How the Inflation Reduction Act’s Tax Provisions Will Strengthen Our Economy
August 3, 2022
By Emily DiVito
The tax provisions in the Inflation Reduction Act (IRA) are fundamentally fair and equitable, and help address the economic inequality that stems from our current, biased tax code. Moreover, they enable crucial short- and long-term economic investments—especially around climate and energy—that will spur economic growth and hasten a just transition.
There’s more to be done, but taking each of the IRA’s main tax provisions one by one, we see how each is not only an improvement over the current tax code, but makes our economy stronger. The IRA:
- Establishes a minimum corporate income tax (CMT) of 15 percent of book income on the largest, most profitable corporations;
- Shrinks the carried-interest loophole that lets financial executives pay lower taxes than workers; and
- Provides long-term funding for the Internal Revenue Service (IRS) to restore and bolster tax administration.
The IRA establishes a CMT of 15 percent of book income on the largest, most profitable corporations.
Many corporations maintain two sets of accounting books. One that records the “book” income, or the amount of income that they publicly report on their financial statements. Another contains the tax income that they report on their tax filings. These are often two different figures, allowing corporations to tout their profitability to shareholders, while minimizing their tax liability.
The IRA fixes that by establishing a 15 percent minimum corporate income tax on book income on the largest, most profitable corporations—those with an average annual income over $1 billion or, if they’re foreign-partnered companies, with at least $100 million of financial statement income from the US.
Thus, the CMT helps with the fair and effective application of existing corporate income tax law. In 2020, 50 corporations paid $0 in federal corporate income tax—despite recording substantial profits. In fact, many effectively had a negative corporate income tax, meaning they received more from the federal government in rebates than they paid in taxes.
One of the ways corporations that don’t want to pay their fair share push back on increased taxation is to claim that such taxes would depress their businesses. But to hypothesize about how business investment and productivity may be impacted by only the tax provisions in the IRA is to ignore how the package as a whole will leverage public investment to incentivize private investment, and directly benefit individual consumers and families through cost reductions.
Moreover, because the CMT is highly targeted, it will help rebalance the tax code for smaller businesses and individual taxpayers, who often pay taxes at rates effectively higher than most corporations.
The IRA shrinks the carried-interest loophole that lets financial executives pay lower taxes than workers.
Carried interest, or profit interest, is the compensation private equity investors and hedge fund managers receive for managing a fund, typically calculated as a percentage of the fund’s profits.
Therein lies the loophole. When financial executives are paid out this way, they’re able to claim this income as “capital gains.” At typically 15 or 20 percent, the tax rate for capital gains is about half the rate for the top individual income tax of 37 percent.
Importantly, this loophole only benefits a certain, privileged, mostly white subset of the American taxpayer. Not individuals or families, not small businesses, not workers. Almost by definition, it only benefits the private equity investors and hedge fund managers who already have considerable financial holdings and access to capital. Some of the richest Americans, especially those in private equity, have made their fortune on carried interest.
The IRA helps shrink this loophole by, among other things, extending the holding period that makes a financial executive eligible to claim carried interest on profits from three to five years , thus reducing a manager’s ability to game the system.
And, fundamentally, loopholes are loopholes. They undermine the proper and intended functioning of the tax code and shouldn’t exist. Closing this one, in particular, helps eliminate one way the rich have been allowed to get richer—by leveraging preferential rates on capital to amass wealth that then itself goes untaxed.
The IRA provides long-term funding for the IRS to restore and bolster tax administration.
Intentional IRS defunding over the last several decades has left it understaffed and reliant on antiquated technology, and has dramatically hindered its auditing and enforcement capabilities. Since 2010, the IRS budget has been cut by roughly 20 percent, and the specific portion of its budget earmarked for enforcement by 24 percent. Audit rates for the largest corporations and the uber-wealthy have fallen between 54 and 71 percent, respectively.
This reduction in auditing and enforcement has, counterproductively, had a disproportionate impact on the poorest American families, who are audited at about the same rate as the top 1 percent richest taxpayers. But it’s the wealthiest of taxpayers who are responsible for much of the “tax gap”—the difference between taxes owed and collected. One study estimates that the top 1 percent of taxpayers alone account for 28 percent of underreported tax income.
The IRA provides the IRS with a much-needed infusion of funding, and, importantly, does so over 10 years, allowing the IRS to make long-term personnel and technology investments to rebalance enforcement and auditing rates toward the uber-wealthy, the worst tax avoiders.
One notable tax administration provision in the IRA would allow an eventual direct free file program. Such a program would allow taxpayers to file their taxes directly with the IRS—for free. Each year, Americans spend two billion hours and $30 billion filing their taxes. A direct free file option could transform the experience millions of people have filing their taxes—and therefore improve their experience interfacing with their government. Moreover, this would disproportionately benefit low-income taxpayers, who spend relatively more time and money filing their taxes, and whose tax status is often determinative of access to the vital public support programs administered through the tax system, like the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC).
Currently, the IRS outsources its free file program to private tax preparers. These are profit-driven companies disincentivized from advertising—even going so far as to intentionally hide the free option of their services. As a result, only 3 percent of taxpayers (of 70 percent eligible) use the existing free file option. And relying on private providers has left the program in flux and taxpayers in the lurch: In the last two years, the biggest tax preparation companies—H&R Block and Intuit (makers of TurboTax) withdrew from the IRS’s free file program. Offering prefilled returns—whereby the IRS automatically calculates and sends each individual their tax liability using the information it already has—would go one step further than free file to enhance tax administration and individuals’ user experience with the tax code. But a direct free file program is a solid step forward.
All of these reforms would raise revenue only from the most profitable corporations and wealthy financial executives, creating sustainable revenue streams that will be used to address both short- and long-term economic challenges.
Even more than that, though, the IRA’s tax reforms inject fairness into a tax code that has favored corporations and the uber-wealthy for too long.