There are two ways to tax US business income: at the entity level with a corporate tax, or at the owner level by passing business income through to individual tax returns. The choice affects how much revenue the government can raise, how hard the system is to enforce, and how strongly taxes discourage investment. 

Economists and policy experts have long been skeptical of the corporate tax. But two modern trends challenge the traditional argument, as we explain in a new paper. First, the corporate tax is increasingly efficient because it has come to resemble a cash flow tax focused on economic rents. Second, partnerships, which are one type of pass-through entity, have grown into complex, sprawling structures that are extremely difficult to audit. Both trends strengthen the case for a broader use of the entity-level corporate tax, rather than pass-through taxation.

Trend 1: The corporate income tax has become more efficient

In recent decades, the US business tax system has quietly transitioned from a traditional income tax toward a “cash flow” tax. While an income tax requires businesses to write off the cost of investment slowly over time, the current system increasingly allows immediate "expensing" of the full cost of new equipment and intangibles.

This shift creates a more efficient tax base. By allowing immediate deductions, a cash flow tax effectively exempts the “normal return”—the basic profit needed to justify an investment—from tax. Instead, the tax falls primarily on “economic rents,” or the excess profits earned from unique advantages like market power. Because investors will chase rents even at high tax rates, taxing them generally does not discourage investment.              

However, these efficiency gains do not carry over to pass-through taxation. To work properly, a cash flow tax requires a constant tax rate over time. But pass-through owners face individual tax rates that fluctuate with their annual income. If an owner expenses an investment in a high-tax year but earns the future profits in a low-tax year, the system can generate a negative tax rate, effectively subsidizing inefficient projects. C corporations, by contrast, generally face a stable flat rate (currently 21 percent), preserving the efficiency of the cash flow model.

Historically, a primary justification for pass-through taxation has been the ability to apply progressive, individualized rates to business owners. But this rationale loses weight when the tax falls on economic rents. Because taxing rents doesn’t change behavior, rents can face a high, flat rate without harming the economy; progressivity can be achieved elsewhere. Consequently, the convergence toward a cash flow base has made entity-level taxation more efficient relative to pass-throughs, with fewer fairness concerns.

Trend 2: Partnerships have become very large and complex, stymieing IRS enforcement

Pass-through taxation was originally meant to serve small, closely held firms. That landscape has changed dramatically. Partnerships now account for 35 percent of US business income, most of which comes from large firms (over $100 million of assets). The number of large partnerships has quadrupled since 2003, now vastly outnumbering large corporations.

These partnerships have become extremely complex. Most importantly, when partnerships are “stacked” (a partnership is a partner in another partnership), these complexities compound and multiply. Now over 30 percent of large partnerships involve at least 20 tiers, and the average large partnership has over 500,000 partners once ownership is traced through multiple layers of partnerships. 

This complexity has made tax enforcement extremely challenging. Audit rates for large partnerships have fallen to near-zero, standing at just 0.27 percent in 2019, drastically lower than similarly-sized corporations. When the IRS attempts an audit, it often fails, even after expending many hours. Most complex partnership audits are closed with “no change” to the tax return, often running out of time under the statute of limitations.

Pass-through rules were simply not built for this scale, with many stacked layers, partners, assets, and streams of income. These are the exact types of concerns that led Congress to tax publicly traded partnerships as corporations in 1987.

Policy implications: A practical backstop for complex partnerships

These two trends—the growing efficiency of the corporate tax and increasing complexity of partnerships—point toward strengthening entity-level corporate taxation. Policymakers have several options, each with challenges. The best response might combine more than one.

• Staff up the IRS: Enforcement can be highly cost-effective, with estimated returns of up to $20 for every $1 spent on auditing complex partnerships. But staffing increases may not be enough to unpack the most complex, multi-tiered partnerships, and IRS funding is often politically unstable.
• Enhance information reporting: Policymakers could also mandate detailed information reporting for interconnected partnerships to facilitate automated IRS enforcement and create compliance-based deterrents against excessive structural layering.
• Reduce special tax deductions for pass-throughs: Reducing or eliminating the Section 199A 20 percent deduction for qualified business income could raise roughly $700 billion over ten years and reduce the tax advantage of the pass-through form, though effects may be limited in some sectors.
• Assess a complexity fee: A fee that rises with audit difficulty could discourage unnecessary complexity and cause complex partnerships to internalize the broader social costs of this complexity, but it would be a new instrument that brings its own administrative and political challenges.
• Restrict pass-through treatment to smaller, simpler firms: Requiring complex partnerships—especially those with stacking—to be taxed as corporations would simplify enforcement, but thresholds could create avoidance incentives, require difficult transitions, or discourage efficient business structures.

The US tax system is moving toward faster deductions for investment, and partnerships are becoming larger and more complex. This weakens the traditional case for taxing business income primarily through owners’ individual returns. 

A stronger entity-level corporate tax can raise revenue efficiently and help protect the integrity of the tax system in today’s economy. But designing the right reforms will require more work, especially to weigh enforcement gains against potential disruption to legitimate business arrangements.