A hidden tax hike for the middle class

From Justin Brill, Editor, Stansberry Digest:

Last week, the Federal Reserve wrapped up its latest monetary policy meeting…

On Wednesday, the Fed kept interest rates unchanged this month, as expected. But it also suggested it still expects to raise rates when it meets again in December. As news service Reuters reported at the time…

“The labor market has continued to strengthen and … economic activity has been rising at a solid rate despite hurricane-related disruptions,” the Fed’s rate-setting committee said in a statement after its unanimous policy decision.

In keeping with that encouraging tone, the central bank’s policymakers acknowledged that inflation remained soft but did not downgrade their assessment of pricing expectations.

U.S. Treasury yields and short-term interest rate futures were little changed after the release of the statement, while federal fund futures put the odds of a December rate hike at about 98%, according to CME Group’s FedWatch program.

In related news, it’s now official…

On Thursday afternoon, President Donald Trump announced he had finally chosen a replacement for current Fed Chair Janet Yellen, whose term ends in February.

Trump said he would nominate current Fed Governor Jerome Powell for the job, citing his “wisdom and leadership.”

As we discussed, Trump had initially favored some potentially more “hawkish” candidates, including former Fed Governor Kevin Warsh and Stanford University economist John Taylor. But in the end, he chose the more “dovish” Powell. As Reuters noted…

Powell, who has been a Fed governor since 2012, has yet to cast a dissenting vote against the Federal Open Market Committee’s decisions on monetary policy. His views are seen as in line with current Fed Chair Janet Yellen, so his appointment appears to offer investors more certainty on the Fed’s likely policy path…

Importantly, Powell is viewed as unafraid of reversing the current plan to sharply reduce the Fed’s $4.5 trillion balance sheet if the economic or market outlook were to change.

In short, Powell likely represents a continuation of the same easy-money policies of Yellen, and Ben Bernanke before her. Nothing to see here…

Last week also brought some big potential news on tax reform…

The Republican-led House of Representatives released the details of its proposed tax plan – the Tax Cuts and Jobs Act – on Thursday morning. It includes a number of anticipated cuts, as well as a few surprising changes.

As expected, it would slash the corporate tax rate from 35% to 20%. And it would leave it there indefinitely, versus earlier talk of phasing this cut out over time. It would also reduce the so-called “pass-through rate” – what unincorporated business owners pay – from 39.6% to 25%.

On the individual side, it would leave the maximum rate at 39.6%, but it would reduce the number of individual income tax brackets from seven to four, and increase the income threshold for each relative level. It would nearly double the standard deduction, from $6,350 to $12,000 for individuals, and from $12,700 to $24,000 for married couples. And it would expand the child tax credit from $1,000 to $1,600, and provide a $300 credit for each parent and non-child dependent.

The plan would reduce or eliminate several special-interest deductions and exemptions. Most notably, it would cap the mortgage interest deduction for newly purchased homes at $500,000, versus $1 million today.

It would also repeal the controversial alternative minimum tax (“AMT”), continue to allow individuals to deduct state and local property taxes up to $10,000, and phase out the estate tax within six years.

On the surface, at least, the plan appears to be a net positive for individuals and businesses alike…

However, we have a couple of concerns. First, a closer look shows the plan would actually raise the top marginal rate to nearly 50% for the highest earners. As a Wall Street Journal editorial explained on Friday (emphasis added)…

The GOP’s tax bill released Thursday collapses seven brackets into four – 12%, 25%, 35% and 39.6%. But the 12% rate applies to a large range of income, up to $45,000 for individuals and $90,000 for married couples. This means more of a person’s income is taxed at a lower rate, even for folks who earn enough to reach into higher brackets.

But wait. The Ways and Means bill analysis notes that for high-income taxpayers the benefit of the 12% rate “would phase out.” For a single person earning $1 million, and couples who make $1.2 million, the benefit is phased out by $6 on every $100 of income, until the 12% rate relief has been clawed back. A married couple would thus face a 45.6% marginal rate on earnings between $1.2 million and about $1.6 million. Then the rate returns to 39.6%…

The Reagan reform of 1986 lowered the top rate to 28% from 50%, but that has steadily crept back up, including the 3.8% Obamacare investment tax the party failed to repeal earlier this year. With its new bubble bracket, the GOP is repudiating Reagan’s reform and bringing the top income-tax rate back to 50%. Voters might as well have elected Hillary Clinton.

Now, we suspect most folks won’t lose sleep over a ‘stealth’ tax increase on the richest Americans…

But the bill also appears to include a hidden tax increase on the middle class, as well.

It includes a change to how income thresholds are adjusted for inflation. Under today’s tax code, inflation is indexed via the consumer price index (“CPI”). This new plan would use what’s called “chained CPI.”

Now, as longtime readers know, the CPI is a poor measure of real inflation. This is because it only tracks the prices of a specific basket of goods and services. It ignores the prices of assets like housing, stocks, bonds, etc.

This is how the Fed and other central banks can print trillions of dollars of new money, while consumer prices remain relatively subdued. There has been massive inflation… It simply hasn’t (yet) flowed into the areas that the CPI is tracking.

Still, as bad a measure as the CPI is, chained CPI is even worse. You see, it measures the same specific basket of goods and services. But it then adjusts for what the government calls “substitution bias.”

To use a very simple example, suppose the price of beef surges higher. The traditional CPI would track that price increase as “inflation.” However, the chained CPI might assume that many folks would switch to relatively cheaper chicken instead. In this case, your cost of living hasn’t really increased (never mind that you can’t afford to eat beef anymore).

It’s a bizarre and deceitful argument that only a politician or government economist could make. Yet this “adjustment” means the chained CPI consistently lags the traditional CPI.

And if included in this new tax plan, it would likely amount to a stealth tax increase in coming years as real prices rise faster than income thresholds are raised.

Regards,

Justin Brill

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