The weirdest part of the Republican tax bill almost sunk the whole effort earlier this week.
As you've probably heard, the centerpiece of the tax plan is a massive cut in the federal tax that corporations pay on their profits. But technically only C-corporations pay it — about 5 percent of all businesses, as of 2011. The rest pay taxes by an alternative route. Sens. Ron Johnson (R-Wisc.) and Steve Daines (R-Mont.) were both upset that the latter group is getting a raw deal compared to C-corporations.
Johnson sits on the crucial Senate Budget Committee, which passed the bill on Monday in a squeaker 12-to-11 vote. Had Johnson stuck to his guns, he could've flipped the outcome, and possibly killed the bill's chances of reaching the Senate floor, so his change of heart was understandably big news.
But what's not getting as much attention is how this weird corner of business tax policy almost undid Republicans' tax reform dreams in the first place.
Think of it this way: Most taxes are levied at the point that income hits an individual's pocketbook, or at the point that an economic exchange is made.
The individual income tax and the payroll tax both fall into the first category — we pay them out of our paychecks. Capital gains taxes on dividends do as well, as dividends are just payments to individual stockholders. The sales taxes that states rely on, and the value-added taxes that lots of other Western countries use, all occur when a good or service is bought or sold. Same goes for the capital gains taxes paid when a person makes money by selling an asset.
Then there are the companies that aren't C-corporations — S-corporations, partnerships, sole proprietorships, and so forth. Their profits are just passed along as regular income to the owners, and then taxed accordingly. So they're often called "pass through" businesses. The whole idea here is pass-through companies are ostensibly smaller businesses and mom-and-pop outfits that have simple internal hierarchies and one owner or a small number of owners, so just treating their profits as someone's paycheck makes logistical sense. In other words, pass through businesses are also an example of taxes paid at the point that income hits someone's pocketbook.
That brings us to C-corporations.
C-corps are usually the big entities whose shares are sold on the stock markets — what we usually think of when we hear the word "corporation." They don't have one clear owner who can take their profits as income. Their owners are the hundreds or thousands (or more) of shareholders who own their stock.
C-corps' profits ultimately go into dividend payments to those shareholders. If the revenue gets plowed back into investments or job creation or whatever, it isn't hit by the profits tax. (C-corporations have all sorts of deductions they can take on expenses too.)
So C-corporations' profits exist in a weird accounting netherworld. There isn't an economic exchange — that event was already taxed when customers did business with the company. The money hasn't arrived in anyone's wallet yet, either — that happens when the dividend payments go out, and that event is also already taxed as a capital gain.
So when Johnson and Daines complain that pass-through businesses are getting an unfair deal relative to C-corporations, they're making a total apples-to-oranges comparison. It may seem like they're talking about the same thing, since "profits" are referenced in both cases. But the economic realities are totally different.
You can see this confusion show up in the GOP's various remedies.
Instead of simplifying the tax code, the House version of the bill makes things more complex by introducing an arbitrary cap of 25 percent on the tax rates that pass-through businesses pay. But that's significantly lower than the top rate people pay for the individual income tax, so wealthy people might duck their taxes by just reclassifying themselves as a small business. And House Republicans are tying themselves into knots trying to get around that problem.
Meanwhile, the Senate bill gives pass-through business owners a new deduction they can take on their taxes. Johnson has been pushing for an increase in that deduction's size, and it sounds like he got some understanding to that effect from the president. That's its own form of weirdness, and once again adds complexities and loopholes to the code when the whole point of this "reform" was supposedly to simplify it.
To really equalize treatment of pass-through profits and C-corp profits, we should focus on dividends. That's the place where the C-corp profits actually turn into someone's income. Since pass-through business owners already pay the regular income tax, the easiest way to equalize everything would be to just kill the C-corp profits tax entirely and treat all dividends as ordinary income.
Republicans would love the part about killing the C-corp profits tax entirely. But lots of dividends are taxed at special low rates of 15 percent or 20 percent. Neither the Senate nor the House bill would lower the top income tax rate anywhere near there. So treating dividends as regular income would mean a big tax hike on wealthy shareholders, which is completely anathema to GOP ideology.
Alternatively, you could cut the top income tax rates down to 15 or 20 percent. But that would be an even more flagrant giveaway to the wealthy than the Republicans are already contemplating.
So there are ways to actually rationalize the tax treatment of C-corps and pass-through companies. But none are politically pleasant for Republicans.
It could be easier for Democrats. Eliminating the C-corp profits tax would be a tough pill to swallow. But offsetting it with higher rates on capital gains wouldn't pose an ideological problem for them.
Point being, the tax on C-corporations profits is a mutant outlier. If you were to imagine a taxonomy of taxes, with phylums and orders and species, the C-corp profits tax wouldn't fit anywhere. For that reason, it tends to throw everyone for a loop.