In Unpacked, Brookings experts provide analysis of Trump administration policies and news.
THE ISSUE: House and Senate Republicans are working on a tax bill that will overhaul several parts of the U.S. tax code. By introducing new complexities to the tax code, the new bill creates tax sheltering opportunities for many Americans, especially the wealthy and those with good financial advisers.
The most sophisticated tax payers and the highest income tax payers will have a multiplicity of choices about how to structure their income and businesses in order to reduce taxes the most.
THE THINGS YOU NEED TO KNOW
- By taxing wage income and business income at different levels, the bill adds complexity to the tax code and creates many new opportunities for more sophisticated and well-advised taxpayers to reduce their tax burdens.
- One of the least desirable parts of the bill is a provision that allows pass-through business owners to deduct 23 percent of their income before they calculate their taxes. This would result in very large differences in the tax burden of taxpayers in very similar circumstances.
- For example, if a plumber makes $60,000 a year as wages paid by an employer, he or she will pay 60 percent more in income taxes than if that plumber had been a sole proprietor or self-employed and takes advantage of the pass-through rate.
- The most sophisticated taxpayers and the highest income taxpayers will have a multiplicity of choices about how to structure their income and businesses in order to reduce taxes the most.
- For most people, the preference will be to form pass-through business and be a sole proprietor or be a partner at a partnership, but at higher income levels certain individuals will want to form a C-corporation.
- It won’t be hard to form a C-corporation. If you already have a pass-through business like an LLC, S-corporation, or a partnership, all you’ll need to do is check a box on a form.
- We’ve never seen the tax rate that applies to wage earners be so different from the tax rate that applies to partnerships or sole proprietors. That is one of the key simplifications in our current code.
- Because wages are currently taxed at the same rates as income from a sole proprietorship or income earned in a partnership, we don’t need to have special rules to determine whether somebody is an employee or a partner, and we don’t need to have special rules to classify whether their income is from labor or from a business.
- Kansas offers us a good example of the impact this change in the tax code could have. During Governor Brownback’s tax experiment, taxpayers were allowed to reduce their taxes by about 3 percent by changing from being a wage earner to being a pass-through business. The change reduced state revenues and contributed to a budget crisis and was ultimately repealed.
- The Kansas experiment was small in the sense that it was a three percentage point reduction in the rate that applied to pass-through businesses compared to wages. It applied only to the state of Kansas, and only to a relatively small handful of Americans. In the Senate’s bill the rate differences are much larger in magnitude and apply to a vastly larger share of the country—especially to many more high income taxpayers.
- The best way to avoid these problems is just to tax all income at the same rate.
- The Senate and House bills both already provided generous treatment for business owners by providing expensing for new purchases of planned equipment and generous simplifications that relieve them from a lot of accounting burdens.
- If Congress wanted to enact a substantial tax cut, they could just cut the individual income tax rates across the board, and that would eliminate sources of complexity, sheltering and gaming, and provide a more general tax cut that would benefit vastly more Americans.