Dalio’s misleading post on tax bill migration

Along with a lot of other people, I read yesterday’s Daily Observations note from Ray Dalio at Bridgewater. In the piece, Dalio argues that the tax bill could result in substantial out-migration from high tax states to low tax states. I agree with Dalio that this is an ongoing issue; I have written before on the large population, employment and income growth differentials between high and low tax states over the last decade in the Eye on the Market.  I also agree that this can be a problem for some states with high tax rates and substantial underfunded pension and retiree healthcare obligations, a topic we have analyzed in depth in our ARC and the Covenant series (see my LinkedIn post from September 2016). In an October 2017 article we published in Business Insider, we discussed our most recent municipal analysis and how our exposure to the riskiest city and county issuers is just 1% of our muni portfolios.

Here’s my problem with Ray’s note. Dalio presents possible consequences resulting from elimination of state and local income tax deductions on Federal returns. He links estimates of increased effective tax rates to out-migration and the dire revenue impacts by state.  However, he presents all of this without considering the other aspects of the Tax Cuts and Jobs Act bill. This can make a very big difference. In Dalio’s table, taxpayers over $500k in a state with a 10% marginal tax rate are assumed to experience a 3.9% increase in their effective income tax rates.  I think there’s too much shorthand going on here.

We compared current tax law and the Senate version of the TCJA for different taxpayer types across different levels of income. While salaried worker and hedge fund managers with over $5 mm in income would see increases close to (but still below) Dalio’s level, there are three circumstances in which Dalio’s estimates are too high:

• For hedge fund managers, salaried workers and retirees, the increase in effective tax rates is much lower between $500k and $2.5mm in income given changes in tax brackets and the levels at which they apply; there’s also a reduced impact of the AMT on some taxpayers given changes to exemptions and phase-out thresholds
• For private equity principals and other control investors that are typically subject to the AMT, which doesn’t allow for state and local deductions anyway, there’s almost no impact from the new bill
• For active owners of businesses subject to the new lower tax rates on pass-through entity income, the bill would substantially reduce effective tax rates, even with the loss of the state and local deduction

Bottom line: while Dalio’s note discloses that his numbers are very rough estimates, I think it’s misleading to discuss the possible out-migration impact resulting from the loss of state/local tax deductions in isolation from the rest of the bill. While this is a pressing issue for poorly funded high-tax states given the economic incentives to move, our take on the changes in these incentives resulting from the bill are not as severe as his. See below for our assumptions on income distribution and itemized deductions.

P.S. Similarly, we are analyzing the impact of a 30% cap on corporate interest deductions as % of EBIT in tandem with the benefit of lower corporate tax rates, and not on its own.

Footnote: Income distributions and other assumptions

In our analysis and in Dalio's, the state/local tax rate is 10%. Our effective tax rates are computed as total Federal, state and local income taxes paid as a percentage of gross income (including ACA taxes), where gross income includes all forms of earned and unearned income, including from tax exempt municipal bonds. Income levels reflect the joint incomes from a married couple filing jointly. We assumed home ownership, where home values are estimated as a multiple of income from data disclosed pursuant to the Home Mortgage Disclosure Act. The home price to income multiple starts out at 4x for median income taxpayers, and falls in a roughly linear fashion to 2.5x by the time incomes exceed $500,000. We assumed a loan to value ratio of 80% and a mortgage interest rate of 5%.

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