In the run-up to the presidential election this year, every candidate has put forward a vision for how they'd change America's tax system. Republican plans typically involve some form of flat tax, and significantly lowering the corporate tax rate. For Democrats it usually means strengthening the progressive tax code, and potentially increasing the corporate rate.
The rift between the two parties reflects a national debate on tax reform that's been hung up for decades by partisan politics in Congress. To successfully simplify the tax code, whomever is elected this November will have to overcome not only that gridlock, but a host of other complicating factors. And the difficulties associated with getting it done have important consequences for small-business owners.
Not since the grand bargain struck between Democrats and Republicans in 1986 has there been a significant overhaul of the tax code, which at the time resulted in the top corporate tax rate decreasing to 34 percent from 46 percent, and the top individual rate dropping to 28 percent from around 70 percent.
As The Wall Street Journal has reported, in recent years more businesses have formed as partnerships, including LLCs, sole proprietorships, or S-Corps, because their profits are taxed at a potentially more favorable individual rate. By contrast, fewer are forming as C-Corps, which essentially require owners to pay taxes twice--at the corporate level, as well as on individual investment income and salary. In addition to making it necessary to overhaul the corporate and individual tax codes together, the growing number of partnerships may be dragging on the economy.
"From an economics perspective, you don't want the tax system to drive decisions about whether to incorporate or not," says Jason DeBacker, an assistant professor of economics at Middle Tennessee State University. Chief among the issues could be difficulties attracting private capital, as venture capitalists and other investors may be reluctant to invest in partnerships because of their potential to create excess taxable income, DeBacker says. Similarly, investment banks may be hesitant to take a company with a partnership structure public, for tax and transparency reasons.
Between 1980 and 2012, the share of business profits earned by C-Corps, including public and private companies, fell to 48 percent from 80 percent, according to recent research by DeBacker. During the same time period, the share of business profits owned by partnerships increased to 26 percent from less than 3 percent.
Here's why: While partnerships are taxed at an individual rate of up to 39.6 percent, corporation owners' rate can be more than five percentage points higher (after dividend and capital gains taxes are taken into account), according to recent research by the U.S. Treasury, the University of Chicago, and U.C. Berkeley.
The same researchers postulate that the rise of partnerships has exacerbated the wealth divide, which is the subject of much of the current presidential campaign season rhetoric. Seventy percent of the top one percent of the wealthiest earn income from partnerships.
The high tax rate has also encouraged the increasing corporate practice of tax inversions, which allow companies to keep their headquarters in the U.S. but incorporate in countries with tax rates that are a fraction of what they are at home. Inversions are also bad for the economy, because they encourage big businesses to leave the U.S. and take their valuable jobs with them, says Elaine Kamarck, a senior fellow at Brookings, a centrist policy think tank, and the co-chair of the RATE Coalition, a tax-reform advocacy group.
Entrepreneurs are likely to get caught up in those large company departures. "Small businesses do suffer from this international competitiveness because a lot of them are [sub-contractors] to big businesses," Kamarck says.
While the presidential candidates have come up with their own plans to stop the hemorrhaging of potential tax revenue into loopholes, ultimately the last word rests with Congress, because it has the authority to write the tax rules, Kamarck says. Over the past few years, tax compromise has come close, with various proposals from former Michigan representative David Camp, House Speaker Paul Ryan, and Iowa senator Chuck Grassley.
And while comprehensive tax reform isn't likely to be passed during an election year, it could come soon after. "There are partisan issues and [other] sticky issues," Kamarck says. "But the general consensus is that we need tax reform, and we will do it in 2017."