How Do Tax Policies Affect Individuals and Businesses?
- Tax policies affect economic decision-making on work, savings, inter-state migration, investment, and business organization.
- Major tax reforms since the 1980s aimed at reducing distortion, incentivizing work, simplifying the tax codes, closing loopholes, and enhancing the global competitiveness of American corporations.
- The effectiveness of tax reforms depends on the overall economy and may not always conform with economic model predictions.
- The efficacies and unintended consequences of tax reforms must be evaluated in both the short run and long run.
In 2020, the total U.S. tax revenue accounted for about a quarter of the country’s GDP 1. Tax policies affect the type and amount of income subject to taxation and the rate at which it is taxed. Changes in the tax codes influence the decisions people make about whether and how much to work, how much to save for retirement, and where to live. Taxation also affects how entrepreneurs organize their businesses, how much to borrow and invest, and where they locate the businesses they create.
This policy brief reviews the implications of some tax policies on the behaviors of individuals and businesses, focusing primarily on the federal income tax. We use examples from major tax reforms in recent decades, including the Tax Reform Act of 1986 (“TRA86”) and the Tax Cut and Jobs Act of 2017 (“TCJA”), to discuss some of the motivations and consequences of tax reforms.
This brief is not meant to be an exhaustive discussion of federal individual and corporate taxation. Rather, it highlights some of the trade-offs that policymakers face when deciding whether to raise or lower taxes and details on exemptions, credits, and other subsidies. The brief is a companion piece to SIEPR’s 2022 Fall Policy Forum on Taxation.
How do tax policies affect individuals?
America has a progressive individual income tax: The higher your income, the higher your tax rate. Tax exemptions and credits, on the other hand, tend to provide more benefits to lower-income earners 2.
Figure (1) displays the progressivity by comparing the share of income earned by individuals in that income bracket with the share of federal individual income taxes paid. In 2019, people earning more than $200,000 accounted for a higher percentage of all federal individual income tax paid than their share of all income received. For example, people making more than $1 million a year earned 15 percent of all income but paid 39 percent of all federal individual income taxes.
Figure 1: Share of Individual Income vs. Share of Federal Individual Income Taxes, 2019
Note: Data are from the Joint Committee on Taxation 3, Table A.6.
The top marginal individual income tax rate has declined dramatically from over 90 percent in the 1950s to 28 percent in 1988 and 37 percent today. Some consider this decline as one of the indicators for declining progressivity in America 2,4–7.
However, the top marginal tax rate doesn’t tell the whole story. For example, the Tax Reform Act of 1986 (TRA86) reduced the top marginal tax rate from 50 percent to 28 percent, which alleviated the tax burden disproportionately for the higher-income group. The tax cuts might be interpreted as a change that scaled back progressivity. However, the TRA86 raised the levels of the standard deductions and the personal exemptions and expanded the earned income tax credit (EITC), all of which reduced the tax burden of the lower income earners 8. As a result, 5.9 million working poor would either pay no taxes or receive rebates 9.
Instead of the marginal individual income tax rate, data on the average tax rate show that households in the lowest income quantiles in 2018 had a 0 percent average total federal tax rate, down from 12.1 percent in 1984. The average federal tax rates paid by the household in the second lowest income quintile were cut in half from over 15 percent to 8.1 percent in 2018 (Figure 2).
Figure 2: Average Total Federal Tax Rates for All Households, by Household Income Quintile, 1979-2018
Tax policies affect people’s decisions about whether or not to work outside the home. One example is the Earned Income Tax Credit (EITC). To qualify for the EITC, one has to be working but make less than certain thresholds based on the status of marriage and children. For instance, a single person with one child earning less than $42,158 in 2021 can claim up to $3,618 EITC 12.
Standard economic theory predicts the EITC will encourage labor force participation because one must work to qualify for the credits; however, the EITC may create a negative income effect, resulting in people working fewer hours. The theory is unambiguous on the net outcome.
Empirical evidence can be drawn from reforms in the 1980s and 1990s that expanded the EITC 13. Studies found that low-wage families, especially single parents, substantially increased their employment and work hours and those who were already working didn’t reduce their hours 14,15. The EITC expansion was found to reduce welfare use and increased earnings among low-income families 16.
