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Pass-Through Tax Break Would Benefit the Wealthiest and Encourage Tax Avoidance

April 5, 2017

A centerpiece of President Trump’s campaign tax proposal and House Speaker Paul Ryan’s “Better Way” tax plan is a special, much lower top rate for “pass-through” business income — which is currently taxed at owners’ individual income tax rates rather than the corporate rate and then as dividend income in the hands of shareholders. About half of pass-through income flows to the top 1 percent of households, while only about 27 percent goes to the bottom 90 percent of households.

Both Trump’s and Ryan’s plans would cut the top rate on this income sharply from its current 39.6 percent rate to 15 percent and 25 percent, respectively — well below the 33 percent top individual income tax rate both plans propose. This would overwhelmingly benefit high-income people and create a costly loophole. Trump’s proposed pass-through rate cut would cost $1.5 trillion over ten years, accounting for about one-fourth of his campaign tax plan’s total cost.[1]

Wealthy Investors Would Benefit Most

The biggest beneficiaries would be the less than 2 percent of pass-through owners that are currently taxed at the 39.6 percent top tax rate and hold a disproportionate share of pass-through income. Not only does this group account for most pass-through income, they’d also get the biggest rate cuts, and thus the largest tax cuts per dollar of pass-through income.

Those who could benefit from this tax break include:

  • Hedge fund managers, doctors, lawyers, consultants, and investment managers, who are the majority of pass-through business owners in the top tax bracket.
  • The 400 highest-income taxpayers in the country, who have annual incomes exceeding $300 million each and receive about one-fifth of their income from pass-throughs.
  • Business owners like President Trump, who owns about 500 pass-through businesses, according to his attorneys. Because he exemplifies the type of business owner who could benefit the most from this tax break, it has sometimes been referred to as the “Trump loophole.”

Proposals Would Encourage Large-Scale Tax Avoidance

A special lower tax rate for pass-through income would spur large-scale tax avoidance by high-earning employees, who would have a major incentive to reclassify their wage and salary income as “business income” to get the lower pass-through rate. For example, a law firm partner who reclassified her $1 million salary as business income from the law firm would save $180,000 in taxes under the Trump provision.

More than 40 percent of the $1.5 trillion cost of the provision in the Trump plan would come purely from such tax avoidance, according to the Tax Policy Center (TPC).  That means that proposal loses $650 billion to tax avoidance by high earners alone, easily exceeding the provision’s total tax cuts for the bottom 99 percent of the population.

It would be hard to prevent such gaming. Congress and the IRS already struggle to design and enforce rules preventing high earners from reclassifying their wages as “business income” to avoid payroll taxes, and this tax break would create an even greater incentive to use such schemes.

Tax Cut Wouldn’t Help Most Small Businesses

Most small businesses are in fact “small,” and most small business owners have incomes that are already taxed at rates lower than the top rate in the Trump and Ryan proposals, so they would not benefit from cutting the tax rates that only high-income filers face. Almost 70 percent of filers with pass-through income are currently taxed at a statutory marginal income tax rate of 0, 10, or 15 percent.  More than 97 percent of filers with pass-through income face statutory marginal income tax rates below 33 percent.  (See Figure 1).

 

Figure 1
Most Pass-Through Filers Are Already Taxed At Lowest Individual Tax Rates

 

“Parity” Argument Is Misleading

Proponents argue that a lower pass-through rate is necessary to establish “parity” between taxes paid by pass-throughs and “C corporations” that pay the corporate income tax. But that’s misleading.

  • Pass-throughs pay only individual tax, while corporations may face corporate income taxes as well as dividend taxes at the shareholder level.
  • Setting the top rate on pass-through income equal to the top corporate tax rate thus means that pass-through income will, on average, be taxed at much lower rates than corporations. Indeed, many businesses already choose to be taxed as pass-through entities instead of as corporations because it lowers their total taxes.

Kansas Has Felt Effects of Ill-Advised Tax Cuts for Pass-Throughs

As part of an aggressive set of tax cuts championed by Governor Sam Brownback, in 2012 Kansas exempted pass-through income from all state income taxes, with damaging results. The Kansas legislature recently passed bipartisan legislation to close the loophole, although Governor Brownback vetoed the bill.

  • Kansas’ private-sector job growth, economic growth, and growth in small business formation have lagged behind the country as a whole since the tax cuts.
  • The tax cuts wreaked havoc on the state’s budget, with the pass-through exemption alone costing $472 million in 2014, leading Kansas to cut services, drain “rainy day” funds, delay road projects, and turn to budget gimmicks. Two bond rating agencies have downgraded the state due to its budget problems.

End Notes

[1] For our full analysis of the pass-through tax break, see Chuck Marr et al., “Will New Trump Tax Plan Include Pass-Through Tax Break for Wealthiest?” Center on Budget and Policy Priorities, February 27, 2017, http://www.cbpp.org/research/federal-tax/will-new-trump-tax-plan-include-pass-through-tax-break-for-wealthiest.