Yesterday, Senate Finance Committee Chairman Max Baucus and Ranking Member Orrin Hatch ruined the July 4th vacation plans of every tax lobbyist in town with they laid out their new “blank slate” approach to tax reform.

In a letter sent to fellow senators, the two announced that they would work under the assumption that all exclusions, deductions, and credits currently written in the tax code have been repealed, and that only the most defensible provisions would be put back in. Sens. Baucus and Hatch called on their colleagues to defend the tax breaks they see as important, and gave senators until July 26 to submit their recommendations on which should be preserved. As the letter states:

In order to make sure that we end up with a simpler, more efficient and fairer tax code, we believe it is important to start with a “blank slate.”

To make sure that we clear out all the unproductive provisions and simplify in tax reform, we plan to operate from an assumption that all special provisions are out unless there is clear evidence that they: (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.

A subsequent colloquy between the two Senators made clear the “blank slate” approach is all about exposing the trade-off between lowering marginal rates and preserving tax expenditures. As Hatch put it:

We wanted everybody to know there’s a tradeoff involved. That is, when you keep tax expenditures, there’s going to be an increase in rates, certainly compared with what otherwise we start with. And the more tax expenditures there are, the less revenue there is for a rate reduction and deficit reduction and the more complicated our tax code will end up being.

Limited to making clear the trade-off between rates and expenditures, the “blank slate” approach is a helpful tool to educate members. It will certainly get them active on tax reform. Beyond that, however, it does have serious limitations, including its failure to answer two key questions:

  1. What is the starting point for rates?
  2. Is this exercise budget neutral, or will it try to raise revenues?

Remember, starting this year, S corporations and other pass through businesses now pay a top marginal tax rate that is significantly higher than the top rate paid by C corporations, putting them at a competitive disadvantage. That rate increase means that pass through businesses already gave at the office when it comes to deficit reduction, too.

Any tax reform effort worth supporting would start with the assumption of marginal rate parity. The top tax rates for individual, pass through businesses, and corporations should be the same and as low as possible. Effective tax rate parity is important too. Pass through businesses shoulder a higher overall tax burden than many of their corporate competitors. Properly constructed, tax reform would help level tax burdens as well as marginal rates. The Baucus-Hatch letter leaves both these issues unaddressed.

Setting those concerns aside, do S corporations and other pass through businesses pass the blank slate test? Pass through tax treatment is (appropriately) not a tax expenditure, but just for fun let’s see how well they stack up to the three questions outlined in the Baucus-Hatch letter?

Do S corporations help grow the economy?

You betcha. According to the 2011 Ernst & Young study, the prominence of pass through businesses in the United States means thereb’s more jobs, more capital, and higher wages than if every business was subject to the double corporate tax. Hereb’s the key paragraph:

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.

Moreover, the recent hike in top rates on pass through businesses is costing us jobs. According to the 2012 Ernst & Young study, the marginal rate hikes that went into effect this year will result, in the long term, in fewer jobs and lower wages. According to the study:

This report finds that these higher marginal tax rates result in a smaller economy, fewer jobs, less investment, and lower wages. Specifically, this report finds that the higher tax rates will have significant adverse economic effects in the long run: lowering output, employment, investment, the capital stock, and real after-tax wages when the resulting revenue is used to finance additional government spending.

Tax reform should start by reversing this rate hike on American’s employers. That would “help grow the economy.”

Do S corporations make the tax code fairer?

Yes they do. According to the 2009 SA study on effective rates, S corporations pay the highest effective tax of any businesses structure, slightly higher than partnerships and significantly more than C corporations. The pass through structure helps to reduce this imbalance by applying a single layer of tax on these businesses. Marginal tax rates are important in affecting behavior and should be lowered, but effective tax rates measure the amount of tax you actually pay.  Tax reform should seek to level out the tax burden among various business structures.

Do S corporations effectively promote other important policy objectives?

YES! They promote economic diversity and economic security. There are 4.5 million S corporations and more than 3 million partnerships and LLC’s. These businesses come in every size imaginable and they are in every industry, every state and every community. They contribute more to our national income than C corporations and they employ the majority of American workers. This diversity of industry, size and location strengthens our economy by spreading out economic power and decision making away from the financial centers and away from the corporate boardrooms. How important is that diversity to our economic security? Think back to 2008 and the financial crisis. Main Street didn’t cause the crisis, but it did act as the backstop.

So pass through businesses pass the “blank slate” test with flying colors.

What’s our outlook for tax reform and congressional action? To us, the big news yesterday was that Chairman Baucus intends to mark-up a tax reform bill this fall. That synchs with expected action by the Ways and Means Committee, and puts tax reform on the front burner right about the time Congress will have to enact FY 2014 spending and raise the debt limit.

Could be a window of opportunity for something really big.