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When talking about Trump’s corporate rate reduction, do not forget pass-throughs

(Daniel Acker/Bloomberg)
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As information dribbles out regarding President Trump’s tax cut plan — that’s “tax cut” plan, not “tax reform” plan — we’re learning that the administration wants to cut the corporate rate to 15 percent. That’s a big drop from its current 35 percent rate, though many businesses pay less than that because of all the loopholes in the corporate code.

Per the Tax Policy Center’s analysis, the latest Trump plan would lose $2.4 trillion in revenue over 10 years (implying the plan doesn’t close nearly enough loopholes to make up the loss from the rate cut). Yes, Treasury Secretary Steven Mnuchin says the tax cut will “pay for itself,” but that’s wishful thinking with no empirical content.

But here’s the thing: In today’s American economy, you can’t talk about business taxation without talking about pass-through businesses, where people claim, or “pass through,” their business income as personal income.

According to the Tax Foundation:

Over 90 percent of businesses in the United States are pass-through businesses, whose income is reported on the business owners’ tax returns and is taxed under the individual income tax. These businesses earn the majority of all business income in the U.S. and employ over half of the private-sector workforce in 49 out of 50 states.

This afternoon the Wall Street Journal confirmed that the administration is planning to take the pass through rate down to 15 percent in the latest iteration of his plan. This creates a costly new loophole, and the revenue loss it generates — $1.5 trillion over the next decade — must be added to the $2.4 trillion loss from the corporate rate cut. About $900 billion comes from the lower rate of the pass-throughs, while the rest — 42 percent, as shown in the figure below — comes from tax avoidance 101: Wage earners incorporating as a business to tap the much lower rate than they’d have to pay on their paychecks.

As Chuck Marr (Director of Federal Tax Policy at the Center on Budget and Policy Priorities) and colleagues recently pointed out, this doesn’t do much for small, lower-income pass-throughs, as they already face low rates. But about half of pass-through income “flows to the top 1 percent of households, or those with incomes above $693,500 in 2016,” their report noted. “The top 400 taxpayers had an average of $37 million apiece in net pass-through income in 2014, the most recent year for which we have these data.”

This idea that we must talk about pass-throughs when we’re talking business or corporate tax reform may sound like a technicality. But if you’re concerned about the actual impacts of the tax plans we’re hearing about — a sea of fiscal red ink and higher after-tax inequality — vs. the fantasized impacts (more growth generating enough revenue to pay for itself), then this is one technicality to which attention must be paid.

UPDATE: This article has been updated to reflect new reporting from the Wall Street Journal confirming that President Trump plans to cut the top tax rate on pass-through businesses to 15 percent in his soon-to-be-announced tax proposal. The article also suggests that the new plan may include a top personal rate of 37 percent. If so, this amplifies my tax avoidance point. The difference between these two rates–37-15, or 22 percentage points–creates a huge incentive to reclassify labor earnings as business income. In the current code, this differential is 16 percentage points (40-24, the current top income rate minus the top capital gains rate).