Much of today’s tax policy debate is premised on the notion that income inequality is bad and getting worse. Economists Piketty and Saez have published numerous papers making this case (here, and here), and Saez recently wrote a book arguing for a wealth tax to address this inequality. But what if their premise is simply wrong? What if the whole income inequality narrative itself is built on a faulty foundation?
It’s been known for a long time that Piketty’s and Saez’s estimates fail to fully account for missing income sources, shrinking households, and the effects of tax policy on reported income. A new paper by Treasury economist Gerald Auten and Joint Committee on Taxation economist David Splinter takes a comprehensive look at all these issues and comes to the conclusion that income inequality since the 1960s is largely unchanged. Here’s the key illustration:
That black line shows that when you fully account for these missing items, the income share of the top 1 percent is essentially flat. As the authors write, “Our estimates for after-tax income suggest that the top one percent share increased 1.3 percentage point since 1979 and a quarter of a percentage point since 1962.”
One interesting aspect of Auten’s and Splinter’s paper is how much the growth of the pass-through sector affects the figures on income inequality. 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. Auten and Splinter do a nice job of identifying and adjusting for that fact:
The most significant tax reform in the period studied was TRA86, which lowered individual tax rates and broadened the tax base. The base-broadening was targeted at high income taxpayers, including limiting deductions for losses on rental income and passive investments. 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.]
This is not a new observation – as we wrote back in 2016, “Pass through taxation doesn’t add to income inequality. C corporation tax treatment masks it.” To our knowledge, however, this is the first time somebody has attempted to fully quantify the income equality effect of the growth in the pass-through sector.
The bottom line is that the Auten-Splinter paper is worth a serious read. While its clear there is a high level of unrest in the country, their analysis suggests our challenges are much deeper than a superficial measure of relative incomes. For tax policy, meanwhile, it suggests there’s a whole lot of policy being driven by bad data these days.
EY has published a new study commissioned by the S Corporation Association entitled “Large S Corporations and the Tax Cuts and Jobs Act: The economic footprint of the pass-through sector and the impact of the TCJA.” The study’s author, Robert Carroll, will be featured at the Main Street briefing today held in the Russell Senate Office Building. You can read the full study here.
Key takeaways from Bob’s work include:
- Pass-Through Tax Parity: In terms of both effective and marginal tax rates, the 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 Employment: 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 Taxes: Finally, 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.
The takeaway 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.
The Peterson Institute held a “Combating Inequality” event last week that included a vigorous debate over wealth taxes. The heavyweight match between Emmanuel Saez – the leading advocate for wealth taxes these days – and Larry Summers in particular is worth watching.
One aspect missing from the debate, however, was how wealth taxes would handcuff successful private businesses. Summer briefly touches on the challenge his family’s hardware store would have paying the tax, but there is so much more to it. Wealth taxes:
- Are far larger than their headline numbers suggest;
- Paid on top of all existing taxes;
- Hit hardest when the economy is bad; and
- Target illiquid, private companies the most.
Add it all up, and it’s hard to see how successful family businesses can survive an aggressive wealth tax.
Wealth Tax — Bigger than it Looks
Senator Elizabeth Warren likes to describe her plan as just “two cents” but it’s so much more than that. The tax would be two percent on the cumulative wealth of families worth more than $50 million, and three percent on those worth more than $1 billion.
So a family business worth $100 million would pay $2 million dollars, per year, every year. Two million dollars a year is obviously a lot of money, but to understand the scale of the tax, you need to compare it to an income tax. As AEI scholar Alan Viard wrote for the Aspen Institute:
A useful way to interpret wealth tax rates is to translate them into equivalent income tax rates. For a taxpayer who holds a long-term bond with a fixed interest rate of 3% per year, a 3% per year wealth tax is equivalent to a 100% income tax because the tax captures 100% of the taxpayer’s interest income. Similarly, an 8% per year wealth tax is equivalent to a 267% income tax.
