Why the GOP's Tax Plan Could Leave High-Wage Earners With Little to Gain

Today, a business owner making $500,000 gets taxed much like a corporate executive with a $500,000 salary. How they make their income doesn't matter much.

That could change dramatically under Republican plans aimed at driving down tax rates on business income, leaving high-income wage earners with much less to gain from a tax overhaul.

Republicans, eager to drive down business tax rates in a bid to boost economic growth, want roughly similar tax rates for corporations and for so-called pass-through firms that report business income on the individual tax returns of their owners.

For them, lowering the 35% corporate tax rate requires also lowering the 39.6% top rate for pass-through business income, even though creating a new special rate for that business income leaves a potentially large gap with the top rate for high-income wage earners.

The exact contours of the GOP tax agenda aren't set. Top lawmakers and administration officials say they will release another blueprint in the coming days.

The 2016 House GOP blueprint called for a 20% corporate tax rate, a 25% tax rate on pass-throughs and a 33% top individual rate. In April the White House proposed a 35% top rate for individuals. President Donald Trump has said he might not cut taxes for the wealthiest Americans, and recently Republicans have talked a lot less about the importance of reducing the 39.6% top tax rate on ordinary income. In the end that rate might not come down much and some deductions could go away.

With GOP senators agreeing to, at most, $1.5 trillion in tax cuts over the next decade, there is a limited amount to go around. Republicans are focused on cutting business taxes and offering a larger standard deduction for middle-income households.

The emerging Republican plan would "open a gulf between wages and pass-through business income that has never existed before, putting the high-wage earners at a disadvantage," said Andy Mattson, a certified public accountant with Moss Adams in Campbell, Calif.

Keeping the top tax rate on wages near 39.6% would be a way for Mr. Trump to defend his argument that he isn't prioritizing tax cuts for the rich, even if other pieces of the tax plan favor wealthy business owners, investors or heirs of large estates.

Under current law, pass-through businesses include partnerships, limited liability companies and S corporations. The income they earn doesn't face the corporate income tax and then a potential second tax layer on capital gains or dividends; instead, it passes through to owners' tax returns and is taxed at their individual rates.

Such firms reported more than 40% of net business income in 2014, according to the congressional Joint Committee on Taxation.

They include global law and accounting firms, real-estate investors, hedge funds, doctors' offices and manufacturers. About 60% of pass-through income goes to households making over $500,000, according to the Tax Policy Center.

In the past, Republicans have seized on the importance of pass-through income to argue against raising the top rate on individuals. They warned tax increases would punish successful small businesses, although many aren't small. By splitting wage and business taxation, the approach under consideration could undercut future arguments against raising the top rate.

Lowering the corporate rate to improve U.S. investment incentives is a core driver of the planned tax overhaul. Other large industrialized countries have lowered their rates. The gap between the U.S. and others affects business investment decisions and encourages tax avoidance, experts say.

Politically, it is nearly impossible to cut corporate rates without cutting the rate on pass-through income. Pass-throughs, prominent in every congressional district, form an essential part of the Republican coalition.

"The pass-through community demands something in the process of the corporate rate going down," said Douglas Holtz-Eakin, president of the center-right American Action Forum.

"There is a difference between high-wage income or some other [business] income," said Sen. Mike Crapo (R., Idaho). "It doesn't have to all be treated identically."

The challenge for policy makers will be separating wage income from business income for high earners. The proposed lower pass-through rate wouldn't help the large share of business owners who don't generate significant high income, because their top rates are below the 25% proposed rate in the House plan. The biggest winners are high earners who can classify their earnings as business income.

"The real fight here is going to be over what income qualifies for the rate reduction and what income doesn't," said Warren Payne, a former House GOP aide who wrote a policy paper for the Bipartisan Policy Center on pass-through taxation.

For more than a year, Republicans have been floating alternatives for defining the line between wage and business income. They haven't settled on anything. One option would assume that 70% of pass-through income is taxable at the wage rate and 30% at the lower business rate.

Alternatively, Treasury Secretary Steven Mnuchin said certain service providers wouldn't get the lower rate. He named accountants specifically, but others could include doctors, lawyers, consultants and architects.

"You have to have dollar bills that are labeled wage income and business income and they don't come that way," Mr. Holtz-Eakin said.

Creating a special, much lower pass-through rate only for business income will lead to big changes in tax planning, said Lily Batchelder, a law professor at New York University who was an Obama administration tax aide.

Already, some pass-through owners engage in techniques to avoid or minimize a 3.8% payroll tax; a bigger tax-rate gap would encourage more avoidance.

"Everyone whose income is high enough to benefit and who can afford excellent tax advice will figure out how to get the lower rate," she said.

Write to Richard Rubin at richard.rubin@wsj.com and Laura Saunders at laura.saunders@wsj.com

(END) Dow Jones Newswires

September 24, 2017 17:26 ET (21:26 GMT)