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NIIT Picking
Tax Notes is out with a new piece that makes the case for expanding the Net Investment Income Tax (NIIT). The article quotes exclusively from individuals who would like to see the tax applied to a broader base of income. Absent is anybody from the business community, which is uniformly opposed to these tax hikes.
Instead, the article comes across as an advocacy piece highlighting people long opposed to the pass-through structure as a whole. The article starts off:
President Biden has proposed addressing a long-perceived flaw with the net investment income tax, but as with his predecessors, political considerations have stopped him from going further. That’s because active business income is carved out of the NII tax, and while Biden has proposed nixing that carveout, one of his campaign pledges has forced him to propose replacing one carveout with another, albeit much smaller, one.
“I think it’s politics at the end of the day,” Kyle Pomerleau of the American Enterprise Institute said May 4 at a conference sponsored by the District of Columbia Bar Taxation Community. “Passthrough businesses do a very good job of describing themselves as small businesses, and that ends up being a very good political maneuver for them.”
Couple things right off the bat. First, this effort is just the latest in a long con to destroy the underlying premise of Social Security and Medicare funding. In 1993, it was unfair and a “loophole” that the Medicare tax was capped and did not apply to wages exceeding a certain threshold. The Clinton administration eliminated the cap. In 2010, it was unfair and a “loophole” that Medicare taxes didn’t extend to unearned income. The Obama administration increased the tax and expanded its reach to include passive investment income. Now, it’s unfair and a “loophole” that the NIIT doesn’t apply to the business income of active business owners. The Biden administration is attempting – unsuccessfully, so far – to expand the NIIT to this income. They would go after Social Security too, except the Byrd Rule blocks them.
But is it really a “loophole”? No. The legislative history on this is clear. The NIIT was a late addition to the health care law that the Administration proposed in February of 2010, after both the House and the Senate had passed their respective health care reforms. From the beginning, the proposal excluded the business income of active owners. Here’s how National Journal reported on the provision at the time:
President Obama’s $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments. The carve-out is a concession to a range of business groups and advocates for the self-employed.
That was the S Corporation Association. We led a broad coalition of business groups to oppose the provision when it was first floated, and we wrote extensively on the provision once it was released (see here, here, and here).
Congress made several key changes to the Administration’s proposal before enacting it – namely, they removed its connection to Medicare; the revenue goes into the general fund, not Medicare – and they increased the tax to 3.8 percent, but the exclusion on income of active business owners remained. As our Advisory Board Chair Tom Nichols summarized in his testimony back in 2012:
This net investment income tax is generally imposed on interest, dividends, annuities, royalties, rents and gains, with one very important exception. Congress recognized that this new imposition should not apply to income derived by owners directly involved in active businesses. Therefore, Congress excluded from the tax base all income derived from a trade or business unless the income was reported by a person who did not “materially participate” under the passive activity rules or the trade or business consisted of trading in financial instruments or commodities.
In short, exempting the business income of active owners from the NIIT was part of the plan from the beginning and is no way a “loophole.”
Second, pass-through businesses “do a good job of describing themselves as small businesses” because – wait for it – they are small. To illustrate, a 2018 Congressional Research Service report found that 99% of pass-throughs had fewer than 100 employees:
Moreover, the report found that while employment at C corporations is largely concentrated at the top, it was more uniformly spread around within the pass-through group. There are of course large pass-throughs, but even they tend to be smaller than their corporate counterparts, averaging about one-fourth as many employees as large C corporations.
The Tax Notes piece is just another example of the revisionist history we saw when lawmakers tried to claw back portions of the 2020 Covid relief bill. In that instance, the same members of Congress who championed the relief later called it a “special-interest giveaway” that was “tucked” into the CARES Act. Now they are using this same playbook in advocating for an expansion of the NIIT.
The Build Back Better Act may be going nowhere this year, but S-Corp members know that no bad idea ever dies in Washington. After more than a decade, we’re still fighting the false notion of a NIIT “loophole.”
