By Richard Rubin
The last big U.S. tax overhaul is making the next one
harder.
A sweeping 1986 law invited business owners to avoid the
corporate income-tax system and enjoy lower taxes by passing
profits through to their individual returns.
Now, instead of a neat separation between business and personal
taxes, the U.S. system muddles them together. The two are tied so
closely that any attempt to equalize tax rates across industries
changes taxes for individuals.
That is complicating Congress's ability--despite bipartisan
agreement--to address discrete business-tax problems such as
inversions, where American firms move their tax address abroad, or
the forces that left the U.S. with the developed world's highest
corporate tax rate. The links between corporate and individual
taxation inevitably lock policy makers in intractable disputes
about popular deductions and the question that divides the parties
most bitterly: Is the U.S. collecting enough money from wealthy
individuals?
The complexities have prevented the biggest U.S. corporations
from getting the tax-rate cut they want. And they are bound to
bedevil the next president, too.
Until 1980, when the top individual rate was 70% and the
corporate rate was 46%, the two systems were largely separate. Big
businesses paid the corporate income tax, then when shareholders
got capital gains or dividends, they paid again on the same
profits. Small businesses paid as individuals.
The 1986 tax overhaul flipped that calculation, dropping the top
individual tax rate to 28% and the corporate rate to 34%. New
businesses saw little reason to become traditional C corporations
that pay the corporate tax--unless they planned to go public. That
has left the corporate tax as the domain of the largest companies.
Meanwhile, states liberalized business-formation laws and Congress
loosened eligibility rules for S corporations that don't pay the
corporate tax.
That brought about a proliferation of so-called pass-through
firms, which pass on profits to owners' individual returns. Today,
these range from small businesses to fast-growing new
companies.
By 2011, 54% of business income was earned by pass-through
entities, including sole proprietorships, partnerships and S
corporations. That's up from 21% in 1980, according to a study by
Treasury Department economists and academic researchers. These
companies pay lower tax rates--and they're not just mom-and-pop
shops anymore. Among them are hedge funds and global accounting
firms whose owners include some of the wealthiest people in the
country. The top 1% of households get more than two-thirds of all
partnership and S corporation income, according to the
study--something lawmakers need to be aware of, its authors
say.
"If they're not addressing pass-through income, they're missing
half of business tax reform," said Owen Zidar, a co-author of the
study and an economist at the University of Chicago's Booth School
of Business.
Still, many pass-throughs think they are disadvantaged because
the top individual rate of 39.6% exceeds the 35% corporate rate.
Last year, Rep. Paul Ryan (R., Wis.), who has since become speaker,
sought political overlap with President Barack Obama on a
corporate-rate cut and explored whether pass-throughs could accept
anything besides a corresponding rate reduction.
The message from the pass-throughs: No rate cut, no deal. Mr.
Ryan moved on.
Why did he listen? Pass-throughs have clout because they're
everywhere. They're the car dealers, manufacturers and real-estate
developers who fund congressional elections, and their focus on
individual tax rates permeates Republican tax rhetoric.
"There are large pass-throughs in every congressional district,
in every town in America," said Jon Traub, managing principal of
tax policy at Deloitte Tax LLP and a former House GOP tax aide.
"There are just more of them."
Now, the biggest corporations pressing for a rate cut are yoked
to pass-throughs and their tax rate. That means they are also yoked
to the movie stars, doctors and private-equity managers in the top
tax bracket.
"We believe in a completely more competitive American economy
and that means all aspects, big and small," said Jim Pinkerton,
co-chairman of the RATE Coalition, which seeks a lower corporate
rate and includes Verizon Communications Inc. and FedEx Corp. "It's
just pure politics. There are a lot of small businesses out there
and we wouldn't want to leave them out."
But if no one is left out, who's paying the taxes?
Senate Finance Committee Chairman Orrin Hatch (R., Utah) is
exploring integrating corporate and individual taxes by effectively
eliminating the second layer of tax on corporate income. The idea
is to make sure business income faces the same rate regardless of
whether it's in a corporation or not. He could give shareholders an
individual tax credit for their piece of corporate taxes or let
corporations deduct dividends.
Difficulties include potential problems for nonprofit
shareholders such as university endowments and the risk of
exempting more income than necessary. Simply ending capital-gains
taxation, for example, would make some income tax-free, such as
profit from selling real estate, because it never faces the
corporate tax. "Although the concept of taxing business income only
once is a simple one, the proposed methods for doing so are
anything but simple," a bipartisan report said last year.
Republicans are considering other ideas. One is a proposal from
Rep. Devin Nunes of California--mirrored by a presidential
candidate, Florida Sen. Marco Rubio--to let all businesses deduct
capital costs immediately and get a 25% rate. Democrats won't
tolerate the foregone revenue--and benefit to high-income
households--tied to those plans. They may prefer treating large
pass-through businesses as corporations.
Any of those solutions could be deemed fair. But what's fair in
tax policy, Mr. Traub says, is a philosophical question.
For now, policy makers are stuck. They agree on the need for
simpler, more efficient business taxes. But something small
inevitably turns into something big, and something big inevitably
turns into something politically impossible.
Write to Richard Rubin at richard.rubin@wsj.com
(END) Dow Jones Newswires
February 07, 2016 12:14 ET (17:14 GMT)
Copyright (c) 2016 Dow Jones & Company, Inc.