Talking Taxes In a Truck
S-Corp is starting a new podcast. In episode 1, Cornerstone Macro Partner Andy Laperriere talks elections, the State of the Union, the future of tax policy, and UFOs with S Corporation Association President Brian Reardon. The podcast was recorded on February 5th and runs 21 minutes long.
You can access the podcast on Libsyn by clicking here or on the play button below.
Brookings and Progressivity
We interrupted our impeachment viewing last week for a Brookings Institute briefing exploring various ways the Congress could raise taxes. A book of revenue raising recommendations accompanying the briefing weighed in at a hefty 368 pages. According to the book’s editors, “This book is about taxes. It poses a simple question: Given that the United States needs more revenue, how should we raise it?”
It’s too early for us to digest all 368 pages, but the book raises one issue that’s worth exploring from the onset – the progressivity of the U.S. Tax Code and which direction we’re headed. In recent years, there’s been a concerted effort to paint the U.S. Tax Code as insufficiently progressive. Brookings and their Tax Policy Center have apparently joined that chorus. Here’s what the book’s editors say:
[M]ost of these new revenues must come from those best able to pay, especially since tax cuts benefiting the highest earners account for so much of the declining share of taxes paid at the federal level. Since the late 1960s, the share of federal revenue paid by working Americans in the form of payroll taxes has increased from just over 20 percent to 35 percent. Yet corporate tax collections have plummeted from more than 25 percent to less than 10 percent of revenues, and the top rate paid by wealthy filers has fallen from 70 percent during Lyndon Johnson’s presidency to 37 percent today. And over the last two decades, Congress has hollowed out the estate tax to such an extent that only 0.2 percent of estates pay any tax at all.
So the Tax Code has gotten less progressive since 1960? Probably not. In recent months, it has become increasingly clear the case for a “regressive” Tax Code rests heavily on cherry-picked statistics and faulty estimates. When you account for those flaws, today’s Tax Code looks more progressive, not less.
On the cherry-picking front, look again at the facts cited by the Brookings’ editors. Each is correct in its own narrow sense, but they hardly comprise the totality of changes made to the tax code over that time. Top rates certainly came down, but as we’ve noted before, reducing rates nobody paid is hardly regressive, especially when they were coupled with base-broadening measures and new refundable tax credits that eliminated tax liabilities for millions of low-income families.
To understand the totality of tax code changes and their effect on tax burdens, you can skip the cherry picking and go right to the Tax Policy Center’s own distribution tables. Here’s what they say (they only date back to 1979):
So after 40 years of changes, low- and middle-income taxpayers pay significantly less of the total tax burden, and the wealthy pay significantly more. That’s the opposite of regressive.
Obviously, the folks at the Tax Policy Center are aware of these numbers – this is from their table — so how do they explain the disconnect? Here’s one explanation from a 2012 Brookings paper:
In 1979, the top 1 percent of Americans earned 9.3 percent of all income in the United States and paid 15.4 percent of all federal taxes. While the share of income earned by the top 1 percent had more than doubled by 2007—to 19.4 percent—the share of federal tax liability paid by that group only increased by about 80 percent, to 28.1 percent. The share of taxes increased less for this group because high-income tax rates fell by more than the tax rates for everyone else—reductions that made the system less progressive.
The burden on the rich went up, and they paid more, but not as much as their income changed, so that’s regressive? This measure of progressivity focuses on incomes, not tax burdens. That’s not what most people have in mind when they are told that the tax code has become less progressive.
Moreover, the income estimates cited here are deeply suspect. Did the income share of the top 1 percent really rise from 9.3 percent to 19.4 percent between 1979 to 2007? Probably not. Last year’s seminal paper by Treasury economist Gerald Auten and Joint Committee on Taxation economist David Splinter demonstrated that these income estimates are deeply flawed:
Top income share estimates based only on individual tax returns, such as Piketty and Saez (2003), are biased by tax-base changes, major social changes, and missing income sources. Addressing these issues requires numerous assumptions, especially for broadening income beyond that reported on tax returns. This paper shows the effects of adjusting for technical tax issues and the sensitivity to alternative assumptions for distributing missing income sources. Our results suggest that top income shares are lower than other tax-based estimates, and since the early 1960s, increasing government transfers and tax progressivity resulted in little change in after-tax top income shares.
