Effects of new tax law pass through to small businesses
Much has been said and written about the new federal income tax bill that recently passed Congress and was signed by President Donald Trump. Some of the more controversial aspects of the bill were related to how taxes would change for businesses, especially smaller businesses.
Many of these smaller businesses are limited liability companies or S corporations. Much of the debate about tax reform revolved around how these smaller corporations, or pass-through entities as they are known, would be taxed under the new law. Sole proprietorships and partnerships also pay taxes on their profits at individual rates.
Pass-through entities usually are smaller corporations that are created to reduce the effects of double taxation. Pass-throughs do not pay income taxes at the corporate level. Instead, the income made by the owners shows up on their individual 1040 form and taxes are collected at the individual owners’ rate.
In the new law, the top rate on the income earned by owners of pass-through businesses is reduced from 39.6 percent to 37 percent. The bill will increase the amount of income allowed to be claimed as pass-through from 17.4 to 20 percent.
“The flip side is that it will benefit top hedge funds and law firms that are organized as S partnerships, and thus the top 1 percent of wage earners in the country, as opposed to corporate dividends, which trickle down further,” according to Vinnie Gajjala, professor of economics and finance at Tiffin University.
Regular corporations face double taxation. These typically larger firms pay taxes at the corporate level and then dividends paid to their shareholders are taxed again at the individual shareholders’ rate. The new law decreases the top rate for traditional corporations from 35 to 20 percent.
The theory behind reducing income taxes for businesses is to put more money in their owners’ pockets with the hope they will invest in growing the business. This increased investment hopefully leads to more jobs and upward pressure on wages and salaries paid to current workers.
Whether decreasing taxes actually leads to increased investment and subsequent benefits for workers depends on who you ask. Conservative economists and their supporters point to the last major tax cut lead by the Ronald Reagan White House and the subsequent growth of the U.S. economy in the 1980s. President John Kennedy, a Democrat, also pushed through a large tax reduction bill in the early 1960s that was followed by robust economic growth.
Liberals argue that tax cuts for business owners never trickle down to the work force and mostly benefit business owners who are already doing well. Minority Senate leader Chuck Schumer recently said the tax plan “helps the rich at the expense of the middle class.”
By its very nature a decrease in rates is going to reduce the amount the taxes for those who make more money. Now, the top 1 percent who are complained about so much by liberals pay about 40 percent of all the income taxes in the U.S.
One of the other criticisms of the new law is that it will increase federal deficits and debt by decreasing the amount of taxes collected. Unlike the 1986 bill, this one is not revenue neutral. However, it could lower the federal deficit if the wealthy invest enough of their tax savings in starting new businesses and growing existing businesses, according to Gajjala.
In the end, nobody knows for sure how much a tax cut from the right or a spending plan from the left really helps the economy. The U.S. economy is made up of complex set of variables that make it very difficult to track cause and effect between government policy changes and economic activity.
Perry Haan is professor of marketing and entrepreneurship at Tiffin University. He can be reached at (419) 618-2867.