Earlier this morning, House Budget Committee Chairman Paul Ryan (R-WI) cited from our Ernst & Young study to defend Main Street businesses. We had been in to see Chairman Ryan back during our annual Board meeting. Apparently, our message connected!

As the Chairman notes:

“We don’t think raising tax rates in 2013 is helping the economy today. Not only is the actual rate going to 39.6, when you take the other stuff that was in Obamacare and everything else, the effective marginal tax rate goes to 44.8 percent. Here is the problem: 54 percent of workers in America get their jobs from these kinds of businesses that file as individuals, subchapter S corporations, partnerships. One in four people in America get their jobs from an S corporation. We are raising their top tax rate to 44 percent in 2013? Their competitors aren’t taxed like that.

In Wisconsin, we are competing against Canadians. They are getting taxed at 16 percent, and we are going to raise taxes on our businesses, our job creators, to almost 45 percent? You throw the Wisconsin income tax rate on top of that, it’s more than 50 percent. We see it as a job killer. More importantly, yeah, these taxes hit in 2013, they are going to hurt jobs today because businesses look forward, they are forward looking. When they see this massive tax increase coming, they are not going to hire today.”

The latter point Chairman Ryan makes is critically important. While the E&Y study focused on how the tax burden would increase for pass-thru firms under the Administration’s corporate tax reform proposal — by $27 billion per year — the study used today’s top tax rate of just 35 percent. Imagine what the tax hit would be on jobs and economic growth if E&Y had factored in a top rate of 45 percent?

The 45 percent rate the Chairman refers to is the sum of the statutory 39.6 percent rate in effect beginning in 2013, plus the higher, 3.8 percent Medicare tax enacted as part of health care reform, plus the rate effect of allowing Pease to expire. Add it up, and it’s nearly 45 percent!

The Big Picture on Taxes

Despite all the tax talk this year, there’s been almost no action. Neither the Senate Finance Committee nor the House Ways and Means Committee have taken up what might be considered significant tax legislation this year. They have marked up smaller, narrow bills on this or that, but nothing affecting more than a couple of industries.

Smart people on both sides of the aisle believe this stagnation could last for much of the year, where any movement on taxes will only happen if it’s directly tied to debt reduction efforts, and maybe not even then.

So what is our outlook on debt reduction?

Overall, we see a two-step process. Step one is some sort of deficit reduction package attached to the pending debt ceiling bill. The recent blowup and resumption of high level talks is real enough, but so is the “must-pass” nature of the debt ceiling. It may take some time, but Congress will need to pass a debt ceiling increase.

The amount of deficit reduction that accompanies that increase is what’s in flux. The President floated a target of $4 trillion (over ten years) a while back, but something in the range of $1 to $2 trillion over ten years appears more likely.

Revenue should make up very little of that amount, if any.

It will be hard enough to get rank-and-file House members to vote for any debt ceiling increase, regardless of how it’s structured. Adding an obvious tax hike on employers, like LIFO repeal, would make that task simply impossible. So the rate debate and other broader tax policy decisions we care about are unlikely to be part of the mix.

Step two in the deficit reduction dance takes place either next year or, more likely, after the 2012 elections. This step would consist of a much larger deficit reduction package, and we expect it to include significant changes to the tax code, all under the heading of “tax reform.” The exact components of this package also depend on many factors, including the election, the state of the economy, and the perceived success or failure of step one.

Perhaps the best way of thinking about it is that at some point, negotiators from the White House and Congress will first agree on the size of the deficit reduction package, say $4 or $5 trillion over ten years, and then they will agree on how much of that amount will come from spending cuts and how much, if any, will come from revenue. They will also outline how much of the spending cuts come from entitlements and how much from discretionary accounts.

Then the Budget Committees and the authorizing committees will be tasked with filling in the details. A large package like this will almost certainly be passed in the form of a budget resolution. A budget resolution would only need fifty votes to pass the Senate (compared to the 60 votes needed under normal circumstances) and it sets the stage for fifty-vote thresholds on the tax and entitlement policy changes that would need to follow.

Here is where S corporations need to pay attention: as our E&Y study demonstrates, budget-neutral tax reform can mean that somebody’s taxes are going to go up dramatically.

So our best estimate is that America’s private business sector has a year to eighteen months to get organized and defend how it’s taxed. The E&Y study we released earlier this year was a good start, but more is needed–more studies, more education, more ally recruitment in the business community and on the Hill. Either we build a convincing case for the superiority of pass-thru treatment and how it helps increase employment and capital investment, or Congress is going to move in the opposite direction. If that happens, everybody loses.