Talking Taxes in a Truck Episode 19: BBB Still “Too Big to Succeed”?
On this special Detroit edition of the Talking Taxes in a Truck podcast, we’re joined by Chris Smith, President of Summit Global Strategies and Executive Director of the Main Street Employers Coalition. Chris and Brian kick off the episode by debating what effect the leaked Supreme Court draft decision will have on the tax policy outlook, and the odds of an overhauled Build Back Better Act being passed in the coming months. They also break down the reconciliation bill’s various tax hikes, and explain how they specifically target family businesses. Finally, Chris shares his favorite DC activity, the origins of his middle name, and his predictions for the November midterm elections.
This episode of Talking Taxes in a Truck was recorded on May 5th and runs 44 minutes long.
More Evidence Tax Hikes Boost Prices
Still more evidence the tax hikes included in the Build Back Better Act would make inflation worse. As noted by Bruce Thompson in the Washington Examiner, a “Working Paper” from the National Bureau of Economic Research shows how tax hikes on businesses result in higher prices for consumers.
The study found that increases in corporate tax rates are passed on to consumers, in part, in the form of higher prices. Here’s the key conclusion from the write-up:
This paper provides evidence that corporate taxes impact retail product prices, and that a significant portion of corporate tax incidence falls on consumers…. The fact that corporate taxes affect product prices, as well as payouts to shareholders and wages, has important implications for tax policy. In particular, models used by policymakers like the CBO and US Treasury may underestimate the incidence of corporate taxes on consumers (CBO, 2018; Cronin et al., 2013).
Exactly how much of a tax hike is passed on to consumers through higher prices?
Informed by our empirical estimate, we can gauge the incidence of corporate taxes on consumers by relating the welfare change of consumers induced by a marginal change in the net-of-tax rate to the sum of the welfare changes of consumers, workers and firm owners (Suárez Serrato and Zidar, 2016; Fuest, Peichl and Siegloch, 2018). We find the incidence on consumers, workers and shareholders is 31%, 38% and 31%, respectively.
While this study focused on C corporations, it does indicate that similar results would apply to S corporations and partnerships. As the authors note, “…we see no price effects for tax rate changes that do not affect the legal entity – neither for C-corporations following personal income tax rate changes nor for S-corporations when corporate income tax rates change.”
Meanwhile, the fact that S corporations pay taxes at individual rather than corporate rates enabled the authors to use S corporations as the test group:
Additionally, we repeat our analysis using a set of firms that are not subject to corporate taxes: S-corporations (Yagan, 2015). S-corporations belong to another legal form of organization and are required to pay personal income taxes rather than corporate income taxes. If our empirical strategy identifying the causal effects of corporate tax changes is valid, we should only find price effects of corporate taxes for C-corporations and not for S-corporations. On the other hand, if changes in state corporate income taxes are correlated with unobserved supply-side shocks, then both C-corporations and S-corporations should be affected. We find positive and significant price effects for C-corporations seeing corporate income tax rate changes. In contrast, we see no price effects for tax rate changes that do not affect the legal entity – neither for C-corporations following personal income tax rate changes nor for S-corporations when corporate income tax rates change.
One key finding from the study is that low-income households are hardest hit:
We find that the lowest price goods tend to respond most to corporate tax changes, with average magnitudes almost twice as high in the lower half relative to the upper half. Similarly, we find evidence of a larger effect for UPCs commonly purchased by households with lower incomes relative to those purchased by high-income households
An interesting result from the study is the effect debt plays in corporate tax burdens and, therefore, their responsiveness to tax changes. As noted elsewhere, more highly leveraged firms pay lower effective tax rates. Would these lower rates reduce the amount of a new tax that is passed on to consumers? Apparently, yes:
US tax law makes interest rate payments on debt deductible for corporations. Thus a natural implication is that firms with higher levels of debt can benefit from tax shields, making them less sensitive to changes in corporate tax rates. Table 8 provides evidence that this is indeed the case. We merged our sample by company name with Compustat to obtain information on leverage, which resulted in a reduced sample. The table interacts corporate tax rates with an indicator of whether a firm is above or below the median debt ratio in the sample (0.24). We find that the effects tend to materialize on firms with lower levels of leverage. For firms with higher leverage, which can take larger debt tax shields, we see no statistically significant effect of changes in corporate tax rates on product prices.
