More chatter about the pending tax reform proposal being drafted by the Obama Treasury Department and its plan to force more pass-through businesses to pay taxes as C corporations. Reuters reported earlier this week:

The Obama administration is considering a plan to force more businesses to pay the corporate income tax, an industry group said, in an overhaul package that could be unveiled as early as this month. Under the proposal, entities with more than $50 million in gross receipts would pay the corporate income tax, instead of the individual income tax they now pay. Partnerships like law firms and hedge firms would likely be the most affected.

The basic outline coming into focus is a plan to reduce the corporate tax rate from its current 35 percent level, to offset the revenue loss by eliminating certain business deductions and by forcing larger S corporations and other pass-through firms to pay taxes as C corporations.

In other words, it appears the Administration is contemplating a plan with major components that move the tax code in the wrong direction. The C corporation structure, with its double tax on corporate income, makes U.S. business less able to raise capital and increase employment.

If tax reform is going to make U.S. businesses (all businesses) more competitive, it needs to move us away from C corporation taxation, not towards it. As authors Bob Carroll and Gerald Prante pointed out in our recent study:

The income of C corporations is instead subject to two levels of tax (the b”double tax”), first when income is earned at the corporate level, and again when the income is paid out to shareholders in the form of dividends or retained and later realized by shareholders as capital gains.

The double tax affects a number of important economic decisions. In particular, the double tax:

  • Increases the cost of capital, which discourages investment and reduces capital formation and economic growth.
  • Increases the cost of equity finance, which encourages greater leverage among C corporations.

The flow-through form provides an important benefit to the economy by reducing the economically harmful effects of the double tax and therefore allowing for a greater opportunity for job creation and capital investment. Moreover, the flow-through form provides businesses with flexibility that may better match their ownership structure requirements and capital needs.

Nonetheless, the Administration’s proposal appears to have allies on the Hill. At yesterday’s hearing on tax distribution, Finance Committee Chairman Max Baucus (D-MT) posed the question to the panel of whether we should ask larger pass-through businesses to pay taxes as C corporations. While the panel got diverted on to other issues and did not directly respond, the question itself demonstrates that this is an issue that is on the Chairman’s mind.

So our work is cut out for us. Word is the plan will be released in the form of a white paper rather than a fully developed legislative draft, and that it would be made public sometime in June, perhaps sooner.

In the meantime, we will be on the Hill discussing the Ernst & Young study and its implications for good tax policy. Tax reform needs to focus on both the individual and corporate sides of the tax code and on making all employers more competitive. Pass-through firms employ most private sector workers, after all. Tax policy that ignores the importance of those jobs or, worse, threatens those jobs makes little sense.