Tax writers need to put a trigger warning on future 199A discussions, particularly for DC tax experts. It appears they are highly sensitive to the topic.
For example, in response to Ways and Means Chairman Jason Smith’s recent support for increasing the 199A deduction to 25 percent, AEI’s Kyle Pomerleau posted some thoughts that, on the surface, appear to make sense:
Pass-through businesses are already tax advantaged. Although C corporations face a 21 percent corporate tax rate, their profits are also subject to the individual income tax when distributed to shareholders. After considering various tax provisions that reduce the tax burden on C corporation shareholders, the Congressional Budget Office (CBO) finds that pass-through business investment faces a lower tax burden than C corporate investment.
Just one problem – the CBO analysis Kyle cites clearly shows pass-throughs pay higher effective rates than C corporations:
Whoops. Moreover, the CBO is not alone. A 2021 Treasury analysis found pass-throughs pay consistently higher rates, even on new investment.
This despite the fact that almost all C corporation income is earned by large public companies, whereas a large portion of pass-through income is earned by smaller businesses paying lower marginal rates. If the comparison were “Big vs. Big,” the advantage for C corporations would be larger.
So that’s an issue. Kyle also appears to confuse a benefit enjoyed by public corporations as one available to all C corporations. He writes:
An enhanced deduction would primarily make it even less attractive to use the C corporate form. This has economic implications because C corporations have better access to outside capital.
C corporations only have better access to outside capital if they are publicly owned. That’s the chief advantage of jumping through the hoops necessary to become a public company — you get access to the public equity and debt markets generally not available to private companies. An S corporation that converts to C with the same ownership does not magically see its cost of capital go down. That’s not how it works.
Kyle also argues that the expensing reduces the effective tax on new pass-through investments to zero, so what’s the problem?
Expanding the deduction would do little to enhance the competitive advantage of pass-through businesses. In fact, they would maintain a tax advantage even if 199A were repealed. This is because expensing already reduces the tax on new pass-through investment to roughly zero, while it only shields C corporations only against the 21 percent corporate rate. The shareholder-level tax on the return is untouched.
Notice the sleight of hand? This analysis only applies to new investment and it only applies to what economists refer to as “normal profits” – the minimum profit necessary to keep a business afloat. Older investments that don’t qualify for expensing and those investments that return greater than normal profits (in other words, just about every business investment worth making) bear the brunt of the statutory tax rate.
Moreover, Kyle’s line about the “shareholder-level tax on the return” ignores reality. As we have noted repeatedly, most C corporation income is never subject to a shareholder level tax. The Tax Policy Center has been writing about this for years, and it’s the principle challenge we face in trying to balance the tax treatment of public and private companies. Here’s the TPC:
Most Shareholders are Not Subject to a Second Layer of Tax
Often, however, there is not a second level of tax. Many shareholders of corporate stock, such as retirement accounts, educational institutions, and religious organizations, are exempt from income tax…. By some recent estimates, the share of U.S. corporate stock held in taxable accounts has fallen from over 80 percent in 1965 to about 25 percent today (Rosenthal and Austin 2016).
There’s more, but that’s enough for now. Every authority we are aware of in this space (here, here, here, here, here) has found that pass-throughs pay higher effective tax rates than C corporations, even with the 199A deduction in place. Jason Smith is right that the 199A deduction should be expanded, even if saying so throws the 199A sceptics into a tizzy.