Five Facts about the Bipartisan Tax Deal

The long-awaited bipartisan tax deal has successfully passed through the U.S. House of Representatives and is now poised for consideration in the Senate. Dubbed the Tax Relief for American Workers and Families Act, this legislation carries significant implications.

Among its key provisions, the tax deal proposes a temporary extension until 2025 of three critical business measures initially implemented under the 2017 Tax Cuts and Jobs Act (TCJA). These include bonus depreciation, research and development (R&D) expensing (limited to domestic R&D), and an expansion of the interest limit.

Furthermore, the package includes temporary adjustments aimed at enhancing the child tax credit (CTC). These adjustments involve recalibrating refundable and base CTC amounts to account for inflation, instituting an income lookback mechanism for credit valuation, and accelerating the phase-in of the maximum refundable CTC for households with multiple children.

Complementing these alterations are additional components such as a tax accord with Taiwan and an augmentation of low-income housing tax incentives. Cumulatively, these tax adjustments are estimated to amount to $78 billion over a decade-long budget window. The funding for these provisions is proposed to be sourced through heightened enforcement measures and modifications to the COVID-era employee retention tax credit.

Permanent Improvements to Cost Recovery Would Deliver the Most Bang for the Buck

Because the adjustments to R&D expensing, bonus depreciation, the net interest limitation, and the child tax credit are temporary, their impact on businesses’ and individuals’ investment or work decisions is limited. While these provisions are active, they may temporarily enhance investment incentives, but this effect is short-lived as the policies expire, resulting in no lasting benefit.

If bonus depreciation and R&D expensing were made permanent instead, they would have a significant positive impact on growth. Among the 11 major expiring tax cuts within the TCJA, bonus depreciation and R&D expensing offer the highest return on investment—they could collectively increase GDP by 0.5 percent in the long run. Temporary tax policies fail to fully realize this potential for economic growth.

The Child Tax Credit Structure Largely Remains the Same

The tax deal introduces several adjustments to the child tax credit (CTC), including increasing the refundable amount beyond tax liability, expediting the phase-in of the refundable portion, and allowing taxpayers to utilize earned income from the previous year for calculating their refundable tax credit. These modifications maintain the basic structure established by the TCJA: to qualify for the credit, taxpayers must earn more than $2,500, possess an individual taxpayer identification number, and furnish Social Security numbers for qualifying children. Additionally, the credit continues to phase out as taxpayers earn above $400,000 for joint filers or $200,000 for single filers.

One estimate from scholars at the American Enterprise Institute explores the ramifications of implementing an income lookback for calculating the CTC on a permanent basis, suggesting it could lead to a net reduction of 150,000 jobs. However, alternative analyses indicate that the lookback would not create a permanent incentive to exit the workforce, but rather an inclination to cycle in and out of employment from one year to the next.

The Joint Committee on Taxation (JCT) estimates that the income lookback accounts for less than $0.8 billion of the $10.7 billion cost of the CTC expansion in 2025, indicating its relatively minor impact.

Furthermore, the JCT projects that the temporary alterations to the CTC included in the deal will have an overall positive effect, primarily attributed to the accelerated phase-in of the credit for families with multiple children. They assert that “the proposed expansion of the child tax credit on net increases labor supply,” albeit insignificantly.

The Deal Would Not Exacerbate Inflation

While the package maintains revenue neutrality over the budget window, it’s unlikely to significantly impact inflation. However, the initial tax cuts in the first two years raise concerns about potentially exacerbating inflation. For instance, in 2024, the tax deal would decrease revenue by $169 billion, followed by a reduction of $46 billion in 2025. However, from 2026 to 2033, it’s projected to generate revenue annually.

This revenue trend primarily stems from changes in the timing of business investment deductions. The accelerated deductions may temporarily stimulate investment and capital stock, thereby mitigating inflationary pressures by bolstering supply and production. Moreover, the anticipation of higher taxes when the pay-for measures take effect will further mitigate short-term inflationary pressures.

If these policies are extended beyond 2025 through subsequent legislation, policymakers should prioritize tax adjustments that enhance investment incentives. Additionally, they should seek additional legitimate and sustainable pay-for mechanisms to maintain fiscal responsibility.

Clamping Down on the Employee Retention Credit Makes Sense as an Offset

To counterbalance the expenses linked to the business and child tax credit provisions, the package implements stricter enforcement measures regarding the pandemic-era employee retention tax credit (ERTC). The ERTC has been marred by fraudulent activities, with unscrupulous entities prompting businesses to illegitimately claim the credit. This fraudulent activity has significantly inflated the fiscal burden of the program: while originally projected to cost $55 billion over a decade in 2020, it is now estimated to accrue nearly $550 billion in long-term expenses if not addressed.

The package discontinues new ERTC claims as of January 31, enhances penalties for ERTC fraud, and extends the associated statute of limitations. Collectively, these adjustments are anticipated to save approximately $78.8 billion over ten years.

Critics contend that Congress should not rely on projected revenue from a flawed program. While it would have been preferable for Congress to avoid this predicament from the outset, the reality remains that intensified enforcement will yield tangible revenue today that would otherwise go uncollected. Dismissing offsets simply because they should have been enacted earlier would severely limit available options for offsetting expenses.

The bipartisan selection of an offset devoid of budgetary or timing gimmicks signifies progress. As our deficit situation continues to deteriorate, there should be a push for more offsets of this nature from Congress, promoting fiscal responsibility and accountability.

Retroactivity Creates No Growth Incentives but Helps Small Businesses

The package includes retroactive tax cuts for both businesses and families. Businesses benefit from R&D expensing for 2022 and 2023, 100 percent bonus expensing for 2023, and a reversal of the tighter limitation on interest deductions for 2022 and 2023. Families with children also receive retroactive benefits, such as a faster phase-in of the child tax credit (CTC) for families with multiple children and a $1,800 refundable CTC limit for 2023.

Retroactive tax changes do not alter future economic incentives; taxpayers cannot alter their behavior retrospectively. Ideally, policymakers should minimize retroactivity when crafting tax policy.

However, regarding R&D expensing and bonus depreciation, many small businesses faced cash flow and liquidity challenges when these provisions expired or were phased down. Given this, it was reasonable for small businesses to anticipate Congress addressing these expirations, especially the unprecedented requirement to begin amortizing R&D expenses from 2022 onward.

R&D expensing and 100 percent bonus depreciation accelerate deduction timing for firms. Retroactive depreciation deductions allow firms to deduct expenses more quickly than they otherwise would, alleviating the tax burden on past investments affected by inflation and the time value of money. While retroactive depreciation changes are not optimal, they differ from retroactive changes that simply reduce taxes paid and do not alter the timing of tax payments.

Disclaimer: This is not legal advice, consult an attorney for legal advice or contact us.

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