A couple of recent publications have highlighted the negative consequences of “corporate-only” tax reform, including a paper put out by Grant Thornton last month that focused on the challenges faced by businesses structured as S corporations, partnerships and sole proprietorships.
The paper, entitled “ Business Equivalency Rate: Fairness for Pass-through Businesses” gets right to the heart of the matter in the first couple paragraphs:
Grant Thornton supports tax reform aimed at lowering effective business rates in order to promote global competitiveness for U.S. businesses. Grant Thornton believes that competitive business tax rates are critical for spurring business investment and job creation. We are concerned with tax policy decisions that put U.S. businesses organized as “pass-through” entities at a competitive disadvantage.
Partnerships, S corporations and sole proprietorships are called “pass-through” entities because their income is not taxed at the entity level, but instead is “ passed through” and taxed at the individual level. Many of the dynamic U.S. companies that drive economic growth are organized as pass-throughs, and they are a critical part of the U.S. business landscape. There are compelling economic and business reasons for pass-through tax treatment. It should be preserved, and an equivalent rate structure for pass-through income should be reestablished.
The Grant Thornton paper focuses on the impact of effective tax rates - the total amount of tax businesses actually pay - as well as marginal rates. Both rates are important, obviously, but the advocates of “corporate-only” tax reform focus almost exclusively on marginal tax rates even as many of their allies pay very little in actual tax. Here’s how GT addresses the issue of high marginal rates:
The U.S. statutory corporate tax rate is the highest among OECD countries, putting U.S. multinational corporations at a competitive disadvantage. Both Republicans and Democrats have proposed lowering the 35% corporate tax rate through tax reform, with any reduction in government receipts potentially offset through the elimination of tax preferences and incentives.
The 39.6% rate on business income faced by pass-through entities puts them at an even greater global disadvantage than C corporations. Tax reform that lowers only the corporate rate does not address this disparity between pass-through businesses and foreign competitors, and it increases the competitive disadvantage between domestic pass-through businesses and domestic C corporations.
In other words, the same arguments put forward to support reducing top corporate tax rates also apply to pass-through rates.
Meanwhile, the Congressional Research Service raises similar concerns in its report entitled “ A Brief Overview of Business Types and Their Tax Treatment” released on June 12th The report shed light on the likely consequences of addressing corporate tax rates while leaving individual rates untouched:
A reduction in the top corporate tax rate without a corresponding reduction in the top individual tax rate could lead to an increase in the number of firms that incorporate to take advantage of the more favorable corporate rate structure. In late 2012, the top individual tax rate was increased above the top corporate rate for the first time since 2002 as the result of the American Taxpayer Relief Act of 2012. If tax reform results in a lower corporate rate while leaving the top individual tax rate unchanged, the incentive to incorporate would increase.
The CRS report also explains a key issue with a number of tax reform proposals that are currently floating around:
Most corporate tax reform proposals offered to date include a reduction in the top corporate rate which currently stands at 35%. It is often proposed that the revenue loss from a reduced corporate tax rate could be offset (either fully or partially) with the repeal or reduction of certain business tax incentives, formally known as tax expenditures. Pass-throughs, however, could experience a tax increase if such an approach were followed. This is because most business tax incentives are incentives that are available to all businesses, not just corporations. Thus, offsetting a corporate rate reduction by curtailing business tax incentives could negatively impact pass-throughs, which do not pay corporate taxes, and therefore would not benefit from the corporate rate reduction.
Exactly. Cutting marginal tax rates for C corporations in isolation means raising effective tax rates on Main Street businesses, which is why Ways and Means Chair Dave Camp is pressing for comprehensive reform that reduces rates on individuals, pass-through businesses, and corporations alike, and why we support him.
Ways & Means Focuses on Base Erosion, Effective Tax Rates
Last week’s Ways and Means hearing on base erosion turned into a pep rally of sorts for Main Street businesses.One member after another expressed support for Main Street businesses and concern that base erosion techniques used by large multinational companies have the effect of shifting the tax burden onto domestic enterprises.
Here’s Chairman Camp:
When you look at the effective tax rates of companies, which is the effective tax burden that they face, it looks like in most countries, if not all countries, the multinationals– which are exposed to international transactions and can therefore play with the different gaps which are there, through transfer pricing rules, tax treaty rules, and domestic legislation, they are exposed to a much lower effective tax rate than domestic companies which cannot benefit from these international instruments. Therefore, the gap is quite significant, and puts domestic businesses at a competitive disadvantage. This is a distortion that is not good from an economic perspective.
And Rep. Todd Young (R-IN):
I think it’s really important that in this country, in the interest of competitiveness, internationally and domestically, we reform not just the corporate code but also the individual code.
Even Rep. Doggett (D-TX):
The real question today about all of the fine print and complicated discussion that we’ve had is whether or not small businesses and individuals ought to bear a greater part of the tax burden so that some of these large, brand-name multinationals can pay less.
Small businesses don’t get the kind of tax breaks that are available to multinationals, and a system that accords General Electric a lower tax rate than the people who clean up the corporate board room, I think is really offensive.
You can watch the whole hearing here. Expect to hear more about effective tax rates, and who’s paying what, in the near future.