Taxing high net worth individuals and corporations while improving tax enforcement is a key issue on the Biden government’s tax agenda. However, raising the corporate tax rate to 28 percent (as in the American Employment Plan) complicates enforcement efforts by encouraging companies to form as passports. by companies that tend to have lower tax rates.
The tax gap is the difference between the amount of tax owed by law and the amount actually paid. Most estimates of the tax gap suggest that it is around 15 percent of the amount legally owed. An IRS analysis of the 2011-2013 data found the net tax gap to be $ 381 billion. A recent study by economists Natasha Sarin and Larry Summers estimated the 2020 tax gap after adjusting for income growth and inflation at around $ 630 billion.
Understanding the root causes of the tax gap is important when considering how to improve tax enforcement. There is a common misconception that corporations are the prime culprits of tax evasion in the United States. In reality, corporate tax compliance is relatively high: According to the IRS’s analysis, the gap between taxes owed and taxes paid on corporate tax was 11 percent, smaller than the overall tax gap of 15 percent.
Instead, the tax with the highest avoidance rates is individual income tax. And tax evasion mostly occurs on income for which only a few reporting requirements apply. This includes many forms of business income, particularly income generated through pass-through business.
Pass-throughs have grown dramatically since 1980 as a proportion of US corporations. As tax experts Donald Schneider and Kyle Pomerleau recently wrote for Bloomberg Tax, the main reason the US has had comparatively low corporate tax revenues as a percentage of GDP is that there are more companies operating in the US than there are constructed gateways.
One of the reasons the US has a high percentage of pass-through businesses is because of corporate tax policies. The US has long had a corporate tax rate of 35 percent. In connection with double taxation of corporate income (through corporate profits and dividends), non-corporate investments received better tax treatment than corporate investments. As a result, companies were less likely to adopt a corporate structure.
By giving preference to non-corporate activities over corporate activities, tax legislation has created an incentive for companies to introduce pass-through structures where the tax gap is larger.
By lowering the business rate to 21 percent, the Tax Cut and Employment Act (TCJA) of 2017 helped reduce these incentives. The TCJA also introduced a new provision for pass-through businesses, Section 199A, which allows people to deduct up to 20 percent of income from pass-throughs. However, the net effect of the TCJA was to reduce the tax distortion between corporate and non-corporate income.
Unfortunately, the Biden proposal would reverse these improvements. Increasing the corporate rate to 28 percent would make starting a business as a pass-through more beneficial than a C-business. In addition, higher tax rates generally increase the incentives for businesses and individuals to engage in tax evasion. At a higher rate, the return for each unreported dollar of income is higher.
Tax reform should be about creating simpler and more growth-enhancing tax legislation, especially given that simpler tax codes are usually easier to enforce. If Biden wants to reduce tax evasion, increase the company rate, increase tax evasion incentives, and create a greater tax break in order to become a pass-through business, it is counterproductive.
Launch Resource Center: President Biden’s Tax Proposals
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