The Tax Foundation Gets it Right (Sort Of)

The Tax Foundation published its annual piece on pass through businesses this week, and as usual, there’s lots of great material in there.  To begin, the Foundation updates its numbers on pass through employment and marginal tax rates.  As in past years, pass through businesses employ the majority of private sector workers even though they face marginal tax rates that often exceed 50 percent!  Talk about shooting yourself in the foot, economically speaking.

Robert Samuelson at the Washington Post noticed.  In an op-ed last week, he highlighted some of the key metrics found in the Foundation’s report:

“Here are some of the key findings in the report: 

  • More than 90 percent of businesses in America are pass-through enterprises. In 2014, that was 28.3 million out of 30.8 million business establishments.
  • Pass-through firms account for more than half of U.S. private-sector employment. In 2014, the number of workers at these firms totaled 73 million, compared with 54 million at C corporations.
  • The total profits of pass-through firms have surpassed the profits of C corporations. In 2012, the net income was $1.6 trillion for pass-through firms and $1.1 trillion for C corporations.”

The employment figure in particular is worth emphasizing.  Back in 2011, EY estimated that pass through businesses employed 54 percent of the private sector workforce.  According to the Tax Foundation, that number rose to 57 percent by 2014.  That’s a big jump in just three years.

Tax Foundation Chart 1

The Tax Foundation report makes clear that far from being second-class citizens, pass through businesses are the dominant business structure and they are clearly the way all businesses should be taxed in the future.  Here’s a nice paragraph on how pass through tax treatment should be the model for tax policy moving forward.

Proponents of [forcing large S corporations into the C corporation tax] argue that some pass-through businesses are just as large and economically significant as C corporations, and that there is little justification for creating two separate tax regimes for similar types of businesses. There is merit to this line of argument, but instead of forcing pass-throughs into the problematic double tax regime faced by C corporations, lawmakers should work to improve the C corporate tax regime, to move it closer to a single layer of tax at the same rates that apply to wages and salaries.[24] In short, the tax code should treat C corporations more like pass-through businesses, not the other way around.

Tax it once, tax it when it’s earned, tax it at the same reasonable, low rate, and then leave it alone!  We’re glad the Tax Foundation agrees.

One concern is how the Foundation continues to miss headline material right in front of them.  Years ago, they did a piece on the “erosion of the corporate tax base” since 1986 that wholly ignored the fact that their numbers showed the “business tax base” (pass throughs and C corporations combined) had actually grown over that time.  That statistic has become one of our principle talking points for tax reform, and we source the Tax Foundation when we use it, even though they never spelled it out.

This year’s report offers a similar opportunity for acknowledging that the glass is half-full.  Consider this chart on business income.

Tax Foundation Chart 2

You can see how pass through businesses have consistently earned more than C corporations in recent years.  This chart fits with the Foundation’s past focus on the corporate tax base and its decline.

But think about a different chart – a better, more informative chart using the same data.  One that compares business income subject to a single layer of tax versus business income subject to two layers of tax.  As we know, pass throughs pay a single layer of tax on their income when they earn it, so the income represented in the blue line falls into that category.

But we also know that most – 75 percent! – of C corporation shareholders are tax-exempt or tax-deferred. They are pension funds, charities, foreign shareholders and retirement accounts.  So upwards of 3/4s of the green line is actually taxed once, too.  In order to measure how much business income avoids the double corporate tax, you should take three-quarters of the green line and add it to the blue line.  Here are the new numbers:

PT Corp Comparison

So there you have it.  The business community has voted with its feet for single-layer taxation, and it wasn’t close.  It was a landslide of historic proportions – 9 to one!

You can quibble that not all tax-deferred shareholder income escapes the second layer of tax, but that misses the point.  Single-layer taxation is the new norm for US companies.  Any analysis of business taxation should begin with that premise.  The double corporate tax is still harmful to jobs and investment, but only because companies and investors take such great pains to avoid it.  The “classic” corporate tax structure is no longer the base case, which means we need to transition to a new way of examining business taxation that reflects the underlying reality of how businesses are taxed today.

More Talk on Corporate-Only Reform

Congressional Quarterly has a really good article on the state of tax reform discussions on the Hill, and the Super Committee in particular. Here’s a few of the key paragraphs:

Advocates of a corporate overhaul argue that a lower corporate tax rate would help spur economic growth by improving the competitive position of the United States, which now has the second-highest corporate tax rate in the world, much to the chagrin of lawmakers in both parties. Moreover, with the unemployment rate hovering above 9 percent, lawmakers are eager to have the deficit panel take steps to boost the sluggish economy, even as the panel tries to write a $1.2 trillion deficit-reduction package by its Nov. 23 deadline.

Still, it would be difficult to pay for a significant rate reduction solely by eliminating tax breaks for companies. And raising more revenue than the government collects under the current tax system, as Democrats have demanded, also presents challenges.

Economists note that eliminating certain corporate tax breaks - such as the research and development tax credit and domestic manufacturing deduction - to pay for a lower overall rate could end up harming some industries that benefit significantly from the tax incentives.

In addition, there is a lingering problem, well-known to lawmakers, that many “pass-through” companies do not pay the corporate tax at all. Instead, they have their profits distributed to individual owners or partners, who are then taxed as individuals. Lowering the 35 percent corporate tax rate and eliminating industry-specific tax breaks without also lowering the 35 percent top individual tax rate could hurt those companies.

Concerns about putting one company at a disadvantage compared with another are precisely what give some lawmakers pause about settling for anything less than a rewrite of the entire tax system. Given those concerns, and Democratic hopes for more revenue from wealthier Americans, it will be hard for some lawmakers to abandon hopes of a complete overhaul.

