The big winners

The big winners from Trump’s business tax cut

How a tiny slice of top earners would reap a windfall from a lower small-business tax rate.

By DANNY VINIK

Will the Trump administration’s proposed cut in small-business taxes create a windfall for the rich?

The new tax proposal released by the White House today—“the biggest tax cut and the largest tax reform in the history of our country,” Treasury Secretary Steven Mnuchin declared—promises to cut the corporate tax rate to 15 percent, and also cut to 15 percent another business rate called the “pass-through” rate. This is how most of America’s small-business owners pay their taxes. By reducing it, Trump promises to put more money in pockets of America’s small business owners, allowing them to expand their operations and hire more workers.

But if it passes, that new lower tax rate is likely to benefit mom-and-pop businesses far less than it helps the ultra-rich. That’s because it’s actually the rich who earn most small business income. In 2016, according to estimates from the nonpartisan Tax Policy Center, the top 1 percent of small businesses earned 50.8 percent of all small business income—and the slice at the very top, the top 0.1 percent of small businesses, earned a whopping 22.8 percent of the money. (The bottom 20 percent, in comparison, received just 4.1 percent of such income.)

The secret about small businesses in the United States is that the really profitable ones aren’t your mom-and-pop shops, the kind of local carpenter or family restaurant that politicians love to visit and talk about. Most of the money in the small-business tax category is earned by a tiny subset of extremely profitable businesses—many in finance—whose owners are in the top of the income distribution, and would be the largest beneficiaries of Trump’s tax plan.

When tax experts talk about small business taxes, they have something specific in mind: entities whose income is “passed through” from the business to the individual owner and taxed according to the individual side of the tax code. So-called “pass-through” businesses generally fall into one of three categories—S-corporations, sole proprietorships and partnerships. They aren’t always that small: S-corporations can have up to 100 shareholders, while partnerships can have an unlimited number of partners and hundreds or thousands of employees.

The pass-through structure has proven increasingly popular in the United States because of the country’s high statutory corporate tax rate of 35 percent. Companies structured this way can “pass through” their earnings and have partners pay at their personal rates, which are often lower than they’d pay under the corporate tax system. And the tax rate on corporate owners can stack up: A company first pays its normal corporate taxes and then its owners—shareholders—pay investment taxes on their dividends and capital gains. As individual tax rates have fallen, the ability to pass income through to the individual side of the tax code, avoiding the corporate side entirely, has proven more and more enticing.

Thus pass-throughs have come to represent a growing share of the American private sector. According to a recent paper by Treasury Department economist Michael Cooper and seven co-authors that used administrative tax data, the share of total business income that accrues to pass-throughs rose from less than 25 percent in 1980 to more than half in 2012. In particular, partnerships have grown from near non-existence in the 1980s to a major business structure today.

Who exactly are the owners of these pass-throughs? There isn’t great overall data on this. Many are small proprietors like an auto mechanic or restaurant owner. There’s more clarity on partnerships. Americans might think of local law firms or doctors’ offices when they think of partnerships, but the Cooper paper finds that about 70 percent of partnership income came from the finance industry or holding companies. Just 11 percent came from professional services, which includes lawyers, and 4.1 percent came from the health care industry. It’s impossible to say more specifically about the financial firms or holding companies that are structured as pass-throughs, but it’s clear they aren’t your local corner store. The paper also has another stark finding on partnerships: Of the partnership income, 69 percent accrues to the top 1 percent of households.

Of course, that is only one of the three main types of pass-throughs. It says nothing about sole proprietorships or S-corps. But other data from the Tax Policy Center provide even more evidence for how the rich benefit from pass-throughs. According to its estimates, in 2016, 94 percent of partnership and S-corp income went to the top 20 percent; nearly 70 percent went to the top 1 percent. As for sole proprietorships, which can have just one owner and include many traditional mom-and-pop stores, more than half of income from such entities accrued to the top fifth. The bottom 20 percent received around 11 percent of sole proprietorship income.

For people worried about income inequality, pass-throughs are becoming an important topic. Last week, two economists released a paper that looked at top income inequality over the past few decades, and found that the top 1 percent and top 0.1 percent of Americans haven’t actually been taking home a greater share of the overall American paycheck—wages and other compensation—since 2000; that trend has been surprisingly flat. But the richest Americans—especially the top 0.01 percent—are earning a greater share of pass-through income. If you want to see where the rise in income inequality is located, that’s where to look. “It really comes from a lot of income flowing through S-Corps to the very, very, very rich, said Fatih Guvenen, an economist at the University of Minnesota and a co-author of the paper. “The top 0.01 percent.”

This brings us back to Trump’s proposed cut in the tax rate on pass-throughs. Nearly 70 percent of small businesses already pay taxes at a marginal rate of 15 percent or lower, which means that Trump’s plan won’t help them at all. The businesses poised to reap the biggest return are the small fraction that paid a marginal rate above 30 percent. Though such businesses represent a tiny slice of the total number—just 2.4 percent of pass-throughs, about 910,000 in total—they earned more than 50 percent of pass-through income last year. It’s those businesses that will see huge increases in their after-tax earnings under Trump’s plan.

Stephen Moore, the conservative economist who helped Trump write his tax plan during the presidential campaign, says that the goal of a low pass-through rate is to encourage small businesses to invest more, benefiting workers. “We don’t want rich people to walk off with more money,” he said in an interview. Moore suggested that there could be a penalty for firms that don’t re-invest the tax windfall in their businesses. “You could potentially have a thing where if you take it out, you’re taxed at dividend or personal income tax rate,” he said. “But if you put income back into the company, then you would get the lower rate.” That’s basically how corporate taxes currently work.

Many people worry that changing the pass-through rate will also create a new loophole for the wealthy, encouraging them to reclassify their income as small business income to avoid the now-higher individual tax rates. Trump’s proposal would have just three rates on the individual side, at 10, 25 and 35 percent, so wealthy people could reduce their tax burden by getting paid as small businesses instead. The government promises that this won’t happen, though hasn’t specified rules for how it would be prevented.

Even if those to-be-determined rules work, the overall portrait of American small businesses suggests that Trump’s 15 percent pass-through rate is unlikely to encourage mom-and-pop shops across America to hire new workers or expand their store. Most of them already pay low taxes, and thus won’t benefit from Trump’s plan. The huge windfall—nearly $900 billion over 10 years, according to the Tax Policy Center—would go to the small subset of Americans who have been already been some of the biggest winners of the modern economy.