Many of us know to expect changes to interest rates after major tax reforms, but why do those changes occur? And how will they impact your clients? In this post, we’re diving into the complex relationship between tax policy and interest rates to help you know what to expect the next time major tax reform comes around.
How does tax policy affect interest rates?
It’s widely recognized that changes to tax policy have clear implications for interest rates. In general, tax cuts lead to higher interest rates. When lower taxes put more money in the pockets of businesses and individuals, they typically spend more and have a higher demand for credit. As with any product, higher demand means the seller can charge a higher price. In this case, the sellers are banks who lend to consumers and businesses and the Federal Reserve (the Fed) who lends to the banks, and the “price” is the interest rate.
The Federal Reserve may also choose to raise interest rates if it appears that the tax reforms could lead to inflation. The increased economic activity after tax cuts as well as the increased national deficit (due to lower federal income from taxes) are both factors that could potentially lead to inflation and cause the Fed to raise interest rates. This theory of inflation is based somewhat off of the premise that lower unemployment rates lead to an increase in wages, which leads to inflated prices, a relationship illustrated on the now controversial Phillips curve.
In a 2018 speech, the Vice Chairman of the Federal Reserve maintained that “it is premature to write off the Phillips curve.” As long as the Phillips curve remains a part of the Fed’s “framework for assessing inflation,” it’s likely that we will continue to see the Fed raise interest rates in response to tax cuts and subsequent economic growth in order to counteract inflation.
Similarly, the Fed usually lowers interest rates in response to a slower economy in order to boost economic activity.
What other factors affect interest rates?
While major tax reform is practically guaranteed to impact interest rates, it’s far from the only factor that affects them. Inflation will usually lead to an increase in interest rates as lenders want to maintain their bottom line. Since the purchasing power of the dollars they will be repaid in the future is lessened by inflation, they charge higher interest to make up for the difference.
Interest rates are also determined by the supply and demand for credit, which typically aligns with the strength of the economy.
How do interest rates affect tax policy?
While tax policy is known to affect interest rates, interest rates’ impact on the formation of tax policy is tougher to predict. Relationships between major tax policy overhauls and subsequent changes in interest rates are relatively easy to spot. But the impact of current interest rates on the decisions of tax policymakers are harder to parse out since policymakers are influenced by the economy as a whole and other political factors.
Still, economists have noted or predicted that sustained low interest rates could have significant impact on tax policy. Even with the recent increases in interest rates, rates still “remain low relative to levels in the past.” These interest rates may lead to a preference for consumption taxes (i.e. taxes that are charged when money is spent such as sales tax) over income taxes, among other changes. These effects on tax policy are more theoretical and less immediate than the relatively easy-to-observe, immediate impact of tax policy on interest rates. Any true changes to tax policy will take a long time to realize.
Be sure to check in regularly with the TaxSlayer Pro blog where we cover everything tax preparers should know to be informed and up-to-date on current tax policies.
This article was last updated on June 21, 2022.