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Blue Skies for Business Tax Reform? Part 4: Larger Role for “Pass-Through” Taxation



The outlook for US corporate tax reform in 2017 seems auspicious. Reform might combine three elements: a lower corporate tax rate; a tax repatriation holiday; and a larger role for “pass-through” taxation. This blog examines “pass-through” taxation.

“Pass-through” firms, unlike standard Subchapter C corporations, are not taxed on their business income. Instead their earnings are attributed to households (either directly or indirectly through trusts and partnerships). Households, in turn, are taxed at individual income tax rates. Pass-through entities include Subchapter S corporations, limited liability partnerships (LLPs), master limited partnerships (MLPs), real estate investment trusts (REITs), and several others. Because of their tax advantage, these entities claim a growing share of US business income. In 1980, pass-through firms accounted for about 8 percent of US business income, sole proprietorships accounted for about 17 percent, and standard Subchapter C corporations accounted for the remaining 75 percent. In 2012, pass-through firms accounted for 54 percent of US business income, sole proprietorships accounted for 10 percent, while Subchapter C corporations accounted for just 36 percent.

Pass-through taxation has the highly desirable feature of aligning the taxation of business income with household circumstances. The case for progressive taxation—namely, that rich people should pay a larger share of their income in tax—applies to natural persons, not to business entities. Pass-through taxation puts the tax burden squarely on households, thereby reducing tax distortions to business decisions. 

By contrast, federal taxation of Subchapter C corporations results in two levels of taxation: first on corporate business earnings at a 35 percent federal statutory rate (plus state tax) and second on households when earnings are realized as dividends or capital gains. The corporate portion of the two-level burden distorts business decisions by discouraging physical and intellectual capital formation in the United States and by giving an advantage to competing goods and services produced in low-tax countries.

Two-level taxation also distorts the alignment of the tax burden with the degree of progressive taxation reflected in institutional and household marginal tax rates. For example, tax-exempt universities, hospitals, and churches indirectly pay corporate tax on their endowment income. Middle-bracket households, who pay 28 percent on their dividends, pay a combined rate of 48 percent on corporate earnings (when such earnings are all distributed as dividends). Upper-bracket households, who pay almost 40 percent on their dividends, pay a combined rate of 57 percent. In other words, assuming that household marginal tax rates accurately reflect the degree of progressivity preferred by the American body politic, adding the corporate tax significantly departs from that template with respect to corporate earnings. Table 1 illustrates the difference. The combined marginal tax schedule is both significantly higher and less progressive than the marginal personal tax schedule taken alone.

Table 1 Degree of progressivity: Personal income tax vs. combined tax
Household taxable income bracketa Marginal personal tax rate Subchapter C corporate tax, average effective rate Combined marginal personal and corporate tax rateb
Zero bracket (nonprofits, universities, etc.) 0.0% 28.0% 28.0%
$9,275 to $37,650 15.0% 28.0% 38.8%
$91,150 to $190,150 28.0% 28.0% 48.2%
$413,350 to $415,050 35.0% 28.0% 53.2%
$415,050 + 39.6% 28.0% 56.5%
a. Income brackets are for single filers.
b. Calculated as: [(1-0.28)*tp+0.28], where tp is the marginal personal tax rate and 0.28 is the average effective corporate tax rate. This expression reflects the fact that the personal tax applies only to after-corporate-tax income paid out as dividends. Assumes all such income is paid out as dividends.
Source: Authors' calculations.

A comprehensive review by Cooper and seven other experts (2015)1 finds that if newly created pass-through firms had been taxed in 2011 in the manner that prevailed in 1980 (mainly as Subchapter C corporations), business earnings would have paid an additional $100 billion of federal tax. The authors report their finding with a twinge of regret. Instead the $100 billion saving should be celebrated. The growth of pass-through business firms over the past three decades has been an important way of curbing the onerous 35 percent federal corporate tax rate.

However, as the third column of table 2 shows, the ratio between earnings of pass-through firms and earnings of Subchapter C corporations is often highest in sectors of the US economy where physical and human capital are least mobile internationally, for example, agriculture, mining, construction, real estate, and health care. The professional, scientific, and technical services sector and the finance and insurance sector stand as major (and welcome) exceptions. By contrast, Subchapter C firms are often dominant in sectors where capital is highly mobile internationally, notably manufacturing and various business services apart from finance and insurance. In these highly mobile sectors, indicated by an asterisk in table 2, US companies actively compete with foreign firms but are disadvantaged by high US corporate tax rates.

