Ryan Rolls Out New Ways & Means Committee

Main Street business tax treatment was a big theme during the Ways & Means Committee’s first hearing of the year.  Its purpose was to look at the state of the economy, but key members kept raising the question of how to best treat pass-through businesses in tax reform.   Carrying the flag for S corps was our longtime S-CORP Champion Dave Reichert (R-WA):

Reichert (1:53:00): In another area where we have the ability to boost our economy – through tax reform, as has been mentioned, and which would benefit businesses large and small — what about pass-through businesses…which face a high marginal tax rate in addition to high compliance costs. How do you see the change in the tax code specifically helping those small pass-through businesses?

Economist Martin Feldstein: I think that’s a major challenge that you face as a committee and in Congress in dealing with tax reform. That lowering the corporate tax rate, where both the President and Republicans have said ‘we’ve got to get down into the twenties,’ will still leave pass-through businesses, who file through their personal tax returns, facing much higher tax rates, so somehow that has to be dealt with. And by treating the business income of individuals differently from other things, so that in effect they get the advantages of the lower tax rate that come with corporate tax reform.

Rep. Vern Buchanan (R-FL) also focused on the challenge faced by pass-through businesses:

(2:22:00): I want to bring up something my colleagues mentioned earlier, about corporate rates being the highest in the world…I think we agree that we need to do something with corporate rates. My concern is pass-through entities. You touched a little bit on effective rate, and how when you add everything the effective rate is 40 percent or more, and if you add in state income tax, the average is 49.6. So if you look to move corporate rates from 35 to 28 to 25, whatever they’re thinking about doing there, I don’t know how you can be competitive in terms of pass throughs.

One statistic I got is 99 percent of the companies registered in Florida and other places are small businesses, obviously a lot of them pass throughs. And 60 percent of job creation comes from these businesses, and many of these start-ups. In terms of reducing the rate, if you’re a pass-through company and you have seventy employees, and you’re giving half your money back to the various governments, it’s pretty hard to be able to grow your business, add equipment, add jobs, when you’re giving half of [your money] away. My point, to the professors here today, is to ask what effect lowering the rates on C corps and pass throughs would have on the economy and on creating jobs….

Economist Doug Holtz-Eakin:  It’s bad tax policy to treat business income differently depending on whether it’s a pass through or a C corporation. And that would drive you to organize your business based on tax considerations rather than business considerations; that’s the hallmark of the tax system interfering with the economy.

And finally, Representative Todd Young (R-IN) weighed in:

(3:00): I’d like to talk about tax reform…but specifically focusing on tax reform for our smaller businesses and younger firms.

 I do have some concerns, going back to the small and younger firms that, about some intimation by the President and by others in this town that we may only consider corporate reform, rather than the individual code so that those pass-through entities like S corporations and LLCs get the benefit of simplification, on one hand, and rate reduction, knowing that many of them pay over half of their profits in taxes, when you combine the taxes at different levels of government.

It bears reminding that, over the past decade, more than six out of every ten new jobs created in this country have been through these smaller firms, and this is where over half of jobs currently exist in this country.

Bottom Line:  Key members of Ways and Means, starting with the Chairman and working down from there, are fully aware of the economic importance of pass-through businesses and the threat that “corporate-only” tax reform poses to them.


Tax Reform Challenge in One Chart

If you’re looking for an illustration of how the tax code fails to treat business income equitably, look no further than this chart on effective marginal tax rates from the CBO (click to enlarge).

Keep in mind that the chart shows effective marginal rates, so it captures the tax on new income from a new business investment, not the average tax paid by businesses on their existing income.  If you’re looking for effective rates on existing business income, you should look at the effective rate study we released back in 2013. (Spoiler alert:  S corps pay the highest effective rate.)  Moreover, since sole props tend to be less profitable and are taxed at lower average rates, their inclusion reduces the effective marginal rate for pass-through businesses below what it would be if S corporations alone were examined.

These points aside, the chart has much to tell us.

First, look at the disparity between debt and equity investment.  Returns on equity are taxed at high levels, while returns on debt financed investment are taxed at much lower levels.  Debt-financed investment by C corps is actually subsidized under the current code!  This disparity encourages businesses to over leverage.  Not good.  Any tax reform worth doing would seek to balance out the tax treatment of debt verses equity.

