Whether they like it or not, S corporations and other pass-through businesses are at the heart of the income inequality debate that has been raging in economic circles for the past two decades. That’s because the shift of economic activity from traditional C corporations to the pass-through sector since 1986 has skewed the income data, making it look like the wealthy gained more than they really did.
The case for growing income inequality has been under scrutiny for years now, at least in academic circles. Numerous papers have revealed the flawed data and assumptions underpinning the work of Piketty, Saez, and Zucman, among others, including:
(Larry Summers’ take-down of Saez at the Peterson Institute is particularly instructive: given the opportunity to respond to Summers’ direct characterization of his data as “substantially inaccurate and substantially misleading,” Saez merely mumbles something about how “maybe we got our numbers wrong.” Seriously.)
How do pass-through businesses get pulled into this debate? Recent work makes clear the shift in taxation of business income from C corporations and S corporations following the 1986 Tax Reform Act is responsible for much of the reported growth of income for wealthy taxpayers over the past 35 years. As Kopczuk and Zwick summarize in their paper from last fall:
One consequence, we argue, is that a considerable part of the increase in the top 1 percent share of income since the 1980s can be accounted for as a shift to the pass-through corporate form, not an actual rise in business income for this group. In addition, we argue that pass-through income has a substantial human capital component: for example, when the partners in a law firm or the doctors in a medical practice receive their end-of-year profit distributions, these are closer to labor income for the previous year than a return to capital. (emphasis added)
This conclusion is similar to Auten and Splinter’s one year earlier:
The most significant tax reform in the period studied was TRA86, which lowered individual tax rates and broadened the tax base. The base-broadening was targeted at high income taxpayers, including limiting deductions for losses on rental income and passive investments. The reform also motivated some corporations to switch from filing as C to S corporations and to start new businesses as passthrough entities (S corporations, partnerships, or sole proprietorships), causing more business income to be reported directly on individual tax returns. This is because all passthrough income is reported on individual tax returns while C corporation retained earnings are not. Before TRA86, the top individual tax rate was higher than the top corporate tax rate (50 percent vs. 46 percent), allowing certain sheltering of income in C corporations with retained earnings. This incentive was even larger when the top individual rate was 70 percent in the 1970s and 91 percent before 1964. TRA86 lowered the top individual tax rate below the top corporate tax rate (28 vs. 34 percent), reducing the incentive to retain earnings inside of C corporations and creating strong incentives to organize businesses as passthrough entities. Our analysis accounts directly for the limitations on deducting losses and indirectly for the shift into passthrough entities by including corporate retained earnings. This leads to important findings for in the 1960s and 1970s, when high individual income tax rates created strong incentives to shelter income inside corporations. Without these corrections, top income shares are understated before 1987. (Emphasis added)
These papers illustrate two points S-Corp has been making for years:
  • S corporations don’t add to income inequality, C corporations mask it. Much of the reported growth in income inequality in recent years is nothing more than a shift in how that income is reported, not who’s earning it; and
  • The growth of the pass-through sector has been healthy for the economy and the tax code – rather than some sort of cautionary tale, the taxation of S corporations should be used as a model for all business taxation. It’s more progressive, it’s more transparent, and it’s less distortionary.
Notice the emphasis of pre-tax reform sheltering in the Auten/Splinter paper? Prior to 1986, it was commonly known that C corporations were used by wealthy taxpayers to shelter their income from taxation. C corporation income was taxed at lower rates, the owners could claim personal expenses as business deductions and, despite numerous efforts by tax writers, the earnings could be retained indefinitely within the corporation. As Summers noted during the Peterson event, the absence of wealthy taxpayers paying the 90 percent top rate in the 1950s wasn’t due to an absence of rich people in the US – it was the result of those rich people hiding their income in C corporations. This sheltering was lucrative in an age of 70-plus percent tax rates, but it was also expensive and highly inefficient.
And it all ended post 1986. By creating more balance between C and S taxation, the Tax Reform Act freed business owners from worrying about the tax code when making business decisions. They simply chose to be taxed as a pass-through, ran their business, and paid their taxes. It was no longer worth their time and money to hide their income within corporate structures.
That balance is now in danger. What was an unqualified success of tax policy – lower rates, broader base, and less cheating – has been turned on its head by Saez and his colleagues. If, as appears to be the case, their conclusions are based on a statistical illusion driven, in part, by the growth of the pass-through sector, then it is time for them to reassess their entire thesis. Policymakers, too. Tax policy should be based on reality, not flawed data. After all, maybe they got their numbers wrong.