An initiative to re-write the U.S. tax code has been circling through the corridors of Congress for a while.
At the core of the initiative is the simplification of the tax code by lowering corporate tax rates, which would likely reduce the average corporate tax return to the "size of a postcard."
There is no doubt that the U.S. needs tax reform and that lowering taxes on both corporations and individuals would benefit the economy, but how exactly would that be funded? By removing tax incentives and reductions, for both businesses and individuals.
Overall, this is a good idea. Rather than maintain the status quo, i.e., complicated tax codes, which effectively lowers the tax burden, instead lower the overall tax burden and abolish all the "little" tax breaks.
In other words, make it simple. But the problem, as always with tax reform, is the specifics.
Each time a new tax code is initiated, whether under the Obama administration or the Trump administration, there always seems to be one specific tax code that is a sticking point: the 1031 exchange. Ironically, the 1031 exchange is the one tax code that, if abolished, could most harm the American middle class.
The 1031 exchange, as it is widely known, allows individuals and businesses to avoid paying a capital gains tax on the condition that they reinvest their funds within 60 days. This can be done either by the direct exchange of assets with the same value or by using a custodian for 60 days until a new investment is found.
If the new investment is smaller and some profits are realized, the tax applies only on the realized gains.
For example, let's say that a farmer decides to retire and sell the farming land that he bought decades ago.
Over the years, the land price has appreciated greatly so that when the farmer eventually sells his farmland he could face more than 30% in capital gains tax. Of course, the exact amount would depend on the value of the land and in the state in which he resides.
But if the farmer chooses to use the 1031 exchange and purchase commercial real estate in the same amount, he would be exempt from capital tax. He could potentially save hundreds of thousands of dollars in tax that would, of course, be used to fund his retirement.
The same 1031 exchange rule would apply to a business owner who wants to sell his old equipment and buy new equipment or really to any other types of fixed asset classes, though it is primarily used for real estate transactions.
Why is the 1031 exchange so important? Because it allows the American middle class to preserve its wealth.
That is accomplished primarily from the direct impact of the capital gains tax and because the exchange provides flexibility of capital allocation in the segment most often associated with the middle class, i.e., small businesses.
Because the 1031 exchange allows more flexibility in the U.S. real estate market and especially the commercial real estate market, which can withstand shocks during an economic downturn, it encourages reinvestment in machinery and allows capital to be reallocated more effectively. Eventually, that would make small businesses and pass-through businesses more efficient and, thus, more immune to economic shocks.
Abolishing the 1031 exchange would cost the American economy 8.1 billion in annual gross domestic product output if the exchange is used to fund a lower corporate tax, according to an in-depth cost benefit analysis by Ernst and Young.
That is, of course, in theory.
In practice, the price tag could be much higher because, while a lower corporate tax would benefit corporations, pass-through businesses -- small businesses owned by a sole proprietor -- would be taxed at a higher rate. Pass-through businesses are taxed under the individual tax rate.
That means that pass-through businesses would no longer be able to allocate assets as effectively as before. They would be forced to forgo many of their investments.
Rather than encouraging reinvestment, that would encourage long holding periods of assets and would reduce liquidity in many commercial real estate markets, especially in states such as California and Washington, where the volume of deals under the 1031 exchange has been particularly large.
When we look at the macro picture it becomes even clearer.
The imposition of a higher capital gains tax burden on small businesses and individuals while the Federal Reserve is in the process of raising interest rates would tighten liquidity for small businesses even further. And pass-through businesses and individuals simply don't have the same ability to borrow as cheaply as big American companies, and these businesses also face higher credit costs and a higher tax burden.
With more than 50% of Americans employed in the private sector working in pass-through businesses, tens of thousands of individuals could lose their job.
In fact, the chart below, which illustrates the impact of capital gains tax on investments, makes it perfectly clear. The chart compiled from data of the Tax Foundation, a leading independent tax policy research organization, shows the ironic link between taxes on capital gains and tax income.
Examining the 10-year average of capital gains as a percentage of gross domestic product (green dotted line), it is crystal clear. High capital gain taxes simply bring less tax income as investments go down, and when investments go down businesses shrink, jobs are lost and real estate prices take a hit.
The commercial real estate sector that has benefited greatly from the 1031 exchange could take a hard hit, especially if the economy takes a downturn.
Chart courtesy of the author; date courtesy of the Tax Foundation
So, what is the solution to orchestrating a new, more effective U.S. tax code? It is cutting spending while reducing the corporate tax rates and keeping the 1031 exchange as well as those other tax codes that benefit individuals and small businesses.
Yes, it would be less popular, but it would be the right path. Individuals and pass-through businesses operate on a scale that is generally too small for corporations or else isn't "commercial" enough.
Moreover, pass-through businesses don't ship jobs overseas. Corporations do.
That is what makes small-business owners the backbone of America, and that is why it is equally important for the health of the U.S. economy to maintain the 1031 exchange code, alongside a lower corporate tax rate.