Here’s an accompanying chart comparing estimates by academics Piketty, Saez and Zucman, with those by Auten and Splinter. The estimates show the importance of accounting for the missing items, as well as the critical role taxes play in reducing the concentration of income. Contrary to the Brookings view, taxes appear to play a growing role in leveling out income growth at the top.
The most significant tax policy change reflected in these revised estimates is the shift from C corporations to pass-through businesses. Reductions in individual rates in the 1980s allowed private companies to move away from the harmful double corporate tax and towards the pass-through single tax system. These changes resulted in an explosion of business activity, higher levels of capital investment, and more jobs.
They also shifted income onto the personal returns of all those business owners. Estimates by Piketty et al. fail to take this shift into account when measuring income inequality, and it totally skews their results. Here’s Auten and Splinter:
The reform also motivated some corporations to switch from filing as C to S corporations and to start new businesses as passthrough entities (S corporations, partnerships, or sole proprietorships), causing more business income to be reported directly on individual tax returns. This is because all passthrough income is reported on individual tax returns while C corporation retained earnings are not. Before TRA86, the top individual tax rate was higher than the top corporate tax rate (50 percent vs. 46 percent), allowing certain sheltering of income in C corporations with retained earnings. This incentive was even larger when the top individual rate was 70 percent in the 1970s and 91 percent before 1964. TRA86 lowered the top individual tax rate below the top corporate tax rate (28 vs. 34 percent), reducing the incentive to retain earnings inside of C corporations and creating strong incentives to organize businesses as passthrough entities. Our analysis accounts directly for the limitations on deducting losses and indirectly for the shift into passthrough entities by including corporate retained earnings. This leads to important findings for in the 1960s and 1970s, when high individual income tax rates created strong incentives to shelter income inside corporations. Without these corrections, top income shares are understated before 1987. [Emphasis added.]
It also exposes the flaw in the prevailing perception that the corporate tax base is “plummeting.” Harvard Economist Jason Furman uses this argument to justify raising the corporate rate. This chart from his chapter in the book shows just how much our corporate tax collections lag behind the rest of the world.
But the rest of the world doesn’t have a robust pass-through business sector. Pass-through businesses pay taxes too, often at higher individual rates than C corporations, and when you account for those taxes, that “plummet” looks more like a steady state.
As our recent EY study showed, pass-through businesses pay more in taxes than C corporations, so including them in the corporate numbers would more than double to total tax paid by businesses. Only focusing on corporate payments is misleading. To get an accurate picture, tax economists should look at taxes paid by the entire business sector.
So that’s it – including the totality of tax changes and income sources makes clear the Tax Code has become more, not less, progressive in recent decades. Will this change the prevailing narrative from Brookings and the Warren and Sanders campaigns? Probably not. As the editors of the Brookings book make clear, the goal of this exercise is not to question the prevailing economic wisdom, it’s to raise taxes.
Our Chairman’s Annual Letter
Dear S-CORP Member:
The S Corporation Association recently surveyed voters and asked them how much private companies and other taxpayers should pay in taxes every year?
Almost without exception, the responses were consistent, reasonable and completely out of step with today’s rhetoric. Voters believed family businesses should pay no more than twenty cents for every dollar of income, or about half what most actually pay and less than one-third what they would pay under a wealth tax as proposed by Senators Warren and Sanders.
How to explain the disconnect? How can voters support reasonable tax rates on one hand and destructive wealth taxes on the other? In my experience, Americans are very moderate in their views, but they don’t always have the clearest picture of where things stand.
So when Senator Warren describes her plan as “just two cents,” voters don’t realize an annual tax equal to two percent or more of a company’s value can easily exceed its annual income, or that taxes that high threaten the future of family businesses nationwide.
That’s where the S Corporation Association comes in. Part of our mandate is to educate policymakers and voters alike on the importance of individually and family-owned businesses and to accurately describe how the policies considered in Washington would affect businesses residing on Main Street.
I was reminded of this mandate while watching Indiana’s new senator on CNBC the other day. Here’s what he said:
I’m a Main Street entreprenuer – I come from the small business world, and its never been better. C corps always take care of themselves. Lowering their nominal rate from 35 to 21 didn’t mean a lot because they had an 18 percent effective rate. Those of us in small business, we pay the full tax rates and when that changed, taking it down to 29.6 from 39.6, that was a big deal. That’s where jobs are created. That’s why we plowed through trade issues with China and so many other areas where recoveries at this stage of the game normally would flame out.
He’s right on both counts – while some sectors and regions could be doing better, its hard to think of another time in our history when so many were doing so well. It really has “never been better.” Meanwhile, the tax reform Congress enacted two years ago has helped Main Street keep the record expansion – now in its 127 month — going.
The S Corporation Association can take some credit for this success. When tax reform was debated, we worked closely with Senators Ron Johnson (R-WI) and Steve Daines (R-MT) on changes to improve the bill for Main Street. As Senator Daines explained at our recent Hill briefing:
Here’s why I think we need tax relief for pass-through businesses… Most of the jobs are created by pass-throughs more than C corps… so if tax reform is the means to an end, the means is lowering taxes and the end is economic growth and job creation. If we’re not addressing the pass-throughs, then we’ve not addressed the heart of what needs to happen to achieve that end.
Those changes included lowering the top individual rate, increasing the size of the Section 199A pass-through deduction, and expanding the deduction to include trusts and estates. The good news is that these efforts succeeded in balancing out the interests of Main Street businesses with those of large C corporations.
What is S-Corp’s plan to build on this success in 2020?
First, we are going to continue to make the case for individually and family-owned businesses. As a group, our companies are critically important to the economy. The stories of how they got started, the challenges they’ve overcome, and their collective contribution to the economy simply cannot be repeated too many times.
Second, we are going to focus on tax policies that help your bottom line now. The 199A deduction is complicated, limited, and temporary. S-Corp and our Main Street Employer coalition are working with allied groups to make the rules issued by Treasury as expansive as possible while building the foundation for making the deduction both permanent and more broadly applied. Getting the rules out of Treasury “right” is a short term effort that will pay immediate benefits to pass-through businesses.
We will continue to enact our SALT Parity reforms too. Limiting SALT deductions for S corporations while allowing them for C corporations is patently unfair. Instead of complaining, S-Corp and its Main Street Employers coalition identified a solution, drafted model legislation, and published the legal analysis demonstrating to states exactly how they can restore the SALT deduction for their pass-through businesses.
We then took the idea to state legislatures across the country. As our President testified before the Louisana legislature last spring:
This legislation would benefit thousands of family businesses operating in Louisiana by restoring their ability to fully deduct the State and local taxes (SALT) they pay on their business income. The bill is intended to be revenue neutral and its effect would be to make these businesses more competitive and Louisiana a more attractive place to do business.
Six states have adopted our approach to date – Connecticut, Wisconsin, Oklahoma, Louisiana, Rhode Island and New Jersey – with several others actively consdering it this year. Our goal is to reach a critical mass of legislatures taking action at the state level and force Congress to revisit the policy for everybody.
Finally, S-Corp is working to build the case for the next tax reform. Since its inception, S-Corp has supported the single-tax system for individually and family-owned companies — tax business income once, tax it when it is earned, tax it at a reasonable top rate, and then leave it alone. S corporations for everybody is our mantra.
Voters overwhelmingly agree. In our recent survey, an overwhelming 77 to 7 percent of respondents opposed the idea of taxing the same income twice. They also supported the ability of businesses to grow as much as possible and still retain its pass-through status. Ultimately, voters are looking for a tax system that is fair for all and encourages the establishment and growth of all types of businesses.
