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Reducing rates for “pass-through” businesses will be tough to justify

Summary:
THERE are two main reasons for a country to paw around in its tax code: to create more economic growth, or to repair a structural deficit. Any politician who wishes to quietly give money to friends or kill a troublesome programme will supply one of them. He will either say “businesses need tax certainty to grow” (meaning: “certainty that they will like the tax code”), or “we don’t have the money”. So as the Trump administration releases its tax plan on April 26th, there are only two questions to ask: whether it will speed up America’s current economic recovery, and whether it will begin to fill in the country’s long-term deficits. If the early leaks from the White House are any guide, it will do neither. According to the Wall Street Journal, the White House wants to reduce the top tax rate on pass-through businesses to 15%. “Pass through” means the business itself has no tax obligations—those are passed to the owners. Last year economists from the Treasury department took a hard look at the administrative tax data for these businesses for the National Bureau of Economic Research. In 1980, they found, levies on income from pass-through businesses made up less than a quarter of America’s corporate-tax revenue. By 2011 that had climbed to more than half. Changes to the tax code in 1986 had made this structure more attractive to owners.

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THERE are two main reasons for a country to paw around in its tax code: to create more economic growth, or to repair a structural deficit. Any politician who wishes to quietly give money to friends or kill a troublesome programme will supply one of them. He will either say “businesses need tax certainty to grow” (meaning: “certainty that they will like the tax code”), or “we don’t have the money”. So as the Trump administration releases its tax plan on April 26th, there are only two questions to ask: whether it will speed up America’s current economic recovery, and whether it will begin to fill in the country’s long-term deficits. If the early leaks from the White House are any guide, it will do neither.

According to the Wall Street Journal, the White House wants to reduce the top tax rate on pass-through businesses to 15%. “Pass through” means the business itself has no tax obligations—those are passed to the owners. Last year economists from the Treasury department took a hard look at the administrative tax data for these businesses for the National Bureau of Economic Research. In 1980, they found, levies on income from pass-through businesses made up less than a quarter of America’s corporate-tax revenue. By 2011 that had climbed to more than half. Changes to the tax code in 1986 had made this structure more attractive to owners. The White House plan will make it even more so. The economists at Treasury also found that pass-through businesses, once limited to single owners who ran small businesses, now include a predictable group of one-percenters in finance and real estate, along with a small group of partnerships so opaque the Treasury was unable to figure out who owned them.

This early signal from the White House is not a full plan, nor is it anything close to what might eventually make it through Congress. But it is dispiriting. It shows that the competent Goldman Sachs alumni in the administration are not serious about either growth or deficits. Last summer the Tax Foundation, a think-tank sympathetic to Republican priorities, estimated that a 15% rate on pass-through income would cost $1.5trn in lost tax revenue over a decade. And there is no evidence that the lower rate would spark enough economic growth to pay for itself, nor that it would spark much growth at all.

The Tax Foundation, like Republicans in Congress, prefers to look at tax cuts through “dynamic scoring”—this year’s assumptions about increased growth become next year’s assumptions about increased tax revenue. Even using this method, the foundation lowered its ten-year estimate for lost pass-through income to a cost of $1.2trn. And that extra $300bn in tax revenue comes from a precarious assumption: that lower taxes will encourage businesses to buy more machines, making workers more productive. This increased business investment from lower corporate taxes is a common feature of macroeconomic models. But economists now dedicate entire conferences to figuring out whether the world continues to work as it used to.

In theory, making it cheaper to buy new equipment—lowering the “cost of capital”—drives companies to buy more. But it almost couldn’t possibly be cheaper to make capital investments; companies’ borrowing costs have not been this low since the 1950s. Companies are even sitting on cash, declining to spend it. From 1975 to 2000, according to the Bureau of Economic Analysis, undistributed corporate profits were stable between $100bn and $200bn. Since then, they’ve climbed to $760bn. But companies aren’t putting this fat wad of cheap money to productive use. Investment in new equipment recovered after the recession, but has plateaued since 2014. 

People who work in financial markets have known about this problem for a while. Or, rather, they’ve known that companies have been providing dividends and buying back stocks, rather than making new investments. But the news has not made it to the White House. Perhaps this will. On April 25th economists from the University of South Carolina, Indiana University and the Treasury released the first study of a decision by the state of Kansas to eliminate its tax on pass-through income altogether. They found that small businesses shifted income to avoid taxes. And they found no meaningful consequences for investment.

There is nothing inherently wrong with making life more pleasant for people who own their own businesses. Trouble is, there is nothing inherently good about it, either. There will be more from the White House on taxes this week—the administration has said it wants to make child care more affordable through tax credits, for example. But in its first targeted leak, it released an idea that fails both basic tests of tax reform, one that will neither create growth nor reduce the deficit. That is not a good sign.

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