The Impact of Tax Reforms – What You Need to Know for the Coming Year
Tax changes affect growth by influencing incentives. For example, lowering marginal tax rates can increase the financial reward for work and savers.
Likewise, changing deductions can distort how investment capital is deployed. For example, some studies show that a long wait for a company to recover capital expenses reduces investment.
1. Inflation Adjustments
Inflation adjustments ensure that income tax brackets, exemption amounts, and deductions rise with inflation (as measured by the chained consumer price index). Without them, people would be pushed into higher tax brackets by rising income alone instead of by an increase in real prices.
The IRS makes these adjustments yearly before the start of the tax year. Whether they will be large or small depends on the pace of inflation over the coming year.
Tax reforms are designed to progressively raise enough revenue for public investment in the economy, while encouraging work and saving, eliminating barriers to inter-state migration, and enhancing global competitiveness of American companies. But they can also cause unintended consequences. These can include higher income inequality and greater compliance costs.
2. Tax Brackets
In addition to inflation adjustments, the IRS is increasing income limits for its seven tax brackets. These new levels could reduce the number of Americans paying taxes in a given bracket. But that number doesn’t necessarily indicate the percentage of their income they will owe in taxes. After all, earnings are taxed progressively and the actual percentage they pay depends on where they fall in the brackets, after deductions and credits are accounted for.
A more accurate measure of a person’s effective tax rate is their total tax liability divided by their gross income. Another potential reform is eliminating tax breaks that encourage immediate consumption, a policy that distorts economic decision-making. It takes people longer to pay their taxes because they have to save for them, which also reduces domestic investment opportunities.
3. Taxpayer Credits
Tax credits can have major impacts on individuals and families. These can cover large expenses such as mortgage interest and charitable contributions, as well as smaller items such as energy-saving adjustments or credit for post-secondary education tuition.
Standard economic theory suggests that these credits encourage labor force participation, as filers must work to qualify for the benefits. However, the elimination of refundable credits like the EITC may reduce this effect.
The tax cuts and other changes are expected to increase after-tax incomes by 1.1 percent on a conventional basis, with the bottom quintile seeing a larger increase in after-tax income than the top 1 percent. On a dynamic basis, adding in the effect of greater economic growth increases these numbers. Changing various aspects of the reform could achieve different distributional effects.
4. Deductions
Deductions are expenses that reduce a taxpayer’s gross income, which reduces the amount of taxes they pay. Taxpayers can choose to itemize deductions or take the standard deduction.
The TCJA limits the ability of companies to deduct interest payments, in part as a way of disincentivizing firms from investing in debt and toward equity. It also limits the deductibility of business investment costs and shifts tax treatment for foreign-sourced profits to prevent firms from shifting earnings offshore.
Changing the availability of deductions could affect decisions by households that itemize, particularly those with top statutory tax rates above 15 percent. For example, eliminating the deduction for mortgage interest and property taxes would reduce the cost of purchasing a home and reduce current homeowners’ wealth, potentially causing them to spend less on other goods and services.
5. Other Changes
Many of the changes made in 2022 will help taxpayers save money by preventing “bracket creep,” which would otherwise push inflation-adjusted incomes into higher tax brackets. In addition, these tweaks will help reduce the need for specialized accounting of corporate and pass-through business income taxes by replacing them with a distributed profits tax that requires only the same type of reporting that is already maintained in regular bookkeeping systems.
But these changes also raise revenue and decrease preferences that enable high earners to avoid taxes. Reducing top tax rates, removing preference for employer-provided health care and retirement savings, eliminating the deduction or interest on student loans and expanding the standard deduction could generate $3.5 trillion in new revenue over 10 years, as could lowering the corporate income tax rate and changing the international tax system.