Neil Irwin seems to get a bit lost in his concerns about treating owners of pass-through businesses fairly. His NYT Upshot column argues that there is a problem where we are left with a choice between large-scale evasion, treating them unfairly, and micro-monitoring their behavior. The story is actually far simpler than he presents it.
The basic story is that the tax rate on a pass-through business is zero. The business itself pays no taxes, all its income is passed on to its owner(s) to be taxed at the individual rate. As it stands now, the income from pass-through businesses is treated as ordinary income and taxed at the same rate as labor income.
The Republicans are proposing to put a cap on the tax for income from pass-through businesses at 25 percent. This means that high-income people who own pass-through businesses will be able to pay taxes at a 10 percentage point lower rate than the 35 percent top marginal rate they are proposing. (The savings are 14.6 percentage points compared to the current 39.6 percent top marginal tax rate.)
Irwin correctly points out that this gap will be an invitation for every high-end earner to set up a pass-through business so that they can pay a 25 percent tax rate on their income rather than a 35 percent rate. Treasury Secretary Mnunchin has noted this problem but said that the I.R.S. will scrutinize pass-through corporations to prevent this sort of scamming. (Mnuchin's claim must be taken with a continent worth of salt. The Republicans have worked for the last two decades to do everything they can to weaken the I.R.S.'s enforcement powers.)
While Irwin recognizes the incentive this structure creates for gaming and also the difficulty of enforcement, he seems to accept that there is some inequity that the lower tax rate on pass-through income would address. This is not true.
Irwin is concerned that genuine pass-through income is income from capital, which we tax at a lower rate than income from labor. The current maximum tax rate on dividends and capital gains is 20 percent, compared to the rate of 39.6 percent on labor income. He argues that by taxing pass-through income at the rate on ordinary income we would be imposing too high a rate on the capital income from these companies.
But the problem with this seeming asymmetry is that income from normal corporations is already taxed at the corporate level. The corporate tax averages a bit over 22 percent of profits. If shareholders then pay a 20 percent tax rate on the remaining 78 percent that is passed back to shareholders in some form, then the effective tax rate is roughly 37.6 percent (22 percent, plus 20 percent of 78 percent), virtually the same as the 39.6 percent tax rate on ordinary income.
In short, the concern that some businesses are treated unfairly under the current system, where owners of pass-through businesses pay higher taxes than shareholders of ordinary businesses, is simply untrue. This proposed tax cut does nothing to make the system more equitable, it just reduces taxes for high-income people.
(It could be argued that owners of normal corporations get the benefit of limited liability and therefore should pay a higher tax rate for this privilege. This is a plausible argument, but is not relevant here since many pass-through corporations also benefit from limited liability.)