This finding is consistent with S-CORP’s experience, where members with significant deductions and relatively low tax burdens are less concerned about public policy changes than those who are more exposed.
What’s the bottom line? More evidence the House-passed BBB would raise prices on consumers and make inflation worse, with low-income Americans being the hardest hit. The tax hikes in the BBB are large and almost exclusively shouldered by businesses, both corporate and pass-throughs, so one might expect the price effect to be significant. Opponents of the BBB have been right for over a year now. Its time to put the BBB to rest.
Small Business “Boom” is Anything But
At a roundtable event on Thursday, President Biden unveiled a new White House report that touts a “small business boom,” and attributes this success to his administration’s economic strategy.
The timing of the event was a bit odd – the Commerce Department had just released its first quarter GDP estimates, showing the economy shrank by 1.4 percent, and businesses continue to face rampant inflation, job shortages, and supply chain disruptions. So what’s this “boom” the President is bragging about?
In framing its success, the White House report leans heavily on 2021 job figures:
Under the Biden-Harris Administration, small businesses are creating jobs. In the first three quarters of 2021, small businesses with less than 50 employees created 1.9 million jobs, the fastest 9-month start to small business growth in any year on record. These 1.9 million jobs represented 49% of net job growth across firms of all sizes over that period, the second highest share on record.
The accompanying chart, shown below, puts this figure into perspective:
That massive dip in 2020 shows just how devastating the Covid pandemic and the ensuing policies were to the small business community. While larger firms were allowed to stay open, small businesses were told to shut their doors, shedding close to 800,000 jobs each quarter. The only way you can describe 2021 as a “small businesses boom” is to completely ignore what happened just one year prior.
The report also highlights data on applications for new businesses to make its case, stating:
In 2021, Americans applied to start 5.4 million new businesses—more than 20 percent higher than any previous year on record and more than two-thirds higher than the annual average of 3.2 million new businesses applications per year in the five years prior to the start of the pandemic. Of these applications, roughly 1.8 million applications were for businesses that planned to hire employees (“high-propensity applications”), an increase of more than 17% over the previous annual record and more than 40% above the pre-pandemic average.
Of course, the same dynamic applies here: as a result of the pandemic, millions of businesses were forced to close their doors for good. The subsequent spike in new business formations is in keeping with a recovery.
But submitting an application is not the same as hiring new workers. To see how small businesses have fared in terms of job creation since 2021, it’s worth taking a look at the ADP payroll data over that time:
The graph above plots monthly changes in employment for companies with fewer than 50 employees versus those with over 500 since the start of 2021. While small businesses were creating jobs at the beginning of the Biden administration, the rate has been trending down for the past year and was actually negative in February. Meanwhile, job creation at larger companies has been positive and accelerating throughout. This trend of economic consolidation away from Main Street and into the hands of a few large, publicly-traded companies is one we’ve been warning about for years, and would only be exacerbated by the tax policies under consideration in Congress.
Speaking of which, the White House report concludes with a series of proposals to further help small businesses. While not explicitly labeled the “Build Back Better Act,” they are suspiciously similar to the stalled reconciliation bill. For example, under the heading “Leveling the Playing Field for Small Business Owners by Reforming the Tax Code,” the report states:
According to a White House analysis, the President’s Agenda would deliver tax cuts to more than 3.9 million entrepreneurs and only raise taxes on those making over $400,000. That means 97 percent of small business owners would not face any income tax increases, and, in fact, millions would be getting tax cuts.
