Trump’s proposed tax rate for “pass-through” businesses is unfair

President Trump has proposed a maximum 25% tax rate on income that individuals receive from “pass through entities”.  Pass through entities are businesses that don’t pay corporate income taxes, but rather pass their net income each year through to the owners to be taxed as part of the owners’ individual tax return.  These pass through entities include S-Corporations, partnerships, limited liability companies (LLCs), and sole proprietorships.  Currently, income from pass through entities is taxed at the same rate as any other ordinary income – up to a maximum rate of 39.5%.  (President Trump’s proposal for ordinary income for most taxpayers is a maximum tax rate of 35%.)  He justifies the lower tax rate for pass through entities because, he says, these pass through businesses are the job creators.

This begs at least two questions:  Do pass through entities really create more jobs than non-pass through entities?  Even if so, why should the income of an employer be taxed at a lower rate than an employee if they earn the same amount?  Tax fairness would dictate that two people with the same income would pay the same amount of tax, regardless of source.

Regarding job creation, it is important to know that pass through entities are not just manufacturers, wholesalers or retailers, who may or may not be job creators.  They are also professionals such as doctors, lawyers, accountants. Most hedge funds and private equity funds are pass through entities.  About 95% of all businesses are pass through entities.  Of those, about 99% have revenues of less than $10 million.  The 1% of pass through entities with revenues of more than $10 million earn about 83% of all profits!  So, some pass through entities are very large, and many owners of pass through entities have very high incomes.  Is it fair for business owners to pay at a 25% rate while regular workers with the same income pay at a 35% rate?  I don’t think so.

I expect to write several blog posts on President Trump’s tax proposal.  The idea of reducing tax rates is a good one – especially if the total plan is revenue neutral and doesn’t increase our $20 Trillion debt.  This means that tax reform that reduces rates must also reduce special tax breaks for politically favored groups and/or reduce spending.  I hope that Congress, which controls all tax legislation, will not “bet on the come” – that is assume future tax revenue will increase due to future growth in the economy.  Our government uses a 10 year look forward to determine the deficit/surplus effect of any change in taxing or spending.  In recent decades, it seems that all tax and spending changes have significant costs up front with the promise of savings toward the end the the 10 year period.  Let’s not keep doing that.

Source: https://www.brookings.edu/research/9-facts-about-pass-through-businesses/

Don’t demonize Walgreens.

Don’t demonize Walgreens for taking action to legally lower its U.S. federal income taxes.  The Des Moines Register and President Obama are wrong when they say that taking advantage of this legal tax break is unpatriotic.  As the Register reported, Walgreens can save $4 billion in federal taxes over the next 5 years by changing its corporate headquarters to Switzerland.  (See Register article: “Walgreens turns back on taxpayers” 8/3/2014)

The Register asked: “How much profit does a company need?”  “How much is enough?”  They went on to list all of the benefits that Walgreens receives by operating in the U.S. They tried to shame Walgreens for their proposed action, and effectively called for a boycott of Walgreens in protest.

The Register gave lip service to the fact that the U.S. has very high corporate tax rates compared to most other modern countries, and that tax reform is needed to close loopholes and bring down rates.  That should have been the primary message of the editorial, that we need to close loopholes and lower rates, not that Walgreens might take advantage of one.

Many companies and other taxpayers pay substantially lower their taxes by taking advantage of loopholes:  Oil and other natural resource extraction industries have their depletion allowance; hedge fund managers have their “carried interest” bonuses payments.  There are many many types of tax credits and deductions that benefit only politically favored businesses.  Many unfair loopholes go to very wealthy and profitable companies and individuals.  How does Warren Buffet pay less than 20% in federal income taxes?  Loopholes.  Why do some of the largest, wealthiest, most profitable research based companies in Iowa pay no income tax?  Loopholes.  Are all of these people and companies unpatriotic because they don’t pay more taxes than required by law?

In this case, the problem is not Walgreens or the specific loophole.  It is the high corporate income tax rates in the U.S.  The U.S. needs to significantly lower its corporate income tax rates.  Otherwise, over time, companies will actually move their headquarters to lower tax countries.  Given the inherent unfairness of special interest loopholes, and given the unconscionably high U.S. federal debt, it seems obvious that we should close as many of these loopholes as possible, and lower tax rates at the same time in a revenue neutral way.

Full disclosure:  I am a Walgreens stockholder.

Link to Register editorial:  http://www.desmoinesregister.com/story/opinion/editorials/2014/08/03/editorial-walgreens-turns-back-taxpayers/13531911/

Raise tax rate on capital gains.

The 15% income tax rate on long term capital gains is a very significant tax break for business owners and investors, including the very wealthy.  It is a big part of the reason why Warren Buffet and Mitt Romney pay such a low rate on their income taxes.  A capital gain is the profit made on investments such as stocks, businesses, and real estate.  For tax purposes, a capital gain is considered “long term”, and receives the low 15% rate, if the asset was held for at least one year.  (Short term capital gains, on investments held less than a year, are taxed at ordinary income tax rates – up to 35%.)

One justification for the lower tax rate is to encourage investment.  In theory, if you lower the tax rate on certain investments, more people will put their money in those types of investments.  But, people who save their money in a bank or who buy bonds also encourage investment, and their profit, the interest they earn, is taxed at ordinary income tax rates – up to 35%.  It seems unfair to tax interest and capital gains at different rates.

Another justification for taxing long term capital gains at a lower rate is to account for inflation.  If you doubled your money on an investment, your real profit, (adjusted for inflation), is quite different depending on how long you owned the investment.  If you doubled your money in only one year, you did great.  But if it took you 20 years to double your money, you did rather poorly.  If your investment grows, but at a rate slower than inflation, then you are actually losing spending power.  The fair way to tax capital gains would be to adjust the gains for any inflation that occurred while the money was invested.  Then, tax the real gain, after adjusting for inflation, using ordinary tax rates – up to 35%.

Interest income could also be taxed the same way.  If interest earned was for a period longer than a year, then it could also be adjusted for inflation and the tax would be paid only on the real earnings, after adjusting for inflation.

Capital gains and interest income would both be taxed at ordinary tax rates – up to 35%.  That would be fair for everyone.