Pass-Throughs & Inequality
Apollo’s “Daily Spark” had a nice blurb last week featuring the “Everywhere Millionaire.” Here’s what they said:
The income that lifted America’s top 1% did not come mainly from tech or Wall Street, according to The Everywhere Millionaire. More than half of the rise in the top 1% income share since 1985, 5.8 of 10.5 percentage points, flowed through pass-through businesses, see chart below.
The authors, Owen Zidar and Eric Zwick, counted roughly 3 million wealthy private business owners, with average net worth near $25 million, running law firms, car dealerships, medical practices, commercial contractors and regional restaurant chains, the kind of businesses that make their owners wealthy and well known in their own communities without ever making them nationally famous.
And here’s the graph:
As you know, S-Corp is all about praising Main Street, but is this praise? More importantly, does it reflect reality? The answer is no. That big jump in pass-through income doesn’t reflect a sudden increase in inequality, but rather a massive shift in how businesses accounted for their profits. They gave up using C corporations as tax shelters and began paying taxes using the more transparent, efficient, pass-through structure instead. Here’s what we wrote back in 2019:
The sizable shift in business activity from C corporations to S corporations following the 1986 tax reform had the side effect of artificially inflating income for higher income shareholders. Income that previously appeared on C corporation returns was now showing up on 1040s.
Just how biased was the tax code pre-1986? Very. This table shows just how tilted the playing field was towards C corporations prior to 1986:
The lesson here is clear – you simply couldn’t maintain a successful S corporation under the pre-1986 pass-through rate structure. The shift in rates post-1986 was less a windfall and more a leveling of the playing field for pass-throughs. In previous work, Eric Zwick recognized the income allocation effects of these changes post-1986.
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.
Obviously, there is more to the tax parity story than headline top rates, but our work with EY and other groups suggests the current mix of rates, deductions, and growing population of tax-exempt shareholders (for public companies) has resulted in rough parity between large pass-throughs and public C corporations, but only with Section 199A in place. Analysis from Treasury, CBO, and other econometric outfits agrees:
Bottom Line: The suggestion that today’s code is “biased” towards pass-throughs just doesn’t hold up. The pre-1986 code punished successful pass-throughs with confiscatory rates. The 1986 Tax Reform Act and subsequent measures adopted by Congress, including Section 199A, fixed all that.
A Ready Reform for Main Street
Congress is looking at targeted, bipartisan reforms to make the tax code work better for taxpayers. That focus creates an opportunity to address the outdated rules governing S corporations.
S corporations are America’s most popular business structure, with more than 6 million businesses employing tens of millions of Americans. Yet one of the basic rules governing them has been frozen for more than two decades. An S corporation may have no more than 100 shareholders, a limit that increasingly gets in the way as successful businesses seek to expand their employee-ownership.
The good news is that lawmakers already have two ways to fix it. The S-CAP Act introduced by Representative French Hill and Senator John Boozman raises the shareholder limit from 100 to 250. As our letter supporting the measure reads:
The current 100-shareholder limitation is an outdated constraint that has no clear policy rationale. Since the creation of subchapter S in 1958, Congress has repeatedly recognized the need to modernize the rules governing S corporations to reflect changes in the business landscape. The shareholder limit was initially set at 10 but was gradually increased through bipartisan reforms, reaching 35 in 1982 and 75 in 1996 before being raised to the current 100-shareholder cap, where it has remained for over two decades.
Meanwhile, the S Corporation Modernization Act introduced by Representative Carey and Senator Sheehy is a broader package updating several longstanding S corporation rules. It adopts a slightly different approach by treating all employee-owners as a single shareholder, just as family owners are now. As we pointed out back in July, the legislation is the latest in a more than three-decade effort to modernize the rules governing S corporations, with a number of those reforms ultimately enacted into law.
Each approach continues a long tradition of Congress modernizing the rules governing the S corporation community. The shareholder cap was last increased back in 2004. More than two decades later, another update is overdue.