To be clear, the tax cuts referenced above are not “business” relief per se. Instead, the White House is counting family tax relief, like the expanded child tax credit. If you are an entrepreneur who has children and you get the credit, then that’s the tax cut referenced above. These aren’t increased incentives for business owners; they are increased incentives for parents. Might be worthwhile, but it’s not the same. If you’re an entrepreneur with no eligible children, no tax cuts for you.
On the other hand, there might be tax hikes, big ones. We’ve covered this before but it bears repeating: under the BBB, family businesses with ownership held in trust would get hit with the new, 5-percent surtax on income exceeding just $200,000. For the proposed expanded 3.8 percent Net Investment Income Tax (NIIT), that would apply to these family businesses when they earn just $13,000. In the context of family businesses, that $400,000 minimum threshold for tax hikes just isn’t accurate.
So the White House report trumpets cherrypicked and flawed data while pushing a tax plan that hurts the very businesses it purports to care about. If this administration is serious about helping small businesses it should abandon efforts to pass the BBB and instead focus on alleviating the real-world problems affecting Main Street right now – inflation, supply chain challenges, and a lack of workers.
Collections Undermine Tax Hike Narrative
The progressive case for raising taxes is premised upon two arguments – 1) income shares are increasingly concentrated at the top and 2) the Tax Cuts and Jobs Act (TCJA) reduced taxes for the wealthy and corporations at the expense of everybody else.
The first premise is simply wrong, as demonstrated most recently by new research by Phillip Magness and Vincent Geloso. This paper lands on top of a growing pile of analyses (see here, here, here, and here) showing that the work of French economists Piketty and Saez is deeply flawed and should not be relied upon by anybody.
Recent revenue data from the CBO and Treasury now shows the second premise – that corporations and the rich have stopped paying their fair share – is also wrong.
As noted by the Tax Foundation, corporate receipts last year were a record-high $372 billion and growing. That’s up from $230 billion in 2019 (pre-COVID), an increase of 61 percent. And the good news is continuing. In just the first six months of fiscal year 2022, corporate receipts were 22 percent above their already-high 2021 levels.
While some of this growth can be explained by inflation, receipts measured against GDP are also rising, suggesting that a premise of the Tax Cuts and Jobs Act – to broaden the corporate tax base while reducing rates – is working to make our Tax Code more competitive while still raising significant levels of revenue.
The growth in revenues isn’t just a corporate phenom. Individual collections are rising sharply too and also headed for record highs.
So the second progressive case for hiking taxes – that corporations and rich Americans aren’t paying their fair share — isn’t keeping up with the times either. Corporations and individuals are paying record amounts and those amounts are only expected to grow this year and into the future.
One item not addressed by the Tax Foundation is how the TCJA affected individual tax receipts. As the data from OMB makes clear, collections from corporations dropped sharply following adoption of the TCJA – much more than was expected. We wrote about this in the past. The surge of revenues in 2021 and 2022 has brought corporate collections to their historic levels, but still there was that sharp drop in 2018 and 2019. (We’re ignoring 2020 because of the effects of COVID.)
On the other hand, tax collections for individuals and pass-throughs never declined. In fact, they rose from $1,587 billion in 2017 to $1,683 billion a year later – after the “tax cuts.” It’s correct that collections in 2018 and 2019 were slightly below pre-TCJA projections, but the decline was small and hardly qualifies as a massive giveaway. Now, with the recent surge, individual collections are well above their pre-TCJA baseline.
The simple way to think about the impact of the TCJA on upper-income individuals and pass-throughs is that the results were a mixed bag. If you ran a business that qualified for the 199A deduction, you probably saw a reduction in your taxes. It you didn’t – if your business was designated as a “specified services trade or business” – then it is possible you saw your taxes go up in 2018 and beyond.
So the recent revenue numbers from CBO and Treasury tell us two things. First, they completely undermine what little justification existed for raising taxes on employers post-pandemic. It’s hard for the federal government to claim poverty when it’s literally awash in tax revenues.
Second, they point to the importance of the 199A deduction in maintaining parity with public C corporations. It’s the only thing standing between Main Street and a massive tax hike.