Concerns over Passthrough Taxation are Understandable but Misplaced

Tax reform should be profoundly pro-growth. The Tax Cuts and Jobs Act legislation recently passed by the House of Representatives and the Senate Finance Committee bill each meet that test. Being pro-growth means the legislation should reduce tax rates and otherwise advance reforms strengthening all kinds of businesses comparably across all industry sectors.

Some members of Congress have expressed concerns passthrough businesses are not given a fair shake in the current tax reform bills. These concerns ought to be taken seriously. However, careful consideration of both bills reveals the concerns to be misplaced. Both the House bill and the Senate bill in its current form are very positive for passthrough businesses and are highly comparable in their benefits between business forms, which not coincidentally explains why the U.S. Chamber of Commerce and nearly all major small business advocacy groups support both bills.

The most obvious comparisons are the tax rates. The House bill would impose a top rate of 20% on corporations and 25% on a proxy measure of passthroughs’ capital income. Taking into account the double taxation of corporate income and the 15% qualified dividend tax rate leaves a 32% combined rate on corporate income.

The Senate bill takes the different approach of specifying a 17.4% deduction against all passthrough income which, when combined with a top rate of 38.5% on individual income leaves an effective rate of 31.8%, or nearly identical to the combined 32% corporate tax rate. Some might argue disregarding the dividend tax rate because corporations retain a lot of income and this is certainly true, but such retentions produce capital gains which are subject to a top 20% tax rate upon realization. Other permutations can complicate the picture further, but the bottom line conclusion is that passthroughs and C corporations face comparable tax rates under the Senate Finance Committee bill.

If business forms pay comparable tax rates, and if the Chamber and small business groups are supporting the bills, then what’s the problem? Why are some members still concerned? The answer pops right out of the Joint Tax Committee revenue tables.

Consider the bill as introduced in the Senate Finance Committee. Under this bill, the lower corporate tax rate generates $1.329 trillion in tax relief over 10 years, while the passthrough deduction generates $459.7 billion in tax relief, or about 34% of the relief going to C corporations. Some of the revenue loss associated with reducing the top individual tax rate also accrues to passthrough owners, but for ease of argument we will set this aside. Also, in both cases much of the revenue loss is offset by various base broadening provisions applying to all forms of businesses. On balance and on the face of it, the revenue figures associated with the rate reduction for C corps and the deduction for passthroughs sure give the impression C corporations are getting the better deal.

This impression is reinforced by observing that passthroughs earn about half the total business income in America; C corporations earning the other half. If passthroughs and C corporations each earn about the same amount of income in the aggregate, then if their rate reductions are comparable then shouldn’t the revenue foregone due to rate reductions be comparable? This is a fair question and members are right in asking it.

The correct answer is that, no, the two amounts of revenues foregone due to rate reduction need not and probably should not be comparable, the confusion deriving from a case of mistaken identities. The issue isn’t a lurking intent to sleight passthroughs, nor is it a clumsy mistake on the part of the bill’s drafters. The issue is that a passthrough’s business income differs from its business profits.

For C corporations, business income is equivalent to business profits, or total returns less all costs including labor and capital costs. But passthrough business income includes a mix of returns to productive capital like machinery and buildings, properly called business profits, and the earnings accruing to the business’ owners over and above what they paid themselves in salary. Passthrough business income is a combination of business profits and additional returns to labor accruing to the owners.

What would be an appropriate relationship of the respective revenue loss if rate reduction benefits passthroughs and C corporations comparably? Answering this question definitively requires a confident estimate of passthrough profits. Unfortunately, as the House bill’s “guardrail” provisions involving 70/30 splits and the like attests, no such ready measure is available. The closest one can come is to estimate how much productive capital and other assets like goodwill a firm owns and then apply some rate of return. Any amount over and above this calculation would then be additional labor income to the firm’s owners.

All is not lost, however. The Federal Reserve has come to our rescue. Table Z1 reports a statistical series including a measure of the total capital “consumed” for passthroughs and C corporations. For 2017, passthroughs will use up about $333 billion in physical capital assets, or an amount equal to about 23% of the $1,413 billion in physical capital C corporations will use up.

Capital-intensive passthroughs and C corporations probably have fairly similar capital stock compositions in the aggregate, and likewise on average earn fairly comparable returns on investment in physical capital. But the differences in totals surely do not render capital employed by passthroughs four times more profitable than for C corporations, which is why comparable reductions in tax rates shouldn’t have comparable tax revenue consequence. In the Senate bill the ratio of tax reduction revenues for passthroughs to C corporations is about 34%, remarkably close to the 23% ratio of their respective capital consumption amounts.

Passthrough businesses play a vital role in America’s economy and should enjoy all the benefits from tax reform as their C corporation cousins. To the greatest extent possible, all forms of businesses should face the same tax system, and tax reform should no more tilt the choice of business form than should current law. Tax reform is unlikely to achieve these goals precisely, but both the House and the Senate Finance Committee tax reform bills make very good progress. Those determined to see passthroughs get a fair shake were right to raise their questions, and should now be more confident that the businesses in their own districts and states calling in to support tax reform and the national small business advocates supporting tax reform have it right.

About the authors

J.D. Foster

Dr. J.D. Foster is the former senior vice president, Economic Policy Division, and former chief economist at the U.S. Chamber of Commerce. He explores and explains developments in the U.S. and global economies.