Don’t believe the news of a new “top rate” in the forthcoming Republican tax plan: Their enormous “pass-through” loophole makes it largely irrelevant
House Republicans look set to unveil their tax bill on November 1. The “Unified Framework” previewing their plan included only three tax brackets: 12, 25, and 35 percent. But given that all independent analysis of their plan shows it adds enormously to deficits, they have publicly contemplated adding a fourth tax bracket above 35 percent to boost revenue. That top bracket may stay at the current 39.6 rate or be lower than the current rate while remaining above 35 percent. But when the tax plan is unveiled, no one should be tricked by this rate. The rate they choose doesn’t really matter all that much thanks to another loophole they’ve added, which all but ensures that that high income households won’t be paying more than 25 percent. They have disguised the loophole as helping small businesses since it’s targeted at so-called “pass-through income.” But while all small businesses are “pass-throughs”, not all pass-throughs are small businesses—lots of them include wildly rich businesses like hedge funds and private equity firms and boutique law firms. 86 percent of households with pass-through income already pay 25 percent or less—think of these as genuine small businesses. But 49 percent of all pass-through income goes to just the top 1 percent of households. This means that lowering the pass-through rate to 25 percent clearly makes this a tax cut for hedge funds, law firms, and private equity partners, not genuine small businesses. But from that egregiously tilted starting point, the loophole will still get worse, as it leads to rich individuals hiring accountants to re-classify other forms of income as pass-through income.
This means that rich households won’t be paying the top rate on ordinary income, wherever Republicans set it. Instead, their lawyers and accountants will ensure that the income they earn is routed through pass-through businesses like LLCs. This will allow rich households to pay a 25 percent top rate instead of 35 or 39.6.
We’ve seen this before. A lower pass-through rate was part of the failed Kansas “experiment.” And in Kansas, the top individual state income tax rate was only 4.6 percent higher than what was levied on pass-through entities. That difference was enough for the University of Kansas men’s basketball coach and football coach to route their income through LLC’s. The Republican “Unified Framework” plan proposes a difference of 10 to 14.6 percent between the top individual rate and the pass-through rate.
Republicans have been hand waiving about corporate taxes trickling down to claim their plan isn’t a tax cut for the rich. But economic evidence doesn’t support this reasoning. It appears they’ll do similar hand waiving with their new top tax rate. But people shouldn’t be tricked by this plank either, as once again there is no substance behind Republican rhetoric. There is overwhelming evidence that the Republican plan is a tax cut for the rich. Importantly, the pass-through loophole means that a new top rate can’t change this. Rich households with competent lawyers and accountants won’t pay more than a 25 percent top rate.