There has been much heated debate and hyperbole about many aspects of the Tax Cuts and Jobs Act, especially regarding the 20-percent deduction for pass-through businesses.
It has been called everything from an “opportunity for businesses to engage in tax planning” to “encourage[ing]…owners to find ways to game the system” to “perhaps the most notorious of the Trump tax changes.”
It is in this context that I would like to address comments made in an op-ed penned by my friend Ed Kleinbard, a respected tax law professor at the USC Gould School of Law and fellow former chief of staff for the Joint Committee on Taxation.
I should note first that Ed and I are actual friends, and not in the sense that some in Washington may call their worst enemies “my good friend.” Ed and I recently had dinner together, in fact, and I greatly respect him (even if I sometimes disagree with his conclusions).
Ed’s Op-Ed was entitled “Congress’ worst tax idea ever,” so right away I have to agree to disagree. More importantly, the op-ed makes a number of bold claims that have to be fleshed out, including:
“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.”
Clearly the provision provides significant tax benefits to owners of businesses who everyone will accept as being small — the Joint Committee on Taxation (JCT) estimates that 95 percent of taxpayers who will claim the deduction are “small,” and only 5 percent of those who will claim the deduction are “medium,” “large,” or “extra-large.”
Kleinbard: “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.”
I am starting to lose track of how often I need to explain this, but the current top marginal tax rate on income is not 37 percent. Ignoring state and local taxes on such income, which is another matter, that rate is 40.8 percent (just as it was 43.4 percent prior to the Tax Cuts and Jobs Act).
For passive owners and owners (passive or otherwise) of financial businesses, this includes the 3.8 net investment income tax, which is simply a surtax on income. For all other active owners, this includes the 2.9 percent additional Medicare tax and 0.9 percent Affordable Care Act tax — both of which are simply a surtax on income.
Obscuring an income surtax under the guise of taxing for Medicare, the ACA or upon net investment income is one of the more dishonest things that Congress has ever done in the history of the tax code.
Kleinbard: “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.”
The notion that corporate income is subject to double-taxation is one of the great myths of tax policy. In fact, very little corporate income is ever (or currently) subject to a second level of tax.
Because so little corporate income is in fact subject to a current, second-level of tax, it is simply incorrect that the taxation of an individual’s earned income (i.e., the treatment that applies to pass-through owners) would, but-for the section 199A deduction, be in “rough parity” with the taxation of corporate income.
First, the myth of the double-taxation of corporate income ignores the fact that the imposition of the tax is generally optional. For corporations that choose not to pay dividends and instead retain their earnings, the second-level of tax can be deferred in perpetuity.
Second, the myth of the double-taxation of corporate income ignores the fact that in many cases, dividends from a corporation are not subject to current tax.
The majority of corporate shares are held by tax-exempt (e.g., non-profits, foreign investors domiciled in a country with a zero-withholding tax treaty with the U.S., the beneficiary of a 529 account) or tax preferred entities (e.g., pension funds, owners of a 401(k), owners of an IRA).
Steven Rosenthal, senior fellow at the Tax Policy Center (TPC), testified at Senate Finance Committee Chairman Orrin Hatch’s (R-Utah) 2016 hearing on this subject.
Taking into account his testimony and other available information, it is likely that the amount of U.S. corporate earnings paid as dividends to currently taxable accounts is no higher than 9 percent, and the amount eventually subject to a second layer of tax in later years is likely no greater than 14 percent.
In contrast, owners of a pass-through business are always currently subject to full, current taxation at a maximum rate significantly higher than the corporate rate.
Kleinbard: “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).”
There are several problems with this argument. First, it conflates the amount of income that qualifies for the deduction with the number of persons earning the income who are eligible.
Second, it assumes that more income (by total amount of income) should be excluded from the deduction in order for the “guardrails” to be working properly. There is no data to support that claim.
The statutory guardrails are only designed to prevent high-income owners of certain types of service businesses from utilizing the deduction and likewise to limit the deduction where high-income owners do not either have significant amounts of depreciable property invested in their business or employ significant numbers wage-earners.
Thus, the statute is very targeted, and opponents of the provision have marshaled no data that demonstrates that less than 92 percent of pass-through income meets the criteria for inclusion.
For the many reasons described above, I respectfully (and completely) disagree.
Ken Kies is managing director of the Federal Policy Group, LLC. He is the former chief of staff of the Joint Committee on Taxation.