Column: The ‘pass-through’ loophole in the Trump tax plan is a huge handout to the 1%
One nauseating chore that comes up whenever congressional Republicans propose a tax cut is hunting down all the tax breaks for the wealthy concealed in its thickets.
The big one in the tax plan issued last week by the GOP and President Trump involves what’s known opaquely as “pass-through” business income. Even that term might have been too revealing, so the document the Republicans issued described it even more obscurely as a “tax rate structure for small businesses.” That’s also dishonest, however, because the businesses it affects are often nothing like “small.”
We’ve mentioned this particular tax giveaway in conjunction with a broader analysis of the GOP tax plan, but it’s worth detailed scrutiny all by itself. That’s especially true because among the rather large taxpayers with lots of businesses subject to pass-through rules are President Trump and his offspring. They’re in line for some healthy tax breaks if the proposal goes through.
Pass-through business income is substantially more concentrated among high-earners.
— Economist Michael Cooper and colleagues in a 2015 report
Let’s start with some basic definitions. “Pass-through” income is business income that’s reported to the IRS only by individual owners of, or partners in, the business. These businesses can be organized as partnerships, S-corporations, or sole proprietorships. They’re distinguished from C-corporations, which are almost always big businesses with public stockholders; C-corporations pay the corporate income tax, and the shareholders pay personal income tax on their dividends and capital gains.
Over the last 30 years or so, pass-through rules have been a boon to the 1%, who take great pains to designate as much of their business income as possible as pass-through earnings rather than C-corp income. That’s because individual tax rates are generally lower than corporate tax rates.
The Trump/GOP tax plan wants to make this arrangement even better for the 1%, by taxing pass-through income at a rate even lower than the ordinary individual tax rate. Currently, the top marginal individual rate is 39.6%; the new tax proposal would reduce the top rate on pass-through income to 25%. Pass-through income from an S-corporation, by the way, already is exempted from the Affordable Care Act surcharges that raised the top income tax rate on some high-income earners by as much as 4.7 percentage points.
“Pass-through business income is substantially more concentrated among high-earners” than traditional business income, Treasury Department economist Michael Cooper and several colleagues observed in a 2015 paper. They also found that about one-fifth of it went to partners that were hard to identify, and 15% got sucked up into circles of partnership-owning partnerships, complicating IRS analyses. They concluded that the growth of pass-through businesses since the 1980s, when the rules began to get liberalized, cost the treasury an annual $100 billion by 2011, compared with what would have been collected absent the growth of pass-through arrangements. The effect is felt by all taxpayers, who have to pick up the slack from the handouts to the wealthy.
And those arrangements sure have grown. Roughly 80% of all business income was earned by traditional C-corporations in 1980. That figure was down to 45.8% by 2011, Cooper and his co-authors found.
The trend, moreover, has been a major contributor to the growth of income inequality in the United States. The income share of the top 1% doubled to 20.1% in 2013 from 10% in 1980, and more than 40% of that increase can be traced to higher pass-through income.
Despite the tax plan’s claim that the pass-through cut is aimed at “small businesses,” that’s a misrepresentation. Aaron Krupkin and Adam Looney of the Brookings Institution point out that while sole proprietorships tend to be small — “babysitters and housekeepers, ride-sharing drivers, construction or handyman services, and even some doctors and lawyers” — other forms of pass-through businesses can be immense.
“Most hedge funds, private equity funds, law, consulting, and accounting firms are partnerships,” they note; “these businesses can be large, global enterprises.” About one-fourth of all pass-through partnership income is earned by finance, real estate and holding companies, and another 13% by law firms.
Over the years, tax legislation has made these arrangements ever more lucrative for their wealthy exploiters. The top individual income tax rate fell below the corporate tax rate in 1986, Krupkin and Looney observe, creating an incentive for C-corps to de-incorporate and reorganize as pass-throughs. The law raised the maximum number of S-corporation shareholders in stages to 100 today from 15 in 1980, they add, while allowing up to six generations of family members to be treated as a single shareholder.
Experience with liberalized pass-through rules isn’t encouraging. The only state that has done so is Kansas, which completely exempted pass-through income from state tax in 2012, under its tea-party Republican Gov. Sam Brownback. The consequences emerged quickly, with pass-through income reported by eligible taxpayers spiking by 11% between 2012 and 2014. Although Brownback promised that supercharged economic growth would allow the exemption and other tax cuts to pay for themselves, in fact revenues plummeted, creating a budget crisis. The state Legislature repealed the pass-through carve-out in June, over Brownback’s veto.
The GOP’s tax “framework” says it’s counting on Congress to adopt rules to prevent rich taxpayers from manipulating the pass-through rules to avoid paying the top personal tax rate, but why should anyone believe that? The whole goal of loosening the rules on pass-through income over the last 35 years has been to deliver a benefit to the wealthy, and there are no signs that today’s GOP will adopt a different goal.