Tax policies have a significant impact on the economy of a nation. They determine the amount of revenue collected by the government to finance its numerous programs and services. Tax policies also influence the financial decisions made by individuals and businesses. Over the years, tax policies have undergone significant changes, with key tax reforms defining the tax code and influencing the economy.
In this blog, we will examine the effects of tax policies on the behaviour of individuals and companies, with the federal income tax as the primary focus. The TRA86 (Tax Reform Act of 1986) and the TCJA (Tax Cuts and Jobs Act of 2017) will be examples to illustrate some of the motivations and effects of tax compliance and advisory services in recent decades. It is important to note that this article emphasises some key trade-offs that policymakers must consider when deciding tax policies.
Top Two Impacts of Tax Policies on Businesses
Legal structures for businesses
Tax policies influence the decisions entrepreneurs make regarding the legal structure of their enterprises. Businesses can be C-corporations or pass-through entities such as S-corporations, partnerships, LLCs (limited liability companies), or sole proprietorships. C-corporations are subject to double taxation (individual dividend tax and corporation income tax), whereas pass-throughs do not pay corporate income tax.
Tax reforms such as the TCJA and TRA86 have influenced the legal structures chosen by businesses. Reduced individual income tax rates made pass-through businesses more attractive as a result of the TRA86. Consequently, C-corporations filed fewer tax returns, while pass-throughs such as S-corporations and partnerships filed more.
The Tax Cuts and Jobs Act (TCJA) introduced an updated deduction for pass-through entity proprietors, making pass-through entities more attractive. However, the influence of this exemption on business structures as a whole is still being assessed.
Changing the regulations governing the interest expense exemption influences the borrowing decisions of businesses. The Tax Cuts and Jobs Act lowered the deduction limits for company-related expenses, which may have influenced firms’ borrowing decisions.
An Overview of Other Ways Tax Policies Affect Businesses
Tax policies influence the investment decisions of companies and also depreciate capital assets. Changes to depreciation regulations can affect businesses’ investment incentives and cash flow. For example, the Tax Cuts and Jobs Act (TCJA) introduced increased expense allowances and incentive depreciation, which should encourage businesses to invest.
Tax rates for corporations can significantly impact multinational corporations’ location decisions. Countries with reduced tax rates are desirable investment destinations. It also altered the corporate tax structure to a territorial system, which impacts multinational corporations.
All About the Influence of Tax Policies on Individuals
Redistribution of income is a fundamental component of tax policy. Individual income tax is progressive, meaning those with greater incomes pay more taxes. Tax exemptions and credits often provide incredible benefits to those with lesser incomes, rendering the tax system progressive.
The rate of taxation has decreased substantially over the years, sparking debates about America’s diminishing progressiveness. Nevertheless, it is crucial to take into account the entire tax legislation, not just the highest marginal tax rate. For example, the Tax Reform Act of 1986 (TRA86) lowered the highest marginal rate of taxation from 50 to 28 percent while also introducing measures to reduce the tax burden on people with lower incomes, such as increasing standard discounts and personal exclusions and broadening the tax credit for earned income.
In order to comprehend the effect on average rates of taxation, data reveals that individuals with the lowest earnings during the year 2018 had an average overall federal tax rate of 0%, compared to a rate of 12.1% in 1984. In 2018, the average federal tax rate paid by households in the second-lowest income group dropped from 15 to 8.1 percent.
Tax policies may influence whether or not individuals choose to work beyond the household. The Earned Income Tax Credit (EITC) provides a tax credit to low-income workers who satisfy certain criteria. Individuals have to work to be eligible for the EITC, which encourages participation in the labour force. Information from EITC growth in the 1980s and 1990s indicates that low-income families, particularly single parents, increased their work hours and jobs significantly.
Additionally, payroll taxation influences the employment decisions of businesses. Employers fund medical, unemployment, and social security insurance through payroll taxes. Since the 1960s, the proportion of federal revenues derived from payroll taxes has doubled. However, the degree to which employers are able to transfer payroll tax expenses to employees influences labour demand and wages. According to studies, only a portion of the extra tax burden caused by increase in payroll tax rates is transferred to workers in the short term.
Place of residence
SALT (State and local income taxes (SALT) significantly impact where individuals choose to live and work. Major variations in local and state taxes make individuals relocate from high-tax to low-tax regions. Studies indicate that migrating from states with high tax rates and relocating to states with low tax rates are common.
By limiting the total SALT exemption per individual to $10,000, the Tax Cuts and Jobs Act of 2017 exacerbated tax disparities between states. This modification increased individuals’ incentives to flee high-tax states. Nonetheless, the long-term effects of these developments are still being evaluated.
Tax policies also influence individuals’ decisions regarding retirement savings. The decision to choose between tax-benefitted retirement accounts, such as traditional 401(k) plans and post-tax Roth accounts, depends on the individual’s financial situation and anticipated future tax rate. Tax code modifications can influence people’s choices for savings for retirement.
For instance, the TRA86 considerably reduced the annual contribution limit for retirement plans and imposed stricter restrictions on releasing savings from tax-free retirement plans for purposes other than retirement. These modifications affected people’s willingness to save through particular retirement accounts.
Individuals and enterprises are profoundly affected by tax policy. They affect economic behaviours like employment decisions, savings decisions, business structures, and investment activities. Tax reforms such as the Tax Reform Act of 1986 and the Tax Cuts and Jobs Act have demonstrated that tax policies are a potent instrument for shaping the economy. However, the actual efficacy of modifications to tax policies may not always match the predictions of economic models due to a number of external economic factors.
When devising tax policies, policymakers must strike a balance between income redistribution, competitiveness, and economic growth. To develop effective and equitable tax systems, it is essential to comprehend the consequences of tax policies on businesses and individuals. Ongoing assessment and investigation can assist policymakers in refining tax policies to accomplish desired outcomes and promote economic growth. Contact Fortius Consulting Services (https://www.fortius.consulting/) if you wish to get professional guidance with tax services for your firm.