President Donald Trump promised a huge, bold tax reform plan within his first 100 days aimed mostly at reducing taxes for the middle class.
But on Wednesday he released a whittled down outline centered around a reduction in the corporate tax rate, which is currently at 35 percent, to 15 percent. More details of a larger tax reform package, as well as how this one can be paid for and passed, are coming later, officials promise.
More troubling than Trump’s corporate tax reduction, though, is that the plan applies this rate not just to traditional corporate entities, but also to firms known as pass-through businesses such as law firms, hedge funds, and real estate companies. These companies — including LLCs, partnerships, and S corporations — currently pay taxes through the individual code because their money shows up on owners’ own returns.
Some of these are small, but they also include enormous companies, like much of the Trump Organization itself. Pass-through business income flows mostly to high earners: 70 percent of income made by partnerships and S corporations is captured by the richest 1 percent of Americans. In 2012, 40 percent of all S corporation income was made by firms worth more than $50 million, while 70 percent of partnership income went to a similarly sized group.
Allowing these companies to pay a 15 percent rate, and not the higher rates in the individual code for well off taxpayers, would be an big and very profitable loophole for them. Only income below $37,950 a year is currently taxed at 15 percent or less. But anyone who makes their income as a pass-through entity would enjoy that rate no matter how much they made.
It would therefore be difficult to ensure that individuals don’t incorporate as pass-through businesses to reap the rewards of such a lower tax rate. On Wednesday, Treasury Secretary Steven Mnuchin promised, “We will make sure there are rules in place so that wealthy people can’t create pass-throughs” and thus avoid the personal income rates. But Congress has already had difficulty policing pass-through business taxation.As an example from the Center on Budget and Policy Priorities of how enticing this can be, a lawyer earning a $1 million salary could incorporate as a pass-through business and thus save $180,000 in taxes under Trump’s proposal.
Trump himself is already poised to benefit from the lower tax rate. It’s impossible to know exactly how such a change would impact him since he has refused to release his tax returns. But he reported owning more than 200 LLCs in his presidential disclosure forms and in a follow up letter his attorneys indicated that his approximately 500 businesses are almost all pass-throughs. Given that he says his assets are worth $10 billion, this could potentially save him millions of dollars a year.
Just reducing the corporate tax rate, without also reducing it for pass-throughs, would come at a very high cost. According to the Tax Foundation, dropping the rate to 15 percent would reduce government revenue by $2 trillion over a decade, or about 5 percent. Add to that the estimated $1.5 trillion cost of allowing pass-throughs to pay the lower rate and the whole proposal becomes very expensive.
The Trump administration has maintained that the tax plan will pay for itself because it will boost economic growth, thus increasing tax revenues as businesses expand and more people work. But the unleashed growth would have to be dramatic. Just to pay for the standard corporate tax rate reduction, the economy would have to be about 5 percent larger.
An illustration of what can go wrong is on full display right now in Kansas. In 2012, the state passed a huge tax reduction package that included exempting pass-through businesses from state taxes. That ended up incentivizing residents to recharacterize their income as pass-through and not regular salary in order to take advantage of the change; more than 333,000 state residents filed taxes this way the year after the change.
The exemption ended up depressing state revenue by an additional 1.7 percent on top of all the money it was losing from the overall legislative package. It cost $206 million in 2013 and another $472 million in 2014. It’s part of why the state is now struggling to fill a budgetary shortfall of $1.1 billion, passing deep cuts in government programs and even leading state lawmakers to reverse course and vote for raising taxes (although Gov. Sam Brownback (R) vetoed it).
Kansas’s tax reforms, meanwhile, haven’t unleashed economic growth. Instead, its economy has grown at half the national rate and job growth has flatlined.