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The “Main Street Fairness Act” (H.R. 5076 and S. 707) requires tax “parity” between businesses organized as pass-throughs and corporations. The legislation has been endorsed by the National Federation of Independent Businesses, the National Association of Manufacturers, and the National Retail Federation. President Trump advanced a similar notion in his tax reform principles and so did the House Republican leadership in its Better Way tax blueprint. But the Main Street Fairness Act is not directed at Main Street, fairness, or parity. If enacted, it would create more problems than solutions.
Pass-through businesses are sole proprietorships, partnerships, and S corporations, and these entities, unlike the traditional C corporations, are not subject to a business-level income tax. Instead, their income is passed-through to their owners—and then taxed at individual rates (today, at a top rate of 39.6 percent).
The Main Street Fairness Act would cap the tax rate of pass-through businesses at the corporate rate. Today, the top corporate rate is 35 percent, but President Trump has proposed cutting it to 15 percent and the House Republican leadership would lower it to 20 percent. As a result, the top rate on income from pass-through businesses could be lowered from 39.6 percent to 15 or 20 percent.
Many people equate pass-throughs with small businesses, but that characterization is inaccurate. Pass-through businesses can be large multistate pipelines, timber product companies, real estate developers, and other types of large active businesses. Pass-through businesses include high-profit partnerships of doctors, lawyers, consultants, investment managers, and other professionals. (Investment funds also can be pass-through businesses, but investment gains are not treated as business income under the Main Street Fairness Act.) The Tax Policy Center estimates that the top 1 percent of households collect more than half of the total business income of pass-through businesses.
Would a cap create “parity” between pass-through businesses and corporations? Not really, because the income of pass-throughs would still be taxed once, while the income of corporations would be taxed twice, at the firm level and again when income is distributed to shareholders either via dividends or through stock appreciation and subsequent capital gains. The proposed legislation ignores that extra level of tax.
Is a lower rate for pass-through businesses fair? Fairness is always in the eye of the beholder but under this bill the tax rate for a billionaire hedge fund manager could be substantially lower than the rate of his or her secretary.
Could we limit the lower rate to actual Main Street businesses, like grocers, barbers, car dealers, and restauranteurs, and exclude large businesses, real estate developers, investment managers, lawyers, and lobbyists? Not really. There is no principled or practical way to separate “main street” businesses from others. All businesses use a mix of labor, capital, and entrepreneurship to make a profit—and untangling these contributions is impossible.
Inevitably, arbitrary distinctions, and lower tax rates on certain types of income, invite abuses as taxpayers would attempt to wrap pass-through businesses around their personal labor contributions (and, for example, recast wages as business profits). The legislation does not try to stop such gaming, which would be nearly impossible. Recall the efforts by Gingrich-Edwards-Trump to avoid the 2.9 percent Medicare tax—and consider how many more business owners would try to save taxes by exploiting their pass-through status if the rate differential were 15 or 20 percentage points.
Finally, under present law, any pass-through business can convert tax-free to a corporation. So, a sole proprietorship, or other pass-through, that is attracted to the lower proposed corporate rate can always self-help and convert to a C corporation—without legislating a new rate cap that would add inefficiency and complexity to our tax code.
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