This recent note from Oren Cass over at American Compass caught our eye:
Kim Clausing and I disagree on tariffs and have enjoyed debating each other a number of times, but we agree on this: There is a smarter way to tax the rich (Financial Times). Tax capital, folks. This statistic, especially, fascinated me: “Despite having the world’s most successful public companies, the US raises much less from corporate tax (about 2 per cent of GDP less) than other rich countries.”
Sure, it’s a fascinating stat. It’s also entirely bogus, as it ignores the taxes paid by 95 percent of American businesses. That’s because the US is unique in its reliance on pass-through taxation – taxing the owners of businesses directly rather than taxing the corporate intermediary. Most other countries (apart from Germany) don’t have pass-throughs.
That’s to their detriment, as the American approach has two key advantages. First, it allows for business income to be taxed at the progressive rate schedule applying to individuals. Low-income earners pay less while high-income owners pay more. Under the corporate tax, the same rate applies to billionaires and retirees alike.
Second, there’s only one layer of tax on pass-through businesses. In case you’re confused, that’s a good thing too. Taxing the same income multiple times increases the overall tax burden while creating enormous distortions between investments. It also distorts taxpayer behavior, encouraging decisions based on tax outcomes rather than what would otherwise be best for their families and businesses. Here’s George Callas from a recent post:
It has always been a principle of good tax policy that taxing income once is sound, and that both double taxation and non-taxation of income are distortive. People will argue until the End Times whether tax rates should be higher or lower, but the principle that those rates should be applied to an item of income once and only once remains. Rather than seeking to double tax family businesses, we should be pursuing corporate integration, so that corporate profits are taxed exactly once — neither zero times nor twice — either at the entity level or at the shareholder level. Rather than taxing pass-through businesses as corporations, we should be taxing corporations more like pass-throughs.2
Taxing business income once rather than twice means the US has more jobs, higher wages, and more investment than if we subjected all businesses to the corporate double tax. Here’s how EY characterized the challenge in the run-up to the fiscal cliff in 2012:
The double tax also increases the cost of investment in the corporate sector relative to the rest of the economy. This tax bias against investment in the corporate sector leads to a misallocation of capital throughout the economy. That is, capital is not allocated to its best and highest use based on economic considerations. This reduces the productive capacity of the capital stock and dampens economic growth. As noted before, the diversity of organizational forms can be seen as a useful choice for businesses to make in organizing themselves, but the impact of differential treatment should be recognized. Finally, the double tax raises the overall cost of capital in the economy, which reduces capital formation and, ultimately, living standards.
So what happens to Dr. Clausing’s stat when you add in all those pass-through taxes? The US “deficit” with Europe and other “rich” countries largely disappears. The US business sector pays just about as much as anybody else. Here’s what we wrote way back in 2019:
Measured against the overall economy, the business sector today is literally bigger than it was before the 1986 tax reform opened the door to pass through taxation. Tax Foundation numbers show that business income made up 9 percent of GDP pre-1986 (8 percent corporate income and 1 percent pass through). Today, business income makes up 11 percent of GDP (5 percent corporate and 6 percent pass through).
So the business community is larger, and pays more tax, with pass-throughs than if we returned to the bad-old days when all profitable businesses were C corporations and everybody used them as tax shelters.
That’s the lesson for today – pass-throughs are a boon to workers and the federal treasury alike. Rather than throw shade at them, we should use them as the model to build a better tax code. Next up, we’ll focus on the absolutely nutty idea that Congress should raise taxes on savings… er, capital. Sure, that will work out.
Our full “Experts Are Wrong” series is linked below: