While there is no chance that Congress will agree to broad-based tax reform before the next president takes office in 2017, lawmakers are making one last effort to enact a more narrow business-based reform. But they face a big challenge: reforms under consideration could raise taxes paid by many small businesses. To help lawmakers understand the implications of this choice, I testified on April 15 before the House Small Business Committee.
There is a developing consensus that our corporate tax system is broken and needs reform. The President and Republican tax-writers both favor reducing the corporate rate, scaling back business preferences, and reforming our international tax rules.
The effects of business tax reform, however, cannot be limited to corporations alone. Most U.S. businesses are not subject to corporate income tax. Instead, owners of these firms -- sole proprietorships, partnerships, and subchapter S corporations -- pay individual income tax on their business income. These “pass-through” firms account for 95 percent of all U.S businesses and report about 40 percent of all business receipts.
A reform that eliminated business tax preferences, such as accelerated depreciation and the special deduction for domestic manufacturing, and reduced the corporate income tax rate but not individual income tax rates would increase taxes on owners of pass-throughs. This raises a legitimate concern that corporate tax reform could hurt small businesses, most of which pay individual instead of corporate tax rates.
In my statement, I argued that the best way to address this problem is to expand tax benefits that primarily benefit small businesses rather than granting general relief for all pass-throughs. Congress could extend or increase the higher limits that expired at the end of 2014 for expensing equipment under Section 179 of the Internal Revenue Code. It could also adopt a suggestion by University of Southern California law professor Ed Kleinbard to expand the 15 percent corporate tax bracket that now applies only to the first $50,000 of corporate profits.
I cautioned lawmakers against enacting special tax rates for pass-through income. Large and mid-sized firms generate most of that income and most business income reported on individual tax returns goes to the highest income taxpayers. A special rate would give these high-income recipients of business income, including many lawyers and accountants, a special benefit not available to wage earners. In addition, it would introduce market distortions as firms seek to convert highly-paid employees into independent contractors eligible for the favorable rates.
Although other witnesses at the hearing did not share all my views, we did agree that rules for taxing business income are much too complex. Even business representatives expressed more concern about how much it costs small businesses to comply with the tax law than with the amount of tax they pay. That strengthens my view that tax relief should emphasize provisions that also lower business compliance costs, such as expanding section 179 expensing and allowing small businesses to use cash instead of accrual accounting for inventories.