Senate’s “Pass-Through” Tax Cut Favors Biggest Businesses and Wealthiest Owners

The tax bill that the Senate Finance Committee will consider this week includes a tax cut for “pass-through” businesses that’s heavily skewed to the biggest businesses and the wealthiest business owners.

Pass-through income is income from businesses such as partnerships, S corporations, and sole proprietorships that business owners claim on their individual tax returns and that’s taxed at the same rates as wages and salaries. The bill would let business owners deduct 17.4 percent of their pass-through income from their taxable income, meaning that that amount would be tax free. The plan imposes some restrictions for service businesses and limits the deduction amount to 50 percent of certain wages that the business pays.

We don’t yet have estimates for how the proposal would affect different income groups, but the Tax Policy Center (TPC) examined a similar 2012 proposal from then-House Majority Leader Eric Cantor for a 20 percent deduction for certain pass-through income, capped at 50 percent of the business’s wages. It would have given 49 percent of its tax cuts to households with annual incomes over $1 million, TPC found, and just 16 percent to households with incomes below $200,000. The percentage increase in after-tax incomes would have been 20 times as much for millionaires as for households making less than $100,000, on average, TPC concluded.

The Senate proposal differs from Cantor’s in some ways, but it has the same underlying deduction structure, which delivers the bulk of its benefits to very large businesses and high-income business owners because:

• Most pass-through income flows to the very highest-income people, and from very large businesses. The top 1 percent of filers reap more than half of all pass-through income. And while only 0.4 percent of S corporations had receipts over $50 million in 2012, they earned 40 percent of all S corporation income.
• Higher-income people get a larger share of their total income from pass-throughs. The top 1 percent of households get more than a fifth of their income from pass-throughs, compared to less than 6 percent for households in the middle 60 percent of the income distribution.
• As with every deduction, each dollar of pass-through income that’s deducted is worth more for high-income people, since they face the highest tax rates. The value of a deduction is tied to a household’s tax rate. For example, under the Senate bill’s proposed rates, each dollar deducted would save up to 38.5 cents of tax for a multi-millionaire, since she’d be in a 38.5 percent bracket, but only up to 22.5 cents for a small business owner in the 22.5 percent bracket (those with adjusted gross incomes between $77,400 and $120,00 for a married couple).

For these reasons, any distributional analysis of the new Senate proposal will also almost certainly show that it’s very concentrated on the highest-income filers and businesses, and that it boosts their after-tax incomes by a greater percentage than for lower-income households and truly small businesses. And the Senate bill has weak “guardrails” to stop high earners from engaging in tax-avoidance schemes to reclassify their salaries as “business income” in order to take the deduction.

Moreover, other parts of the Senate bill could harm true small businesses. For instance, its “territorial” tax system, which gives foreign earnings preferential treatment over domestic earnings, would give a huge tax advantage to multinationals over domestic corporations and small businesses. And its regressive tax cuts would add at least $1.5 trillion to budget deficits, which could create a drag on the economy and increase the risks that policymakers would respond to the higher deficits by cutting federal investments in areas that are critical for thriving U.S. businesses, like infrastructure and education.