Now that the dust has settled on the passage of sweeping tax code overhaul legislation, it’s worth taking time to consider what the federal Tax Cuts and Jobs Act (TCJA) may do for public sector retirement systems. The broader effects of tax reform on the economy are difficult to estimate (and predictions often fall along partisan lines), but there are two phenomena worth highlighting for those following pension policy.
Tax Cuts and the Impact on Pension Funds’ Investment Returns
First, the tax cuts will likely boost growth. Proponents of the bill have relied on this argument, though the effects on the economy more broadly are up for debate. The Joint Committee on Taxation estimates TCJA would increase growth by 0.8 percentage points on average over 10 years. There is the possibility that, in the long-run, the second-order effects of larger deficits and national debt could wind up inhibiting growth, but the general consensus appears to be that there will at least be some gains to growth after of TCJA’s passage.
The largest effect of the tax law is a cut to the corporate tax rate to the tune of $1.5 trillion over 10 years. Cutting corporate taxes should help shareholders. Increased profits would lead to higher dividends, which would, in turn, boost share prices. This is definitely a plus for pension funds, as increased asset prices would, all else equal, boost their funded ratios. This won’t be enough to help pension funds meet their unsustainably-high assumed rates of return (7.5 percent on national average) in the long run, as the “new normal” of low returns is caused by structural features of the global economy, but higher investment returns for the time being would be welcome news.
What’s arguably more important is what didn’t happen. We already know that the market had its finger on the pulse of the tax reform debate, rising or falling as TCJA’s prospects improved or worsened. If TCJA had died or hopelessly stalled, it may have had a detrimental effect on pension fund balances everywhere in the form of a market slump, or even a crash (albeit a small one since a certain amount of risk was already baked into stock prices).
I’ve previously written about how the “Trump Bump” is less a boom than a sugar high, and despite stellar returns for FY 2017, investment officers for pension systems would do well to prepare for a bust somewhere down the line. The most likely cause of the Trump Bump is increased business confidence. Though more a state of mind than an outlook based on “harder” metrics, it’s incredibly important to economic growth. Skeptics of subjective metrics like business confidence may chalk up the faith in the market in the year after Trump’s election to irrational exuberance. Even if this measure were totally irrelevant (it isn’t, though confidence is no substitute for structural factors) the Trump Bump was in no small part fueled by anticipation of tax cuts. In that regard, TCJA has been good for the market, and consequently good for pension funds and their investment returns. But it is important to note that years like 2017 are the exception, not the rule, and pension systems certainly shouldn’t count on them.
The Changes to State and Local Tax Deduction
Shifting gears, the other major impact of TCJA on pension systems is the repeal of one of the largest deductions in the current tax code—the State and Local Tax (SALT) deduction (see appendix below for a more detailed description). Though previous versions of the legislation scrapped SALT entirely, under the law passed by Congress and signed by President Trump, the SALT repeal will only allow a $10,000 deduction for property taxes.
On the one hand, TCJA will increase tax revenue in a number of states from day one. In 36 states, tax bills are based on federal taxable income. TCJA has broadened the base of tax revenue by removing a number of deductions, increasing income subject to taxation. This will potentially bring in hundreds of millions of dollars in new revenue to some states. Whether states will use this revenue to buttress failing pension systems is another story, but putting any potential windfall into an ailing pension system is one of the smartest investments a government could make.
On the other hand, there could be long-run effects that depress revenue growth. Legislators from high-tax states like California and New Jersey have expressed concerns that changes to SALT will hurt their constituents and states by encouraging those with higher tax bills to leave for lower-tax jurisdictions. The effects of out-migration are up for debate (see appendix below), but even if current residents aren’t scared away, future businesses and taxpayers may be less willing to live and work in these states, leading to reduced revenue in the long-run.
Where do pensions fit in? The marginal effect of tax rates on out-migration is relatively small because tax rates are generally secondary to the other factors residents take into consideration, like the quality of life and employment opportunities. However, as pension expenses grow and swallow up larger and larger portions of state budgets, quality of life will decline as governments are forced to do more with less. The mixture of higher taxes and reduced services, combined with the economic risk that comes from living in a jurisdiction with high borrowing costs will exacerbate the more general effects of a tax hike and likely on whether or not people decide to live in a particular state.
Eliminating the SALT deduction won’t break the bank in the short-term, but if state and local governments don’t get serious about putting more money into their pension systems as soon as possible, and reforming those systems to prevent further underfunding, the long-run effects of higher tax rates could hit them hard.
Broadly, the TCJA’s effects on public sector pensions will be relatively small in the short-term; 2017’s high returns are dwarfed by the size of already existing pension debt, and a mass-exodus to lower-tax states won’t happen anytime soon. But state lawmakers concerned that TCJA will drain public coffers should take the opportunity to implement structural reforms to both pension system funding policy and pension plan design to shield plans from any negative shocks that TCJA, or any other economic development, may cause.
Appendix: What is the SALT Deduction?
The SALT deduction, first created in 1862 and carried over to the 1913 Revenue Act, allows taxpayers to deduct state and local property, income, and sales taxes. It was among the most controversial provisions of the TCJA.
The arguments in favor of repealing the SALT deduction are focused on progressivity in the tax code and federal tax revenue. About 90 percent of those who claim the SALT deduction make over $100,000 per year, and of the 30 percent of taxpayers who itemize their deductions (as opposed to taking the standard deduction), 93 percent of them (28 percent of all taxpayers) use the SALT deduction. Eliminating the deduction is expected to increase federal revenue by $1.8 trillion over 10 years.
On the other side are philosophical concerns about double-taxation and depriving states of tax revenue. Proponents of the SALT deduction maintain that its elimination would deprive state and local governments of revenue by incentivizing out-migration from high-tax states or by creating pressure from voters on state and local governments. On the margins, these arguments are sound. But to what extent higher taxes decrease revenue is an empirical question.
Unlike federal taxes, it’s relatively easy to avoid paying state and local taxes. If I live near the border, I can do my shopping in a state with a low sales tax. And if I’m well off (as many of those who claim the SALT deduction are), I can likely move to a jurisdiction with lower taxes.
That there is some effect of state tax rates on migration has been empirically verified, and the effect of out-migration is strongest when neighboring states have lower tax rates. even if current residents are willing to tolerate higher taxes in exchange for staying put, new residents and business consider tax rates when choosing a place to live during retirement or picking a location to start or relocate a business. This effect is stronger than the effect on current residents, and as one report by the Political Economy Research Institute stated, “taxes do not cause out-migration, but do influence the choice of destination for some migrating households.”
Many high-tax states are attractive places to live or do business despite their higher taxes. Out-migration from high tax states has been observed, but many argue this can be explained either due to broader demographic trends or the emergence of new economic opportunities that are independent of tax policy.
These states also tend to be progressive, making residents more sympathetic to the high taxes necessary to fund government programs—though it would be interesting how many would be willing to pay the price for their pension systems if they were properly priced. This phenomenon, known as Wagner’s Law tells us that the wealthier a population becomes, the more government services it demands.