Edward Kleinbard, the former Director of the Congressional Budget Office, has a piece in Bloomberg on the prospects of corporate tax reform that makes some interesting points worth considering.
To start, he argues that Congress should pass corporate-only tax reform and pass through businesses can just convert to C corporation status and access the new lower rates. He’s made this case previously, and we address it here,
But why is corporate-only reform necessary? Well, it’s just impossible to reduce pass through rates these days:
Reducing top individual tax rates is a nonstarter. The Barack Obama administration would be adamantly opposed, and the revenue drain would be unacceptable. Many affluent individuals, after all, earn large salaries working for big companies. Lowering individual rates in the purported service of “small business” would bestow windfalls on these fortunate owners and employees.
It is true the President is unlikely to support lower rates. He has made clear he wants individuals and private businesses to pay more, not less. But supporting a tax hike is a non-starter for the Republican Congress, so that leaves us with a null set. The President won’t sign a law that doesn’t raise revenue, while Congress won’t pass a law that does.
Kleinbard’s next point is that shifting pass through businesses into the C corporation world will help stabilize the corporate code by giving multinationals more political clout:
The great fear of U.S. multinationals is that Congress will play them for fools: A few years after surrendering business tax subsidies in return for lower corporate tax rates, Congress will jack up the rates again. The best insurance against this is for the corporate-tax rolls to swell with tens of thousands of successful small- and medium-sized businesses, as found in every congressional district. They would serve as the enforcers of tax reform’s bargain.
It might be true that Main Street businesses could help defend the results of corporate-only tax reform, but those same businesses oppose being forced there in the first place. Without their support, corporate tax reform faces a really steep climb. How exactly does Congress pass a rate cut for large corporations without the support of Main Street businesses?
Finally, Kleinbard argues that reform should make the corporate rate structure more progressive by offering less profitable C corps lower rates. This sounds like a really good idea, but doesn’t the pass through structure offer that already? With pass through taxation, business income is taxed at different rates depending on the income of the business owner. High income owners pay more, and low income owners pay less.
On the other hand, C corporations are subject to an entity level tax, so there’s no certainty that progressive C corporation rates would reflect the shareholder’s income. A less profitable C corporation might pay low rates even if it’s owned by a wealthy shareholder. That’s not the result Kleinbard is seeking.
A better solution would be to preserve and grow the pass through structure. It imposes a single layer of tax on business income (good), the tax is applied when that income is earned (good), and the tax is at progressive rates that reflect the income of the shareholder or partner of the business (also good). It is simply superior to the corporate tax, and should be the starting point for any real business tax reform.
Rubio-Lee Plan Hits the Right Notes
To get an idea of what that might look like, Senators Marco Rubio (R-FL) and Mike Lee (R-UT) have proposed a tax reform plan that truly lives up to the concept of “reform.” You can read about the plan here, but the basic bits for businesses are:
- Fully integrates the corporate code by eliminating taxes on capital gains and dividends;
- Restores rate parity by reducing the top rate on corporate and pass through business income alike to 25 percent;
- Allows for full expensing of business investment; and
- Shifts the treatment of international business income from worldwide to territorial.
To get to rate parity for all businesses, the plan adopts something similar to the Grant Thornton “Business Equivalency Rate” where the top rate on pass through business income would be capped at the top corporate rate of 25 percent. Here’s how the sponsors describe the provision:
This plan eliminates double taxation for all business income. C corporations would pay a 25 percent corporate tax. Since the businesses’ income would be taxed at the entity level, dividends and capital gains on stock would not be subject to additional tax at the individual level. Shareholders would receive an annual informational statement indicating how much corporate tax had been paid on their behalf.
As under the current tax system, pass-through entities (partnerships, LLCs and S corporations) and sole proprietorships would not be subject to entity-level tax. Instead, this income would be reported as taxable income on the owners’ tax return. The maximum tax rate applicable to pass-through entity income would be 25 percent. This maximum tax rate would be statutorily linked to the tax rate on C corporations, and would be referred to as the business tax rate.
In order to prevent abusive misallocation of labor income as business income, this plan also creates strong rules that preserve current tax arrangements for partnerships and independent contractors while discouraging abusive reclassifications. We also require that reasonable compensation be paid by pass-through entities to owners that work for the business.
Why We Make These Changes:
The high tax rates faced by many pass-through entities and the double taxation of business investments are both barriers to investment. This bias against investment hurts long-term economic growth and prevents job creation. Double taxation also has other negative properties. Double taxation obscures the true burden of taxation, as rates reflect a lower tax burden than really exists. Double taxation is also inherently unfair, as individuals must pay taxes many times on the same income source. By eliminating double taxation and giving small firms access to the lower rate, we help balance the playing field between large and small firms.
It is important for the tax code to encourage investment in the United States. Our policy reforms will significantly reduce the tax incentives for businesses to participate in inversions, offshoring, profit shifting, and other activities that diminish economic activity within the borders of the United States.
By creating a single-layer of taxation while decreasing the business rate to 25%, and allowing for the full expensing of capital purchases, the United States will once again be a prime destination for business. Reforming the business tax code so that it is internationally competitive must be a top priority for policymakers.
According to our friends at the Tax Foundation, the move to lower rates, expensing, and territorial combine to help grow the economy significantly:
After modeling the plan, we find it to be indeed strongly pro-growth. As the table below shows, it would grow GDP by 15 percent by the end of the adjustment period, roughly 10 years. That means the economy would be 15 percent larger than CBO predicts under current law. As well, relative to a current law, we find the capital stock would grow by almost 50 percent, wages by almost 13 percent, hours worked by almost 3 percent, and jobs by 2.7 million.
For three years, the pass through community has argued that tax reform should be comprehensive, restore parity in the top tax rates, and seek to reduce the harmful double tax on corporate income. Over seventy business groups signed a letter making those points. The Rubio-Lee plan is one of the few efforts to hit on all three principles, and it’s a valuable addition to the discussion on the future of the tax code.