Armed with this support, when Congress next reviews the tax code, our goal is to be at the table, making the case for Main Street and the single tax system.
That’s our advocacy plan for 2020 and beyond. What can you do to help?
- Renew your membership for 2020: S-Corp is not flashy, and we don’t have a lot of bells and whistles. What we do have is great advocacy, and advocacy starts with our members. Renew today.
- Support the S-Corp PAC: The Main Street Community needs to support those members of Congress that support us. Political giving isn’t for everyone, but if you have the ability, support the PAC and help us support our champions.
- Spread the word: Our best ambassadors are our members. Let other private businesses in your community know about S-Corp and the important work that we do.
Again, I am deeply appreciative of your support and look forward to working with you in 2020 to defend the greatest vehicle for private enterprise ever invented – the S corporation.
Sincerely,
Tony Simmons
Chairman, S Corporation Association
Former President & CEO, The McIlhenny Company
Video on Main Street Employers’ Briefing
Video on Main Street Employers’ Briefing
In case you missed it, S-Corp has posted video of its October briefing on Main Street tax issues on its website. The briefing, which took place in the historic Senate Russell Caucus Room and was hosted by the Parity for Main Street Employers coalition, featured Senator Steve Daines (R-MT), Martin Sullivan (Tax Analysts), Bob Carroll (EY), David Winston (The Winston Group) and Chris Smith Parity for Main Street Employers).
It also featured new work from EY and the Winston Group focused on the challenges individually and family-owned businesses face in the post-tax reform world. You can watch the whole briefing on S-Corps YouTube channel and access the new reports by clicking on the links below:
Key takeaways from the briefing:
Section 199A the Key to Pass-Through Tax Parity: In terms of both effective and marginal tax rates, EY’s analysis shows that prior to TCJA, large S corporations and C corporations faced similar tax rates. Rough parity remained following enactment of the TJCA. However, the sector will face significantly higher tax rates in 2026 than C corporations with the expiration of key TCJA provisions, such as the 20% Section 199A deduction for qualified business income.
Pass-Through Businesses Employ Most Workers: Looking at the latest data available (2016), EY estimates that the pass-through sector (S corporations, partnerships, and sole proprietorships) employed 58 percent of the private sector workforce, up several percentage points from our last estimate. Large S corporations, defined as those with 100 or more workers, employed 13.1 million workers, or 10% of the 133 million private sector workers in 2016. States with the highest levels of pass-through employment include 1) Montana (69.7%), 2) South Dakota (67.4%), 3) Idaho (67.2%), 4) Wyoming (65.6%), and 5) Vermont (64.9%).
Pass-Through Businesses Pay the Most Taxes: EY found that in 2018, individual owners of pass-through businesses paid 51% of federal business income taxes ($326 billion), while C corporations and their individual shareholders paid 49% ($316 billion). The $131 billion in individual income taxes paid by owners of S corporations in 2018 comprised 20% of all business taxes and 40% of pass-through business taxes.
Voters Support Reasonable Top Rates: The Winston Group survey found voters support moderate rates of taxation, even for the wealthy and big business. When asked what the maximum acceptable rate should be for a list of taxpayers, voters responding with rates well below those that are being debated today. Moreover, for all the entities listed, the maximum acceptable rates for each entity was well below the top tax rate many already pay.
Voters Oppose Double Taxation: The Winston Group survey found voters overwhelmingly agree that it is unfair to tax the same business net income twice (77-7 percent agree-disagree). They also believe that a business should be allowed to grow as much as it can and still retain its pass-through status. Some 46 percent believe that once established, pass-through businesses should be able to grow without restriction and be taxed on their net income (46-20 percent believe-do not believe).
