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Tax reform is one of the top goals of the Trump administration.
But the most important tax reform is being overlooked—even
ignored. Reworking the taxation of pass-through income and
reducing its burden may have a far broader effect on economic
performance. This includes workers’ wages and employment demand.
Lowering corporate taxes will surely have an impact on the
actions of businesses… but not to the extent of lowering
pass-through tax rates.

People who own their own companies (i.e., partnerships, LLCs, and
certain types of corporations) pay taxes that are
“passed-through” to them. Instead of paying taxes at the
corporate level, the taxes are paid at the individual’s marginal
tax rate. This distinction matters. And the way in which the tax
code evolves to address this issue will affect the economic
efficacy of tax reform.

Small businesses are the lifeblood of the US
economy

There’s a well-known saying: small businesses rule the US
economic landscape. From employment to hiring, they are the
lifeblood of the US economy. Google and Facebook may get the
headlines, but make no mistake, the US economy relies on the
little guys.

These same small businesses make up the vast majority of
pass-throughs. In fact, according to the IRS, the number of
pass-through entities has increased over the past 30 or more
years. Since this is where the US economic engine is housed,
there should be no confusion about where the tax code could have
the biggest impact. Despite this rise in popularity, there has
been little talk about just how much these businesses matter to
the US economy.

But will pass-throughs garner more attention with a renewed
policy toward job creation? Maybe, but it is quite unclear. The
Trump administration’s main focus thus far has been manufacturing
and trade fairness…not on reforming the US economy to get the
most out of its spending.

But manufacturing rules the day

The emphasis placed on manufacturing could be why pass-through
income tax reform is on the back burner. (Or why it has yet to
become a part of the debate.) According to the Census Bureau,
manufacturing is largely formed under the traditional corporate
umbrella. This means that there would be a greater effect on
manufacturing employment and profits through corporate tax reform
than pass-through tax reform.

Politically, it could also be tricky. Many of the higher wage
earners in the US get their income from pass-through channels. It
could easily be seen as a tax break for the rich without a real
accounting of the potential benefits.

Viewing it as a tax break for the rich, though, is too simple.
Individuals being taxed at the highest marginal rates on
pass-through income are in the top bracket of personal income.
And, reducing pass-through tax rates without changing the tax
code fully would require lowering the highest brackets of
individual tax rates to at least as low as the corporate tax
rate.

It’s too important to ignore

With the sheer importance of what pass-throughs have become to
the US economy, it is strange that there has not been more talk
of their health and security. More people in the US are employed
by these structures than traditional corporations… and
pass-throughs rule the services industries.

Yet, according to the Tax Foundation, the average marginal tax
rate is over 47%, (with some states higher and some lower). If
there is ever a real debate on whether companies or individuals
should get the bulk of the tax cuts, it should be noted that
often they are one and the same.

Yes, this complicates the debate on tax reform. After all, the
taxes paid by most of the businesses in America are not at the
often-cited corporate tax rate. To truly reform the business tax
code, Congress will also need to tackle the individual tax code
or make a specific provision.

The House GOP “A Better Way” plan calls for a top tax rate on
pass-through income of 25%. This contrasts with the top tax
bracket for income proposed at 33%. This may mean there is some
recognition of the importance of pass-throughs, but it may just
be part of an emphasis on lower corporate taxes.

Tax reform is needed. The code is highly complex. There are too
many loopholes. But pass-throughs—the intersection of individual
and corporate taxes—are arguably the most important and least
acknowledged area. Whether you are a business owner or an
employee, more Americans will benefit from reforming the
pass-through tax code than from traditional corporate reform.
Pass it on.