Second, look at the long lines showing the range of effective marginal tax rates.  These signify the difference in effective rates depending on the industry and assets involved.  The longer the line, the greater the disparity.  The range of effective tax rates for C corps using equity ranges from 21 to 47 percent.  The range for C corp debt is from 22 percent to negative 42 percent!  Pass-through businesses also show significant ranges, if not quite as extreme.  Once again, any tax reform worth doing would seek to shorten those lines and balance out the tax treatment of investing in different types of assets.

One of our concerns with the Camp plan released last year was that it did little to balance out either the debt verses equity differential or the differing treatment among asset types.  In fact, the JCT analysis of the plan showed the Camp draft would have increased the effective tax burden on business investment.  Tax reform should encourage, not discourage, business hiring and investment while balancing out the tax burden on differing industries and business structures.

If you want a sense of how difficult that task will be, look no further than this CBO chart.


It’s All About That Rate

Speaking of tax rates, Bloomberg’s Richard Rubin had a nice story this week outlining the challenge tax reformers face in trying to reconcile corporate and pass through taxation.   S-CORP’s own Brian Reardon was highlighted channeling singer Meghan Trainor:

The administration’s proposals are an “absolute non-starter,” said Brian Reardon, president of the S Corp Association, a group of pass-through companies whose board of directors includes an executive from Tabasco sauce maker McIlhenny Co.

“Main Street businesses have to be an equal partner in this,” he said. “And what that means is rate parity. It’s all about the rates.”

It’s all about the rates, indeed.  You can bet that’s going to be our major theme this year as Congress takes another look at tax reform.

CBO Gets Effective Rate Wrong

February 6, 2014

The tax reform effort may face significant headwinds, but the debate over who pays what continues, with the business community doing a good job of articulating just how much they pay in taxes and entities like the Congressional Budget Office, well, not.

Embedded in yesterday’s economic update is a section entitled “Corporate Income Taxes” that includes a chart showing the effective tax rate of the domestic profits of C corporations declining over time.  The effective corporate tax rate was in the 30s during the 1970s, in the 20s during the 1980s and 1990s, but now is down in the teens.

On its face, this chart would support the case that the corporate tax base is eroding and needs to be fixed.  But does it?

Not exactly.  As our friends at the Tax Foundation observe, the measure of “corporate” profits used to create the chart include both C corporation and S corporation profits, but only C corporation taxes.  In other words, the inclusion of S corporation profits has the effect of artificially reducing the measured tax burden on C corporations.  Here’s the Tax Foundation:

The main difference between the CBO and IRS numbers is that the CBO has included the pass-through businesses in their measure of profits, even though those businesses are not subject to corporate taxes but rather pay under the individual tax code. Particularly, the CBO is using as their corporate tax base measure domestic economic profits from the BEA, which includes both C and S corporations, even though S corporations are pass-through entities not subject to the corporate tax. This matters more and more, as S corporations have been growing relative to C corporations for over 20 years. It is now the case that about 30 percent of the profits measure used by CBO and BEA is due to S corporations. Hence, any calculation of the average corporate tax rate based on these numbers will be about one-third too low. 

So the C corporation number in the CBO report is incorrectly low because it includes pass-through profits but not pass-through taxes.

Why is this of concern?  Aside from the fact that it violates the basic virtue of using numbers accurately so we have a clear picture of what’s really going on in the economy, left unchallenged the report just lends fuel to the argument that the C corporation tax base is “eroding” and that Congress needs to take steps, like forcing large S corporations into C corporation taxation, in order to fix it.

To the contrary, as our effective rate study made clear, pass-through businesses pay lots of business taxes.  In fact, at 32 percent, S corporations pay the highest effective rate of any business type.  Moreover, as the Tax Foundation notes, an increasing share of business income shifted from the C corporation world to the pass-through world over the past thirty years, so much of the decline in the average tax rate shown in the chart above can be attributed not to a loss in taxes, but rather to a shift in collections from one tax code to another.  The government is still collecting those taxes and at the same time; it just shows up in another accounting column.

Perhaps the CBO can make that clear next time?

Entitlement Death Spiral

February 5, 2014

Yesterday’s CBO report has started a firestorm here in DC, with most of it focused on the portion that says Obamacare will result in 2 million fewer workers by the year 2017.  That’s certainly an eye-opening number, and it adds to the long list of reasons why the health reform effort is deeply unpopular.

