GOP proposing big departure: same income, different tax rates

In most places, a dollar is a dollar. But in the tax code envisioned by Republicans, the amount you make may be less important than how you make it.

Consider two chefs working side by side for the same catering company, doing the same job, for the same hours and the same money. The only difference is that one is an employee, the other an independent contractor.

Under the Republican plans, one gets a tax break and the other doesn’t.

That’s because for the first time since the United States adopted an income tax, a higher rate would be applied to employee wages and salaries than to income earned by proprietors, partnerships and closely held corporations.

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The House and Senate bills vary in detail, but both end up linking tax rates to a whole new set of characteristics, such as ownership, day-to-day level of involvement, organizational structure, even occupation. These rules, mostly untethered from income level, could raise or lower tax bills by hundreds or thousands of dollars for ordinary taxpayers and millions of dollars for the largest eligible businesses.

“We’ve never had a tax system where wage earners were substantially penalized” relative to other types of income earners, said Adam Looney, a senior fellow at the Brookings Institution and a former Treasury Department official.

So a decorator, an artist or a plumber would have a higher tax rate than an owner of a decorating business, an art shop or a plumbing-supply store. A corporate accountant could have a higher rate than a partner in an accounting firm. And under the House bill, which differentiates between active and passive investors, the head of a family business who works 60-hour weeks would have a higher rate than her brother, who doesn’t work there and can spend his days sleeping on the couch.

The proposals’ impact rises steeply as paychecks grow. High-income earners — roughly the upper 10 percent — who can take advantage of the new distinctions would be rewarded with substantial gains compared with those who can’t.

Supporters argue that the revised tax structure is an attempt to update the code to reflect changes in the economy. Rather than depend primarily on individual rate cuts to further power the economy, the Republican plans focus on cutting taxes on certain types of business income. The idea is that these businesses will reinvest those higher returns and stimulate growth.

“This is a radically different approach,” said Fred Goldberg, commissioner of Internal Revenue under President George H.W. Bush.

Wage earners left out

Corporations and other types of businesses get the biggest cuts. Employees don’t.

“Theoretically, this makes a certain amount of sense in a vacuum,” said Jared Walczak, a senior policy analyst at the conservative Tax Foundation. “It’s just difficult to define what constitutes wage income compared to business income.”

Indeed, economists and tax experts across the political spectrum warn that the proposed system would invite tax avoidance. The more the tax code distinguishes among types of earnings, personal characteristics or economic activities, the greater the incentive to label income artificially and restructure or switch categories in a hunt for lower rates.

Expect the best-paid dentists to turn into corporations so they can take advantage of the new 20 percent corporate tax rate, instead of having to pay a top marginal rate of nearly 40 percent on some of their income. Individual income taxes can be deferred on profits left inside a corporation instead of deposited in a personal account. What’s more, corporations can deduct local and state taxes, which individual filers can’t.

Look for a wave of promotions as staff lawyers on salary suddenly turn into partners to qualify for the 23 percent deduction the Senate bestowed on pass-through businesses.

Pass-throughs, which range from an ice-cream stand to multibillion-dollar operations like Georgia-Pacific (a Koch Industries subsidiary) and Fidelity Investments, don’t pay corporate taxes. Instead, they pass through income to their owners or shareholders, who pay taxes at the ordinary rate on their individual returns.

The Republican provisions applying to pass-throughs have been singled out for some of the greatest scorn. Writing about the House version, Dan Shaviro, a professor of taxation at New York University Law School who worked on the 1986 tax overhaul, said it “might be the single worst proposal ever prominently made in the history of the U.S. federal income tax.”

Unintended outcomes

Uneven treatment is compounded by other rules that unintentionally introduced preferences.

To prevent certain professionals and specialists like investment managers, doctors, athletes, performers and others from reorganizing themselves as pass-throughs, the Senate excluded households with joint incomes of $500,000 or more (and $250,000 for single taxpayers). But the peculiar way the income scale is phased out means that solo practitioners and partners who earn roughly $529,000 to $624,000 could face a tax of up to 85 percent on income between those two thresholds, according to the nonpartisan Tax Policy Center.

A graph of the rate increase looks as if a skyscraper were plopped in the middle of an open field. That is a powerful incentive to search for tax shelters.

At the same time, an unrelated rule that closes a loophole affecting highly paid corporate executives will have the effect of allowing pass-through corporations — but not traditional corporations — to deduct compensation over $1 million.

“The more you look at any of the major rules, the more ambiguities, glitches, clearly unintended consequences and tax-planning opportunities you see,” said Michael L. Schler, a lawyer in the tax department of Cravath, Swaine & Moore. He has written a 50-page summary of the more glaring problems, scheduled to be published soon in Tax Notes.

The proposed classification system is unusual. Although the gains on long-term investment have generally been taxed at lower rates for most of America’s tax history, all other income was taxed at the same rate since the federal income tax was instituted in 1909.

That included both earned income — money generated by a day’s labor — and what is called unearned income, which includes dividends, interest on bonds, alimony, rent, royalties, licensing fees and pension checks.

If anything, wage earners, at least in the popular imagination, were elevated above the original “coupon cutters” — not thrifty housewives but those who lazed on the couch and collected income generated by securities, which they clipped at the corners to redeem. In the 1920s, steely capitalists worried that such indolent fat cats would undermine entrepreneurship while fiery radicals ridiculed their only work as picking up a ticket at the opera box office.

But despite countless loopholes, exemptions and special breaks in the tax code, there was never a move to single out employee compensation from other earned income.

A new direction

Efforts to simplify the system and move closer to uniform rates were most successfully championed by President Ronald Reagan and congressional Democrats when they sharply lowered individual rates in the Tax Reform Act of 1986. Earnings and even long-term investment gains were briefly taxed at the same rate for the top bracket.

“There was a simple notion there,” said C. Eugene Steuerle, a deputy assistant Treasury secretary for tax policy during Reagan’s second term and now an economist at the Urban Institute. “We said, ‘Let’s create a top rate that is as even as we can get it across all sorts of structures and most types of capital income.’” The source didn’t matter.

Long-term capital-gain rates were again lowered in the 1990s. And the tax code took a major step away from the Reform Act in 2003 under President George W. Bush, when short-term capital gains, like dividends, were taxed at a lower rate than wages.

Relative to the Reagan approach, Steuerle said, the latest Republican bills are “moving in the opposite direction.”

In some eyes, the message contained in the bills is as disturbing as the practical impediments. Tax codes are as much about values as they are about accounting. And rates and breaks are deployed to encourage or discourage various types of activities.

“Wage income will be the highest taxed income,” said John L. Buckley, a chief of staff for Congress’s Joint Committee on Taxation in the 1990s. That’s what more than 80 percent of working Americans get.

“I think it’s grossly unfair,” he added. “Somebody working for a wage gets a higher tax rate than somebody doing the same job under a different legal structure.”

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