Federal tax policies not only influence the financial well-being of farm families but also can have important effects on the number and size of farms, their organizational structure, and their use of land, labor, and capital. Federal taxes represent about three-quarters of the total tax burden on farm households. The most significant Federal taxes paid by farmers are income, social security, self-employment, and estate taxes.
In recent years, Federal income taxes on both farm income and income earned off the farm accounted for nearly two-thirds of farmers' total Federal tax burden. Tax legislation enacted over the last decade has reduced Federal income taxes for both individual and business taxpayers. The cumulative effect of these Federal income tax policy changes has been the lowest Federal income tax burden on farm income and investment in decades.
While Federal estate and gift taxes only account for a relatively small share of the Federal tax burden, their potential effect on the ability to transfer the farm business to the next generation has been an important concern for both farmers and policymakers. Changes to estate and gift tax policies, including those contained in the Economic Growth and Taxpayer Relief Reconciliation Act of 2001 have reduced tax rates and raised the value of property that can be transferred to the next generation free of the Federal estate tax.
Federal tax policies are also of considerable importance to the financial well-being of rural households. Rural taxpayers have lower incomes and higher poverty rates than urban taxpayers. As a result, they have benefited from the expanded use of the Federal tax code to provide income support to low-income households, primarily through the use of refundable tax credits. These credits have provided a substantial boost in income and have reduced the rural poverty rate.
Many of the tax policy changes affecting both farm and rural households enacted over the last decade were temporary; however, the American Taxpayer Relief Act of 2012 made many of the expiring provisions permanent. Many of the policies made permanent by the 2012 Act are of considerable importance to both farm and rural households.
Federal Income Tax and Farm Households
The Federal income tax is a progressive tax imposed on net income. Taxable income is computed by subtracting allowable adjustments, deductions, and personal exemptions from total income. Numerous provisions of Federal income tax law allow taxpayers to reduce their tax liability if they undertake certain tax-favored activities. Farmers benefit from both general tax provisions available to all taxpayers and from provisions specifically designed for farmers.
These tax benefits generally accrue to those with higher incomes—generally large farms with high farm income and very small farms with high levels of off-farm income. Although very small farms do not generate enough farm income to support a family, most small farms benefit from farm losses for tax purposes because these losses reduce taxes on nonfarm income. At the same time, many farmers devoting full time to the farming operation do not generate enough taxable income—either farm or nonfarm—to fully utilize available tax benefits.
Examples of special tax treatment for farmers include cash accounting, farm income averaging, depreciation, the current deductibility of certain capital costs, and capital gains treatment for certain assets used in farming. These and other provisions reduce the farm income tax base. Such incentives have likely encouraged greater investment in productive capacity than would have been warranted without tax incentives, and this has affected farmland prices, organizational structure, and farm profitability.
The favorable tax treatment for farm income is reflected in the size of farm profits and losses reported for income tax purposes. Since 1980, IRS data indicate that farmers have reported negative aggregate net farm income for taxes. These farm losses reduce taxes by offsetting taxable income from nonfarm sources.