The tax-rate translation is more complicated for risky investments. Suppose that, alongside her holdings of the 3% bond, the taxpayer holds a stock with an annual return that could fall anywhere between 2–10%, with an expected value of 6%. The 3% per year wealth tax could end up being anywhere from 30–150% of the stock’s return. It is not immediately clear what income tax rate the taxpayer would perceive as equivalent to the wealth tax in advance, when the stock return is uncertain.
As Alan notes, returns on capital vary, but if the average return on capital in the US is 6 percent, then the Warren tax is the equivalent of a 33 percent income tax rate, not 2 percent.
While investments might earn 6 percent on average, they can lose money too. The wealth tax doesn’t account for losses – the tax is owed whether an investment earns positive returns or not. This “pro-cyclical” aspect of the wealth tax is particularly dangerous, as it can force investors to divest their capital interests at times when the economy is doing poorly, encouraging a vicious downward cycle.
To counter this issue, the Warren tax allows tax payments to be deferred for five years, with interest. This provision mitigates the worst cyclical aspects of the wealth tax, but it doesn’t eliminate them. The tax is still owed, after all. For the family business worth $100 million, they could defer payment of one year’s tax for five years, but then they would owe $4 million in year five, plus interest on the deferred payment of $2 million. It’s effectively a loan that lenders will take into account when assessing the credit worthiness of the business. For credit constrained companies, there’s a limit to how much they can borrow.
What if the business loses value over the five years the tax is deferred? Income taxes account for losses. A business that loses money in year two can get a refund for the taxes paid in year one. The idea is to accurately measure and tax the income of the business over time. This approach has the benefit of being counter cycle, meaning the income tax provides refunds when the economy is soft and business lose money, and taxes them when they earn money. Even with deferral, a wealth tax doesn’t have this valuable feature.
Layer upon Layer of Tax
The Warren wealth tax is layered on top of other taxes, so a 2 percent bond would be subject to both the wealth tax and the income tax. For a $100 bond that pays 2 percent, the income tax is 82 cents (the 37 percent income tax plus the 3.8 percent NIIT), while the wealth tax is $2 dollars. The bondholder is losing 82 cents for every $100 in bonds they hold, every year. If it’s a 10 year bond, then the bondholder will be left with just $91.80 of the original $100 they invested. Instead of earning money on the investment, they lose it.
For private businesses, the layering effect will be similarly harmful. A 2 percent wealth tax is equal to a 33 percent income tax on a business earning 6 percent, which would be paid on top of the existing income taxes. In last year’s report, EY estimated the top marginal tax rates on S and C corporations were effectively equal at around 33 percent. For a successful S corporation earning 6 percent profits, then, the effective tax on its earnings, on average, would be 66 percent.
Those businesses will also be subject to the estate tax. Every generation, they will be required to buy back a portion of their business from the federal government. At a 40 percent estate tax rate and a $12 million exemption, the tax on the $100 million business could be more than $30 million. Estate planning can help to reduce this tax and spread the costs out over time, it’s still a cost private companies will have to shoulder. If the total tax ends up being $20 million and the company passes from one generation to the next every 30 years, the annual tax would be an additional $666,000 a year, on top of the $2 million in income taxes and the $2 million in wealth taxes. The company’s effective rate is now 78 percent.
Bullseye on Private Businesses
This chart from the Visual Capitalist illustrates how the wealth tax targets private businesses. Most multi-millionaires or billionaires are not liquid and most of their wealth comes from private business interests. See all that dark blue area in the bottom two income categories? Those are private businesses that will need to pay the Warren wealth tax of 2 or 3 percent per year. They will owe the tax whether the business is profitable or not.
Private vs Public Businesses
So private companies are n the bullseye of the wealth tax. Public companies, on the other hand, are largely immune to it. Public companies have access to capital from many sources – charities, pension funds, retirement accounts, and foreign investors – not easily accessible to private companies, and nearly all of these investors are not subject to the wealth tax.
To be clear, some corporate shareholders might be subject to the wealth tax, but it’s unlikely it will have any impact on their planning. At most, the corporation’s cost of capital might rise slightly as its billionaire shareholders sell off stock to pay the tax, but the effect will only be slight as the public stock markets are extremely liquid and open to so many alternative sources of capital.