The White House was quick to respond by pointing out that those 2 million lost jobs are the result of workers voluntarily leaving the workforce – rather than employers cutting jobs — but we’re not sure that makes much difference.  Either way, the workforce has shrunk by 2 million, which has negative implications both for economic growth and the deficit moving forward.

For deficits, the CBO forecasts they are going to bottom-out next year and then begin climbing again.  The source of the increase is growing entitlement costs – including the cost of Obamacare – plus the interest expenses on existing debt:

In CBO’s baseline, spending is boosted by the aging of the population, the expansion of federal subsidies for health insurance, rising health care costs per beneficiary, and mounting interest costs on federal debt. By contrast, all federal spending apart from outlays for Social Security, major health care programs, and net interest payments is projected to drop to its lowest percentage of GDP since 1940 (the earliest year for which comparable data have been reported).  

In other words, the items that the President spent zero time discussing in his State of the Union Address are the reasons why our budget outlook is so depressing. Fear of entitlement growth is the reason the entire business community joined hands back in 2012 to call on the Administration and Congress to make entitlement reform a priority.  As the letter warned:

Our nation’s entitlement programs are unsustainable. If we do not make sensible reforms, the programs will go bankrupt—and so will the nation. No one can dispute that.

Critics of Obamacare worry about a death spiral in the health care exchanges, where expensive premiums scare off younger, healthier workers, resulting in higher costs and higher premiums, scaring off even more young workers.

The CBO report makes clear we also need to worry about an entitlement death spiral too, where growing entitlements squeeze the very economy that is supposed to produce the taxes to fund the programs.  Entitlement growth is fueled by the retirement of the Baby Boomer population, which means we’ll have fewer workers in the job market in coming years.  Couple that with new incentives for workers below the retirement age to leave the workforce – in this case 2.5 million by the year 2024 – and you’ve got a real problem.

That should be the real lesson coming from the CBO’s report.

The Importance of Marginal Rates

Another item that stood out in the CBO report is its focus on how higher marginal tax rates affect worker behavior:

CBO’s estimate that the ACA will reduce employment reflects some of the inherent trade-offs involved in designing such legislation. Subsidies that help lower income people purchase an expensive product like health insurance must be relatively large to encourage a significant proportion of eligible people to enroll. If those subsidies are phased out with rising income in order to limit their total costs, the phaseout effectively raises people’s marginal tax rates (the tax rates applying to their last dollar of income), thus discouraging work. In addition, if the subsidies are financed at least in part by higher taxes, those taxes will further discourage work or create other economic distortions, depending on how the taxes are designed.

This analysis comes the same week as an interesting Wall Street Journal piece suggesting that the sharp hike in the capital gains tax last year had a significant impact on federal tax receipts and the stock market last year:

In late 2012, investors sold huge amounts of investments with long-term capital gains to take advantage of the expiring 15% ” Bush ” long-term capital-gains tax rate before the current 23.8% rate for higher-income investors took effect on Jan. 1, 2013. These sales left investors with few unrealized long-term gains going into 2013.

Instead, as the market surged, investors’ new gains were held mostly in short-term positions, which they were loath to sell given that short-term gains are taxed at ordinary income-tax rates (39.6% for high earners). With this inhibition there was less sales pressure last year, and for that reason the market may have risen more than it would have otherwise.

So high marginal rates affect the behavior of workers and investors alike.  What about employers?  Right now, S corporations pay as much as 9.6 percentage points (44.6 percent versus 35 percent) more than our C corporation competitors on the initial layer of tax they owe to the IRS.  Do these higher rates impact jobs and growth?  You betcha.

Our Ernst & Young study from 2012 made clear that the tax hikes that (largely) took place at the beginning of last year will have the effect of reducing long-term employment by more than 700,000 jobs.  Wages would be lower too.

So the CBO report reinforces their analysis that marginal rates do matter.  They affect taxpayer behavior in a meaningful way, with higher rates leading to less worker participation and fewer jobs.  This is the key reason S-CORP has been actively supportive of Chairman Camp’s efforts to reform the tax code and lower marginal rates for businesses and individuals alike.  But then, that’s another item the President barely mentioned last week.

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