House Speaker Paul Ryan (R-WI) says the House GOP tax bill will retain the top 39.6 percent individual income tax rate for taxpayers with very high incomes, instead of cutting the top rate to 35 percent as Republicans proposed earlier this year. Here are three reasons why that plan is likely to create more problems than it solves.
1. “Let me tell you about the very rich. They are different from you and me.”
While most Americans get the bulk of their income from wages and salaries, taxpayers making more than $1 million dollars per year receive just 30 percent of their income as wages. More than 60 percent comes from qualified dividends, capital gains, or some form of pass-through income—all of which is likely to be taxed at rates much lower than 39.6 percent under the House GOP plan.
2. “You’re gonna need a bigger boat.”
Or at least bigger “guardrails.” The House bill is expected to include a provision to reduce the maximum income tax rate on pass-throughs, such as partnerships, to 25 percent. The bill’s authors are struggling to address tax avoidance problems that result from taxing pass-through income at lower rates than ordinary income. But preventing abuse is more difficult when the tax rate differential between the two forms of income is nearly 15 percentage points (39.6 percent v. 25 percent) instead of 10 percentage points (35 percent v. 25 percent).
3. “Corporations are people, my friend.”
Or rather people may choose to be corporations. An under-appreciated consequence of a 20 percent corporate income tax rate is that corporations may become a source of tax avoidance. Here’s how: As far as we know, the House GOP bill would cut the corporate rate to 20 percent and retain the maximum 23.8 percent tax rate on dividends and capital gains. Thus, $100 earned within a C corporation and immediately distributed to shareholders would pay $20 in corporate tax and another $19 in individual tax (23.8 percent of the $80 of after-tax profits) for a total tax rate of 39 percent, lower than the 39.6 percent top ordinary individual income tax rate.
But that second layer of tax is not collected unless the corporation pays a dividend or the owner sells shares in the firm and realizes a capital gain. Wealthy individuals might very well decide to incorporate, pay the 20 percent tax rate, and try to defer any remaining tax by retaining the income within the corporation. They might also start lobbying for the “Dividend Tax Holiday Act of 2020.”
Congress might be able to fix all these problems over the next several months. Previous experiences have led Congress to enact provisions to tax accumulated earnings and so-called “collapsible corporations.” But they illustrate what can happen when lawmakers make ad hoc changes in complicated tax legislation they are rushing to pass.
