By Dr. Mike Walden
Few issues generate more discussion and debate than taxes. For example, my 90-year-old uncle is a quiet man, but a mention of taxes will set him to grumbling and complaining for almost an hour!
One reason taxes generate such interest is they take a significant amount of money. All taxes in the country – federal, state and local – collect almost 30 percent of every dollar earned in the economy. By far the single biggest tax is the federal income tax applied to both individuals and businesses. This tax currently takes 13 cents from every dollar earned.
The U.S. Congress is now working on making some major changes to federal income taxes, but even before a tax bill has been passed there are already debates over potential elements and impacts.
Here I’ll look at some of the key debates over tax changes and let you decide how the changes might affect both you and the broader economy.
Who Benefits? Critics of the current proposed income tax plans have already said the changes will mainly benefit richer taxpayers. In reality, this is difficult to avoid since higher income households pay the bulk of federal income taxes. The top one percent of taxpayers in income pay about 38 percent of total federal income taxes, and the top 10 percent of taxpayers in income pay 70 percent of total federal income taxes.
There are some ways to reduce the benefits to the rich of tax cuts. Tax rates could not be cut for higher income taxpayers. Some have even proposed higher income tax rates for the rich while other households receive tax rate cuts. Also, tax deductions could be limited or eliminated for those at the top of the income ladder.
Yet there’s a worry that limiting the benefits to the rich of tax cuts could create complications and unintended consequences. An income cutoff for defining “rich” would have to be established. This could reduce incentives to earn beyond that limit. Also, higher income households tend to be big investors in technologies and equipment that benefit us all by improving efficiency in the economy. Increasing tax rates could deter some of this activity.
What Deductions Are Kept? Tax deductions reduce the amount of income on which taxes are paid. Tax deductions come in two varieties – standard and itemized. All households can take the standard deduction. Itemized deductions are types of spending deemed by Congress to be worthy of public support. By being able to deduct these types of spending, the spending reduces taxable income and hence reduces taxes. With this tax-saving benefit, Congress expects people to spend more on these designated positive activities.
Taxpayers use itemized deductions if their sum is greater than the standard deduction. If not, taxpayers use the standard deduction.
There is a move in the current round of tax proposals to simplify the tax code by limiting tax deductions. This can be done in two ways. One is to increase the standard deduction. This would motivate more people to use the standard deduction instead of itemized deductions. The second is to limit or eliminate some itemized deductions.
Limiting tax deductions – like those for mortgage interest payments, charitable contributions and state and local taxes – would make those types of spending less lucrative and hurt businesses that rely on that spending such as: homebuilders, charities and state and local governments. But taxpayers who usually don’t have large itemized deductions – and thus who use the standard deduction – would gain.
Who Benefits from Corporate Income Tax Cuts? There’s a strong likelihood that any tax bill passed by Congress will include a substantial reduction in the corporate income tax. Corporations are a legal creation, so any tax is effectively paid by three groups: consumers of the corporation’s products through higher prices, workers at the corporation through lower wages or investors in the corporation through smaller investment earnings.
Whichever group pays most of the corporate income tax would have the most to gain from a rate cut. Economists have sparred over the years about which group this would be. Initial studies indicated investors, but some new research suggests workers might be the biggest beneficiaries from a corporate tax rate reduction.
Would Tax Changes Stimulate Economic Growth? Today’s supporters of tax changes – in particular tax rate cuts – say they are needed to increase economic growth. Faster economic growth can lead to more jobs, higher wages and a higher standard of living.
While many economists agree lower tax rates can increase both investing and work, they disagree on the size of the impact. Some say the impact will be small – maybe a couple tenths of a percentage points – while others say it would be one or two full percentage points. Which is correct has big implications for both the payoff from tax changes as well as whether the changes will “pay for themselves” and not increase federal borrowing.
My 90-year-old uncle is not an economist, but he still likes to debate the economics of tax changes. Hopefully the background I’ve given you on the current debate will help you decide on the best tax approach.
Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.