Lawmakers Need To Get Serious About Business Tax Reform

Last week, House Ways and Means Committee Chairman Jason Smith (R-MO) said he wants to revisit expanding Section 199A. He argues that the deduction should be as high as 25 percent because pass-through businesses need to compete with C corporations, which face a 21 percent corporate tax rate. Chairman Smith is right that legal form should not determine a business’s tax burden, but that is an argument for repealing the deduction, not expanding it.

Section 199A is a 20 percent deduction that reduces the effective tax rate on qualified income earned by sole proprietors, partnerships, and S corporations. These pass-through businesses, in contrast with traditional C corporations, do not face an entity-level tax. Their profits are “passed through” to their owners and taxed as ordinary income.

The deduction was introduced in 2017 as part of the Tax Cuts and Jobs Act (TCJA). The goal of the deduction was to ensure “parity” between C corporations and pass-through businesses. The deduction was scheduled to expire at the end of 2025, but the One Big Beautiful Bill Act (OBBBA) made it permanent. The House version of the OBBBA proposed expanding the deduction to 23 percent. The current 20 percent deduction reduces the top marginal tax rate on pass-through business income to 29.6 percent. Raising the deduction to 25 percent would reduce that rate to 27.75 percent.

Pass-through businesses are already tax advantaged. Although C corporations face a 21 percent corporate tax rate, their profits are also subject to the individual income tax when distributed to shareholders. After considering various tax provisions that reduce the tax burden on C corporation shareholders, the Congressional Budget Office (CBO) finds that pass-through business investment faces a lower tax burden than C corporate investment.

Expanding the deduction would do little to enhance the competitive advantage of pass-through businesses. In fact, they would maintain a tax advantage even if 199A were repealed. This is because expensing already reduces the tax on new pass-through investment to roughly zero, while it only shields C corporations only against the 21 percent corporate rate. The shareholder-level tax on the return is untouched.

An enhanced deduction would primarily make it even less attractive to use the C corporate form. This has economic implications because C corporations have better access to outside capital.

The deduction also encourages tax avoidance. Owners of certain pass-through businesses are required to split their compensation between labor and capital income. The salaries that these owners pay themselves face a combined marginal rate of 40.2 percent. Meanwhile, profits are taxed at a top rate of 29.6 percent. As a result, taxpayers can save 10.6 cents per dollar of labor income reclassified as a profit. Smith’s proposal would increase that to 12.4 cents.

Finally, this deduction is inconsistent with canonical, pro-growth tax reform. Proposals such as the Hall-Rabushka flat tax, the Bradford X Tax, the FairTax, Treasury’s 1977 Blueprints for Basic Tax Reform, Treasury’s 1992 corporate integration proposals, the Bush Panel’s Growth and Investment Tax Plan, and the Nunn-Domenici USA Tax differ in many respects, but they share one feature: they seek to treat all business entities the same. They all accomplish this in various ways, but none of them use a special deduction for pass-through business income.

Instead of expanding this deduction, lawmakers should find ways to repeal it entirely. In a previous paper, I explored various reforms to standardize business taxation and improve tax parity. These reforms include taxing all businesses under a single entity tax, taxing all businesses as pass-throughs, and enacting what is called “credit imputation” corporate integration. All three proposals would improve business “parity” to some degree. Short of reform, simply repealing the deduction outright would be an improvement.

Expanding the pass-through business deduction would be a mistake. After the passage of the OBBBA, lawmakers now have time to plan the next business tax reform. Such a reform should tax business income neutrally and eliminate this deduction.

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