Table 2 Distribution of business income by sector: Pass-through entities vs. Subchapter C corporations, 2012
Sector Pass-through entities Subchapter C corporations Ratio of pass-through to Subchapter C corporate, business income sharea
Agriculture, forestry, fishing, and hunting 0.99% 0.31% 3.17
Mining 4.65% 0.67% 6.93
Utilities -0.28% -2.48% 0.11
Construction 2.85% 0.19% 15.24
Manufacturing* 7.80% 43.55% 0.18
Wholesale trade* 4.33% 8.59% 0.50
Retail trade 2.83% 8.77% 0.32
Transportation and warehousing* 1.15% 1.93% 0.59
Information* 3.75% 6.43% 0.58
Finance and insurance 45.12% 16.72% 2.70
Real estate and rental and leasing 6.96% 0.69% 10.12
Professional, scientific, and technical services 9.95% 0.21% 48.48
Management of companies and enterprises* 2.37% 10.93% 0.22
Administrative and waste management services 1.25% 0.69% 1.81
Educational services 0.19% 0.16% 1.17
Health care and social assistance 4.43% 0.74% 6.02
Arts, entertainment, and recreation 0.35% 0.01% 42.42
Accommodation and food services 0.70% 1.74% 0.40
Other services 0.61% 0.14% 4.27
Total 100.00% 100.00% n.a.
a. Ratios may not be exact due to rounding.      
* denotes industries where the ratio is under 1.00 and capital is highly mobile across international borders.
Source: Internal Revenue Service, SOI Tax Stats,

The United States would be more competitive if pass-through taxation covered highly mobile sectors to a greater extent. Since manufacturing production and jobs are now at the center of national concern and political debate, Congress should consider extending pass-through treatment to that sector. This could be achieved by enlarging the tests for a firm to qualify as an MLP—a firm organized and taxed as a partnership that issues traded securities (partnership interests akin to common shares). To qualify as an MLP under current law, the firm must earn at least 90 percent of its gross income from “qualifying” sources designated in section 7704(d) of the Internal Revenue Code. “Qualifying income” is limited to interest, dividends, real property rents, gains from the sale of real property, and profits earned from the exploitation of natural resources (oil and gas, timber, mining, etc.). The technical issue comes down to adding all, or designated subsets, of manufacturing income to the definition of qualifying income.

To illustrate the possibilities, table 3 summarizes Subchapter C taxable income reported in 2012 by industries within the manufacturing sector. Based on the experience reported by Cooper et al. (2015), the average tax rate on Subchapter C corporations and their shareholders is 31.5 percent of business earnings, whereas the average tax rate on the business earnings of pass-through firms is 19.5 percent. Assuming that these rates apply to US manufacturing firms that might choose to reorganize as MLPs under a revised statutory test, every $10 billion of earnings shifted from the Subchapter C status to MLP status would entail a static (all else equal) revenue loss of 12 percentage points (31.5 percent minus 19.5 percent) or $1.2 billion. Thus if 50 percent of manufacturing earnings migrated from Subchapter C to MLPs, the static revenue loss would be $28 billion annually.

Table 3 Taxable income by industry within the manufacturing sector, 2012 (billions of dollars)
Industry Taxable income
Food manufacturing 22.6
Beverage and tobacco product manufacturing 17.4
Textile mills and textile product mills 0.6
Apparel manufacturing 1.5
Leather and allied product manufacturing 0.2
Wood product manufacturing 0.6
Paper manufacturing 7.5
Printing and related support activities 1.0
Petroleum and coal products manufacturing 151.0
Chemical manufacturing 85.0
Plastics and rubber products manufacturing 4.2
Nonmetallic mineral products manufacturing 1.5
Primary metal manufacturing 6.1
Fabricated metal products manufacturing 9.6
Machinery manufacturing 31.2
Computer equipment, appliance and component manufacturing 60.2
Electrical equipment, appliance and component manufacturing 15.3
Transportation equipment manufacturing 32.5
Furniture and related product manufacturing 1.2
Miscellaneous manufacturing 13.3
Total 462.2
Source: Internal Revenue Service, SOI Tax Stats,

Induced investment and expanded employment in the US manufacturing sector would, to a significant extent, offset the static revenue loss. An illustrative calculation may be useful. On average, US manufacturing employees in 2012 earned taxable income of $35,334 annually, whereas US employees in the retail trade sector earned taxable income of $15,964 annually.2 If one-fifth of employees in the retail trade sector (3 million) moved to the manufacturing sector, additional tax revenue on their higher earnings, calculated at a rate of 15 percent, would amount to $8.7 billion. Taking this effect into account, the net impact on tax revenue from enlarging the MLP definition might be a loss of about $19 billion annually.3 This seems like a small price to pay for a tax reform that would boost the global competitiveness of the US manufacturing sector and ease popular angst about US participation in free trade agreements like the Trans-Pacific Partnership.


1. Michael Cooper, John McClelland, James Pearce, Richard Prisinzano, Joseph Sullivan, Danny Yagan, Owen Zidar, and Eric Zwick, 2015, “Business in the United States: Who Owns it and How Much Tax They Pay,” Tax Policy and the Economy 30.

2. On average, annual earnings for US manufacturing employees and employees in the retail trade sector in 2012 were $41,284 and $21,914, respectively. The standard deduction for a single filer was $5,950, and this figure is subtracted to estimate average taxable income.

3. –$28 billion + $8.7 billion = –$19.3 billion.