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An Easy Call on How to Pay for Student Loan Plan

Policymakers across the political aisle agree that we should avoid the sharp increase in interest rates on student loans scheduled for July 1, but that consensus falls apart when it comes to how to pay for the proposal.

It shouldn’t.  This should be an easy call.

One option, which the House approved last week, would eliminate a fund that promotes preventive health care.  The other, much more sensible option (which the Senate will consider next week) would crack down on people who underreport their income to the IRS, thereby addressing a significant tax compliance problem that we have previously described.

The issue concerns S corporations, which — instead of paying corporate income tax — “pass through” their profits (and losses) to shareholders, who pay taxes on those profits at individual rates.  Many S corporation shareholders receive both wages from the S corp and a share of the S corp’s profits, but they pay payroll tax only on their wages.  This gives them a huge incentive to underreport the share of their income that consists of wages in order to reduce their payroll tax liability.

While such employee-shareholders are supposed to report “reasonable” compensation to themselves, many don’t — as several investigations have documented:

  • The Government Accountability Office calculates that in 2003 and 2004, S corporations underreported about $23.6 billion in wage compensation to shareholders, “which could result in billions in annual employment [i.e., payroll] tax underpayments.”
  • The Treasury Department’s Inspector General for Tax Administration has concluded that “The S corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses.”
  • Separately, analyzing 84 suspect S corporation tax returns, the IG found that shareholders reported average wages of $5,300 and average profit distributions (which are exempt from payroll taxes) of $349,323.

The Senate proposal is a step in the right direction — and far preferable to the House approach, which would eliminate the Prevention and Public Health Fund, which Congress established under health reform to help improve overall health and contain health care costs.

Among other things, the fund supports community-based initiatives to prevent obesity, reduce tobacco use, improve treatment for those with mental illnesses and substance abuse problems, and promote better nutrition and more physical activity.  It also helps states and localities prevent, detect, and respond to outbreaks of infectious diseases.

But, in opting for better tax compliance over eliminating support for improved preventive health measures, Congress should also change the Senate provision so it applies to all taxpayers, not just those with incomes above $250,000.  There shouldn’t be an income limit on honesty.  Besides, the provision should not violate no-tax pledges of any kind because, after all, we are talking about a measure intended to ensure that people pay taxes that they already owe under current law, not tax increases that policymakers are suddenly imposing on them.

Chuck Marr
Vice President for Federal Tax Policy