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Three big natural experiments

Summary:
Natural experiments in economics don't occur very often, at least not big ones of the sort that interest macroeconomists like me. But today we had not one but three big natural experiments. One is already concluded; the other two will play out over the next few months and years. Experiment #1. Does the powerful real estate lobby have enough political power to prevent Congress from taking away the mortgage interest deduction from the vast majority of taxpayers? Most people previously assumed the answer was yes. But today we found out the answer is no. Under the new tax bill very few taxpayers will deduct mortgage interest. Experiment #2. Does the mortgage interest deduction play a big role in

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Natural experiments in economics don't occur very often, at least not big ones of the sort that interest macroeconomists like me. But today we had not one but three big natural experiments. One is already concluded; the other two will play out over the next few months and years.

Experiment #1. Does the powerful real estate lobby have enough political power to prevent Congress from taking away the mortgage interest deduction from the vast majority of taxpayers? Most people previously assumed the answer was yes. But today we found out the answer is no. Under the new tax bill very few taxpayers will deduct mortgage interest.

Experiment #2. Does the mortgage interest deduction play a big role in supporting the price of residential real estate? I suspect the answer is no, but we'll know for sure within a few months.

Experiment #3. Do state income tax rate differentials play a big role in interstate migration? I've argued that state income taxes play a bigger role than many progressives assume, but the effect seems to be declining over time as the younger generation cares more about non-material amenities, rather than material goods like a big house and an expensive car.

I'll watch this one with great interest. Two things to look for:

a. Is there migration from New York and Connecticut to Florida's Gold Coast, or from California to places like Las Vegas, Seattle and Austin?

b. Do politicians in high tax states panic and cut the top rate, in order to hold on to the goose that lays the golden egg?

Both will be fascinating to watch. Kansas was not a test of supply-side economics. This really is a test of supply-side economics.

A few initial reactions:

The good:

1. Smaller marriage penalty.
2. No corporate AMT, and far fewer affected by the personal income tax AMT (which now will be restricted to married couples with incomes over one million (singles over $500,000). That's not very many people. Of course it was stupid not just to eliminate it entirely, and make up the revenue with a tiny boost in the top rate.
3. A limit of $10,000 on SALT deductions. Basically this means that high income people get no deduction for state income taxes, as their property tax will use up most if not all of the $10,000. A huge blow to blue states. (Wait, I'm in California now! Oh well . . . .)
4. Lower marginal tax rates for most people. My family's MTR will fall from 33% to 24%, although of course I'll lose some of that in the limit on SALT deductions.
5. Much higher standard deduction---perhaps the single best change. Far fewer people will itemize.
6. No more health insurance mandate. But I'd label this an incomplete because the GOP will then have to fix Obamacare, and we don't yet know how.
7. Death tax exemption was doubled to $22 million for families. At least my daughter won't have to worry about that one!
8. Corporate rate cut from 35% to 21%
9. Investments can be written off immediately, instead of the complicated and pointless depreciation schedule.
10. Some limits placed on (big) business interest deductibility. I don't know the details on this one yet.

There are probably other good provisions that I don't know about yet---did the go after business lunches? (One of the most outrageous tax breaks)

The bad:

1. Nothing done about health insurance deductibility, the single worst aspect of the tax code. Indeed health expenses are now slightly easier to deduct, but only in 2018. Why? This one is a massive disappointment. Perhaps doctors are more politically powerful than realtors?
2. The 529 education savings account program expanded to cover K-12. This is actually not that bad, but I don't like loopholes.
3. Carried interest loophole maintained? Not certain if I have this one right.
4. Small businesses can deduct interest on loans. Why do we tax equity-financed investments at higher rates than debt-financed investments?
5. Marriage penalty is smaller, but still there. Why?
6. Deductions for quasi-government bonds that finance private activities are maintained.
7. Tax cut will cause the budget deficit to expand sharply---we'll pay a price for this fiscal irresponsibility down the road.
8. Many of the good provisions expire after a few years.

Neutral:

1. Child tax credit increased. I generally don't like loopholes, but this one is pretty simple to handle, and does provide some needed tax relief to lower income families.
2. Deduction for pass-through business. Don't know enough to comment. Could be justified as providing backdoor relief for taxes on investment income, but will rules to prevent wage income diversion add too much to complexity? I don't know.
3. Corporate territorial system. Don't know enough to comment, but we were an outlier with the previous system.

I don't have much to say about the distributional impact, as I don't trust any of the estimates. Distributional effects are an order of magnitude less important than efficiency effects.

Why didn't blue state Republicans object more to the SALT deduction limit? They were bought off with a reduction in the top rate from 43.4% to 40.8% (wrongly reported by the media as 39.6% to 37%) It seems like blue state Republicans care more about affluent Republicans than they do about the states they live in. After all, the cut in the top rate won't in any way discourage people from moving out of New York and California, rather it will simply prevent wealthy taxpayers from being noticeably worse off.

In other words, individual Orange County professionals (my neighbors) will be fine. The state government of California may not be fine.



Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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