Key Points
- The Tax Cuts and Jobs Act included a new deduction for pass-through business income (Section 199A), allowing taxpayers to deduct up to 20 percent of qualifying business income against their taxable income.
- The concept of neutrality is central to the debate over Section 199A. Violations of neutrality across income and business forms can encourage reclassification of income, distort investment decisions, and affect the choice of legal form of organization.
- Under current policy, pass-through business income and investment generally face a lower effective tax rate than other forms of income and investment.
- After 2025, lawmakers have an opportunity to revisit Section 199A and consider alternative reforms to the tax treatment of business income.
Executive Summary
In 2017, the Tax Cuts and Jobs Act included a new deduction for business income: Section 199A. This provision allows taxpayers to deduct up to 20 percent of qualifying business income against their taxable income and provides a special tax benefit for “pass-through” businesses—those not subject to the corporate income tax. Supporters of the deduction argue it is necessary to maintain “tax parity” with corporations and that, without the deduction, pass-through businesses would be at a competitive disadvantage. Opponents argue that parity is not well-defined and that the deduction is unnecessary, complex, and non-neutral.
This report compares the tax burden of pass-through businesses and corporations using three measures of effective tax rates: the effective statutory tax rate, the marginal effective tax rate, and the average effective tax rate. Each measure captures different aspects of a business’s tax burden and how the tax code influences behavior. This report also evaluates how select changes to the tax code would affect the relative tax burden on business income and investment.
Introduction
In 2017, the Tax Cuts and Jobs Act (TCJA) included a new deduction for business income: Section 199A. This provision allows taxpayers to deduct up to 20 percent of qualifying business income against their taxable income. This deduction provides a special tax benefit for “pass-through” businesses—those not subject to the corporate income tax.
Over the past several decades, the share of economic activity generated by pass-through businesses has grown. As of 2016, pass-through businesses account for more than 95 percent of business tax returns and 61.8 percent of all business profits reported on tax returns.1
Supporters of the deduction argue it is necessary to maintain “tax parity” with corporations and that, without the deduction, pass-through businesses would be at a competitive disadvantage. Opponents argue that parity is not well-defined and that the deduction is unnecessary, complex, and non-neutral.
The concept of neutrality is central to the debate over Section 199A. The tax code should strive to treat taxpayers in similar economic situations similarly. Violations of neutrality are seen as unfair and can distort taxpayer behavior. Non-neutral taxation can distort decisions to report certain types of income, the level and type of new investment, and the legal form of organization.
To evaluate how Section 199A affects neutrality, this report compares the tax burden of pass-through businesses and corporations using three measures of effective tax rates. Each measure captures different aspects of a business’s tax burden and how the tax code influences behavior.
The report’s analysis finds that under current policy, pass-through business profits face a lower tax burden than do other forms of income, such as wages and certain types of corporate profits. In addition, pass-through business investment, on average, faces a lower tax burden than does corporate investment.
The report also evaluates how select changes to the tax code would affect the relative tax burden on business income and investment. Selected policies include allowing the TCJA to continue as scheduled, repealing Section 199A, integrating the corporate and individual income tax, and taxing all business income (C corporate and pass-through) under a single cash flow tax.