Tax reform won't help most businesses

Non-corporate businesses may end up subsidizing tax breaks for corporations.

To the Obama Administration, tax reform means corporate tax restructuring. Both the president and Treasury Secretary Tim Geithner have argued that at least the first tranche of reform would scale back tax preferences, cut corporate rates, and, in all, raise the same money that the tax code does today. In Obama’s vision, redesign of the individual tax system would wait for another day.

But there is a problem with this scheme: It appears that while all businesses would lose some tax preferences, the rate cuts would apply only to corporations. Thus, non-corporate businesses would end up paying higher taxes. In effect, firms such as partnerships, sole proprietorships, and LLCs—about 90 percent of U.S. businesses—would subsidize the rate cuts for a handful of corporations. The House Ways & Means Subcommittee on Select Revenue Measures held an interesting hearing on all this yesterday featuring, among others, Tax Policy Center director Donald Marron.

As a matter of policy, treating corporate and non-corporate businesses more equally is an excellent idea. But Obama’s approach leaves much to be desired. And as politics, this arrangement will be exceedingly dicey. The inevitable headline will be “Small Businesses Pay for Multinationals’ Tax Cut.” This headline will be wrong, but effective.

Here’s the deal: Today, corporations are doubled-taxed. They pay corporate income tax on their profits. Many of their shareholders pay tax again when those earnings are distributed as dividends or when they sell stock and receive capital gains (some, such as non-profits and foreign investors, don’t pay the extra tax). By contrast, non-corporate businesses (often called- pass-through firms) pay no income tax at all at the firm level. Instead, their profits or losses are included on the individual tax returns of their owners.

Keep in mind that while these firms report their income on individual returns, they are hardly all small businesses. Former Treasury official Bob Carroll estimates that one-quarter of firms with taxable profits of $1 million or more are organized as pass-throughs.

Donald walks through the basic math in his testimony: Corporations pay at a maximum rate of 35 cents on the dollar. Then, their shareholders pay up to 15 percent on the remaining 65 cents for a total rate of about 45 percent. Non-corporate business owners pay only a top individual rate of 35 percent. This is why nearly all businesses choose the non-corporate form.

But Obama’s concept of tax reform would change this equation. Corporations would lose the benefit of some tax breaks but in return may pay at a top rate of as low as 25 percent (Obama has yet to propose a plan so I am guessing here). Non-corporate businesses would lose those same deductions and credits, but get no benefit from the corporate rate cut. In fact, Obama would have very successful pass-throughs, whose owners pay the top individual tax rate, pay even more.

He’d raise the statutory rate to 39.6 percent and restore the phase-outs of itemized deductions and personal exemptions (worth about another 2 percentage points). Thus, he’d cut the top corporate rate to, say, 25 percent, while raising the top rate for non-corporate businesses to 42 percent. If Congress wanted to use some tax revenues to help reduce the deficit, it could raise those individual rates even more.

To make things more complicated, Obama would also raise the capital gains rate to 20 percent (with another add-on in the law to help pay for health reform). This would further disadvantage double-taxed corporations.

For real people, a decision that was once a no-brainer would suddenly become awfully complex. Do I organize as a corporation and pay a relatively low corporate rate but a rising rate on gains and dividends, or do I organize as a pass-through and pay a much higher individual rate but no second-level tax?

For politicians, the decision would be just as agonizing: Do I equalize the tax treatment of corporate and non-corporate businesses by raising taxes on the pass-throughs and lowering taxes on some corporations? Obama seems convinced that reforming corporate and individual taxes together is too heavy a lift, and focusing on corporate first will be easier. I keep thinking about that about that small business and multinationals headline and am not so sure.

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