With lawmakers focused on targeted, commonsense improvements to the Tax Code, updating the S corporation shareholder rules should be an easy one. America’s most popular business structure deserves rules that reflect how businesses operate today. Raising the S corporation shareholder cap for Main Street businesses would extend opportunities to the employees who help these businesses succeed.
Tax Relief Takes Center Stage
Republicans in Dallas had plenty to say about last year’s Working Families Tax Cuts bill. Ways and Means Chairman Jason Smith made the case directly, recounting the marching orders he gave his colleagues when he took the committee gavel:
When I was selected by my colleagues to chair the House Ways and Means Committee, I told them that we were done writing tax cuts for millionaires and billionaires. Our priority was going to the working class, men and women we represent in Washington….
Today, thanks to the working families tax cuts, if you are a family of four and make less than $73,000 a year or less in the United States, you pay zero in federal taxes because of the big beautiful bill…The personal stories I’ve heard from working families across the country speak to the real impact this tax relief has had on their lives.
House Speaker Mike Johnson followed suit:
We delivered the largest middle and working-class tax cut ever in history…97% of filers got a tax cut this year, averaging $3,400 each. That’s more money in your pockets and less to Uncle Sam.
Millions have claimed no tax on tips, no tax on overtime, the enhanced senior deduction. Nearly 40 million families claimed the enhanced child tax credit. And more than 127 million taxpayers benefited from the permanently doubled standard deduction.
Don’t forget the benefits for Main Street businesses included as well. For small- and family-owned businesses, the Working Families Tax Cut bill offered major tax relief that encouraged them to hire more workers and invest more in their communities, including:
- Permanent 199A: Made the 20-percent Main Street deduction permanent, staving off a looming rate hike on over 26 million pass-through businesses;
- Immediate Expensing: Restored 100-percent bonus depreciation and full R&D expensing, letting businesses write off investments in new equipment, machinery, and innovation right away;
- Permanent Lower Rates: Locked in the individual rates Main Street businesses pay, avoiding a massive tax hike and allowing private companies to stay competitive with their C corporation competition; and
- SALT Parity: Preserved state laws that restore the federal SALT deduction for pass-through businesses, the same treatment public corporation already get.
Representative Rob Bresnahan, himself a business owner, explained the importance of the tax bill from the Main Street perspective:
Every decision Washington makes can determine if the next investment or the next job happens here in America or somewhere else. That’s why tax relief matters. When manufacturers can keep more of what they earn, they can buy equipment, hire workers, and train apprentices, and the people doing the work should keep more of what they earn, too.
That’s the second half of the Working Families Tax Cuts benefits, and it’s a story we’re going to continue telling.
How (Not) To Fix Social Security
Senators Elizabeth Warren and Bernie Moreno recently proposed lifting the Social Security wage cap to address the program’s pending insolvency. It’s the lazy solution (i.e., throw more money at a problem, declare victory, move on) and also the wrong approach.
Tax expert (and friend of the podcast) George Callas has an excellent writeup on this, along with his thoughts on what Congress should actually be considering.
Nixing the cap would impose a massive marginal tax increase (12.4 percent) on wages above the current $184,500 threshold. That increase would come on top of existing federal, state, and Medicare taxes, and apply to millions of S corporations and other pass-through businesses as well as individual workers. George summarizes the result:
Along with the 3.8% Medicare payroll tax, such a change would push the top federal tax rate on labor above 50% — above 60% when including the state income taxes of high-tax states. That’s a recipe for less work, lower wages, and lower tax revenues
And we have a pretty good idea of just how damaging those higher rates would be. As George notes:
In its recent tax reform options guide, the Tax Foundation provided estimates of two payroll tax increase proposals that, when combined together, we can use to approximate the negative economic impact of such a large marginal tax rate increase on high-wage skilled labor:
The two highlighted options would expand the payroll tax cap to cover 90 percent of wages and then apply the tax again to earnings above $400,000. And the results aren’t pretty. Back to George:
Taken together, the Tax Foundation projects that these two tax increases would raise nearly $2.8 trillion over ten years on a conventional basis, but only $1.3 trillion on a dynamic basis. That’s because this pair of policies would reduce employment by a combined 1.7 million full-time jobs (!) and would reduce GDP by 1.4%. (Emphasis added.)
