As President Biden proposes an increase in the capital gains tax, it got me thinking about a discussion around tax increases I had with a colleague about five years ago. We were debating the merits of a potential property tax increase in the City of Chicago, which could have mitigated the City’s various budget pressures at the time. It was a classic IR+M discussion – no slamming phones, yelling, or belittling someone who had a different opinion. Instead, it was respectful, data-driven, and civil, despite two vastly different positions. As I look back on that day, it was active listening at its best, something possible even with passionate views on both sides. At the end, neither my colleague nor I completely changed our opinion of what constitutes optimal tax policy. Instead, we achieved respect for, and a better understanding of, another person’s views and we moved slightly closer to a middle ground.
That conversation kicked-off with something like, “If the government increases taxes, won’t people vote with their feet and leave?” I put together a spreadsheet (not a shocker for those who know me) to highlight the cumulative impact of property tax increases relative to the transaction costs of selling a home. My primary takeaway from the calculations was that it takes a long time for the present value (PV) of the cumulative tax increases to match the immediate real estate transaction costs – roughly 12 years. The tax increases would rise on a percent of the value (i.e., the tax on your home is 2%, so you are only growing this smaller amount), while the real estate transaction costs (broker fee) would be based on the total value. Further, since property taxes are fully deductible on federal tax returns (assuming itemized), a taxpayer would incrementally favor not moving despite a tax increase, since they effectively receive a refund at the rate of their marginal tax rate – i.e., if the taxpayer’s marginal tax rate was ~40%, they would only pay ~60% of the tax increase.
Fast forward to today, and I will admit I have tweaked my line of thinking. As an investor, we must adapt to the changing environment, and several factors are materially different today. In other words, maybe I was wrong. First, following the Tax Cuts and Jobs Act (TCJA) of 2017, more homeowners now pay the full freight of their property taxes, as the federal government no longer helps subsidize tax increases given the more limited State and Local Tax (SALT) deduction. Before 2017, most upper-income individuals, who would most likely move due to tax increases, itemized their taxes. Since then, these numbers have fallen materially, with the total number of filers itemizing at less than half of what it was prior. Before, for every $1 in increased local taxes, top earners would have paid $0.60 net; now, they pay the full $1. This makes incremental tax increases much more difficult to endure.
Second, the advent of COVID has resulted in a new remote-work environment. As companies seek to retain talented individuals, they are more open to flexible work arrangements, such as allowing employees to work remotely. As of this writing, the temperature this morning is 47* in Chicago and 79* in Palm Beach. Retaining individuals in high-tax, low-temperature environments may become increasingly difficult.
We used to opine that the elasticity of federal taxation was less than that of state and local taxes. The difference in elasticity is now even greater. Local taxation is most elastic. Increase taxes too much in one county, and some people may move one town over while keeping their same job, especially if they don’t have school-aged children. State taxation is a little less elastic, as moving states typically requires a job change, seeing less family, and a whole host of other complications- although for the right opportunity, anything can happen. Most people, however, do not change countries due to tax policy (yes, I know a couple will, and they’ll make headlines, but it is rare), and thus federal taxation is much less elastic, although some elements of the Laffer Curve must be considered.
So, what does all this mean for investing? For starters, it potentially has a fundamental impact on the long-term credit health of municipalities. Those entities that have mismanaged fiscal policy for a long time, and only recently have started to right the ship, may find it more difficult than ever. Relief on the SALT cap has been presented in Congress but has been met with mixed feelings as the Administration needs the associated revenue to help cover parts of the proposed infrastructure bill. At IR+M, we have been incrementally going up-in-quality in our municipal portfolios and in the taxable munis held in our institutional portfolios. We believe that credit risk in the municipal market is presently mispriced amid exceptionally tight spreads, making the basis between low- and high-rated securities near all-time tights. We understand the underlying long-term pressures that have become exacerbated for some municipalities and are positioning the portfolios accordingly. As the taxable muni universe continues to grow and presents more opportunities for diversified relative value, being even more selective amid these growing challenges will become increasingly important. We look forward to the changing dynamic, adding and protecting value along the way.
Footnote- The Laffer Curve highlights the relationship between tax rates and tax revenue received by the government. When tax rates are lower than a certain threshold, an increase in rates results in higher revenue collected. However, at a certain level, incremental increases in tax rates result in less revenue as the incentive to work becomes lower. The Laffer curve is most simplistically presented as an upside-down, wide “U,” with revenue collected on the Y-axis and tax rates on the X-axis. The Laffer Curve was introduced by Arthur Laffer, who later served in the Reagan Administration.
