While proponents of the Section 199A pass-through deduction claimed it would boost investment and critics claimed it would encourage 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. avoidance and income shifting, new research casts doubt on both claims. The Tax Cuts and Jobs Act of 2017 (TCJA) enacted the new provision that allows taxpayers with income from pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es (S corps, partnerships, and sole proprietorships) to exclude up to 20 percent of their Qualified Business Income (QBI) from their taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . Initial research from Treasury economists finds some evidence of income shifting for partnerships, but the researchers did not find large behavioral changes overall or major changes in real economic activity like new investment.
The deduction reduces 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. s on QBI earned by pass-through businesses by between 2 and 7 percentage points, depending on a business owner’s reported income. Businesses with income above a certain threshold who receive their income from a “specified services trade or businesses” (SSTB) cannot receive the full 20 percent deduction, and at certain income levels the deduction is disallowed altogether.
For businesses that qualify for the deduction, the policy change could have stimulated real economic activity by incentivizing owners to increase investment or hire more workers. Alternatively, rather than generating new economic activity, the deduction could merely shift economic activity if businesses restructured their organizational form to pay taxes at a lower rate. In addition, owners of partnerships and S corps may have an incentive to reclassify their labor compensation as business profits to receive the deduction, and employees might become contractors to also qualify for the deduction.
Using 2018 tax data and comparing pass-throughs with non-SSTB income to those with SSTB income, the authors find only modest economic responses to the deduction and no large changes in taxpayer behavior. QBI overall did not increase in 2018, as one would expect if there were large-scale tax avoidance. The authors do not find that workers changed their status to contractors to claim the deduction and do not find S corps reduced their labor compensation to owners. However, the authors find that payments to partners dropped, consistent with certain tax avoidance strategies and prior research on a similar pass-through deduction enacted in Kansas in 2012 (and later repealed).
As the authors note, one-year data following a tax change will not fully capture its long-run impacts. More research to fully assess the effects will be needed. Nonetheless, when considering other factors, we should expect muted effects overall. As the TCJA altered both the taxation of pass-through entities and C corporations, it is not clear which legal form confers additional benefits to owners. Research suggests that since the Tax Reform Act of 1986, business owners have generally preferred to organize as pass-throughs, and their average effective tax rate could be as low as 13 percent based on recent IRS data or as high as 19 percent based on pre-TCJA research. However, the TCJA also cut the corporate tax rate to 21 percent, reducing the effective tax rates on corporations.
Given that partnerships and S corps were already growing as a preferred organization form for many businesses prior to the TCJA, it is unclear whether the TCJA accelerated the trend. Recent research suggests that “an array of factors make the organizational form decision more difficult and less predictable than in 1986,” especially when considering that the pass-through deduction is set to expire after 2025 while the corporate rate change remains permanent.
While the long-term effects of the pass-through deduction remain unclear, the provision almost certainly introduced more complexity into the tax code and opportunities for abuse. When policymakers are deciding whether to renew it in 2025, they should consider other alternatives to reduce the effective tax rates on pass-through businesses or better structure the deduction to ensure it is simpler and more effectively incentivizes additional investment.
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