chose not to, and others that didn't need to be cut or at least not cut so substantially.”
For example, Ricketts said, the largest tax payed by those who are self-employed is the self-employment tax, unless individuals make a lot of money, in which case their income tax will be higher. No one thought to cut that tax, nor did they think to cut the payroll tax that makes it more expensive to hire employees. Of course, Ricketts said, that is related to Social Security revenue, so it may not be a justifiable cut.
In essence, there is no cohesiveness to this tax system.
“I just finished updating a textbook, so I have a fairly current knowledge of things that are happening to the system,” Ricketts said. “I don't think any of these laws by themselves are particularly bad policy, but putting them all together and not thinking about revenue sufficiency, if nothing else, this bill really failed to consider that.”
Ricketts provided some helpful tips for when the time comes to prepare a tax return, whether that is now or in the future:
- Take advantage of deductible retirement contributions, like 401K, things like that, because those things have the biggest long-term impact.
- If possible, move expenditures to what we call “above the line,” either adjustments or business expenses. Many people can't do that if they don't have a business activity. But a lot of people do make money on the side.
- Make sure your withholdings and quarterly estimated payments are as accurate as possible so you don't get surprised at the end of the year with a big tax bill. You don't want to borrow money to pay taxes, and you don't want to have to pay penalties, either.
- Use tax preparation software or a Certified Public Accountant so you don't miss anything you are entitled to claim.
- If you have a side business, make sure to report all income and keep your receipts for your expenses. The statute of limitations on fraud is unlimited. So, if I go every year and just don't report some income, even if you have a chance of being audited of only about 2 percent, you do that for 10 years, you're going to get caught. That's 2 percent compounded by 10 years, so you could have some real issues.