Long-time S-Corp ally George Callas is out with a great piece on the history of the NIIT and how the effort to expand the tax to active business income is nothing more than a money grab built on revisionist history. Congress exempted active business income from the NIIT on purpose, and for good reason.
This is a big deal for S corporations. As George explains:
Despite this extensive effort by both Congress and Treasury to limit the NII tax to taxpayers who “lived off investments,” the proponents of higher taxes are now characterizing the exemption of active business income as some sort of unintended loophole that should be closed. In 2021 then-President Biden first proposed this tax increase in his fiscal 2022 budget proposal, claiming that the current design “is unfair, inefficient, distorts choice of organizational form, and provides tax planning opportunities.”
Later that year, the House passed the Build Back Better Act, which adopted the Biden proposal and raised $252 billion over 10 years. The Ways and Means Committee described the proposal as closing “the loopholes that allow some wealthy taxpayers to avoid paying the 3.8 percent Medicare tax,” but — as with the creation of the NII tax in the ACA — failed to put any of that revenue into the Medicare program. Rather than extend Medicare solvency, the House preferred to use the money to pay for new social programs and green energy subsidies.
So while most C corporation income is taxed at a flat 21 percent with no additional tax owed – most C corporation shareholders are tax free or tax advantaged, after all – the focus by some policymakers is to take the higher pass-through rates and push them even higher:
Imposing the tax on business owners whose business income is subject to the top federal income tax bracket would increase their marginal rate from 37 percent to 40.8 percent. (The subset of this income that is eligible for the 20 percent deduction for qualified business income would see its marginal rate increase from 29.6 percent to 33.4 percent.)
Would these higher rates result in more revenues? Not likely.
[A] new study by three economists at the Joint Committee on Taxation estimates that the revenue-maximizing individual income tax rate is only about 40 percent, meaning that as one approaches that tax rate — say, from 37 percent to 40.8 percent — little added revenue is raised because the resulting economic damage reduces revenue in an amount roughly equal to the revenue raised by the tax directly. That the proposal’s negative impact on GDP largely offsets the direct revenue raised casts doubt on previous revenue estimates that failed to account for the proposal’s macroeconomic impact.
Meanwhile, we are all worse off:
But if the revenue effect is a wash, the economic effect is not. Revenue-maximizing does not mean economy-maximizing, and the fact that we are even approaching the revenue-maximizing rate is evidence that such high rates are damaging the economy. As Jared Walczak, senior fellow at the Tax Foundation, says, “The slope of the curve before it goes flat is highly relevant here” (emphasis in original). And as that slope’s steepness declines, Americans are made worse off.
Where does that leave us? George sums it up nicely:
Make no mistake — Biden, Harris, and others are engaging in revisionist history to justify increasing tax rates by nearly 4 percent on family businesses and risk-takers. They want to complete the deception by turning the unearned income Medicare contribution into something that is neither on unearned income, nor about Medicare, nor a contribution. The idea should be abandoned.
Exactly.