GOP Sells Tax Break for the Rich as "Small Business Relief"

In light of President Trump's proposed framework for major tax legislation, Americans should be on the lookout for high-income and special interest tax breaks masquerading as tax relief for working class families or small businesses. One of the most egregious examples of this is the rate cut on “pass-through” income included in both President Trump’s tax plan, announced Wednesday, and House Speaker Paul Ryan’s “Better Way” agenda. This costly tax break would increase budget deficits and likely force cuts in critical programs such as education and health care.

This proposal flies in the face of the president’s promise that “every decision” on taxes would “be made to benefit American workers and American families.” Instead, the provision would provide a windfall of hundreds of billions of dollars to the wealthiest Americans, including hedge fund managers and other investors as well as wealthy business owners like President Trump himself.

Both President Trump’s and Speaker’s Ryan’s plans would cut the top rate for “pass-through” income. “Pass-through” income is income from businesses such as partnerships, S corporations, and sole proprietorships claimed on individual tax returns and taxed at the rates that apply to wages and salaries. These businesses already have the advantage of being exempt from the corporate tax on profits and taxes on dividends. The Ryan and Trump plans would add to this advantage by providing a special, lower rate for pass-through income. The Ryan proposal would cut the top rate on pass-through income from 39.6 percent to 25 percent, while the Trump campaign plan would cut it even more — to just 15 percent.

Supporters of these proposals often advance a misleading argument of “parity,” implying that pass-through businesses and corporations should be taxed at the same rate. Corporate income faces both the corporate tax and taxes on dividends paid to shareholders. Setting the top rate on pass-through income equal to the top corporate tax rate means that pass-through income will, on average, be taxed at significantly lower rates, providing an expensive tax cut tilted in favor of the richest people in the country.

About half of all pass-through income flows to the top 1 percent of Americans — those with incomes over $700,000 in 2017. Only 27 percent of pass-through income goes to the bottom 90 percent of households. On top of that, the wealthy would get a bigger tax cut per dollar of pass-through income than middle-income people because pass-through income for high-income people is taxed at higher rates today.

Meanwhile, most small business owners would get nothing from either the Trump proposal or the Ryan proposal. That’s because most tax filers with pass-through income are already taxed at rates at or below the top rate in the Trump and Ryan proposals (see chart).

So who is the type of taxpayer that would benefit from this tax break?

1. Business owners like President Trump, who owns about 500 pass-through businesses according to his attorneys. Because the president exemplifies the type of business owner who would benefit the most from this tax break, the proposal has sometimes been referred to as the “Trump loophole.”

2. Hedge fund managers, consultants, investment managers, and other professionals who are among the pass-through business owners in the top tax bracket.

3. The 400 highest-income taxpayers in the country, who have annual incomes exceeding $300 million each and receive about one-fifth of their income from pass-throughs, on average.

A special lower rate for pass-through income would also create a major new loophole in the tax code, spurring large-scale tax avoidance. That’s because it would give high-earning employees a major incentive to reclassify their wage and salary income as “business income” to get the lower pass-through rate. For example, a law firm partner who reclassified her $1 million salary as business income from the law firm would get a $180,000 tax cut from the Trump pass-through proposal.

In fact, of the $1.5 trillion revenue loss from the Trump version of the pass-through proposal, more than 40 percent — or $650 billion — would come purely from tax avoidance, according to the Tax Policy Center.

And then there’s the historical record. A tax cut on “pass-through” income has been tried at the state level, with very damaging results. As part of an aggressive set of tax cuts that Governor Sam Brownback championed, Kansas exempted pass-through income from all state income taxes. Since this measure was enacted in 2012, the state’s economy has lagged the country as a whole. Moreover, the large revenue losses from this and other tax cuts have wreaked havoc on the state’s budget, forcing cuts to key services including funding for education. The Kansas legislature earlier this year passed bipartisan legislation to close the loophole, though Gov. Brownback vetoed the bill.

Federal policymakers should learn from Kansas and reject costly, regressive proposals to create a special tax break for pass-through income.

Chuck Marr is director of federal tax policy at the Center on Budget and Policy Priorities.