The Spurious Allure of Pass-Through Parity

Abstract

In 2017, Congress reduced tax rates on both corporate and noncorporate income. The drafters invoked the concept of pass-through parity to justify lower rates on noncorporate business income, resulting in a new and highly controversial deduction for pass-through owners under § 199A. The concept of pass-through parity conflates equitable treatment of different entity forms with equitable distribution of the ultimate tax burden among labor and capital. The flawed rationale for § 199A may be viewed as an attempt to preserve the pre-2017 preference for pass-through income; conceptually, the advantage of lower corporate rates is limited to the availability of a higher after-tax rate of return on reinvested corporate earnings, obviating concerns about mass conversions. Despite the stated goal of distinguishing labor income from capital income in noncorporate businesses, the purported guardrails under § 199A provide a substantial subsidy for active passthrough owners by offering a lower tax rate on commingled labor and capital returns. Notwithstanding the rhetoric of parity, the reduced corporate tax rate seems unlikely to significantly alter the choice of organizational form, at least in the near term, given the inherent instability of the 2017 legislation. More significantly, the altered rate structure enhances the ability of owners of close corporations and pass-through businesses to recharacterize labor income as capital income and to avoid employment taxes. The pass-through deduction benefits primarily high-income owner-managers and undermines the equity and efficiency of the tax system. In light of growing concern over inequality and unsustainable deficits, the case for outright repeal of § 199A is even more urgent.

Keywords: corporate tax, partnerships, passthrough deduction, 199A, dividends, employment taxes

JEL Classification: K34,H24,H25,H25