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Pass-Through Deduction Benefits Wealthiest, Loses Needed Revenue, and Encourages Tax Avoidance

A centerpiece of the 2017 tax law is a new, 20 percent deduction for certain “pass-through” income, or income from businesses such as partnerships, S corporations, and sole proprietorships that business owners claim on their individual tax returns.[1]  This deduction effectively reduces the marginal tax rate on this type of income — which before the 2017 law was taxed at the same individual tax rates as the business owner’s other ordinary income — by as much as one-fifth and well below the rate on labor income, such as that from wages and salaries.

This pass-through deduction is a prime example of the 2017 tax law’s three fundamental flaws:  it is heavily tilted toward the wealthy, loses significant revenue at a time when we need to be raising revenue, and makes it easier for wealthy people to game the tax system.  This provision, which a leading tax scholar recently dubbed “one of the worst provisions that’s been added into the tax code in the last several decades,”[2] should be repealed.

Heavily Tilted Toward Wealthy

The pass-through deduction effectively cuts the marginal tax rate on pass-through income by up to 20 percent.  While the 2017 law’s proponents have said the deduction is designed to help “small business,” it is heavily tilted to the wealthy and big business:  an analysis by the Joint Committee on Taxation (JCT) estimates that 61 percent of the pass-through provision’s benefits will go to the top 1 percent of earners in 2024 (see chart). A mere 4 percent will go to the entire bottom 67 percent.

The deduction’s regressivity is baked into its basic structure for three reasons:

  • Most pass-through income flows to the very highest-income people, and from very large businesses. The top 1 percent alone receive more than half. And while only 0.4 percent of S corporations had receipts over $50 million in 2012, these (hardly small) businesses earned 40 percent of all S corporation income.
  • Pass-through income makes up a much larger share of income for high-income households than for the middle class.  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.
  • Each dollar of pass-through income that’s deducted is worth more as a tax break for high-income people, since they face the highest regular individual tax rates. For example, each dollar deducted would save up to 37 cents of tax for a multi-millionaire since she is in the 37 percent bracket, but only up to 22 cents for a small business owner in the 22 percent bracket (those with taxable incomes between $77,400 and $165,000 for a married couple).

Loses Much-Needed Revenue

The 2017 tax law will cost a total of $1.9 trillion from 2018 to 2027, according to the Congressional Budget Office (CBO). CBO estimates that the law could generate additional economic growth to offset a small share of this revenue loss, but — when adding interest costs from the new debt that the law will incur — it still costs $1.9 trillion.  The pass-through deduction is a major contributor to these revenue losses. In December, JCT estimated that the deduction will cost more than $50 billion per year and that it will make up more than a fifth of the law’s overall cost beginning in 2021.  Like other elements of the law, it is set to expire after 2025, though leading Republicans say they want to make it permanent — without offsetting its cost.  And some experts estimate that the cost could grow even larger if predictions for widespread abuse prove true.[3]

These large revenue losses are irresponsible given the fiscal challenges the nation will face over the next several decades, such as the aging of the population, health care costs likely continuing to rise faster than the economy, interest rates returning to more normal levels, potential national security threats, and challenges such as large infrastructure needs that cannot be deferred indefinitely.  The nature and magnitude of these fiscal pressures will require revenue to rise as a percentage of GDP to prevent an unsustainable rise in the nation’s debt ratio over coming decades.

Invites Rampant Gaming of Tax System

The pass-through deduction weakens the integrity of the income tax system because of its fraught design.  And it could wind up being even more expensive and delivering larger tax cuts to high-income filers than current estimates show because it creates a significant gaming opportunity:  high-income individuals may now be able to secure very large tax savings by converting their labor income into pass-through income to take advantage of the new deduction.

This incentive existed under prior law, but to a lesser extent.  For instance, since profits from certain types of pass-throughs, such as S corporations, aren’t subject to the payroll tax, wealthy S corporation owners previously could understate their labor income and overstate their income coming from pass-through profits, thereby avoiding the 3.8 percent Medicare payroll tax that high earners pay.  Under the 2017 law, the same shifting of labor income to pass-through income can provide roughly triple the tax savings, as the potential disparity between the tax rates on labor income and certain pass-through profits for the highest earners has now grown from 3.8 percent to 11.2 percent.

While the 2017 tax law includes complex “guardrails” intended to prevent such abuse, they are poorly designed.  Tax experts have suggested, for example, that highly paid doctors’ medical practice income is not eligible for the pass-through income deduction, but that a group of doctors could create a real estate pass-through company, which would be eligible.  Then, having the company own the medical practice’s building and charge extremely high rent would mean that a significant portion of the doctors’ income would accrue to that company and qualify for the deduction.

Beyond inviting abuse, these guardrails’ arbitrariness weaken the entire income tax.  For instance, a last-minute change to the tax bill excluded architects and engineers from the list of “professional services” that cannot receive the deduction.  The law’s drafters provided no policy rationale for this last-minute change; rather, these industry-based exclusions appear simply to favor some industries over others.  As New York University law professor David Kamin noted in recent congressional testimony, “This pass-through deduction represents the very worst kind of tax policy, picking winners and losers haphazardly in a complex tax provision, and then generating significant incentives for people to rearrange their businesses to try to get on the right side of the line.”[4]

May 10, 2018

[1] For further information, see Chuck Marr, Brendan Duke, and Chye-Ching Huang, “New Tax Law Is Fundamentally Flawed and Will Require Basic Restructuring,” Center on Budget and Policy Priorities, April 9, 2018, https://www.cbpp.org/research/federal-tax/new-tax-law-is-fundamentally-flawed-and-will-require-basic-restructuring.

[2] See Chye-Ching Huang, “Senate Hearing Testimony Highlights 2017 Tax Law’s Fundamental Flaws,” CBPP, April 25, 2018, https://www.cbpp.org/blog/senate-hearing-testimony-highlights-2017-tax-laws-fundamental-flaws.

[3] Mihir Desai, “Tax Reform, Round One,” Harvard Magazine, May-June 2018, https://www.harvardmagazine.com/2018/05/mihir-desai-tax-reform.

[4] Huang, “Senate Hearing Testimony Highlights 2017 Tax Law’s Fundamental Flaws.”

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