Twenty-five years after the last significant change to the U.S. tax code, just about everyone can agree the system is in desperate need of fundamental reform. In fact, virtually the only source of agreement between Republicans and Democrats in Washington, D.C., is that the current tax code puts American businesses at a crippling disadvantage relative to the rest of the world. A simpler code with fewer deductions could increase revenue while lowering rates by broadening the base. Some in Congress, including key members of the Joint Select Committee on Deficit Reduction, have pointed to corporate tax reform as a way to make the United States more competitive in the global economy. While bipartisan support for tax reform is a promising sign, a corporate-only approach would be tremendously shortsighted. Not only would so-called “corporate” tax reform fail to spur economic growth, but it also would leave the vast majority of American businesses worse off than before.
Corporate tax rates directly impact only a fraction of American companies. In fact, 95 percent of all U.S. businesses are structured as “pass-through” entities: companies organized under Subchapter-S (S-Corps), along with LLCs, partnerships, sole proprietorships and other arrangements by which taxes are paid at individual rates by the respective shareholders. This business community employs 54 percent of all workers in the United States. These pass-through entities outnumber corporations in 48 of 50 states, while accounting for 44 percent of all federal business income tax. The structure is particularly prevalent in commercial construction, where a staggering 80 percent of companies are subject to individual rates.
Not only will lowering corporate rates ignore this overwhelming majority, but the elimination of various business credits and deductions used to finance such a corporate cut would amount to an enormous tax increase on pass-through entities as well. According to a recent
study by Robert Carroll and Gerald Prante for Ernst & Young, budget-neutral, corporate-only reform effectively would raise taxes on pass-through businesses by 8 percent, or more than $27 billion. Among the hardest hit industries would be construction, which would face a 9 percent increase amounting to more than $2 billion.
Worse yet, pass-through businesses already are staring at a 20 percent increase in 2013 with the expiration of the so-called Bush tax cuts. Absent congressional action, the top marginal rate will jump from 35 percent to 43.4 percent in just over a year, including a 3.8 percent surtax levied on "high" earners under the new health care law. Given that four out of every five construction companies pay taxes at individual rates, this is a huge problem. While Democrat leaders in Congress and the White House demand billionaire private jet owners pay their "fair share," it's impotant to remember the brunt of this increase would be borne by pass-through businesses making as little as $250,000 per year. The one-two punch of corporate cuts and individual hikes would not only expose the majority of businesses to higher rates on a broader base of income, but it also would further distort the system by creating an incentive for companies to opt for the inherent double taxation of the corporate structure.
The Tax Reform Act of 1986 was a groundbreaking piece of legislation, and served as a key turning point in America’s subsequent decades of economic expansion. Twenty-five years and 70,000 pages later, the Internal Revenue Code has grown into a complex and cumbersome morass. As the public grows increasingly hostile toward partisan gridlock in Washington, D.C., one rare point of agreement lies in restructuring corporate taxation. While this emerging consensus is an acknowledgement of the indisputable burden of the current tax code on American businesses, its focus on corporations reflects a fundamental misunderstanding of the economic landscape.
Indeed, with among the highest corporate taxes in the world, it is imperative that the United States remains competitive with its international counterparts in attracting and retaining capital. Yet it is just as important that corporate tax reform not be conflated with business tax reform. Because most companies are taxed under similarly high individual rates, corporate reform is just one piece of a much bigger puzzle. The current debate on how America taxes its companies is a healthy one, and it comes at the right time. Any credible reform must be considered in the context of a truly comprehensive solution that keeps tax rates low and similar for corporations and individuals alike.