Let’s not leave America’s small businesses behind in tax reform

For the first time in a generation, we are within reach of meaningful tax reform. Permanently reducing the corporate rate to 20 percent, a significant middle class tax reduction, and bringing back profits currently held overseas will do much to grow our economy.

Despite this pro-growth agenda, Sen. Ron Johnson (R-Wis.) recently said he could not support the tax package because “neither the House nor the Senate bill provide fair treatment” to small businesses. Johnson raises a valid point, and with only a 52-vote majority, Congressional leaders and the White House would be wise to address his concerns.

Johnson’s concerns include, in part, the treatment of “pass-through” taxation, which is often used by small businesses electing to operate as an “S” Corporation, LLC or partnership. In effect, the profits of the business are “passed through” to the owner and then taxed as personal income. These pass-through entities make up 95 percent of U.S. businesses and account for the bulk of business tax revenues.

{mosads}Under current rules, if business income is relatively low, then profits are taxed at a lower rate than the current corporate tax rate (35 percent). But small businesses accounting for nearly half the income of pass through entities pay the highest personal marginal tax rate of 39.5 percent on portions of their income. Given the deep cuts in the corporate tax rate proposed in the Republican bills, many of the more successful pass-through entities would be at a substantial tax disadvantage under the new law.

To illustrate the problem, consider two small businesses, one with income of $300,000 and another with income of $1 million.

Under plausible conditions, the effective tax on rate on a pass-through entity with $300,000 of income is today 32.1 percent, whereas the effective corporate tax rate would be 36.8 percent. A slight advantage since more income is taxed at the progressive personal income rates. For the current Senate bill, the effective tax rates for the two business forms would be 28.6 and 27.3 percent. A small difference. For the House bill, the spread is large, when the pass-through entity paying an effective rate of 32.5 percent, the corporation 26.8 percent.

At $1 million in income, the differences are stark. Under existing law, the effective rates are 40.1 percent for the pass-through entity and 38.4 percent for the corporation (more income is taxed at the highest personal tax rate). For the Senate draft bill, the effective tax rates are 35.7 and 28.6 percent, a huge tax penalty of nearly seven percentage points for pass through entities. The House bill is worse, with effective tax rates of 39.0 and 28.9 percent, better than a ten-percentage point difference. Success, if measured as income, is being punished under the both bills. This tax discrimination is even more pronounced against small businesses that provide the vaguely defined “professional services” that are excluded from the pass-through provisions.

Obama-era policies such as the Affordable Care Act, joint-employer liability, aggressive overtime rules, significant minimum wage increases and, of course high taxes, made it difficult — if not outright impossible — for many small businesses to survive. While many of these policies are being rolled back, without meaningful tax reform for America’s small businesses we will fall short on employment and economic growth.

Fortunately, there is time to fix this discrepancy.

The Senate’s 17.4 percent deduction is a means of lowering rates on pass-through businesses, but it is too small and temporary. The deduction’s 50-percent payroll limitation would leave behind pass-through businesses who do not add direct payroll at a one-to-one ratio as they grow, while the portion of pass-through businesses that do get the full deduction would be subject to a 32 percent effective rate. This rate falls well short of the 25 percent rate forecast in the Republican framework and it is significantly higher than the bill’s 20 percent rate applying to C corporations. 

The controversial disallowance of the State and Local tax deduction would increase this gap further, raising effective tax rates on pass-through businesses operating in States with income taxes. As a result of these provisions and others, tax reform may increase the tax burden on many pass-through businesses relative to current law, while the bill’s rate disparity with C corporations creates a significant competitive disadvantage for many more. 

If growth is the goal, then it would be senseless to leave many of America’s job creators better off under the status quo. Small businesses are held to be the engine of job growth, including, for instance, the franchised organizations that have created double the rate of new businesses since the recession, provide nearly 7.6 million jobs to the economy, and create opportunities for the rewards of self-employment.

As the Senate continues to refine its proposal, addressing Johnson’s concerns will ensure that tax reform doesn’t leave America’s small businesses behind.

George Ford is the chief economist of the Phoenix Center for Advanced Legal & Economic Public Policy Studies, a nonprofit group dedicated to studying broad public policy issues related to governance, social and economic conditions, with a particular emphasis on the law and economics of the digital age.