In contrast, a single shareholder S corporation worth $100 million is, by definition, subject to the wealth tax on its entire valuation and it’s generally the person who runs the company who pays the tax. There’s no “arms length” separation between the taxpayer and the company.
Just how would they pay the tax? Private companies tend to be illiquid and the market for partial stakes in a private company stock is all but non-existent. Selling off a “few shares” to pay the tax is not really an option. Few investors are interested in buying a non-controlling interest in an illiquid asset, and as a result minority stakes of these businesses often sell at steep discounts compared to controlling stakes.
The wealth tax will require private companies to get valuations every year even as the tax drives down those valuations.
Think about it this way – for a certain level of risk, an investor needs to earn 4 percent after-tax on their investment. A business that fits that risk level and makes $6 million pretax would be worth $100 million to the investor. It would return 6 percent pretax, and 4 percent post tax. With the Warren wealth tax, however, the business only returns 2 percent – 6 percent minus the 33 percent income tax and the 2 percent wealth tax. For that rate of return, the investor is only willing to pay $50 million.
Not all private businesses will lose half their value, of course. The challenge to estimating declines in asset values under a wealth tax is that it doesn’t apply to all taxpayers, just those whose wealth exceeds a certain threshold. To a buyer not subject to the wealth tax, the business still is worth $100 million. The dilemma is that a single buyer won’t be able to buy the business at that price, since they would be subject to the wealth tax. Meanwhile, a group of buyers could buy the business with each of their stakes below the wealth tax threshold, but they would insist on steep discounts for lack of control, as they each would be purchasing a minority stake in the business.
Who could buy the business at something approaching its previous valuation and still avoid the tax? Private equity and public corporations come to mind. Private equity because they can raise capital from diverse sources but can still enjoy a controlling stake in the business, and public corporations because, as discussed above, they are largely immune to the tax. Individuals and families, on the other hand, would be locked out.
This combo platter of excessive tax rates, counter-cyclical applications, broad exposure, and uneven application will result a wholesale migration of business activity into the public corporate sector.
Family-owned businesses over a certain size would begin to disappear – they either would be sold to public corporations or private equity firms with large, diverse investor bases, or they would continue on at a competitive disadvantage, paying effective tax rates more than twice what a public company pays. In the end, the wealth tax would cause increased concentration of business activity and decision making.
The irony is that S corporations were created 60 years ago to counter this consolidation. As it says on the history page of our website:
At the same time, Republicans and Democrats were increasingly alarmed that too much economic power was being consolidated into the hands of a few wealthy, multinational corporations. This economic centralization was characterized by economists like John Kenneth Galbraith, who saw America’s economic future as a grand balance of power between Big Labor, Big Business, and Big Government. Private enterprise was viewed as a thing of the past.
In response to these concerns, Eisenhower embraced the Treasury proposal and recommended the creation of the small business corporation to Congress. In 1958, led by Democratic Finance Chairman Harry Byrd, Congress acted on Eisenhower’s recommendation, creating subchapter S of the tax code as part of a larger package of miscellaneous tax items.
Be sure to watch the Peterson Institute event and the debate between Saez and Summers. It’s very compelling, even if it does underemphasize one of the key challenges of implementing the wealth tax – the existential threat it poses to successful, private companies.
The Parity for Main Street Employers coalition and the S Corporation Association will host a Hill lunch briefing at noon on October 24th in the Kennedy Caucus Room (SR-325).
The briefing is open to Hill staff and tax professionals, and will focus on the pass-through sector and how it has fared under tax reform. Speakers include Senator Steve Daines (MT), Marty Sullivan with Tax Analysts, Bob Carroll with EY, and David Winston with the Winston Group. Box lunches will be provided.
You can see the official event flyer here. To RSVP, please contact us at email@example.com.
