President Trump has promised to release his tax plan this Wednesday, April 26. While details are lacking, one thing we can be sure of is that it will include a reduction in the tax rate on so-called ‘pass-through’ business income. Pass-through income is the net income of a business that passes through to a business’ owner or partner and is taxed at that individual’s tax rate. The income received by an individual who is the sole owner of a business like a bakery or deli after all expenses are paid is an example of pass-through income. So it is the net income of high flying partnerships that is distributed to the wealthy partners in private equity firms, hedge funds, and Wall Street law or tax accounting practices. President Trump, who is a partner in hundreds of real estate ventures and other businesses, receives pass-through income.
The top tax rate on individual incomes is currently 39.6 percent, but only the wealthiest owners and business partners pay a marginal tax rate that high. The vast majority of recipients of pass-through income — owners or partners in small businesses like a dry cleaner or neighborhood restaurant — is taxed at much lower rates. Indeed, more than 70 percent of business owners and partners are taxed at a marginal rate of 0, 10 or 15 percent; another 17 percent are taxed at 25 percent. Only the wealthiest partners — many with incomes in the hundreds of thousands of dollars or more — are taxed at a marginal rate of 33 percent or higher, and less than 2 percent are taxed at the 39.6 percent top rate (see the figure below).
During the campaign, President Trump proposed reducing the top tax rate on pass-through income to 15 percent — a tax break that would benefit him tremendously. Speaker Paul Ryan’s proposed tax plan would reduce the top rate to 25 percent. Both have claimed this reduction would benefit small business owners and grow the economy. However, these proposed cuts in the pass-through tax rate benefit only a small number of wealthy households; the majority of business owners and partners are already taxed at rates lower than Ryan’s or Trump’s proposed top rates.
Proposals to reduce the top pass-through tax rate have been put forward before. As with the Trump and Ryan proposals, they are sold to the public as a benefit for small businesses, under the rubric of Main Street Fairness. But as Figure 1 shows, most of this tax break will go to households at the top of the income distribution. Do these very rich partners in Wall Street firms really need another tax loophole? While small in number, wealthy households collect the bulk of pass-through income. They — and not small business owners — will be the true beneficiaries of the Trump or Ryan tax cut.