Under the tax bill working its way through Congress, the self-employed, sole proprietors, partners, or owners of S-corporations (“pass- through business owners”) are eligible for a new deduction equal to 20 percent of their business income. The deduction reduces their taxable income and thus drops many of them into lower tax brackets. Wage earners will not get this new benefit.
How much is it worth? A lot. Take two people, each of whom earns $65,000 a year. The wage earner will pay $7,600 in income taxes; the self-employed person will pay $5,270. That’s a $2,330 difference. In other words, if the wage earner could instantly become a pass-through entity, he could afford 4 percent more stuff.
As the graph below shows, the differences are even larger the higher up the income ladder you go, rising toward 10 percent after $300,000 of income. It shows how much more tax a wage earner will pay compared to an otherwise identical self-employed individual, measured as a percentage of after-tax income. This shows how much more stuff the wage earner’s pass-through-owning neighbor can buy.
This a new dimension of unfairness: People doing the same exact job for the same exact pay but often paying 30 to 40 percent more in taxes if they’re paid in wages rather than “profits”. Policing this distinction will be complicated for taxpayers, a compliance headache for the IRS, but a windfall to those who plan well.
The fix is easy: tax all income at the same rate.