The American Enterprise Institute has a new“Trump Tax Reform Blog” series on its website. Over the next month, tax policy folks from both sides will weigh in on the reform and whether it’s working. You can read the current posts here. Our invitation to comment must have got lost in the mail, but no worries, it’s a brave new world and we can comment anyway. Here’s our report:
Has the TCJA helped American workers and businesses with additional economic growth? Such questions are impossible to answer with absolute certainty, since we will never know what the economy would have done without the TCJA’s adoption. The counter factual is an elusive beast.
That said, a solid case can be made that the TCJA has enabled our long-in-the-tooth economic expansion to continue with more energy, more investment, and higher wages, than it would have otherwise.
First, let’s start with economic growth. Jason Furman argues that the six months following the TCJAs adoption were slower than the six that preceded it. This is the wrong comparison, however. The counter factual might be elusive, but we know markets are forward looking. As soon as Trump was elected, business owners began to factor in expectations of a sizeable tax cut together with other pro-growth fiscal policies.
So the correct comparison would be the ten quarters prior to Trumps’ election verses the ten quarters that have followed it. You could include some sort of discount for the four quarters that followed the election but preceded the TCJAs adoption, since those quarters reflect an expectation of tax cuts rather than their reality, but we’re not sure that’s right. Wouldn’t investments made in the anticipation of tax cuts be just as valid as those made once it’s adopted?
So how does the correct comparison look? Pretty good for the TCJA. The pre-election average was 2.2 percent, while the post-election average is up at 2.7 percent. Half a percentage point of additional growth is significant, but the reality might be better than that. Take a look at the table below. Economic growth in the years prior to Trump’s election was a roller coaster ride of highs and lows, despite the fact that the economy was coming out of a financial crisis where you’d expect to see more consistent — and higher – growth levels. Despite coming six years into the expansion, the post-election growth numbers are more consistent, stable, and positive.
Second, let’s look at timing. Much of the economic pop of the TCJA comes from the combo platter of lower rates, full expensing, and international reforms designed to increase capital investment. But the American economy primarily is made up of consumption, so higher capital investment levels will only have a small immediate impact on the growth data. Their real contribution comes over time, as increased investments generates more jobs and higher wages. So how is Capex doing since Trump took office?
As Doug Holtz-Eakin recently wrote, it’s up consistently across the board for structures, equipment and intellectual property. Here’s the chart he used:
These higher levels of Capex promise better jobs and higher wages in the future, but just two years following adoption of the TCJA, its simply too early to see that in the economic data. We’ll just have to wait.
Third, a discussion of economic growth under Trump would be incomplete without a discussion of his trade policies. Just as the deregulation under Trump has helped spur economic activity, the trade battles he’s waged against Mexico, Canada, Europe, China – well, just about everybody – have instilled uncertainty and held back growth. CNBC had an excellent discussion of our trade challenges the other day, particularly regarding China and their recent history of stealing our intellectual property. The take-away from the conversation was that a stand-off with China was long-overdue. But the fact that our trade war with China may be justified doesn’t stop it from retarding growth and job creation, at least in the short term. Anyone reviewing the growth data over the past two years needs to take our trade policies into account when measuring the success of the tax cuts.
Our fourth observation is that the TCJA included many moving parts, with some of those provisions imposing short-term costs on the economy. A good example are the international reforms. The move from a world-wide tax system to a quasi-territorial system may be good for investment and growth in the long term, but businesses are still learning how the new rules work and many need to adjust their operations to fit the new regime. Both impose transition costs that should be taken into account. Over time, those transition costs will fade away.
Which brings us to our fifth observation – permanence. One item that popped from our member survey earlier this year is how many S corporations decided not to convert to C this year because they didn’t have confidence the 21 percent corporate rate was going to be around for long. This feedback was slightly ironic, as it’s the Section 199A pass-through deduction that’s temporary, not the lower corporate rate. It is counter intuitive that companies would choose to stick with the temporary policies because they don’t believe the “permanent” rates will survive long. Businesses don’t make long-term plans based on temporary tax policies. If Congress wants to see the full benefit of the TCJA, they need to convince the business community that these policies are going to be around for a while. The right first step in that direction would be to make the 199A permanent.