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Pass-Throughs and Corporations Had No Parity to Maintain

May 1, 2018 at 11:00 AM

Among the 2017 tax law’s most flawed parts is a large tax break for certain “pass-through” income — which the owners of businesses such as partnerships, S corporations, and sole proprietorships report on their individual tax returns rather than pay the corporate tax. Its proponents misguidedly argued that it was needed to maintain “parity” (i.e., a level playing field) between these businesses and corporations, since the latter would benefit from the law’s deep cut in the corporate tax from 35 percent to 21 percent. Although there was no parity between these two types of business taxes before the 2017 tax law to begin with, proponents continue to argue for parity in order to justify this tax break, as a recent Senate Finance Committee hearing shows.

The parity argument has always been misguided. Pass-through businesses enjoyed a significant tax advantage over corporations before the 2017 law, researchers found, and the owners of pass-through entities who think they’ll pay less in tax if their businesses are organized as corporations can always convert their businesses to corporate status. With a faulty rationale to address a problem that didn’t really exist, those who wrote the new tax law gave pass-through businesses a new tax break that created real problems: it mainly benefits the wealthy, loses large amounts of revenue, and greatly expands an existing tax loophole that invites many wealthy individuals to game the system.

To reverse the damage of this and other flawed provisions of the 2017 tax law, policymakers need a clear-eyed view of the tax challenges the nation confronts.

Consider:

  • There was no parity to maintain. The parity argument is based on a comparison between pass-through and corporate tax rates, but a proper comparison would account for both levels of tax that corporate profits face. Along with the corporate tax, corporate profits face a second tax when shareholders receive the profits (in the form of dividends) and must pay tax on them. In contrast, a pass-through business pays tax at only one level, on the owner’s individual tax return. Proper comparisons — like those by the Congressional Budget Office and economists from the Treasury Department — showed that before the 2017 law, pass-through businesses enjoyed a significant tax advantage over corporations. Indeed, the share of income going to pass-throughs has grown dramatically in recent decades due to this advantage.
  • If businesses desire parity, they can easily attain it. The owners of pass-throughs can always achieve parity with corporations simply by converting their businesses to C corporations. Under the 2017 tax law, as tax expert Michael Schler noted, “by merely checking a box on a tax form, a pass-through business can elect, on a tax-free basis, to be a C corporation and obtain” the new 21 percent corporate tax rate. That businesses could do so makes it hard to justify the pass-through break’s large fiscal cost and the numerous loopholes it creates.
  • Responding to a false parity problem has made a real disparity larger. Under the 2017 tax law, the individual income tax will now treat the profits from certain types of pass-through income differently from labor income. This is a powerful incentive for high-income pass-through owners to understate their labor income and overstate their pass-through income to maximize the pass-through break. That was already a big problem for the payroll tax before the 2017 law, since profits from certain types of pass-throughs, such as S corporations, aren’t subject to the payroll tax. Wealthy owners of these pass-throughs, therefore, frequently understated their labor income to avoid the Medicare payroll tax, which tops out at 3.8 percent for the highest earners. But under the 2017 tax law, the potential disparity between labor income and certain pass-through profits for the highest earners has grown from 3.8 percent of that income to 11.2 percent, or roughly triple its size before the law. This and other features amount to an open invitation for wealthy individuals to engage in rampant tax gaming.

In short, the pass-through provision is deeply flawed. From a Joint Committee on Taxation analysis, we estimate that 61 percent of its benefit will flow to the top 1 percent. This windfall will cost $415 billion over ten years, and roughly $50 billion a year after 2021. And because of its incentive for rampant gaming, it poses a risk to the integrity of the income tax. That’s why policymakers should repeal the pass-through tax break.

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