by Dalip Malik CPA | Mar 7, 2018 | Tax Tips and News
Tax Policy – Maine Tax Conformity Bill a Step Toward Better Policy
The Tax Cuts and Jobs Act didn’t end the debate on tax reform – it’s shifted the discussion to state capitols across the country, and Maine Governor Paul LePage (R) is joining the conversation. Governor LePage has put forth a comprehensive tax bill that cuts taxes by $111 million over the next two years and conforms Maine’s code to many of the recent federal tax code changes.
The bill, LD 1655, makes substantial changes to both the individual and corporate income sections of the tax code. The bill eliminates the personal exemption in Maine (it was previously tied to the federal amount, which is now $0), but creates a new 0 percent tax bracket, effectively exempting the first $4,150 (or $8,300 for joint filers) in income from taxation. The bill recouples Maine’s standard deduction to the federal level, raising the amount to $12,000 for single filers and $24,000 for joint filers. It also raises the estate tax exemption level to the new federal amount, $11.2 million, and creates new child and dependent tax credits.
On the corporate side, the bill will conform Maine to the federal treatment of bonus depreciation, net operating losses, and the interest deduction. Maine will conform to the new full expensing of short-lived assets rules, allowing businesses to immediately deduct 100 percent of the value of newly purchased assets. This change is incredibly important and one of the most pro-growth elements in tax reform. Coupling to full expensing will incentivize investment in Maine and encourage the growth of Maine’s economy.
The bill also couples to the federal NOL treatment, so firms in Maine will no longer be allowed to carry back losses, but can carry them forward indefinitely, subject to a cap of 80 percent of taxable income. LD 1655 couples to the federal interest deduction changes as well, limiting the deductibility of net interest expenses to 30 percent of earnings.
These changes are all proposed together in part to help offset the front-loaded cost of full expensing. To mitigate any small increase in corporate income tax liability, the legislation also includes a modest cut to the corporate income tax rate, from its current 8.93 percent to 8.33 percent. Maine has one of the highest corporate tax rates in the country, and this provision is a step in the right direction for the state.
What legislators should consider, however, is their treatment of revenue from deemed repatriation. Maine estimates that it will receive approximately $31 million in one-time revenue from deemed repatriation. Ideally, any revenue from deemed repatriation should be considered one-time money, not funds with which to finance ongoing budget or tax code changes. Good options for any Subpart F income include depositing it into rainy-day funds or pension funds, or financing one-time expenditures. Oregon legislators recently set a good example by passing legislation that would direct that revenue into their pension fund.
Conformity is important, and states conform to the federal tax code in part to reduce complexity for taxpayers. Like my colleague Jared Walczak noted,
“Doing so allows state administrators and taxpayers alike to rely on federal statutes, rulings, and interpretations, which are generally more detailed and extensive than what any individual state could produce. It provides consistency of definitions for those filing in multiple states, and reduces duplication of effort in filing federal and state taxes. It permits substantial reliance on federal audits and enforcement, along with federal taxpayer data. It helps to curtail tax arbitrage and reduce double taxation. For the filer, it can make things easier by allowing the filer to copy lines directly from their federal tax forms.”
Overall, this plan advances Maine toward a more sound, simple, and competitive tax code by adopting broader bases and lower rates. Lawmakers should consider some of the funding sources like repatriated income, but would deserve credit for adopting some enormously pro-growth provisions.
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Source: Tax Policy – Maine Tax Conformity Bill a Step Toward Better Policy
by Dalip Malik CPA | Mar 7, 2018 | Tax Tips and News
Tax Policy – The Tax Reform Bill Will Raise Interest Rates. Good or Bad?
Interest rates are likely to increase following enactment of the recent tax reform bill (Tax Cuts and Jobs Act). Rising interest rates stemming directly from the growth provisions of the tax reform bill would be a positive sign that the tax cut is working to encourage capital formation, and should not be cause for alarm. However, the Federal Reserve may choose to increase interest rates even more out of unwarranted fear that growth, per se, is inflationary. That would have a negative effect on the economy, and would offset some of the growth that would be expected from the tax bill.
Growth provisions work mainly by raising returns to investment and saving, including interest rates
The biggest pro-growth provisions in the bill are the corporate rate cut to 21 percent and the immediate expensing (depreciation write-off) of equipment, which will encourage additional capital formation. Other growth-related provisions are the deduction of some pass-through business income, and the modest reduction in income tax rates on wages, salaries, and interest on savings. These will encourage some additional investment, work, and saving.
