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

UPDATED
June 9, 2017

A centerpiece of President Trump’s tax plan and House Speaker Paul Ryan’s “Better Way” tax plan is a special, much lower top rate for “pass-through” business income, or income from businesses such as partnerships, S corporations, and sole proprietorships that is claimed on individual tax returns and currently taxed at the same rates as wages and salaries.  These businesses already have the advantage of being exempt from the corporate tax on profits and taxes on dividends.  Both Trump’s and Ryan’s plans would sharply cut the top rate on this income, from 39.6 percent to 15 and 25 percent, respectively — well below the plans’ proposed top individual income tax rates of 35 and 33 percent. This would overwhelmingly benefit high-income people; millionaires would receive more than two-thirds of the tax cuts ($114,000 on average) in 2018 from cutting the top pass-through rate to 15 percent, for example.  It would also create a costly loophole.  Reducing the top tax rate on pass-through income to 15 percent would cost $1.9 trillion over ten years, about 30 percent of which would be due to tax avoidance by high earners.[1]

Wealthy Investors Would Benefit Most

The biggest beneficiaries would be wealthy investors, since they receive most pass-through income and would receive the biggest rate cuts.  They include:

  • Households with incomes above $1 million, who would receive more than two-thirds of the benefits of cutting the tax rate on existing pass-through income to 15 percent, the Tax Policy Center (TPC) estimates.  Millionaires would receive tax cuts averaging $114,000 apiece in 2018, boosting their after-tax incomes by more than 5 percent. (These figures don’t include millionaires’ gains from tax avoidance, as explained below.) 
  • Hedge fund managers, lawyers, consultants, and investment managers, who are a significant share of pass-through business owners in the top tax bracket.
  • The 400 highest-income taxpayers in the country, who have average annual incomes exceeding $300 million each and receive about one-fifth of their income from pass-throughs, on average.
  • 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 earners, 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 $200,000 in taxes under the Trump provision.

About 30 percent of the $1.9 trillion cost of reducing the top tax rate on pass-through income to 15 percent would come purely from such tax avoidance, according to TPC.  That means that proposal would lose $584 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.  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’ incomes are already taxed at lower rates 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).  Indeed, only about 2 percent of households with incomes below $100,000 would get any tax cut from the provision.

 

Figure 1
Trump-Like Pass-Through Rate Cut Would Not Benefit Low- and Middle-Income Americans

 

“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 C corporation profits may face the corporate income tax and, when distributed to shareholders, the tax on dividends.
  • 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.

  • 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.

In recognition of these poor outcomes, in June, a bipartisan two-thirds majority of the Kansas legislature overrode Gov. Brownback’s veto reversing most of the tax cuts — including repealing the pass-through exemption.

End Notes

[1] For our full analysis of the pass-through tax break, see Chuck Marr et al., “Trump Tax Plan’s Pass-Through Tax Break Would Provide Massive Windfall to the Wealthy,” Center on Budget and Policy Priorities, May 22, 2017, http://www.cbpp.org/research/federal-tax/will-new-trump-tax-plan-include-pass-through-tax-break-for-wealthiest.