Wednesday, December 13, 2017

Another perspective on the passthroughs

Mark the Knife posted a comment on a prior blog post of mine in this series. As I found it perceptive, I hope he doesn't mind my pasting it in here:

The push for a passthrough tax seemed based on some sort of odd understanding by members of Congress regarding "fairness" between passthrough businesses and C corps. I think there's a sense that corporate E&P is (ignoring the fact it isn't really "income") capital income par excellence, and income from passthroughs which is like E&P should receive the special rate.

So if I were to say what the theory behind the guardrails is intended to be, it's: If this passthrough were a business operating as a C corporation, would a particular allocation of income be retained (or allowed to be retained) in earnings and profits? If so, it deserves the special rate. Else, it should get the regular rate.

You can then see the two bills as focusing on a different problem--the House hates that labor income could be disguised as "E&P-like" income, and the Senate is aimed at attacking passthroughs that are the equivalent of corporate pocketbooks (a sort of personal holding company rule, but one that determines classification by looking to employment by a holding company instead of its income).

I don't think this is a terrific theory by any means, and certainly each bill deviates in some way from this theory, but it's my best shot at a cohesive theory thus far.

(Back to me): This strikes me as a very plausible account of how some of the thinking might have developed. Unfortunately, as grounds for policy it's incoherent nonsense (as I suspect Mark the Knife would agree).

A C corporation's E&P is kind of, very roughly, its "capital income" if not swelled by underpayment of salary to owner-employees. In a pure public company where only deductible compensation is paid to employees who lack significant owner interests, it's kind of a match for capital income, defined as the residue after paying labor costs, only it may include rents that a consumption tax would reach, not just normal returns that it would exempt. If you're using expensing to exempt the normal return, why exactly do you need to also have a low tax rate here? This was one of the points about the DBCFT - in principal the rate could be high without driving out capital a la an origin-based corporate income tax.

Now we go to the passthrough setting, and supposedly equity as between different types of entities - a nonsensical concept since (a) only people matter and (b) passthrough owners can incorporate - dictates also giving a low rate to the passthrough income that's left after paying out salary. Only, here we are very far from the setting of a publicly owned company in which owner-employees may only own a smallish piece. In the classic passthrough, a small group of owners has the whole thing, and has little need to pay themselves salary as that's just moving money between pockets of the same suit. So they all underpay themselves labor income, at least once the new law is in place, and they want a lower rate because - well, just because.

Mark the Knife's final nice point goes to the House versus the Senate having different aims. Apparently Ryan et al hate lawyers and such more, while in the Senate maybe they hate ?? more? (Not quite sure who they're after or why.)

I guess we'll see what comes out in conference, but we can be sure that it will still have no coherent rationale.

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