Voters Support Main Street: Voters have favorable views of the private sector (59-20 percent favorable-unfavorable), seeing it as more nimble than government and more responsive to consumer needs. Voters believe that small, private, and new business owners face serious competition from large corporations. Some 73 percent believed the statement, “Someone who wants to start their own business will have a hard time competing with large corporations” (73-15 percent believe-do not believe). Another 64 percent believed that “excessive taxes on businesses make it difficult for average Americans to start their own businesses” (64-20 percent believe-do not believe).
The bottom line for S-Corp is that tax reform succeeded in maintaining rough tax parity between large pass-through businesses and large C corporations, but only if the 199A is in effect and only if it’s made permanent. Meanwhile, voters support a tax system that is fair for all types of businesses and encourages the establishment and growth in all types of businesses, and believe that the pass-through structure helps achieve these goals.
Main Street Responds to House SALT Bill
Yesterday, the Main Street Employers coalition sent a letter to House tax writers raising concerns with their plan to provide temporary relief from the SALT deduction cap by raising the top tax rate applied to pass-through business income. As the letter states:
Individually and family owned businesses organized as S corporations, partnerships and sole proprietorships are the heart of the American economy. They employ the majority of workers, and they contribute the most to our national income. They also pay the majority of business taxes. A recent study by EY found that pass-through businesses pay 51 percent of all business income taxes.
The legislation introduced today would raise these taxes by 1) increasing the top rate pass-through businesses pay from the current 37 percent to 39.6 percent and 2) lowering the income threshold of the top rate from $622,050 to $496,600 (Joint) for the years 2020 through 2025, after which the 37 percent rate is scheduled to expire under current law.
The bill, titled the “Restoring Tax Fairness for States and Localities Act”, is scheduled to be considered by the House Ways & Means Committee today and voted on by the full House next week. According to the Joint Committee on Taxation, the bill provides the following relief from the SALT deduction cap:
- The proposal increases the dollar limitation on the deduction of certain State and local property, income, and sales taxes to $20,000 for married individuals filing a joint return and $10,000 for a married individual filing a separate return for taxable years beginning after December 31, 2018, and before January 1, 2020.
- The proposal removes the limitation on the deduction for certain State and local property, income, and sales taxes for taxable years beginning after December 31, 2019, and before January 1, 2022.
To pay for the SALT relief, the bill would repeal the new 37 percent tax bracket and return the restored 39.6 percent rate to its pre-tax reform income thresholds (from $622,050 to $496,600). Again, from the Joint Committee Taxation:
- The proposal increases the top individual income tax rate of 37 percent to 39.6 percent and reduces the dollar amounts at which the 39.6 percent bracket begins.
The relationship between the new SALT deduction cap and the pass-through business community is complicated. The SALT cap only applies in states with income taxes, and then only if the businesses taxes are paid at the shareholder level. So for S corporations residing in Texas (no income tax) or Wisconsin (where they adopted our SALT Parity legislation), SALT isn’t an issue and this legislation is just a tax hike. On the other hand, SALT is likely the reason so many California S corporations have converted to C corporation. The business community letter reflects this challenge, noting:
While this SALT relief will benefit some pass-through businesses, those savings will be reserved only for businesses residing in certain states, while the tax hike will apply to businesses in all fifty states.
One suspects the SALT issue is complicated for the bill’s proponents too. The SALT benefit is primarily enjoyed by the same upper-income taxpayers who will be subject to the higher top rate. As Richard Rubin at the Wall Street Journal tweeted yesterday:
“You can think of this as cutting taxes for some of the top 1% (and others below that) and paying for it by raising taxes on the top 1%. On balance, at first blush, it would be good for NJ/NY/CA rich/upper-middle-class people, not so much for TX/FL/WA rich people.”
Amid all this complexity, one point of clarity is that C corporations can continue to fully deduct their SALT while S corporations cannot. For that reason, S-Corp will continue to press for its SALT Parity legislation at the state level. Connecticut, Wisconsin, Oklahoma, Rhode Island, and Louisiana have already acted and restored the SALT deduction for their S corporations and partnerships, while several additional states are teed up to act early next year. The more quickly they act, the more quickly SALT ceases to be an issue for the pass-through community.