When progressives advocate raising taxes on the top bracket, they envision the government taking more money from jet-setters and C-suite execs. But raising the top rate would also hit lots of small businesses and their employees.
The big corporations that dominate the stock market and make headlines in the business sections of newspapers are known as C corporations for tax purposes. They have a separate tax system from individuals. They pay the corporate tax on their profits, with a unique set of rules for calculating what that means.
It’s not so easy to separate out business taxation from individual taxation, though, because over 95 percent of American businesses are not C corporations.
A new report from the Tax Foundation shines a light on these “pass-through businesses,” so called because their income passes through the individual tax code. Roughly half of business profits in the U.S. are taxed through the individual tax code rather than the corporate tax code.
Sole proprietorships, partnerships and S corporations are the most common kinds of pass-through businesses. Eighty percent of them employ fewer than 100 people. But there are so many of these entities that six in 10 workers in the private economy are employed by pass-throughs.
Among other major developed countries, only Germany has a similarly large pass-through sector. This fact is important to keep in mind for international comparisons of high-earners based on tax data.
The U.S. top bracket has a bunch of small businesses in it that other countries don’t have in their top brackets. A small business can easily have yearly income over $626,350, which is where the top tax rate kicked in for an individual last year.
In 2022, the most recent year for which data are available, $1.6 trillion of the just under $15 trillion Americans reported in personal income to the IRS came from pass-through businesses. That $1.6 trillion is heavily concentrated in the top tax bracket. For individual tax returns reporting over $1 million, 29 percent of that income was actually from pass-through businesses.
Reasonable people understand that a small business with income of $1 million should not be taxed the same as an individual who makes $1 million. That’s why Congress created a special deduction for pass-through businesses to help equalize their tax treatment with C corporations.
Pass-through business taxation is notoriously complicated. Small business owners frequently make innocent mistakes, and there are also countless legal ways to avoid taxes.
The Tax Foundation estimates that compliance costs for those filing as pass-through businesses are over $100 billion per year. That’s basically the entire annual revenue of Target or the entire annual budget for food stamps vanishing due to the costs of tax paperwork.
An obvious solution would be to separate business income entirely from individual income. If the government decided to go that route, though, it would mean that almost a third of the “millionaire” income that progressives want to tax more heavily would disappear from the top bracket.
And it would mean that decisions about raising the corporate tax would then need to include consideration for the millions of small businesses that politicians generally don’t want to burden more.
As things stand, taxing “the rich” would affect most private-sector workers, who are employed by pass-throughs but are not rich themselves. Jacking up taxes on small employers isn’t going to help make the American economy fairer or more competitive.
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