Interestingly, the EITC expansions created bipolar incentives for marriage. For an unemployed single parent marrying a low-wage earner, the marriage penalty declined with the EITC expansion. But for a working single parent in similar situations, the marriage penalty increased between 1986 and 1997, and because their joint income would be too high that disqualified them from the credits 17.
Payroll taxation can affect companies' decisions on how many people to hire. Federal payroll taxes finance Social Security, Medicare, and unemployment insurance. The share of U.S. federal revenues raised by payroll taxation has doubled since the 1960s. The effects of payroll taxation depend primarily on whether employers can pass the cost of payroll taxes onto workers in the form of lower wages 18. If employees fully absorb the payroll tax costs, then employers' labor demand won't change, but wages will fall.
Many factors, such as downward wage rigidity and minimum wage, may prevent a full pass-through and thus reduce the labor demand 19,20. Estimates for the U.S. found that only a fraction of the additional tax burden created by payroll tax rate increases would be shifted to employees in the short run 21.
Where to live?
People decide where to live and work based on many factors, such as climate, employment opportunities, and public goods and amenities. One crucial factor is state and local income tax (SALT). There are significant differences in state and local taxes. In 2022, the highest tax states include New York (15.9 percent of the net product in the state going to state and local taxes), Connecticut (15.4 percent), Hawaii (14.9 percent), and California (13.5 percent). In comparison, Texas (8.6 percent) and Florida (9.1 percent) are often considered to be more tax-friendly 22.
People tend to leave high-tax areas and move to areas where taxes are lower 23–26. For example, in response to an increase in California marginal tax rates, an additional 0.8 percent of the residents that landed in the top bracket left California in 2013 27. In 2016, 24 of the 25 highest-tax states had net out-migration, and 17 of the lowest-tax states had net in-migration 28.
The Tax Cuts and Jobs Act of 2017 (TCJA) intensified the tax differences across states. Before 2017, taxpayers could deduct sales taxes, property taxes, and state and local income taxes when filing federal income tax returns. These deductions help reduce the tax burden for residents in high-tax states. In 2017, the TCJA capped the total state and local tax deduction at $10,000 per person. This change further increased the incentives to leave high-tax states.
California taxpayers who would experience a large increase under the TCJA rules due to the elimination of the SALT deduction were more likely to move after 2017 29, which can create challenges to California’s state budget. However, not everyone is worried. Some people point out that out-migration in California is partially offset by those moving into the state, and thus the income tax revenues in California continued to grow, albeit at a slower rate 30.
How much to save for retirement?
One of the most important savings decisions is saving for retirement. Workers may choose to save in tax-advantaged vehicles such as employer-sponsored 401(k) plans and Individual Retirement Accounts (IRAs). People also have choices among post-tax Roth versions of 401(k), 403(b), and 457(b) accounts. Studies have shown that Roth accounts are more valuable for risk-averse workers if the future tax rates are uncertain because the post-tax accounts help them lock in the current known tax rate 31. On the other hand, the existing tax rate schedules are progressive, which incentivize people to choose the pre-tax accounts like the traditional 401(k) plans. This is because most people expect their income to be lower in retirement than in working age, so it's cost-effective to contribute tax-free money while working and pay taxes when withdrawing.
Changes in the tax codes can affect people's plans for retirement saving. For instance, IRAs experienced robust growth in the late 1970s to early 1980s 32, but this trend stopped in1986. The TRA86 substantially lowered the annual contribution limit on retirement plans and imposed tighter restrictions on withdrawing savings from tax-deferred retirement plans for nonretirement purposes 33. Such changes dampened individuals’ inclination to save through IRAs in subsequent years 34,35.
How do tax policies affect businesses?
Legal Forms of Businesses
Entrepreneurs choose the legal forms of their businesses to optimize tax liability, and such choices can be influenced by tax policies 36–40.
