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February 2, 2015
News Analysis: JCT Passthrough Report Informs Tax Reform Debate
by Luca Gattoni-Celli

Full Text Published by Tax Analysts®

An unreleased Joint Committee on Taxation report obtained by Tax Analysts shows that the United States gives more favorable tax treatment to passthroughs than other developed economies, complicating the prevailing narrative that a high corporate rate best illustrates U.S. tax uncompetitiveness.
This narrative generally consists of conservatives pointing to the high U.S. statutory corporate rate and progressives grousing about corporate tax revenue as a percentage of GDP. These metrics omit passthrough businesses, severely limiting their usefulness, but the JCT report adds some of that context.

Dated October 2013 and requested in April 2012 by then-Senate Finance Committee Chair Max Baucus, the report compares the corporate share of net business income in the United States with that of five other OECD countries: Australia, Canada, Japan, Germany, and the United Kingdom.

The report found that: Australia has the largest corporate share of net business income (81.9 percent), followed by Canada (74.5 percent), the United Kingdom (67.5 percent), and Japan (50.1 percent). The United States' corporate share (42.1 percent) exceeds only that of Germany (34.1 percent).

However, the most recent year of data the JCT used in its analysis was not the same for each country. The JCT used data from 2010 for Japan, 2009 for four other countries, and the data for Germany, which had the smallest reported corporate sector, were from 2007, before a global depression that may have affected passthroughs and corporations differently. This inconsistency and other limitations should be kept in mind when drawing conclusions from the report. Yet the business income statistics still show a striking correspondence to international differences in passthroughs' legal and tax treatment.

A simple comparison of the U.S. ratio of corporate tax revenue to GDP with the same ratio in other countries leaves a biased impression of the relative tax burden on the U.S. corporate sector. As previously pointed out by Peter Merrill of PricewaterhouseCoopers LLP, the low ratio of corporate revenue to GDP in the United States compared with other countries is in part because of the relatively small share of its business conducted in corporate form (Tax Notes, Oct. 8, 2007, p. 174).

Potential Motivation

The report adds welcome context to the question of business tax competitiveness, but that does not explain why it was requested or even how it applies to U.S. tax policy per se.

Baucus, who was working on tax reform at the time, may have been concerned by passthroughs' increasing popularity in the United States. A major tax policy priority, especially for Democrats, is reducing corporate base erosion, and U.S. business owners have long faced strong incentives to not incorporate.

In a recent meeting with small business lobbyists, Treasury Secretary Jacob Lew said passthroughs seeking benefits from tax reform should probably incorporate, Reuters reported. Although Lew has not expressed those sentiments publically, his statements and those of other administration officials about including passthroughs in business tax reform remain highly ambiguous, frustrating Republicans who want business tax reform to be comprehensive.

Although Baucus's motivation for requesting the report is unknown, some Democrats are uncomfortable with how U.S. law currently treats passthroughs. Based on the report, a smaller U.S. passthrough sector might look more British or even Australian.

4 Factors

Four broad factors help explain the report's basic findings about whether businesses choose to incorporate in the different countries.

First, the relative tax burden of corporate versus passthrough business affects the choice of entity. The experience of the United States demonstrates this. The Tax Reform Act of 1986 reduced the difference between the top individual rate and the corporate rate from 4 percent to -6 percent. After its enactment, there was a marked shift in the choice of entity in favor of passthroughs.

In the other five OECD countries the JCT examined, the difference between the statutory corporate rate and the top individual rate was larger. Although relative tax attractiveness depends on a whole slew of factors, including the tax rate on dividends, the tax treatment of capital gains, and payroll taxes, the smaller differential in the United States likely contributed to passthroughs' relative prevalence here.

Second, extending limited liability, the basic feature at the heart of the corporate form, to the owners of passthroughs removes a huge incentive for incorporation. The increasingly widespread and now universal availability of limited liability companies in the United States has greatly contributed to the shrinkage of the corporate share of U.S. business, and the tax implications that come with that shrinkage. The JCT report tells us that of the six countries studied, only Australia restricted the privilege of limited liability to businesses that pay entity-level tax, likely contributing to its large corporate share.

Third, different countries have different restrictions on ownership of entities that qualify for passthrough tax treatment. In general, the report reports that in countries other than the United States, passthrough entities that provide limited liability to owners often have significant restrictions on the number or the nationality of owners. For example, in Australia, partnerships generally cannot have more than 20 partners without incorporating. In Canada, partnerships cannot be passthroughs whose partners are not Canadian residents.

Fourth, passthrough ownership interests generally may not be publicly traded in other countries. In the United States, however, there are over 100 publicly traded partnerships that qualify for passthrough treatment under section 7704. According to the National Association of Publicly Traded Partnerships, the market capitalization of these partnerships, the majority in industries related to energy and natural resources, was about $450 billion at the end of March 2013.

Perspective and Limitations

Germany sticks out as the only country with a smaller corporate sector (as of 2007) than the United States (as of 2009). The JCT mentioned two possible tax factors that made passthrough status relatively attractive in Germany: partnerships' ability to recognize losses for tax purposes and to repatriate foreign earnings at a more favorable rate than corporations.

JCT collaborators Wolfgang Schön and Christine Osterloh-Konrad, director and senior research fellow, respectively, at the Max Planck Institute for Tax Law and Public Finance in Munich, told Tax Analysts that many features of German business entity taxation reflect the German trade tax levied on all commercial enterprises, complicating international comparisons.

A senior JCT official told Tax Analysts that the staff and collaborators considered the report of great value to academics in particular because it was the first deep comparative analysis of international passthrough regimes.

Report collaborators who responded to requests for comment agreed that it was novel and significant, an unprecedented compilation of such data in one place, but they added that key limitations ultimately render the work a preliminary step.

The report says the JCT originally requested data from different countries, distributing firms by business assets, gross receipts, net income, and number of full-time equivalent employees. But the committee ended up with more general data, a key limitation according to Edward D. Kleinbard, a professor at the University of Southern California Gould School of Law and former JCT chief of staff.

Kleinbard said that more "granular detail" about passthrough income from small and medium-size enterprises versus large firms would be particularly informative. He predicted the United States would be an even bigger outlier by this measure because large firms disproportionately account for passthrough income.

There were additional limitations to the report's analysis. Interest income was counted for corporations, but not individuals, and available data did not distinguish between business and nonbusiness interest income and capital gains.

By this omission, individual business income was understated, although as noted, the portion of individual income derived from business activity was small. Rental income, largely from real estate, was a significant portion of individuals' business income, and was counted toward individual as well as corporate business income.

Income was reported generally net of losses incurred in the reporting year, whether or not they affected tax liability, creating potential differences from taxable income, the JCT said. The report also generally excluded dividends received from corporate income.

Not discussed in the report but nonetheless important is that business profits have been historically volatile, especially in the last 10 years. Thus, analysis of additional years of data would allow for stronger conclusions to be drawn, especially within the individual countries, and more recent data would likely yield more directly applicable findings.

Nevertheless, good cross-country comparisons of tax burdens are extremely difficult, and one year of data, even compiled from different years, offers some value.

Martin A. Sullivan contributed to this article.

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