The expansion begins as the tax reductions raise the after-tax returns on physical investment in equipment, buildings, and other structures. Higher returns on plant and equipment lead to rising investment to expand factories, mines, farms, commercial real estate, and rental housing. The amount of productive physical capital in the economy grows. As it does so, returns are eventually driven back to pretax-cut levels, and the capital stock settles at a new, higher equilibrium level.
During this period, interest rates on bonds and other forms of lending tend to rise in line with the returns on the physical investments. While returns on business assets are high, investors in those assets are willing to pay more to lenders to attract the saving needed to buy the additional machines, buildings, or other assets. Savers can buy bonds, lending to businesses that are adding capacity. Savers can buy stock, helping companies to raise money for expansion through new share issues. Savers may also invest directly in noncorporate businesses of their own, or through partnerships and venture capital funds. These financial and physical assets are competing avenues for saving, and their returns must rise and fall apace.
Deficit concerns are real, but need perspective as to cause and effect
Some observers may fear that the larger federal budget deficit and federal borrowing stemming from the tax reductions might raise interest rates by absorbing national saving, thereby “crowding out” private borrowing for capital formation and retarding the expansion. This is unlikely for two reasons.
- First, the business tax reductions in the tax plan will contribute directly to higher business saving, in the form of higher corporate-retained earnings and depreciation set-asides, and corresponding higher cash flow for pass-through business. There will be a modest increase in labor force participation and hours worked due to the modest reduction in income tax rate on wages and salaries. Personal saving will increase as well due to the incentive of higher returns and higher after-tax incomes. State and local government revenues will rise, their deficits fall.
- Second, the United States is part of a large, open, global financial market. World saving will shift toward the United States as U.S. residents and businesses lend more at home and less abroad, and as foreign investors send money to the United States to participate in the U.S. expansion. U.S. government bonds will not exhibit any increase in the risk of default due to the modest expansion of federal debt forecast over the period. Attracting the required capital inflow to aid in the financing of the budget deficits should require no more than a few basis points in higher interest rates, as, for example, a Treasury bond rate of 2.7 percent rising to 3.0 percent.
This is not to say that deficits are without cost. The ability of Congress to spend without imposing taxes results in more government spending than the public would support if it saw the full cost of government every year. Higher borrowing also raises interest payments, which crowd out other government spending priorities. It is also crucial to distinguish between deficits that arise from policies that promote growth and output, and deficits that arise from additional government consumption.
Reaction of the Federal Reserve may be important
The Federal Reserve might instigate a further increase in interest rates in reaction to the tax bill. It may do so out of concern that economic growth or higher federal deficits alone would cause inflation. However, this is not a valid concern. A tax cut that lowers production costs and expands the capital stock and labor force participation does not cause inflation. It expands production of goods and services. More goods chasing the same money supply tends to reduce prices along with the cost of production.
The Federal Reserve’s economic model includes the old concept of a trade-off between low unemployment and rising inflation, called the “Phillips curve.” In this model, the tax cut could cause inflation by reducing unemployment and putting upward pressure on wages, which would put upward pressure on prices. The Federal Reserve treats this as a source of inflation.
This view is mistaken. A reduction in the supply of unemployed labor might raise the level of wages once, but not repeatedly. Systemic inflation – continual, repeated, ongoing increases in the general price level – can only occur if the Federal Reserve continually overexpands the money supply (as was done by central banks in interwar Germany, recent Zimbabwe, or contemporary Venezuela).
The apparent connection among unemployment, wages, and inflation is a misreading of history. Sometimes, if the Federal Reserve triggers unexpected inflation, it can induce people to work and produce more for what appears to be a rising real wage or price, leading to a short burst of growth. But in this case, the growth is caused by the inflation, not the inflation by the growth.
Recent comments by Randal Quarles, vice chair for supervision at the Federal Reserve, suggest that the Fed is more open than in the past to the possibility that the tax reduction could expand economic capacity, and raise supply along with demand. He allowed that a capacity-increasing expansion might not put as much upward pressure on prices as a demand-driven expansion. If that is the case, we may avoid an unnecessary and harmful clampdown by the central bank on the growth of credit. However, Quarles also said it is premature to write off the Phillips curve. If that is the case, then we must keep a watchful eye on the Federal Reserve, lest it prematurely choke off the growth promised by the tax reform.[1]
[1] See Vice Chair Quarles’ speech, “An Assessment of the U.S. Economy,” delivered Feb. 26, 2018, at the 34th Annual NABE Economic Policy Conference, Washington, D.C., available at https://www.federalreserve.gov/newsevents/speech/quarles20180226a.htm. Selected highlights include:
“What would be the likely consequences if growth were to shift up on a sustained basis? Here I think … it matters whether growth is embodied in a sustained increase in the productive capacity of the economy or, instead, is primarily the product of a boost to aggregate demand.
