Who wants to read more analysis of Donald Trump’s one-page, “tremendous,” “bigly,” “massive,” double-spaced, wide-margined tax plan, that looks like it walked out of a high school student’s Trapper Keeper or maybe like Kellyanne Conway typed it up in Word 10 minutes before Gary Cohn and Steve Mnuchin presented it to an angry press corps?
Raise your hands…
Ok, so that’s one (maybe two) of you.
I guess that’s good enough to present Goldman’s latest take on a plan that absolutely doesn’t matter because it will never fly on Capitol Hill.
Long story short: the 15% business tax rate in Trump’s proposal will end up costing $2 trillion or, about 28.5 “bigly,” “beautiful,” Mexican border walls.
Last week the White House announced a set of principles for tax reform, including a 15% tax rate on both corporate and pass-through income. While lower tax rates can boost investment, a single 15% business tax rate would also incentivize corporations and individuals to reduce their tax burden by organizing themselves as pass-throughs. In this comment, we estimate the effect of tax avoidance on receipts and discuss how it might affect the shape of the eventual tax package.
Taxes are a critical factor in how businesses choose to organize themselves. While corporations pay corporate income taxes, the income of pass-through entities is not taxed at the business level; instead, the owners pay individual taxes on allocated profits. The White House proposal increases incentives for businesses to choose a pass-through form. While a pass-through owner in the top income bracket pays $39.6 federal income tax per $100 of profits under current law, the federal tax bill would fall by $24.6 to $15 under the proposal. The total tax bill for corporate owners—corporate taxes plus individual taxes on dividends/capital gains—would also fall, but by a smaller amount of $18.5 (Exhibit 1). The total tax rate on capital would thus fall 6.1pp more for owners of pass-throughs than for corporate owners.
The White House proposal would likely boost the share of pass-throughs in total business income. The economics literature has found that relatively lower tax rates for pass-throughs since the 80s have contributed to the gradual decline in the corporate share in total business income from 75% in 1980 to 35% (Exhibit 2). For instance, Austan Goolsbee estimates that a 10pp increase in the corporate tax rate reduces the corporate share in the number of firms by 5-10%.
The shift from corporations to pass-throughs would likely continue under the White House proposal, as the total tax rate on pass-through income would be about 17pp lower than the all-in capital tax rate on corporate income. A shift towards pass-throughs of 2.5% of corporate income each year would reduce tax receipts by around $280bn over 10 years. To be sure, the uncertainty around this assumption is high, and there are likely limits to how much the corporate share can fall.
The White House proposal also creates incentives for owners of pass-through income to shift wages and salaries to business income. While top-income earners would face a 35% tax rate on wages under the proposal, the tax rate on pass-through profits would be just 15%. The international evidence from the UK, Finland, and Sweden, together with recent experience in Kansas, suggests that such a large gap of 20pp between tax rates on wage and business income would likely lead to significant shifts in wage income (Exhibit 3). The Tax Policy Center estimates that the shift of 5% of high-income labor earnings to pass-through structures each year would lower tax receipts by about $650bn over 10 years.
Exhibit 4 shows our ballpark estimates of the various revenue effects of lowering the pass-through rate to 15%. The decline in the total tax rate on pass-through income directly lowers revenue by around $1,000bn over 10 years. This calculation also assumes a hypothetical 70/30 rule—this has been raised as a possibility in congressional tax reform discussions— that considers 70% of pass-through income as labor income and 30% as business income. In addition to the direct effects, the shifts of corporate income and of labor income would likely further lower tax receipts over 10 years by around $280bn and $650bn respectively.
The upshot is that the 15% business tax rate in the White House proposal could cost almost $2 trillion over 10 years, with about half of the cost arising from plausible income shifting. While this cost should be weighed against potential growth benefits, we think that the potentially very large cost will likely lead policymakers to opt for a higher pass-through rate. Indeed, the House Republican Blueprint on tax reform calls for a 20% corporate rate, 25% pass-through rate, and 33% top individual tax rate. In light of our expectation that the corporate tax rate might end up at around 25% in an eventual compromise plan, and that the top marginal rate might end up at 35% as the White House has proposed, a pass-through rate of perhaps 30% looks more likely than the 15% rate the White House has proposed. Given the costs involved, if fiscal constraints become an important consideration, Congress might instead opt to simply continue taxing pass-through income at ordinary income tax rates.