Tax reform is one of the top goals of the Trump administration. But the most important tax reform is being overlooked—even ignored. Reworking the taxation of pass-through income and reducing its burden may have a far broader effect on economic performance. This includes workers’ wages and employment demand. Lowering corporate taxes will surely have an impact on the actions of businesses… but not to the extent of lowering pass-through tax rates.
People who own their own companies (i.e., partnerships, LLCs, and certain types of corporations) pay taxes that are “passed-through” to them. Instead of paying taxes at the corporate level, the taxes are paid at the individual’s marginal tax rate. This distinction matters. And the way in which the tax code evolves to address this issue will affect the economic efficacy of tax reform.
Small businesses are the lifeblood of the US economy
There’s a well-known saying: small businesses rule the US economic landscape. From employment to hiring, they are the lifeblood of the US economy. Google and Facebook may get the headlines, but make no mistake, the US economy relies on the little guys.
These same small businesses make up the vast majority of pass-throughs. In fact, according to the IRS, the number of pass-through entities has increased over the past 30 or more years. Since this is where the US economic engine is housed, there should be no confusion about where the tax code could have the biggest impact. Despite this rise in popularity, there has been little talk about just how much these businesses matter to the US economy.
But will pass-throughs garner more attention with a renewed policy toward job creation? Maybe, but it is quite unclear. The Trump administration’s main focus thus far has been manufacturing and trade fairness…not on reforming the US economy to get the most out of its spending.
But manufacturing rules the day
The emphasis placed on manufacturing could be why pass-through income tax reform is on the back burner. (Or why it has yet to become a part of the debate.) According to the Census Bureau, manufacturing is largely formed under the traditional corporate umbrella. This means that there would be a greater effect on manufacturing employment and profits through corporate tax reform than pass-through tax reform.
Politically, it could also be tricky. Many of the higher wage earners in the US get their income from pass-through channels. It could easily be seen as a tax break for the rich without a real accounting of the potential benefits.
Viewing it as a tax break for the rich, though, is too simple. Individuals being taxed at the highest marginal rates on pass-through income are in the top bracket of personal income. And, reducing pass-through tax rates without changing the tax code fully would require lowering the highest brackets of individual tax rates to at least as low as the corporate tax rate.
It’s too important to ignore
With the sheer importance of what pass-throughs have become to the US economy, it is strange that there has not been more talk of their health and security. More people in the US are employed by these structures than traditional corporations… and pass-throughs rule the services industries.
Yet, according to the Tax Foundation, the average marginal tax rate is over 47%, (with some states higher and some lower). If there is ever a real debate on whether companies or individuals should get the bulk of the tax cuts, it should be noted that often they are one and the same.
Yes, this complicates the debate on tax reform. After all, the taxes paid by most of the businesses in America are not at the often-cited corporate tax rate. To truly reform the business tax code, Congress will also need to tackle the individual tax code or make a specific provision.
The House GOP “A Better Way” plan calls for a top tax rate on pass-through income of 25%. This contrasts with the top tax bracket for income proposed at 33%. This may mean there is some recognition of the importance of pass-throughs, but it may just be part of an emphasis on lower corporate taxes.
Tax reform is needed. The code is highly complex. There are too many loopholes. But pass-throughs—the intersection of individual and corporate taxes—are arguably the most important and least acknowledged area. Whether you are a business owner or an employee, more Americans will benefit from reforming the pass-through tax code than from traditional corporate reform. Pass it on.