Businesses in the U.S. can be broadly divided into two groups: C-corporations and pass-throughs. The latter includes S-corporations, limited liability companies (LLCs) a, partnerships, and sole proprietorships b. Although the term “corporation” is often associated with large companies like Microsoft and Walmart, C-corporations can be both large and small businesses. The distribution of assets and size of C-corporations are extremely skewed. Less than 1 percent of all C-corporations paid for more than 85 percent of all federal corporate income taxes in 2000 42.
One significant difference between C-corporations and pass-throughs is how they pay taxes. C-corporations are taxed twice: The business pays the corporate income tax, and their shareholders pay tax on dividends from after-tax profits. In contrast, pass-throughs don't pay any corporate income tax. Instead, their business income passes through the business entity, and the business owners would then pay individual income tax.
In addition to this difference in tax treatments received by C-corporations and pass-throughs, the TRA86 created an even stronger incentive for C-corporations to convert to pass-throughs, particularly to S-corporations 43. The TRA86 cut tax rates broadly but more on individual income tax. After the reform, the individual rate went below the corporate rate (28 percent vs. 34 percent). The new rates made it even more attractive than before for businesses to choose pass-throughs as their legal form c.
The number of tax returns filed by C-corporations peaked when the TRA86 was enacted and declined afterward (Figure 3). The decline in C-corporations was mirrored by a rise of pass-throughs, especially S-corporations and partnerships 40,44.
Figure 3: Number of Tax Returns by Type of Organization
Note: Data are from IRS. SOI Tax Stats – Integrated Business Data. Table 1.
The TCJA of 2017 created a new deduction for pass-through owners effective 2018-2025 45. The new law allows individuals to deduct up to 20 percent of their pass-through qualified business income, which essentially drops the effective top individual income tax rate from 37 percent to 29.6 percent 46. Although various limitations restrict what business income is considered eligible for this new deduction, the provisions have been generally viewed as generous for business owners 47.
In theory, the TCJA deduction for pass-throughs may incentivize people to switch from employees to contractors or report their salary income as business profits to avoid payroll taxes and to benefit from the deduction 48. However, researchers have not found evidence of large responses to the TCJA deduction provisions in the year after the TCJA was enacted 41.
Tax policies affect businesses’ borrowing behaviors by changing rules on the interest expense deduction. In general, businesses can deduct interest on their borrowing but cannot deduct dividends they pay to shareholders. This is one of the advantages of debt financing over equity financing 49.
The TCJA reduced the limits
So far, the outcomes of the policy changes are unclear. Some studies found that firms affected by the TCJA rules decreased their debt leverage significantly by cutting long-term domestic debt or curbing new borrowing 50; however, other studies show that tax incentives don’t seem to have a consistent, first-order effect on corporate capital structure 51.
Tax policies governing how businesses depreciate capital assets can influence investment behaviors 52.
Businesses depreciate capital assets by deducting part of the purchasing costs over the “class life” of that asset, which varies from several years to several decades, depending on the type of asset. Bonus depreciation, which allows for additional first-year depreciation, allows businesses to deduct capital acquisition costs immediately. Faster depreciation, in theory, incentivizes capital investment, reduces the user cost of capital, increases the cash flow of investing firms, and stimulates the economy 53.
Depreciation write-offs for investment were made more generous in the mid-1950s and again in the 1960s with the introduction of the investment tax credit. In 1981, the “accelerated cost recovery system” was enacted, which essentially shortened the depreciation write-off period. Critics said these periods were much too short compared with the useful life of the capital. For example, factory buildings and warehouses used by their owners could be written off in 10 years, although many buildings can be used for longer than 10 years 54. The TRA86 reversed the trend. It repealed the 10 percent investment tax credits for machinery and equipment and changed the accelerated depreciation schedules 8.
The effectiveness of tax instruments on stimulating investment is prone to the overall economic environment. In 2002 and 2003, for example, depreciation allowances for equipment investment were raised twice to stimulate investment. The policies were deemed ineffective in restoring investment, perhaps because investment in the 2000s became less sensitive to prices 55.
The TCJA of 2017 changed the tax codes governing business expensing and deduction. The new law raised the maximum expensing allowance to $1 million and expanded the definition of qualified properties. Regarding bonus depreciation, the new law increases the percentage from 50 percent to 100 percent for assets bought and placed in service between 2017 and 2023 56.
