Most Americans lack familiarity with federal tax increases. Starting in the 1980s, Congress has consistently reduced tax rates for individuals and corporations, with only occasional tax increases during periods of fiscal restraint in Washington.
These trends may have reached their peak as the U.S. grapples with the increasing costs of healthcare. This has resulted in higher spending on health programmes and reduced tax revenue due to more substantial business deductions. Additionally, there are projected higher expenses for Social Security as the population continues to age.
Dealing with the ever-increasing healthcare costs and the challenges posed by an ageing population is not a novel issue. However, the recent surge in interest rates and the resulting inflation have introduced a new and complex problem that hasn’t been tackled directly in decades.
The impending expiration of a significant portion of the 2017 tax-rate reduction, which was implemented during Donald Trump’s presidency, is causing quite a stir. This includes the lower income-tax rates for individuals, whose temporary nature enabled the legislation to be passed with a simple majority in the Senate. In the past, there was always the possibility of utilising debt to lower tax payments. However, there is growing concern that implementing another set of tax cuts could potentially lead to an undesirable situation of increasing prices, which could have negative political implications.
However, both President Joe Biden and his White House predecessor, who is expected to be his opponent in the November election, are both in favour of making the majority of the cuts permanent. Biden’s proposal includes extending tax cuts for all individuals except for the highest earners, while Trump aims to permanently implement the entire tax package.
“When President Trump returns to the White House, he will prioritise advocating for additional tax cuts that benefit workers, families, and all Americans. Additionally, he plans to revitalise America’s energy industry, which will help reduce inflation, lower the cost of living, and address our debt,” stated Karoline Leavitt, a spokesperson for the Trump campaign, in a comment to MarketWatch.
According to Erica York, a senior economist and research director at the Tax Foundation, the deficit problem will lead to increased pressure next year to find ways to cover expenses, which often involves tax hikes and budget cuts.
Affluent individuals
Republicans have consistently opposed tax hikes, while Biden, a Democrat, has made a commitment to refrain from increasing taxes for households earning less than $400,000, which encompasses approximately 98% of American taxpayers.
The Biden administration’s latest budget aims to target the top 2% of earners with a more assertive approach. It proposes raising the tax rate on income above $400,000 from the current 37% to 39.6%. Additionally, it suggests increasing the Medicare surcharge tax for these earners from 0.9% to 2.1%. The budget also includes substantial hikes in capital gains taxes, among other provisions.
In total, Biden aims to impose taxes on this particular group, consisting of approximately 3 million households out of a total of around 130 million in the U.S., amounting to $1.4 trillion over the next decade, as per a Tax Foundation analysis.
Big businesses
Large corporations in the S&P 500 SPX find themselves in a rather fortunate position due to the permanent corporate-tax cut from 35% to 21% that was implemented as part of the 2017 tax overhaul.
The measure proved beneficial in reducing the tax burden for American business owners, both big and small. However, critics argued that it was intentionally more favourable towards the large multinational firms that make up the S&P 500, due to their significant profits.
According to John Butters, senior earnings analyst at FactSet, the median effective tax rate for S&P 500 companies decreased significantly from 31.2% in 2017 to only 20% in 2018.
According to a 2018 Bloomberg analysis, S&P 500 companies saved $12.8 billion in taxes during the first quarter that the new tax law was effective.
Given the current sentiment towards corporations among certain groups of voters, it is probable that these substantial reductions will be considered as a way to finance the extension of certain individual tax cuts worth $3.2 trillion that are scheduled to end after 2025.
It has been suggested by Biden to raise the corporate rate to 28%. Interestingly, even Republican House Ways and Means Committee Chairman Jason Smith of Missouri mentioned that some members of his party believe that increasing the corporate rate is necessary to reach an agreement.
The 2017 tax-code revamp proved to be highly advantageous for owners of pass-through businesses such as partnerships, S corporations, and sole proprietorships. Previously, these businesses were subject to taxes on their profits as if they were regular wages.
Republicans advocated for a provision that would allow pass-through business owners to deduct up to 20% of their business profits from their taxable income. This measure aimed to reduce taxes for smaller businesses in a manner consistent with the tax cuts provided to larger corporations.
The provision is costly, nonetheless, with over 50% of the benefits ultimately benefiting the top 1% of earners.
Even organisations such as the Tax Foundation, known for advocating lower taxes, contend that the pass-through deduction distorts the economy by incentivizing owners to reclassify their businesses and alter profit distribution. This, in turn, reduces tax revenues without yielding substantial economic growth.
Allowing this deduction to expire would provide lawmakers with the opportunity to extend more popular and economically sound provisions of the 2017 law, at a cost of $700 billion over 10 years.
Stock-market enthusiasts
Democrats will strongly advocate for increasing taxes on various sources of investment income, such as capital gains, by taxing them at the same rate as income from labour. This will be in addition to their plans for higher taxes on wealthy earners.
In his proposal, Biden suggests raising the current top capital-gains tax rate from 20% to 39.6%. Additionally, he plans to increase the excise tax on stock buybacks to 4%.
Based on the analysis by the Penn Wharton Budget Model, this approach would significantly reduce the tax benefits of share buybacks compared to dividends and generate $265 billion in revenue over a decade.
For stock-market investors, though, it may discourage public companies from distributing cash to shareholders and instead encourage them to keep it on their balance sheets.
According to Democrats and other critics, the Trump-era tax overhaul had a significant impact on the increase in corporate share buybacks. According to critics, this indicated that the tax cut had not succeeded in incentivizing companies to invest in business expansion or hiring new employees.
Recipients of Social Security and Medicare
Republicans faced significant backlash in the past for proposing cuts to Social Security and Medicare for future recipients. As a result, Trump and other GOP elected officials are now cautious about advocating for reductions in future benefits as a way to ensure the long-term sustainability of these programmes.
According to current law, there is a projected 21% reduction in Social Security benefits in 2033 when the program’s trust fund is expected to run out, and in 2036, Medicare’s hospital insurance fund is also projected to become insolvent, leading to potential limitations on medical benefits for seniors.
Without tax increases, which Republicans are against, it’s challenging to envision how these programmes can be sustained at their current spending levels.
Investors and customers
Given the hesitancy to raise taxes or reduce benefits, Congress may opt to further expand the federal budget deficit.
In a recent note to clients, Henrietta Treyz, director of economic policy at Veda Partners, highlighted the potential consequences of extending some of the 2017 tax cuts. According to Treyz, regardless of the outcome in November, both Congress and the president will have to address the issue of funding these extensions through additional deficit spending.
If Trump were to win the White House but Democrats control the House of Representatives, deficit increases could reach unprecedented levels, according to the analysis. The estimated deficit increases could potentially reach around $3.5 trillion, taking into account the additional $2 trillion revenue from tariffs.
She made the case that if Biden becomes president and Republicans maintain control of the House, their focus on reducing the deficit will likely resurface and have a significant impact throughout Biden’s second term. However, this could still result in over $1.2 trillion in additional debt.
According to her, having one party in control of the government would result in a moderate outcome.
According to an April report from the International Monetary Fund, continued deficit spending will pose challenges for the Fed in lowering interest rates. The report highlights how America’s budget deficits, which are unprecedented during a peacetime expansion, are contributing to inflation and higher interest rates.
Continued deficit spending could potentially worsen these trends, negatively impacting consumers and those who hold U.S. Treasury bonds BX:TMUBMUSD10Y the most.
