Analysis of Sen. Wyden’s Pass-through Deduction Proposal

August 17, 2021

Senator Ron Wyden (D-OR) recently introduced the Small Business Tax Fairness Act—the impact of which we modeled—to reform the Section 199A pass-through business deduction created in the Tax Cuts and Jobs Act (TCJA) of 2017. The provision currently allows taxpayers to deduct up to 20 percent of their qualified business income from their taxable income, subject to certain limitations. Wyden’s bill would make the following changes to the deduction, which is scheduled to expire altogether in 2026:

  • Phase out the deduction for taxpayers with taxable income above $400,000, with a full phaseout at $500,000
  • Remove the limitations of the deduction for a “specified service trade and business,” which include services in health care, law, finance, accounting, athletics, consulting, and the performing arts
  • Forbid deduction for married taxpayers filing separately, and for estates and trusts

There are a few smaller changes within the bill that we did not model, including:

  • New limitations for agricultural cooperatives
  • New limitations for qualified real estate investment trusts (REITs).

Using the Tax Foundation’s model, we estimate that the bill would raise about $114 billion on a conventional basis over the next four years. The changes raise no revenue from 2026 to 2031, as the pass-through deduction is scheduled to expire at the end of 2025.

Taxpayers earning above $400,000 would face higher marginal tax rates due to the phaseout of the deduction between $400,000 and $500,000 in income, which would discourage pass-through investment and slightly reduce the return to work from 2022 to 2025. This reduces dynamic tax revenue slightly to about $112 billion over the next four years on a dynamic basis.

Revenue Effect of the Proposed Small Business Tax Fairness Act, 2022 to 2031 (Billions of Dollars)
  2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Total
Conventional $27.0 $28.1 $28.8 $30.2 $0 $0 $0 $0 $0 $0 $114.1
Dynamic $26.7 $27.6 $28.3 $29.5 $0 $0 $0 $0 $0 $0 $112.1

Source: Tax Foundation General Equilibrium Model, August 2021. Note: Figures may not sum due to rounding.

As the pass-through deduction is set to expire in 2026, these changes have no impact on long-run GDP.

On a distributional basis, all taxpayers would see slight reductions in their incomes, but the largest impact would be for those in the top quintile. Their incomes would decline by 0.3 percent due to the phaseout in the deduction for those earning over $400,000.

Breaking the results down by type of filer (not shown) indicates single filers earning between $200,000 and $500,000, roughly the top 5 percent of earners, would gain slightly, because the deduction would phase out at much higher incomes than under current law. Currently, individuals earning over $165,000 are subject to limitations, while the proposal would phase out the deduction beginning at $400,000.

Distributional Effect of the Proposed Small Business Tax Fairness Act (Percent Change of After-Tax Income)
Income Quintile Conventional 2022 Conventional 2031 Long-Run Dynamic
0% to 20% Less than -0.05% 0% 0%
20% to 40% Less than -0.05% 0% 0%
40% to 60% -0.1% 0% 0%
60% to 80% -0.1% 0% 0%
80% to 100% -0.3% 0% 0%
       
80% to 90% -0.2% 0% 0%
90% to 95% -0.3% 0% 0%
95% to 99% -0.4% 0% 0%
99% to 100% -0.3% 0% 0%
       
TOTAL -0.2% 0% 0%

Source: Tax Foundation General Equilibrium Model, August 2021.

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A 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.

The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by $1.47 trillion over 10 years before accounting for economic growth.

After-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income.

The 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.

Taxable 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.