Letter Leaves Pass Through Employers Behind

For seven years, your S-Corp team has repeated the same mantra for tax reform – tax all income once, tax it at similar reasonable rates, and then leave it alone.  If Congress wants to make the tax code simpler and encourage more job creation, this is the place to start.

A competing view is one where the largest corporations pay very low rates while everybody else – individuals and pass through businesses alike – pay rates significantly higher.  Recall that pass through businesses are taxed via the individual tax rates of their owners.  The idea is that while US corporations can always move someplace else and therefore need lower rates to stay, US citizens and private companies are less mobile.  They are effectively trapped, and we can tax them accordingly.

This view of imposing higher tax rates on individuals was embraced in a letter signed by 45 of the 48 Senate Democrats sent to President Trump, Senate Majority Leader Mitch McConnell, and Finance Chair Orrin Hatch today.  You can read the whole letter here.  According to Politico:

The Democrats who signed onto Tuesday’s letter, spearheaded by Minority Leader Chuck Schumer (D-N.Y.) Schumer and Oregon Sen. Ron Wyden, the top Democrat on the tax-writing Finance Committee, also made two blunt demands on taxes: They will not back any bill that gives new breaks to the wealthiest individuals and will not back any legislation that adds to the deficit.

“Tax reform cannot be a cover story for delivering tax cuts to the wealthiest,” the senators wrote. “We will not support any tax plan that includes tax cuts for the top 1 percent.”

The Democrats added that they “will not support any effort to pass deficit-financed tax cuts, which would endanger critical programs like Medicare, Medicaid, Social Security, and other public investments in the future.”

Our concern is that this push against rate reduction for high income individuals could end up hurting pass-through businesses, where Senate Democrats support cutting rates on the largest multinational companies, but oppose rate reduction for the successful S corporation down the street.  Keep in mind, that large S corporations already pays higher marginal rates than do C corporations – 40-plus percent versus 35 percent – and also likely pays higher effective rates as well.  Our 2013 study on effective tax rates found that large S corporations pay the highest effective tax rate of any business type – 35 percent.

And while the letter targets high-income tax payers, workers at pass through businesses could be affected too.  The burden of business taxation falls on owners and workers alike.  Here’s CRS on the issue back in 2012:

The analysis above found that the majority of pass-through income accrues to higher income earners. The income these individuals receive is the result of an ownership stake in either a sole proprietorship, partnership, or S corporation. But there are other taxpayers, namely the employees at these firms, who receive income from pass-throughs as well. If taxes are increased on passthroughs, it is possible that pass-through owners could lower wages, scale back benefits, or reduce employment in an effort to reduce the burden of the tax increase on themselves. Thus, although the majority of pass-through income is concentrated at the upper-end of the income distribution, the tax burden could be shared with lower- and middle-income taxpayers who work at these businesses.

An Analysis of Individual Tax Return Data on who bears the corporate tax burden can be utilized to understand who would bear the burden of increased pass-through taxation generally0owners (capital), or workers (labor).  The traditional analysis of the corporate tax indicates that it is capital that bears the burden. In contrast, a number of more recent theoretical studies find labor bearing the majority of the corporate tax burden. These results, however, appear to rely critically on particular assumptions (e.g., an open economy with highly mobile capital) which drive the results. When these assumptions are relaxed the burden of the corporate tax is found to fall mostly on capital, in line with the traditional analysis. (Emphasis added)

But we do live in an “open economy with highly mobile capital.”  That’s why so many US corporations are able to move their profits, IP, and headquarters overseas.  Which means the burden of the corporate tax falls increasingly on workers through lower wages and lost jobs.

We suspect this is the reason the Senate Democrat letter doesn’t oppose lowering rates on C corporations.  The letter implicitly concedes that for the US to be competitive and improve our jobs base, tax rates on corporate employers need to come down.  What is missed is that same argument applies to pass through employers as well.

For a clearer view of how much pass through employment would be affected by this approach, refer to the Treasury Department 2011 report entitled “Methodology to Identify Small Businesses and Their Owners.”  Table 15 reports that two-thirds of the income earned by pass through employers is earned by individuals making more than $500,000.  Those are the individuals targeted for high rates under the Senate Democrat letter.

How many jobs are we talking about?  There is no direct measure, but the Tax Foundation reported back in 2015 that “a significant number of employees work at large pass-through businesses. According to 2011 Census data, a combined 27.5 percent (18.1 million) of pass-through employment was at firms with more than 100 employees, and 15.9 percent (10.3 million) of pass-through employees work at large firms with 500 or more employees.”

So if the point of tax reform is to bring jobs and investment back to the US, pass through businesses – all of them – need to be part of the reform.  Successful pass through businesses employ millions of workers, and excluding them from rate cuts puts those jobs at risk.

That’s the reason we have kept the same mantra going for seven long years.  Tax all income once, tax it at similar reasonable rates, and then leave it alone.  It’s a recipe for success for C corporations and pass-through employers alike.  The business community has embraced this approach.  It is time for tax writers to do the same.

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