Excerpted testimony of Scott Hodge, president of the Washington, D.C.-based Tax Foundation, before the U.S. House of Representatives Small Business Subcommittee on economic growth, taxes and capital access.
America”™s entrepreneurs are facing tremendous uncertainty, thanks to the stalled economy and the impending expiration of the Bush-era tax rates at the end of this year.
While there are many in Washington who believe that allowing top marginal tax rates to jump from 35 percent to 39.6 percent will have a minimal impact on pass-through businesses and the economy, this view is badly mistaken.
The issue is not how few businesses will be impacted. The relevant economic question is how much business income will be hit with higher tax rates. No matter how you parse the data, the evidence is clear that the vast majority of pass-through business income is earned by high-income taxpayers and they would be disproportionately impacted by such a tax increase.
Indeed, past Tax Foundation research determined that nearly 40 percent of any new tax revenue raised by boosting the top two tax rates would come from the top 2 percent of private businesses. These are the most successful, growing and profitable firms that are key to America”™s economic recovery. In every sense of the word, this would amount to a “success tax” on our best and brightest entrepreneurs.
The implications of allowing top marginal tax rates to rise are considerable because of the tremendous growth in non corporate business forms over the past 30 years. Today, there are vastly more non corporate businesses than traditional corporations and they now earn more net income than traditional corporations. Thus, an increase in the top individual tax rates could mean a substantial tax hike on a broad swath of private, or non corporate, business income ”¦
The growing, pass-through business sector
To understand the impact of higher tax rates on business income, it is instructive to look at the tremendous growth in taxpayers reporting business income over the past three decades as sole proprietors, S corporations, limited liability corporations (L.L.C.s), and partnerships.
These non corporate firm types are often referred to as “pass-through” entities because the firm”™s profits are passed directly through to the owners and taxed on the owner”™s individual tax return. By contrast, the profits of traditional C corporations are taxed at the corporate level first before being distributed to the owners (shareholders) who are then taxed again at the individual level.
Between 1980 and 2008, the total number of pass-through businesses nearly tripled, from roughly 10.9 million to 31.8 million. Specifically ”¦ the number of sole proprietors grew from 8.9 million to 22.6 million, while the number of S corporations and partnerships (which include L.L.C.s) grew from 1.9 million to more than 7 million.
Meanwhile, the number of traditional C corporations declined steadily from 2.2 million to 1.8 million between 1980 and 2008. The popularity of C corporations as a business form ended by the late 1980s when they were exceeded in number by S-corps and partnerships. These alternatives to the C-corp have continued to grow at such a rapid rate that there are now three and one-half times as many S-corps and partnerships as traditional corporations.
Over time, as these pass-through firms grew in number, size and profitability, they began to collectively generate more net business income than traditional C corporations ”¦ Between 1980 and 2008, after adjusting for inflation, net income for C-corps roughly doubled during the period, from $752 billion to $1.4 trillion in 2005; and then collapsed to roughly $1.1 trillion in 2008. By contrast, the combined net income from pass-through businesses increased six-fold, from $315 billion, after adjusting for inflation, to more than $1.8 trillion in 2007, before settling to $1.7 trillion in 2008.
In 1998, the combined net income of pass-through businesses exceeded those earned by C-corps for the first time and, except for 2005, have remained above C-corp net income in every year since. Indeed, in 2008, the net income of pass-through businesses comprised 61 percent of all net business income.
It is often assumed that a tax increase on high-income individuals will have little impact on business activity because only 2 or 3 percent of taxpayers with business income are taxed at the highest rates. While it is true that there are a small number of high-income pass-through businesses, the more economically meaningful statistic is how much overall business income will be taxed at the highest rates.
Millionaire status is fleeting
Debates over the equity of the tax burden tend to treat millionaires as a monolithic group even though research suggests that there is a significant amount of churning in and out of this elite status. Indeed, a recent Tax Foundation study used special Treasury panel data to look at the mobility of “millionaire” taxpayers between 1999 and 2007.
It found a great deal of mobility among the so-called rich.
During this nine-year period, about 675,000 taxpayers earned more than a $1 million for at least one year ”¦ Of these taxpayers, 50 percent (about 338,000 taxpayers) were millionaires for only one year, while another 15 percent were millionaires for only two years. By contrast, just 6 percent (38,000 taxpayers) remained a millionaire in all nine years. Based on these results, it is clear that taxpayers move in and out of millionaire status with great frequency. The volatile nature of capital gains realizations and business income appear to be the leading factors for the transiency of millionaires.
The key question is, what is the ultimate impact of raising the top two tax rates on the most successful pass-through businesses? Tax Foundation economists measured this cost in 2010 when the Bush-era tax rates were first set to expire. They found that assuming that business income is the last dollar of income taxpayers earn, that 39 percent of the total tax increase on high-income taxpayers would be extracted from business income.
According to the most recent revenue estimate from the Joint Committee on Taxation, the revenue gain from increasing tax rates on taxpayers earning more than $250,000 would raise $966 billion over the next 10 years. Assuming that the Tax Foundation”™s earlier 39 percent estimate still holds, this means that roughly $377 billion of these new revenues would come from successful pass-through businesses.
As lawmakers consider policies to improve the competitiveness of American businesses, they should not forget that individual income tax rates are just as important to business activity as the corporate rate. The various proposals to raise income taxes on high-income earners, either by increasing the top marginal rate, closing “loopholes,” limiting deductions or implementing a minimum tax, would fall very heavily on America”™s non corporate businesses. These flow-through businesses account for a large percentage of business income and employment in the United States. Raising taxes on them at this time could curtail their hiring and other investment plans, further delaying economic recovery.
