Apparently income isn't just income any more

The group of us that published the "Tax Games" piece is hard at work drafting a follow-up that preliminarily evaluates the extent to which the sorts of problems that we identified with the House and Senate bills have been addressed, ignored, or worsened under the conference agreement. To be honest, several others in the group are much harder at work on it than I am at the moment (I'm in Munich in the aftermath of a quite interesting, interdisciplinary international tax conference at the Max Planck Institute), but I will try to chip in as well.

I will post the link here when it's available, hopefully soon. We have an aim of posting it before the bill is voted into law, in part lest anyone in Congress whose vote isn't entirely pre-committed might actually care about what the legislation does. (No, we are not deluded about the probabilities in this respect, but if we weren't idealistic we wouldn't be bothering with this to begin with.)

But I wanted to follow up here on a point that I mentioned in my last post, and that was brought to my attention by co-authors (who were looking at the bill while it was the middle of the night here in Munich).  It pertains to the special exclusion in the passthrough provision of architects and engineers from the list of personal service businesses that automatically can't, past a specified income level, take advantage of the special 20% deduction for passthrough income.

When the House was initially drafting the passthrough rule, there was a provision excluding business owners who worked in personal service businesses from claiming the special low rate. Now, this never made sense from the beginning. There was some sort of a clumsily mal-expressed intent in the House bill to separate out pure labor income a bit, and deny it the benefits of the special rule, apparently on the view that it was kinda like employee wages.

Now, this never actually made any sense. Capital income already was effectively exempted under the bill due to expensing, and so the special rate was really for labor income that was intermingled with capital income. It was a way of giving, say, real estate, oil and gas, retail, manufacturing, etc., lower tax rates than doctors, lawyers, and such. (Plus, the idle business heir who is busy skiing in Gstaad gets the special rate.) So I wouldn't call it very principled even if there was a sort of woolly rationale lying underneath.

Even the House bill really did amount to saying that work - labor - wages in the economic sense - would get lower tax rates in some businesses than others, for no reason beyond Congressional favoritism. But one could imagine that someone imagined they were drawing a coherent line of some kind for some reason. Hence, for example, the absurdly misguided attempt to deny the full benefit to people who were materially participating under the passive loss rules - arguably aimed at implementing the underlying idea, badly confused though it was, that this was somehow about lowering the tax rate for capital income rather than labor income.

If one squinted at it that way, one could almost see a rationale for excluding the personal service businesses that would be sincere to a degree, even if fallacious and incoherent. But how to define personal service businesses that would be cordoned off (subject, of course, to their playing games such as renting buildings to themselves)? Easy, they found a list in an existing tax statute that had defined personal service businesses for a wholly different purpose, and that does actually look like a good faith effort to draw up a comprehensive list, including most of the obvious candidates and then with a catchall phrase at the end for the rest.

Not only doctors, lawyers, athletes, consultant, etc., but also architects and engineers, were on this list. But then something happened in conference. They decided to strike architects and engineers from the list of personal service businesses for purposes of determining eligibility for the 20% passthrough deduction. No explanation offered, so far as I can see.

Here's an illustration of what this means in practice. A doctor and an architect are both in the 37% bracket. Each then earns an extra $100,000.  The doctor pays an extra $37,000 of tax. The architect manages to structure the receipt as qualified business income that gets a 20% deduction. Hence, the architect has only $80,000 of extra taxable income and pays only $29,600 of extra tax. The doctor's marginal rate is 37%, the architect's is 29.6%.

There is no whisper of a rationale for this. They had a list of personal service businesses that they didn't make up themselves, and even if using it didn't make sense to begin with, at least they were just plugging it in, as it stood. Now two favored professions have been taken off the list, apparently because someone with influence over the final product wanted to benefit architects and engineers relative to doctors, lawyers, athletes, consultants, etc.

As it happens, they may have bungled this effort to exclude architects and engineers, through incompetent drafting. The personal service business exclusion still applies to "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners." (The words "or owners" were newly added in the conference version.) Wouldn't that generally apply to architects and engineers? But they certainly seem to have meant to take out architects and engineers, and even with the bungled drafting - no doubt, just one of dozens or even hundreds of examples, if one carefully read the bill as a whole - that might influence its interpretation by the Treasury, IRS, and courts. So let us credit them with deliberately taking out architects and engineers, on the view that they should have a lower tax rate than doctors, lawyers, consultants, and athletes, without prejudging how this bungled drafting job is actually best interpreted.

This is in effect industrial policy, although we haven't as yet learned why Congress should use the tax code to direct business activity away from medicine and into architecture and engineering. But of course to call it industrial policy would verge on granting that there was an underlying policy aim, however misguided. (Does someone think that there are negative externalities to healthcare and/or positive ones, under-compensated by the market, that are particular to architecture and engineering?) On the other hand, corrupt explanations, at least in the colloquial (as distinct from legally punishable) sense, come readily to mind.

This gets to why I titled this blog post "Apparently income isn't just income any more." Congress appears to be moving towards creating lists of professions and businesses that should get higher versus lower tax rates. It's not just a matter of, say, more favorable cost recovery rules in one profession rather than another. Now actual labor income (with sufficiently well-advised structuring) gets different marginal tax rates, depending on whether it's earned in a business that Congress likes more, or one that it likes less. And this is completely ad hoc and decided on in secret, without even a statement of broader underlying rationales. A dollar isn't just a dollar - its tax rate depends on whether and how much Congress likes the relevant trade group.

I put a marker down early in the game, when I said that the passthrough rules looked like the worst provision ever even to be seriously proposed in the history of the federal income tax. I'm feeling increasingly vindicated as the legislation proceeds through Congress, and I anticipate (without pleasure) that this feeling will only grow as we see the provision play out in practice across real time.