“Real expenditures on capital equipment increased at a double-digit pace in the second half of last year, providing early hope that the investment drought that has weighed on growth in recent years might finally be breaking.
“That inflation has remained low even as activity has picked up and the labor market has tightened has led a number of commentators to question the relevance of the Phillips curve analytical framework that ties inflation to the strength of the economy.
“In my view, it is premature to write off the Phillips curve. Indeed, I think it is likely that tightness in labor markets will eventually show up in wages and prices.
“Fiscal policy is likely to impart considerable momentum to growth over the next couple of years not only by increasing demand, but also by boosting, to some degree, the potential capacity of the economy.
“It might seem reasonable to assume that faster growth would lead to firmer inflation. However, I think a lot remains to be seen. … A demand-led increase can be expected to have a greater positive effect on prices than a step-up in the pace of potential growth. Growth led by an increase in the economy’s productive capacity, either through increased labor force participation or higher productivity growth, is likely to impart less upward pressure on prices.”
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Source: Tax Policy – The Tax Reform Bill Will Raise Interest Rates. Good or Bad?
by Dalip Malik CPA | Mar 6, 2018 | Tax Tips and News
Tax Policy – States Explore Taxing Carried Interest
The taxation of carried interest is a subject of frequent debate at the federal level. Now, states are jumping into the debate. A number of states, including New York, Illinois, New Jersey, and Maryland, have been discussing proposals to increase state-level taxes on carried interest. Several of these proposals, however, are flawed – regardless of one’s view of how carried interest should be taxed.
For some background: the debate about carried interest focuses on financial arrangements in which an investment manager receives a share of investment profits. Under current federal tax law, these investment profits are classified as capital gains, and are taxed at a top income tax rate of 20 percent. However, many argue that this income is more akin to compensation for investment managers’ labor, and that it should be taxed at a top income tax rate of 37 percent, like other wages and salaries.
In general, the debate about carried interest on the federal level is often overblown, because the actual amount of revenue at stake is relatively small. But the issue has taken on symbolic importance. In fact, the recent federal tax bill contained a minor change to make it slightly harder for investment managers to receive capital gains treatment on their carried interest, requiring managers to hold on to assets for at least three years in order to qualify.
However, some states are hoping to go farther, and have proposed measures to significantly increase the taxation of carried interest.
The New York proposal from Governor Andrew Cuomo’s (D) budget would tax carried interest at a 17 percent rate, to offset the difference between the federal top marginal income tax rate of 37 percent and the capital gains tax rate of 20 percent. The New York proposal is also conditional on the states of Connecticut, New Jersey, Massachusetts, and Pennsylvania passing legislation with “substantially the same effect,” to limit the ability of investment managers to shift their location to avoid the tax. However, the bill is not explicit on what would constitute “the same effect,” and even with that language, it is difficult to imagine that investment managers would not try to relocate their operations to avoid the hefty new tax.
Another issue with the New York proposal is that it may be overly broad, applying the 17 percent surtax on carried interest to C corporations that act as investment managers and to investment management services owned by C corporations. This does not make conceptual sense, because C corporations face the same tax rate on their ordinary income and on their capital gains, so cannot be said to benefit from preferential treatment of carried interest.
The proposals in Illinois and New Jersey suffer from similar statutory language challenges.
The Maryland proposal is slightly different. It would establish a new tax of 19 percent on investment management services. But instead of being conditional on passage in other Northeast states, Maryland’s proposal is a key funding vehicle for its higher education reform package. The package includes free community college for those with less than $150,000 in federal adjusted gross income, among a few other changes. The fiscal note from the state’s Department of Legislative Services illustrates one of the risks of this proposal: the new tax would likely encourage “restructuring of… compensation agreements” to avoid the levy. The new tax is predicted to raise $79 million in revenue in fiscal year 2019, falling to $58 million in fiscal year 2023. Maryland should proceed cautiously; funding a new government program, such as free community college, from a declining revenue source is a risky strategy.
These proposals suffer from an additional flaw: if carried interest income is categorized as labor compensation when received by investment managers, it should also count as a deductible business expense when paid by investors, a point made in an excellent paper by Donald Marron of the Tax Policy Center. Neither New York nor Maryland provide investors with the ability to deduct the amount of carried interest income paid to the investment managers who will be hit by the new surtaxes.
All in all, even for those who think that carried interest income should be subject to higher tax rates, the New York, Illinois, New Jersey, and Maryland proposals come with significant policy concerns.
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Source: Tax Policy – States Explore Taxing Carried Interest
Dalip Malik CPA