That’s the problem in a nutshell. If enacted, the policy yields a smaller economy and nearly two million fewer jobs, with more than half of the anticipated revenue disappearing in the process. Not exactly a “fix.”
George spends the balance of his piece exploring what a more thoughtful solution might look like, including benefit reforms, a more targeted revenue component, changes to the taxable wage base, and income tax relief designed to mitigate the economic harm from higher payroll taxes. There’s a lot more to it, and we’d encourage readers to check out the full piece for the details.
As we wrote earlier this year, wage taxes are particularly destructive. Workers ultimately bear their cost through lower wages and higher rates of unemployment. These taxes impose huge costs on employers too, as they are forced into the role of tax collector for the IRS. That means policymakers should be looking for ways to reduce our reliance on wage taxes, not dramatically expand them.
One option is to swap the payroll tax for a VAT or other broad consumption tax. It sounds like a radical departure from the current system, but there’s a healthy body of economic literature behind the idea. Studies examining shifts from payroll taxes to consumption taxes have found they can increase employment, improve work incentives, and raise wages, all while preserving the revenue needed to fund the program.
There’s no shortage of good ideas for fixing Social Security. What they have in common is a recognition that the economic effects of reform matter, and that Congress has options beyond simply cranking up the tax rate on wages and Main Street businesses.
US Best for Workers
If you’re looking for a Canadian-themed joke this Labor Day, look past Ryan Reynolds blaming the 1980s on the Cuban Missile Crisis — was he drunk? — and focus instead on senatorial candidate Abdul El-Sayed’s claim that if “you want to achieve the American Dream, well, you should move to Canada because it’s twice as likely there.”
That argument is so laughably wrong, even the Canadians disagree with it. A 2024 study by the Vancouver-based Fraser Institute compared the per capita income for the Canadian provinces and US states and found the Canadians are a little behind:
Only one Canadian province—Alberta— appears in the top half of all 60 jurisdictions, with the other Canadian provinces accounting for nine of the ten jurisdictions ranked at the bottom. The four Atlantic Canadian provinces rank last among the 60 jurisdictions.
It gets worse. The study also found changes in median income since 2010 only made the gap between the US and Canada larger:
Only one Canadian jurisdiction is in the top half of growth in earnings after 2010. British Columbia leads Canadian provinces with a $7,732 increase in earnings per person between 2010 and 2022, yet it is ranked 19th overall in terms of the value of the increase.
British Columbia was respectable, but look at the bottom of the chart. Whatever Alberta is doing, they should stop. Out of sixty jurisdictions, their economic standing dropped from 13th to 51st in just twelve years!
Can you imagine a young person following El-Sayed’s advice and moving to Alberta in 2010? They might be hard working, but with Alberta committing economic suicide, they’ll have a hard time getting ahead. More from the study:
Albertans, who out-earned Texans in 2010, fell behind by 2022 as a result of negative income growth in Alberta combined with strong growth in Texas, Alberta’s lead of $3,423 per person became a deficit with Texas of $5,254 by 2022.
Which begs the question, what exactly have they been doing up there? Not investing in their workers, for starters. A more recent Fraser Institute study found that Canada’s business investment per worker declined from 87.3% of US levels in 2014 to just 54% in 2024:
The result is that Canadian workers fell further behind:
Simply put, this section demonstrates that Americans have experienced greater overall improvement in their standard of living and incomes compared to Canadians, thus far into the 21st century. However, it is important to recognize that this was not a foregone outcome. During the years leading up to 2014, Canada outpaced the United States in terms of GDP per person growth and median employment income growth. But over the decade following 2014, outcomes in Canada began to stagnate while they continued to improve in the United States, and any progress Canada had made relative to its southern neighbour was ultimately wiped out.
So while Ryan Reynolds moves back to Canada to avoid the Vietnam War, young people looking for good jobs and opportunities would be better off staying right here in the good old USA. We have our problems, but losing an “Economic Dream” contest with Canada isn’t one of them.