I applaud Trump’s willingness to lower the business tax rates in our country, which are among the highest rates in the industrialized world. Yet there are serious problems with his plans. It’s clear that Trump’s heart is in the right place — as evidenced by his pro-growth ideas — but the magnitude of issues within his proposal makes this reform plan a non-starter. As a practical matter, what he wants to implement can’t be done.
On a basic level, reducing the corporate tax rate to 15% is too much of a cut. Under Trump’s proposal, the corporate rate reduction would be offset to some degree by also eliminating tax preferences and loophole deductions — which is not necessarily a bad approach. Unfortunately, there are not enough of them to eliminate to balance out the revenue lost to the reduction or reduce individual rates.. If we want to be fiscally responsible, we have to choose a percentage that can be made up with economic growth; a 20%-25% rate is more realistic — which can then also be used to reduce the individual margins.
A reduction in individual rates is necessary as well, for two important reasons. First, the substantial tax increase from Obama’s elimination of the Bush tax cuts and the institution of Obamacare tax increases at the higher brackets have had a stifling effect on economic growth and must be reversed. Second, because most businesses in the United States are actually structured as flow-through entities (FTE’s) (S corporations, sole proprietorships, and partnerships, and LLC’s) rather than as separately taxed corporations, any business tax cut must have a corresponding personal rate cut.
Trump has proposed that the new corporate 15% rate also apply to FTE’s, though not to other individual income. This is absolutely and totally unrealistic, since it is simply not practical to separate business income from non business income that are also generated by FTE’s. For instance, if you are a partner in a partnership making widgets, the partnership income would be taxed at individual rates (max 39.6%). But partners do not get salaries – the partnership income also includes what is earned by the partner’s work effort. And to tax the partner’s labor at 15% while the other employee’s labor is taxed at higher rates is nonsensical. And the complications of trying to separate the partner’s labor from the business profits would be an administrative nightmare, and just far too ripe for abuse.
So, what’s a good solution? First, the corporate rate should be lowered to 20%-25%, not 15%. That guarantees that the revenue loss would be less and more easily be offset, and it allows room for a meaningful rate reduction for individuals. The corporate rate should be less than the individual rate, and here’s why: corporate shareholders face a punitive double taxation. Income is subject to the corporate tax rate (currently max 35%) and then that same income is taxed again when it is paid to shareholders as dividends (currently max 23.8%) at the individual level.
In contrast, income from FTE’s are taxed one time (currently max 39.6%), so their rate can be a little bit more. A target maximum rate should fall somewhere between 27.5%-33%. If individual rates can be reduced to about 30%, and the corporate tax reduced to about 20-25%, it puts the rates close together so businesses are on somewhat equal footing.
Trump’s desire to reduce taxation on our businesses is admirable, but his reforms need to be grounded in reality. Meaningful tax changes would include cuts to both the corporate rate and individual margins, but not so deep that they cannot be made up or are administratively burdensome to implement. This would ensure businesses have a fighting chance to bring about economic revitalization and would be a good start to true, broad reform that our tax code desperately needs.