Opinion | Finance

Congress' worst tax idea ever

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There's $400 billion or so lying on the sidewalk of the tax landscape that can fund really useful public spending, if only Congress could be bothered to pick it up. That's what Congress gave away in 2017 in the form of a tax subsidy for "qualified business income."

New data from Congress' own tax watchdog, the Staff of the Joint Committee on Taxation (JCT), confirms what many of us suspected all along: The subsidy isn't targeted to small business, or yeomen farmers but rather simply excuses the affluent from taxes imposed on the rest of us.

This is an extraordinary opportunity in an environment where Congress wages pitched battles over every billion dollars - or less. It's time to repeal this farcical giveaway and redirect the revenues to more worthy projects.

First, a little background: The top individual federal income tax rate (other than that applicable to capital gains and dividends) is now 37 percent, imposed on that portion of income that exceeds $600,000 (married filing a joint return - $500,000 for a single taxpayer).

A high-income employee pays tax at that top marginal rate. Income earned by partnerships and similar entities is not taxable to the entity but instead is taxed directly to the owners. (This is why they are called "pass-through" entities.)

In the absence of any giveaway, the top marginal tax rate imposed on individual owner-entrepreneurs in pass-through companies therefore also would be 37 percent.

Corporations pay tax at a 21 percent rate, but dividends paid out of after-tax profits are taxed at 20 percent in the hands of an affluent taxpayer, for an "all-in" tax cost of about 36 percent on distributed profits.  

The result is rough parity across different ways of earning money from a business. Pass-through businesses do not need a special low rate to be competitive.

And if for some reason the owners of a pass-through business look with envy on the corporate tax environment, they have a simple remedy - just incorporate the business. It's tax free to do so.

Most every privately-owned local business these days is organized as a pass-through - car dealers, restaurants, insurance agencies, real estate development or leasing, you name it. As a result, every congressional district is packed with pass-through companies, whose most successful owners populate the local country clubs and fund electoral candidates.

These owners believe that tax parity is an insufficient expression of national gratitude for all that they have done for us. In 2017, they therefore demanded and ultimately got a special low top marginal tax rate on their pass-through income of about 30 percent, rather than 37 percent.

The new discounted tax rate was enacted as an eight-year temporary provision for which the estimated revenue cost (tax revenues that would have been collected but for this new subsidy) was over $400 billion.

The rule has seven years to run, and, if anything, the original projection underestimated the cost to all taxpayers of this provision. Already, the drums are beating to make this permanent. President Trump's Byzantine structure of businesses are all pass-throughs, and it seems likely that he personally has benefitted from the new rule.

Of course tax giveaways are not presented as such when it comes time to lobby. Instead, lobbyists habitually envelop them in some shopworn tax nostrums, like "small business," "job creation" and "level playing field" (in this case, between pass-throughs and corporations, notwithstanding the absence of any demonstrable problem).

To that end, the 2017 tax law introducing the discounted tax rates for pass-through income included all sorts of purported guardrails and limitations to create the impression that this tax subsidy was aimed only at the most-deserving sorts of active businesses.

But the new data from the JCT staff puts the lie to all this. Some 92 percent of all pass-through income in 2019 will qualify for the discounted tax rate, which means that the guardrails and limitations are largely just opportunities for tax professionals to create work-arounds (and bill for doing so).

It is true that in 2019 about 95 percent of the claimants for "qualified business income" status will make less than $315,000/year ($157,500 for single taxpayers).

But the small minority of qualified business income claimants whose incomes are greater than that threshold (an income level that puts these fortunate individuals in the top 3 percent of all tax returns) will claim two-thirds of the benefits.

And by virtue of some of the technical intricacies of the law, many of those affluent individuals will be purely passive investors in various real estate ventures and the like, not heroic job creators. Indeed, the giveaway does not require any beneficiary to create new jobs as the price of enjoying the subsidy.

America's vast numbers of pass-through businesses have no legitimate claim to tax rates that are systematically lower than those imposed on comparable wage earners or corporate investors.

Phrased differently, if you were tasked with designing innovative federal programs to improve the lot of working Americans (enhanced earned income tax credits, or enhanced support for college and job training programs, for example), don't you think you could come up with better ways to spend $400 billion or so over the next several years than this?

Congress should repeal this shameful subsidy immediately and redeploy the money in ways that truly benefit all working Americans.

Edward Kleinbard is the Robert C. Packard Trustee chair in Law at the University of Southern California Gould School of Law. He's the former chief of staff at the U.S. Congress Joint Committee on Taxation.

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