The Trump Tax Reform's Pass-Through Boondoggle
Here's an interesting passage from the "Unified Framework for Fixing Our Broken Tax Code" released Wednesday by the White House and Republican congressional leaders:
The framework limits the maximum tax rate applied to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25%. The framework contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.
These are what are called pass-through entities. Most are in fact small. But many aren't, and most of the income earned by pass-through entities goes to the big ones. Consider one partnership that's been in the news this week, the Dallas Cowboys Football Club Ltd., which has annual revenue of $840 million and an operating profit of $350 million, according to Forbes. Jerry Jones, the primary owner, has a net worth of $3.8 billion, according to the Bloomberg Billionaires Index -- which puts him about $100 million short of the global top 500 but does make him wealthier than 99.9999 percent of Americans (among them President Donald Trump, whose net worth Bloomberg puts at $2.9 billion). Overall, 69 percent of income from partnerships, which includes limited liability companies, and 66.9 percent of S corporation income goes to those in the top income percentile, 1 the Treasury Department estimated in 2015. (The percentage for sole proprietorships was just 16.2 percent.)
So yes, this provision would almost certainly amount to a tax cut for Jerry Jones and a lot of other rich people -- among them the members of the Trump family, who conduct business through more than 500 pass-through entities. To keep other people who make lots of money from shifting their income into these vehicles to take advantage of the 25 percent rate, Congress will have to "adopt measures," whatever those might be. And while there's nothing about this in the framework released Tuesday, Treasury Secretary Steve Mnuchin has said that some service partnerships, such as law and accounting firms, won't get the lower pass-through rate. So much for the "simple, fair and easy to understand" tax code promised at the beginning of the tax reform framework.
The reasoning behind the pass-through tax cut is, I guess, that if the top corporate tax rate drops to the 20 percent promised elsewhere in the tax reform framework, limited partnerships, LLCs and S corporations may end up paying higher taxes than the owners of the C corporations that face the corporate tax. At the moment, the top federal tax rate faced by C corporations is 35 percent, while pass-through-business owners face federal personal income tax rates of up to 39.6 percent. But the income of C corporations is taxed twice: once at the corporate level, and again when shareholders receive dividends or take capital gains. As a result, the Congressional Budget Office concluded in 2014 that the effective tax rates on C corporation shareholders were generally higher than those on the owners of pass-through entities. Which is a big reason why pass-throughs' share of business income in the U.S. has risen from 13 percent in 1980 to almost 40 percent now (I have published this chart before).
This, in turn, is a big reason why corporate tax revenue in the U.S. has fallen from 2.6 percent of gross domestic product in 1979 (and 5.9 percent in 1952) to 1.7 percent now. Yes, some of that gap has been replaced by the regular income taxes paid by pass-through owners. And yes, there is an admirable elegance to the pass-through approach of simply running everything through the personal income tax code instead of levying multiple layers of taxes.
But the new tax reform plan proposes to sully this elegance by subjecting pass-through owners to a different, lower tax rate, and it's not at all clear what economic purpose this would serve. If lowering the corporate tax rate causes the effective tax rate on pass-through entities to rise above that on C corporations, the Donald Trumps and Jerry Joneses of the world have an easy remedy at hand: They can convert their businesses into C corporations. As for the millions of non-plutocrats with sole proprietorships (myself included), 2 the vast majority of whom are already paying taxes at a 28 percent marginal rate or lower, this change won't help much. In fact, if the 28 percent bracket is done away with, as envisioned in the tax reform proposal, it won't help at all.
That's right: If all goes according to plan, this tax break for "small and family-owned businesses" would be a break only for those in the 35 percent tax bracket and higher, which currently means, for married couples filing jointly, those with incomes of $416,700 or more. And the bulk of the savings would go to people who make lots more money than that. Now that's fixing our broken tax code and helping out the middle class!
What would help the middle class, small-business owners included? A simpler personal income tax with lower rates might (and that seems to be part of the tax reform plan, although the devil is in the details). Reducing corporate tax rates might, indirectly, by bringing investment to the U.S. that is now going abroad (that's definitely in the tax plan). Then again, so might cheaper, more reliable health care, better roads, better transit and better schools -- taxes do often pay for useful things.
One could I guess argue that a pass-through tax cut would stimulate business investment. But the case for that isn't nearly as strong as with corporate taxes. Mainly, it just seems like a really great deal for people like Donald Trump and Jerry Jones.
Taxpayers with adjusted gross incomes of $465,626 or higher as of 2014.
For book royalties and payments for the occasional outside book review I write. I used to make money giving speeches, too, but that's not allowed for Bloomberg News employees.
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