Last week, the Ways and Means Select Revenue Subcommittee held a hearing that sought to counter the momentum building within the Administration and in the press to tax pass-through businesses to pay for corporate-only tax reform.

Robert Carroll of Ernst and Young was one of the witnesses. As you’ll recall, S-CORP has asked Carroll to author a study on the economic importance of pass-through businesses and what impact corporate-only reform might have on them. His testimony last week touched on those themes and provided us with a nice preview of the study to come - including the news that pass-through firms employ more than half of all private sector workers.

Chairman Pat Tiberi (R-OH) set the tone of the hearing in his opening remarks:

“Reforming corporate taxes means only reforming roughly ten percent of federal revenues. That’s not comprehensive tax reform. Many small businesses pay taxes as under the individual income tax rates, as pass-through entities. The last thing we want to do as a part of tax reform is create a situation where we are putting small businesses at a competitive disadvantage. I fear leaving them out of tax reform will do just that.”

Carroll went further, noting that if the goal is to make American businesses more competitive, Congress should move everybody towards the flow-through structure and not away from it. As Bob stated, the corporate structure “creates a tax bias toward debt financing, with the result that companies can become overleveraged. It also raises the cost of capital for businesses, and results in misallocation of capital throughout the economy.”

Alternatively, another witness — Donald Marron from the Tax Policy Center — appeared to endorse taxing flow-throughs to pay for corporate reform:

“Such revenue-neutral reforms could increase the tax burden on pass-throughs since they would lose the tax preferences, but not benefit from the rate reduction. On the other hand, such reforms would reduce the tax burden on corporations, since the benefit of the rate reduction would be larger than the loss of corporate tax preferences. Such changes raise important questions about the distribution of the tax burden among different types of businesses. One potential benefit of such reform is that it would reduce the disparity in tax treatment between pass-throughs and C corporations.”

This is exactly the approach the Obama Administration appears to be considering and the threat we are preparing for. Reforming the tax code by taking firms taxed under the more efficient approach (pass through) and making them pay under the less efficient approach (corporate) does not make American business more competitive. It might be good for a handful of large public corporations, but not for jobs and the economy as a whole.

Fortunately, this line of reasoning was in the minority on Thursday. Even Marron pointed out during questioning that moving towards a single layer of tax was the better approach. Instead, the two major themes that emerged from the hearing were: 1) reform that moves pass-throughs into the C corporation structure moves us in the wrong direction, and 2) reform that ignores pass-throughs or that increases their tax burden to pay for corporate-only rate reduction is not likely to be workable.

You can watch the hearing here as well as read all the submitted testimony. And be on the lookout for Robert Carroll’s study. We’re confident it’s going to add a valuable perspective for policymakers to consider in this debate and those that follow.

The Importance of Choice

Another important point made by Robert Carroll during the hearing was the economic advantage of offering entrepreneurs a choice of business structures when they organize their firm. This is the flip side of the argument that all businesses should be forced to organize under a single business form in pursuit of simplifying tax enforcement. This “one size fits all” approach might make the IRS’s job easier, but what about the people risking their capital and hiring all of those workers? What approach helps them? As Carroll observed:

“One of the distinguishing features of the US business tax system is do we afford companies with different choices on how to organize themselves. I have always thought of that as a virtue. It allows companies the make the choice that best fits and suits their capital requirements and their management needs. It is probably one of the many distinguishing features of the US economy in comparison to our major trading partners that, that flexibility, probably adds to the dynamism of the US economy.”

This is another aspect that we have asked Carroll to look into as part of his study on pass-through firms. We’re looking forward to a more detailed exploration of this perspective.