“You have to look at the plan in its entirety. It doubles the standard deduction, so in the end, even the lowest rates get a tax cut.” - Rep. Jim Renacci
Last week the House Ways and Means Committee introduced its 400+ page tax reform proposal, simply titled the Tax Cuts and Jobs Act. The proposal has now been in the public domain for nearly a week, and there is no shortage of analysis and commentary examining all the nuances from every imaginable angle. If tax reform does end up being passed it will surely go through additional iterations before a final bill is ratified, but this document does give us a good idea of what Republicans are targeting.
While we will likely have more to say on tax reform in the coming weeks, we’d like to narrow in on a couple particular elements of the proposed reform in this post: the increase of the standard deduction, along with the related changes to the personal exemption and child tax credit. This particular combination of changes has caught our eye as we’ve read through mainstream coverage over the past few days. In our opinion it is being grossly misreported and misunderstood despite its important implications for middle class families. The media is simply not analyzing it with a sharp enough pencil.
As referenced in the opening quote, the fact that the standard deduction is being increased seems to be one of the primary talking points for proponents of the bill. In rough terms, the proposed reform “doubles the standard deduction”. While we agree with this assertion, we also agree with the representative’s comment that you have to look at the plan in its entirety. And in order to fully capture the impact of the change to the standard deduction, the analysis should also include the changes to personal exemptions and the child tax credit, as these three moving parts are very closely linked. Let’s look at them one by one…
Under current tax law a “married filing jointly” household receives a standard deduction of $12,700 if they don’t itemize. Under the proposed reform this amount would increase to $24,000, an 89% increase (roughly “double”).
Under current tax law the same household would also receive a personal exemption of $4,050 for every member of their household, including children. Under the proposed reform the personal exemption would be completely eliminated.
Child Tax Credit
Under current tax law the same household would receive a $1,000 tax credit (not deduction) for every dependent child. Under the proposed bill this credit would increase to $1,600 per child.
So we have three moving parts here that all need to be analyzed in conjunction with one another to truly understand the impact of the proposed reform. First, everyone is now eligible for a higher standard deduction. But that higher standard deduction is at least partially offset by the elimination of personal exemptions, which appears to hit large households with the highest number of members the hardest. And finally, the increase in the child tax credit then counteracts the loss of personal exemptions.
So, in summary:
We have not seen analysis in the mainstream media that fully synthesizes these three moving parts in order to understand the bottom line impact to a tax-paying household. But like us, many of our clients are middle class working families with multiple children, so we thought we’d crunch some numbers.
In the following illustration we’ll isolate just the proposed changes highlighted above, leaving all else equal. Doing so will reveal the impact of just these items as if there were no other reforms. With that in mind, let’s consider a married couple with three kids earning $80,000 a year. With a starting point of $80,000 gross, we will first net out deductions and exemptions under the current vs proposed structure to arrive at taxable income and federal income tax due.
As you can see, even though the married couple claims a much higher standard deduction, the loss of the personal exemptions ($4,050 X 5 household members) actually leads to more taxable income under the proposed structure. The family’s tax bill is projected to be $1,343 higher as a result. This simple fact shows that any analysis related to the standard deduction cannot be divorced from the elimination of the personal exemption – the two go hand in hand.
But there’s still one more step. The fact that this couple has three children means the loss of the personal exemption hits them especially hard, but what about the increase to the child tax credit from $1,000 to $1,600?
In the final analysis the combined benefits of the increased standard deduction and higher child tax credit slightly outweighs the loss of the personal exemption, resulting in a net benefit of $458 under the proposed structure!
A final curiosity would be what the net benefit might look like under differing income and household size scenarios. We ran the numbers for households with income of $50,000 on up to $110,000 and with 0-5 children. The results are plotted in the table below, with “gross income” plotted along the left hand side and “# of children” along the top. The yellow highlighted cell represents our family of five earning $80,000 in the illustration above.
Honestly, we expected that we might find a bit more variability in these results, and perhaps even discover that the net result of the combined changes might have an adverse impact on certain large households in lower income brackets. Our primary takeaway, however, is that the three moving parts combine to be a benefit slightly greater than a wash, and this benefit accrues relatively evenly to a variety of household sizes and incomes. Once income grows to be over $100,000 the proposed tax structure begins resulting in higher taxes paid. This is due to the fact that at a high enough tax bracket the $4,050 personal exemption becomes more valuable than the additional $600 in tax credit per child. In contrast, there is no net benefit to large households in low income brackets (upper right portion of the chart) given the fact that no federal tax is due in either scenario.
As a final reminder, the analysis above only considered the proposed changes to the standard deduction, personal exemptions and the child tax credit. There is obviously far more going on in the bill, so by holding all else equal the above analysis is in no way a comprehensive look at the proposed reforms.*
The evolution of this conversation will be interesting to watch over the coming weeks as the Senate, White House and major lobbyist groups continue to respond to what has been proposed in the House. As we gain more clarity on what a final reform package might look like we will undoubtedly be weighing in with more thoughts, particularly on the potential impact of key reform proposals on financial markets. Until then we hope this post has provided some clarity around a key talking point of tax reform that we believe is being misunderstood and misreported in mainstream coverage.
*And for all you CPAs out there, we have intentionally chosen to ignore the additional $300 tax credit that the two parents can claim on themselves under the new structure given that this credit expires after five years.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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