The new changes should, in theory, incentivize businesses investment. Some data evidence supports this expectation. For example, the U.S. business investment after the TCJA grew strongly: The real nonresidential fixed investment rose 5.9 percent in 2018, exceeding a forecast of 2.7 percent made in 2017 57,58. Some researchers contended such investment growth was less of a response to the tax cuts but more to factors such as oil prices 59. Yet, others found substantial investment growth in sectors unrelated to oil, such as equipment, software, and intellectual property 60.
Where to conduct business?
Figure 4: Statutory Corporate Tax Rates, U.S. vs. the World
Note: The raw data are from Bray 61 published by the Tax Foundation. The corporate tax includes taxes levied at the central government and sub-central government levels. The tax rate is weighted by GDP.
All else being equal, countries with lower taxes appeal more to multinational companies (MNCs) and foreign direct investment 62,63. While many countries cut corporate tax rates after the 1980s, the U.S. corporate tax rates were largely above average (Figure 4). The tax rate gap incentivized MNCs to shift income and investment abroad.
Under the TCJA, the federal statutory corporate income tax rate was cut from 35 percent to 21 percent, which has made the U.S. more aligned with other nations. Corporate executives rated the tax cuts as either important or very important regarding their companies’ decisions to increase investment in the U.S. 64.
Another change brought by the TCJA was to move the U.S. corporate tax regime from a worldwide tax with deferral to a territorial tax system 64. Before 2017, a U.S. company needed to pay taxes on its foreign subsidiary's earnings when the cash was repatriated to the U.S. In contrast, many other counties have a territorial system that doesn't tax foreign subsidiaries' earnings.
The old tax regime created some adverse economic outcomes. First, companies were incentivized to leave earnings in foreign subsidiaries 65,66. As of 2014, the U.S. multinational companies held at least $690 billion in cash and over $2 trillion in earnings in foreign subsidiaries 67. The locked-out cash due to the repatriation tax costs led some U.S. companies to acquire foreign businesses rather than invest in America 68.
Second, companies were incentivized to move their headquarters abroad to avoid paying U.S. tax on foreign profits. More than 50 U.S. companies have reincorporated in low-tax countries since 1982, including over 20 since 2012 69. Third, the old territorial system made U.S. multinational companies less competitive, as they must pay taxes on foreign profits, but their international competitors often don’t 70.
While the old system had problems, the transition to a new territorial tax system has also been challenging. Companies may shift profits abroad and pay it back as dividends to the U.S. if the repatriation costs were eliminated entirely. To discourage such tax avoidance, the TCJA introduced two provisions: the Global Intangible Low-Taxed Income ("GILTI"), which requires U.S. shareholders of any controlled foreign corporation to include GILTI in their gross income, and the Base Erosion and Anti-Abuse Tax (BEAT), which is essentially a minimum tax aiming at preventing large multinational corporations from shifting profits abroad 71. To incentivize companies to keep intangible assets such as intellectual property in the U.S., the new system introduced Foreign Derived Intangible Income (“FDII”), part of which can be deducted by companies against their taxable income. All these provisions are still new, and we need more time to evaluate their effectiveness.
This policy brief reviews how tax policies impact individuals and businesses, using some examples from major tax reforms in the last several decades. Taxation affects individual and family decisions on work, savings, and their choice of residence. In addition, tax policies influence how entrepreneurs organize their companies and optimize investment and borrowing activities. Moreover, tax codes affect the global competitiveness of the U.S. in attracting and keeping multinational companies. As discussed above, economic theories and models can help policymakers calibrate policy changes to achieve desired outcomes. However, the actual effectiveness of policy changes often depends on the overall economy and factors not built in economic theories. As a result, the consequences of tax reforms may not always conform with model predictions.
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a. LLCs, by default, are taxed as sole proprietorships if they are single-member and as partnerships if they are multi-member. But they can still elect to be taxed as an S-corporation or a C-corporation41.
b. See the U.S. Census for a detailed definition of the legal form of organization (LFO).
c. Other changes brought by the TRA86 related to corporate income deferral and the creation of the alternative minimum tax for C-corporations also made pass-throughs a more appealing organizational form43.