Under current law, inflation and TCJA sunset provisions are both increasing the taxation of business. This year has ushered in two significant tax increases that are pushing the economy toward recession. President Biden's Build Back Better plan would only add to the burden, instead of compensating for it.
The twelve-month inflation rate hit 8.6 percent in May 2022, which is the highest rate in 40 years. The rate has been above 8 percent since March, while having stayed below 3 percent from 2012 through 2020.
Although inflation is often described as part of a process of heating up the economy for faster growth, in fact it is a pernicious tax on business investment. As Martin Feldstein showed 40 years ago, The interaction of inflation and existing tax rules has powerful effects on the American economy because inflation distorts the measurement of profits, of interest payments, and of capital gains. Although tax rules have changed somewhat since Feldstein wrote that, the same principles still apply.
Take the federal corporation income tax, which is essentially 21 percent of the difference between revenue and expenses, as the Internal Revenue Service (IRS) defines them. In 2019, that difference was about $1 trillion and would have been $2 trillion but for about a trillion of depreciation expenses. IRS-defined depreciation is counted as a deductible expense as a rough way of limiting business taxation to the revenue earned in excess of the cost of capital.
As inflation rises, as it did in 2021 and 2022, many businesses see their revenue, labor costs, and materials costs increase together. However, the depreciation expense stays fixed, because the IRS defines depreciation according to what the business paid in the past for its capital, rather than what it would pay now to replace and maintain the capital it uses during the course of doing business. This makes a business's income subject to tax — and its tax liability — grow faster than its revenue, labor costs, and materials costs. If inflation were high enough, it would about double the share of revenue going to corporate tax, even with no change in the statutory 21 percent rate.
To the extent that inflation is expected to continue, the inflation tax on business discourages investment today because businesses expect that the government will get a bigger slice of the proceeds from today's investment. Indeed, the two-percentage-point increase in corporate bond rates suggests that market participants do not see today's inflation as entirely transitory.
Inflation also raises the costs of capital for businesses. Income taxes on business owners have some of the same calculus as the businesses themselves, namely having tax liability defined as a share of the difference between revenue and expenses. For the business owner, one of the allowable expenses is the initial investment (accountants call it cost basis ), which (like depreciation) is not indexed for inflation.
Bracket creep also affects business owners, as with the Affordable Care Act's Medicare and Net Investment Income taxes on annual incomes over $200,000, which is not indexed for inflation. In other words, these two ACA taxes supposedly affecting only rich people actually affect an ever-growing share of the population as inflation changes the meaning of a $200,000 salary.
When he was a presidential candidate, Joe Biden famously promised to undo the 2017 tax cuts for businesses, and this promise was built into early versions of the 2021 Build Back Better bill. The bill has not yet passed, but a slimmer version is rumored to increase tax rates on non-corporate businesses. More importantly, the 2017 tax law itself sunsets some of its cuts, such as its bonus depreciation provisions.
In other words, the sunsets and inflation each increase the share of business income subject to tax and thereby discourage business investment. In order to maintain the investment incentives that have faced businesses since 2018, new tax legislation is needed. Such legislation would take steps for allowed depreciation expenses to keep up with expenses, as well as making the Trump tax cuts permanent.
Casey B. Mulligan is a professor of economics at the University of Chicago's Kenneth C. Griffin Department of Economics, and served as the chief economist of the White House Council of Economic Advisers in 2018–19. He is also the author of You're Hired! Untold Successes and Failures of a Populist President, which details conflicts between President Trump and special interests.