Put on your “must read” list a new paper from our friends at the Tax Foundation highlighting the importance of pass-through businesses to jobs and employment. It’s the best written and most comprehensive summary of the issue we’ve seen to date. Here’s how it starts:

Support for lowering the corporate tax rate – now the highest in the OECD – has been expressed by both Democrats and Republicans in order to improve the competitiveness of American businesses. However, they differ in their plans for the individual tax code. While Republicans have proposed lowering the top individual rate from 39.6 percent to 25 percent, in parity with the proposed corporate tax rate, Democrats are less willing to consider lowering the individual tax rate.

The implications of these policy differences are considerable because of the tremendous growth in non-corporate business forms over the past thirty years. Today, there are vastly more non-corporate businesses than traditional corporations and they now earn more net income than traditional corporations. These businesses face top marginal tax rates higher than 50 percent in some states. Thus, ignoring the top individual tax rate – even while lowering the corporate rate – means the United States will continue to expose a broad swath of business to high tax burdens.

And how it ends:

As lawmakers consider policies to improve the competitiveness of American businesses, they should not forget that individual income tax rates are just as important to business activity as the corporate rate. The various proposals to raise income taxes on high-income earners, either by increasing the top marginal rate, closing “loopholes,” limiting deductions, or implementing a minimum tax, would fall very heavily on America’s non-corporate businesses. Pass-through businesses are currently facing top marginal rates on average between 44.5 percent and 47.5 percent and as high as 51.8 percent in California. These pass-through businesses account for a large percentage of business income and employment in the United States. Raising taxes on them could curtail their hiring and other investment plans, putting more strain on an already struggling economy.

The paper adds something new to the defense of the pass-through structure. Past arguments in support of a strong pass-through sector include:

  • Best Tax Policy: S corporations are the way business income should be taxed. It’s taxed once, when the business earns the money, and then that’s it.
  • High Effective Tax Rates: As our recent Quantria study demonstrates, pass-through businesses already pay a high level of tax, and they pay it when the income is earned.
  • More Progressive: By taxing business income using the progressive individual tax rates, policymakers ensure that business income is taxed in a progressive manner, with high income shareholders paying a higher rate, and lower income shareholders paying a lower one.
  • Diversification: Pass-through businesses spread investment and employment decision making across the country and into local cities and communities. As the recent financial crisis makes clear, diversification of these actions is critically important.

Thanks to the Tax Foundation, we can now add to that list “Economic Stability.” As the Tax Foundation notes:

It is also interesting to note the relative stability of pass-through business income to the volatility of C corp income. The period between 1999 and 2010, shown on Figure 2, is a good example of how volatile corporate income can be. After the tech bubble burst in 2000, C corp income plunged 24 percent over the next two years, after adjusting for inflation, and then rebounded 119 percent by 2005. After this temporary peak, C corp income fell again by nearly 33 percent over the next five years.

By contrast, pass-through income has not experienced such wild gyrations. After the tech bubble burst in 2000, pass-through business income actually increased in 2001. In 2002, net income fell by just 2 percent but then rebounded by 5 percent in 2003. In the four years after the 2003 tax cuts, the net income of pass-through businesses grew by nearly 60 percent, after adjusting for inflation. In 2010, pass-through business income exceeded C corp receipts by 40 percent.

Is there anybody remaining in Washington who still doesn’t understand the importance of pass-through business to our economic health? If you find them, please send them this Tax Foundation paper!

Breaking Up Tax Reform

Last week, Politico Pro is reporting something we’ve been concerned about for a while:

PATH TO PASSAGE? SENATE FINANCE COULD USE SMALL BILLS TO APPROVE TAX REFORM: The universal truth of tax reform is that it is, and always will be, hard to pass. But the folks over at the Senate Finance Committee are considering various ways to more easily push tax reform legislation through Congress – including splitting a comprehensive reform bill into smaller measures. Our Kelsey Snell reported for Pros that “separating business tax reform from the more contentious individual tax code would allow [Senate Finance Committee Chairman Max] Baucus to continue debate on corporate taxes, the international tax code and the treatment of some benefits for small businesses – where there’s more agreement between the parties – without opening a battle over how much revenue should be raised through changes to the individual code.”

The news outlet subsequently filed a couple corrections that left the story’s ultimate meaning in doubt, but the notion that you can split tax reform into small bites is definitely out there. Comprehensive is just too hard, some say, so let’s do a corporate bill where there’s more agreement.

Our concern with this approach is two-fold: First, we reject the idea that you can separate out the corporate tax code without doing significant harm to the pass through business sector. Corporate-only proposals to date would either raise taxes significantly on pass through businesses or they would treat them like second class citizens, instead of the majority source of employment and business income in the United States (see story above).

Second, the “consensus” on corporate reform is less than it appears and it will depend on the same, top line question confronting comprehensive reform — should it be budget neutral or raise revenue? Until that question is answered (and you know where we stand on that), any reform effort is going to face an uphill climb.

We support corporate tax reform, but only as part of a broader effort to reform the entire tax code.