The House Financial Services Committee is holding a hearing today to examine the effects of the Tax Cuts and Jobs Act (TCJA) and their relationship to innovation, growth, and job creation. We’ve written previously that the most pro-growth element of the TCJA is the permanently lowered corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate; this change is expected to boost investment, productivity, and, over time, worker pay. Here are three initial ideas of how the new taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. law could interact with the financial services industry, specifically.
- The TCJA lowered the corporate income tax rate from 35 percent to 21 percent, and likewise lowered individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rates across brackets. Lower tax rates on interest income translates to lower interest rates for borrowers. The theory behind taxes and interest rates is that lenders are willing to accept lower interest payments when they face a lower tax liability. This is evidenced by the interest rates on tax-free municipal bonds, which are lower than corporate bond interest rates for this very reason. The TCJA should be expected to lead to more widely available credit, due to lower interest rates, all else being equal.
- Contrary to what many claimed during the tax reform debate, limitations on the mortgage interest and state and local taxes paid deductions do not appear to be having a negative effect on the housing market. Many in the housing industry predicted that home prices would fall dramatically because of new limitations on deductions that subsidize housing. However, U.S. homebuilding is near an 11-year high, home prices are rising, and signs indicate that housing market activity will remain moderate.
- The TCJA limited tax advantages like the interest deduction and the deduction for Federal Deposit Insurance Corporation (FDIC) premiums, expenditures which could be viewed as benefiting the excesses of the financial services industry. For example, interest deductibility creates holes in the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , and can contribute to overleveraging. Limiting the interest deduction is a good trade-off for lowering the overall tax burden on vital activities of the industry, such as providing credit. The lower corporate rate also implicitly reduces the value of other tax expenditures related to the financial services industry, such as the exemption of credit union income, which levels the playing field between traditional banks and credit unions.
In conclusion, we can expect lower tax rates to lead to more widely available credit and increased cash flow available for investment, which over time translates into higher levels of growth and wages, and a healthier economy. It is important to keep in mind that it will take time for the new tax law’s effects to materialize, and that other changes in the economy could have offsetting effects.
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