Using Pass-Throughs to Pay for Corporate Reform

Tax Notes has an article that pours more gasoline on the fire started by Bloomberg and the Geithner-led Treasury Department last weeks.

The piece, written by Martin Sullivan, argues that pass-through treatment of some firms “erodes” the corporate tax base and concludes:

In the meantime, corporate tax reformers are left in the awkward position of trying to improve a fundamentally unsound tax. If we broaden the corporate tax base by trimming tax incentives (for example, accelerated depreciation), should those same tax incentives be trimmed for passthrough entities? Many would like to keep tax reform confined to the corporate sector. But politics aside, isn’t it reasonable to suggest that passthrough businesses that are relatively lightly taxed pay more to reduce taxes on C corporations?

We’ll answer that: No, it is not reasonable. Why? Well, first, by Martin’s own thinking, real reform of business taxation to make the U.S. more competitive should move towards the pass-through model and away from the old corporate model. As Martin notes, double taxing employers is inefficient and handicaps our largest employers:

Second, we should recognize that the movement from double taxation to flow-through taxation is a step in the direction of sound policy. Tax reformers and professors will tell anyone who will listen that all business income should be taxed on a flowthrough basis. They call it integration.

Second, Martin fails to pair his assumption that pass-through firms are “more lightly taxed” with any empirical support. He’s certainly not the only one to make that assumption — it’s the conventional wisdom around D.C. — yet a 2009 study sponsored by the Small Business Advocate’s office found that S corporations, not C corporations, are the most highly taxed. The study on smaller firms with revenues of $10 million or less, found that S corporations face the highest tax burden, and by a considerable amount:

S

Please note that the C corporation tax burden in the study does not include the second layer of tax. Nonetheless, the gap between S and C is sizable enough that Martin and others should not just assume that C corporations face a higher tax burden and then make policy prescriptions from there.

We agree with Mr. Sullivan that the corporate tax code is inefficient and needs to be reformed. But why then advocate moving more firms into the inefficient system? If most tax experts agree — and in our experience, they do — that reform towards a more competitive tax system means moving away from double taxation, then Congress should focus on reforming both the individual and corporate codes to make the entire tax code more competitive and less of a burden. President Bush’s proposal in 2003 to eliminate the double taxation of corporations would be a good place to start.