A recent NBER working paper authored by academics and U.S. Treasury economists finds that not all types of businesses face the same taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rate. For example, the paper finds that partnerships pay a lower average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. than traditional corporations. These results suggest that having a high corporate tax rate influences the organizational form of businesses.
For most of the 20th century, the U.S. corporate tax rate remained significantly below the top U.S. marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. for individuals. Then during the Reagan administration, the Tax Reform Act of 1986 cut the corporate rate from 46% to 34% and the top marginal rate from 50% to 28%. The corporate rate increased slightly to 35% during the Clinton administration and the top marginal rate rose to 39.6%. The corporate rate has not changed since the early 1990s. Overall, the gap between the corporate rate and the individual rate has shrunk rapidly in the past three decades.
As a consequence of these tax changes, individuals began reporting their business income through “pass-through entities” rather than traditional corporations (C-corps) in order to lower their effective tax burdens. Pass-through entities include sole proprietorships, partnerships, LLCs, and S-corporations. As a percentage of total business income, the income from C-corps has fallen from roughly three-quarter to less than half. The graph below from the NBER paper illustrates these shifts in business income:
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Source: Cooper et al., 2015. “Business in the United States: Who Owns It and How Much Tax Do They Pay?”
Using 2011 tax returns, the authors estimate an average corporate tax rate of 31.6%. For partnerships and S-corps, they estimate average tax rates of 15.9% and 24.9% respectively. However, the discrepancies in these rates are not entirely due to the difference between the corporate rate and the top marginal rate levied on individual incomes. The authors find that 70% of partnership income is generated by financial and holding companies. These companies derive most of their income from capital gains and dividends, which are taxed at lower rates.
An entrepreneur should base his business’s structure on his capital and financial needs, not the tax code. Two tax codes, one for corporate income and another for individual income, introduce unnecessary distortions into our tax system. Integrating the individual and corporate income tax could alleviate many of these economic distortions without reducing tax revenues.
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