Nevertheless, members of the deficit panel are trying to find a creative solution that would be fair to all types of businesses without major changes to the individual portion of the tax code, according to a congressional aide familiar the panel’s discussions.

Such efforts, which have yet to yield definitive, or public, solutions, are reflected in the comments from Hensarling and Ryan, who notably avoided terms like “corporations” and “corporate tax reform” in favor of “business-entities” and “business tax reform.”

This story confirms what we’ve been telling our members since January — there continues to be a strong interest in pursuing corporate or business “only” tax reform.

This time, the idea is to use tax reform to leverage cuts to entitlement programs. Democrats on the Super Committee have made clear that without tax provisions “on the table” they won’t agree to significant changes to Social Security, Medicare, or Medicaid. But there’s concern that reforming the entire tax code is simply too much. So the more narrow corporate reform is seen as the key to unlocking meaningful deficit reduction.

The challenges to this plan remain the same ones we’ve articulated in the past.  How do you construct corporate or business only reform that is budget neutral, or even raises revenue, without hurting specific industries, like manufacturing, or harming pass-through businesses? The lack of any particular plan — either from the Administration or the tax writing Committees — suggests these obstacles have yet to be overcome.

For guidance, an impressive group of 40-plus business groups‘ including the National Federation of Independent Business, the National Association of Wholesale Distributors, the Associated General Contractors, the American Council of Engineering Companies, the Independent Community Bankers of America, the S Corporation Association, and the National Restaurant Association, wrote tax writers earlier this week articulating three key principles to successfully reforming the tax code. These principles might not match up with the goals of some Super Committee members, but if you want to make American employers more competitive, they are a good place to start.

Volcker Report Released. On a Friday. In August.

The headline says it all. The long-awaited Volcker Tax Reform Commission report was released last Friday and was immediately put on a shelf someplace in the basement of the Ways and Means Committee. According to the Commission members:

The Board was asked to consider various options for achieving these goals but was asked to exclude options that would raise taxes for families with incomes less than $250,000 a year. We interpreted this mandate not to mean that every option we considered must avoid a tax increase on such families, but rather that the options taken together should be revenue neutral for each income class with annual incomes less than $250,000.

In general, the report’s authors sought to provide “helpful advice to the Administration” on “options for changes in the current tax system to achieve three broad goals: simplifying the tax system, improving taxpayer compliance with existing tax laws, and reforming the corporate tax system.” The Board was not asked to consider major tax reforms.

Just how helpful this advice is remains to be seen, but the low-key manner in which the report was released suggests the Administration does not see the report itself as a useful message vehicle. Proposals to raise taxes seldom are.

For S corporations, two recommendations stand out:

Payroll Tax Provision: The report suggests that payroll tax policy could be changed so that all active S corporation shareholders, LLC members and limited partners pay payroll taxes on all distributions from their businesses. Under the heading of “Disadvantages,” the report states:

The revenues raised from the proposal would come primarily from owners of small businesses. Moreover, it would impose employment taxes on income that is partially a return on capital rather than a return on labor.

Our point exactly.

Business Structure Neutrality: As a part of corporate tax reform, the report states that “a goal of reform in this area is tax neutrality with respect to organizational form” including these two options:

One option would be to require firms with certain “corporate” characteristicsb – publicly traded businesses, businesses satisfying certain income or asset thresholds, or businesses with a large number of shareholders “to pay the corporate income tax. In effect, this would broaden the corporate tax base by applying the corporate tax to more businesses.”

An alternative option would eliminate the double taxation of corporate income and harmonize tax rates on corporate and non-corporate income through “integration” with the individual income tax. In one example of such a system, individual investors would be credited for all or part of the tax paid at the corporate level against their individual taxes.

 

In other words, you could harmonize the tax treatment of business income by either imposing the corporate tax on more entities or by reducing the double tax currently paid by C corporation shareholders. Again, the disadvantages of option one highlighted by the Commission speak volumes:

Achieving neutrality between corporate and non-corporate businesses by subjecting more businesses to the corporate tax would increase the cost of capital and thus decrease investment in those businesses.

Yep.

More on Pending Tax Hikes

 

Our friends on the Hill pointed out a new survey of the National Association of Business Economists membership on the pending tax hikes. The survey found that more than half of NABE economists support extending all the marginal tax rates (including the upper brackets) while six out of ten support keeping the rates on capital gains and dividends at 15 percent. Other interesting results:

  • Three quarters support promoting economic growth over reducing the deficit;
  • Three quarters oppose further fiscal stimulus; and
  • A large plurality support “clarity on future regulation and tax policy” over other ways in which the government can best “encourage increased employment.”

 

We are hearing this last point repeatedly these days — the best thing Congress can do is provide a little policy certainty to the markets. Congress is not doing the things it is supposed to (budgets, tax extenders, etc.) while it is considering and adopting dramatic changes to rules by which businesses relate to their employees, their customers, and their government. Markets do not like uncertainty, yet the current policy climate here in D.C. is rife with it. CNN points out that in the area of tax policy alone, more than 100 tax relief provisions affecting just about everybody are waiting to be extended.

 

Finally, on the National Commission on Fiscal Responsibility and Reform, four out of five respondents did not believe the Commission would produce a credible plan that could pass Congress. On that one, we’re not so sure.B A growing number of smart folks around town are suggesting the Commission may be the best chance we have in the next couple years to get the federal deficit under control. Maybe; but either way, we’re guessing that report won’t be released on a Friday.

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