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TPC, What About the “Pass-Throughs?”

3 min readBy: Kyle Pomerleau

The 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. Policy Center recently released a report comparing the United States’ overall taxation on wage income to other OECD counties. It claims that even after the tax increase on January 1st on top incomes from 41.8 to 47.9 percent, the United State still compares well within the OECD. They argue that income taxes affect a country’s ability to compete for workers and conclude:

“The United States compares favorably among major OECD countries, particularly for the majority of Americans who live in states with top income tax rates lower than California’s or with no state income tax at all.”

This analysis is correct: looking at the rates throughout the OECD [see chart above], the United States’ average top marginal income tax rate falls in the middle. Workers probably see the United States as a good deal compared to countries like Denmark which imposes a top rate of more than 60 percent on income.

However, this analysis leaves out a unique aspect of the U.S.’s individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. . A significant portion of “pass-through” business income is subject to the individual income tax in the United States. This makes the recent tax increase more than just a hit to wages for Americans. This recent tax increase hits a significant portion of business income in America and as a result will be especially detrimental to the economy.

“Pass-throughs” are non-corporate firms in which the profits of the business are “passed-through” to the owner. The owner then pays the individual income tax. This is in contrast to a traditional corporation where the profits are taxed at the corporate level at the corporate rate before they are dispersed to shareholders to be taxed again at the individual level.

In the United States, these forms of businesses, subject to the personal income tax, are growing in prominence.

From 1980-2008, the number of these “pass-throughs” grew from 10.9 million to 31.8 million, nearly tripling. In fact, “pass-through” businesses generated more net income than traditional corporations in 2008, making up 61 percent of all business income. According to Treasury data, 50 percent of all pass-through income was subject to the top tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. in 2007. So as a result, the tax increase from 41.8 percent to 47.9 percent is going to fall hard on 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. income.

What makes this tax increase worse than TPC claims is that it will exacerbate the competitive disadvantage these firms have with businesses throughout the world. The top tax rate that these “pass-through” businesses now have to pay is much greater compared to their competitors in the OECD that pay an average 25 percent corporate tax rate.

It is vital that one considers that the individual income tax will become an increasingly important factor in whether our tax system is competitive as “pass-through” businesses continue to become an increasingly prominent share of business income. Consequently, income tax rates should be considered just as important as the corporate tax rates when looking at the competitiveness of U.S. business. Unfortunately, the TPC report completely neglects to mention this important point.