June 16, 2017

Ways To Reform Taxation Of Small Business

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On June 14, I testified before the Senate Small Business and Entrepreneurship Committee on how tax reform might affect small business.  I delivered two key messages: Pass-through businesses are not necessarily the same as small businesses and one useful approach to reform for these firms may be tax simplification.

There is a broad consensus that the current system for taxing businesses is in dire need of reform. The US tax system was last overhauled in 1986. And three decades of changing business practices, increased globalization, and expanding aggressiveness in tax planning have made the current system of taxing business income woefully out of date. I told the committee that there are five major problems with the taxation of US businesses:

  1. High statutory corporate tax rates;
  2. Numerous special tax provisions that permit many firms to pay effective tax rates well below the top marginal rate;
  3.  Incentives for multinational firms—both U.S. owned and foreign owned—to locate deductions in the U.S. and locate income in lower-tax jurisdictions;  and related incentives for US-based multinational firms to shift profits abroad and claim they are permanently invested there;
  4. Incentives for certain firms to organize as pass-through entities to escape corporate-level taxation; and
  5. Substantial complexity throughout the tax system.

Tax reform to address these issues should be guided by the goals of efficiency, equity, and simplicity.

Efficiency means a tax system that distorts economic choices as little as possible while raising the desired amount of revenue.

Equity has two components:

  • Horizontal equity is treating similarly situated taxpayers in a similar manner.
  • Vertical equity occurs when tax burdens increase with a taxpayer’s income (or ability to pay tax).

Simplicity is important because if the tax code is too complex, taxpayers cannot understand their responsibilities and comply with them. Much tax complexity reflects our complex economic world, but a large part results from deliberate decisions to run substantial portions of social policy through the tax code.

While all three of these principles come into play when designing tax proposals, the art of successful policymaking is getting the balance right.  When it comes to small business, aiming for simplicity may help achieve all three goals.

Facts on business

Businesses are organized in two basic ways. Traditional C corporations, mostly large publicly-traded businesses, are taxed at both the firm level and the shareholder level. Pass-through businesses, including sole proprietorships, partnerships, limited liability companies, and Subchapter S corporations are taxed only once.  Income or losses pass through to the tax returns of owners. These businesses can be small, large, or very large. 

They represent the vast majority of businesses, with sole proprietorships the most common. By contrast, a relatively small number of firms are traditional C corporations, but they account for most business activity. It is important to note, however, that this share has shrunk over the last three decades.

Therefore, it is not the case that pass-through business equal small business.  Many large businesses–including some well-known firms such as Cargill, Fiat Chrysler (FCA North America), and PriceWaterhouseCoopers operate as pass-through entities.

Their ownership reflects a similar pattern. Most pass-through businesses are small and owned by individuals of modest means. But the largest and most profitable are owned by high-income individuals who pay income tax at the top rates. Over two-thirds of the income of S corporations and partnerships accrue to taxpayers in the top one percent of the income distribution, according to the Treasury Department’s Office of Tax Analysis.

As with all tax reform, changing the taxation of pass-throughs is an exercise in tradeoffs.  Base-broadening tax reform that lowers tax rates but eliminates tax preferences would increase the taxable income of many businesses, no matter their structure.  If business tax reform used all that potential revenue to reduce the maximum corporate tax rate, it could shift the overall tax burden toward pass-through businesses.  One response is to lower the maximum rate of tax on the income generated by pass-through businesses, an idea proposed by President Trump.  But recent TPC analysis shows this could be quite costly and lead to large amounts of gaming.

If Congress is concerned about shifting tax burdens to smaller businesses, it could take steps to reduce complexity. For instance, it could expand expensing, which allows firms to deduct the full cost of capital investment in the year it is acquired. Or it could allow firms to replace complex accrual accounting with cash accounting, which could be simpler and lower tax liabilities. In essence, reducing tax complexity on small businesses can address multiple principles of tax reform.

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