Pass-Through Business Taxation: Taxing Private Business Income

The American Taxpayer Relief Act (ATRA) of 2012 repealed tax cuts for the top income earners in the United States and added a new top tax bracket with income thresholds of $400,000 for single filers, $425,000 for heads of households, and $450,000 for married joint filers. Filing units in the new top tax bracket experienced an increase of the marginal tax rate from 35% to 39.6% on ordinary income, and from 15% to 20% on dividends and realized long-term gains.

As of 2015, pass-through businesses accounted for approximately 80% of firms, 55% of business income, and more than half of employment across all major industries in the United States. The unique corporate structure of pass-through businesses, known as S-corporations, allows for business income to be taxed as personal income rather than as corporate income. Changes to the personal tax rate an of S-corporation business owner is effectively a change on business’s income tax rate. The population affected by the ATRA tax rate increases contained a disproportionate number of business owners, with 57% having some pass-through business income.

Risch (2024) exploits the implementation of ATRA to study the relationship between the top marginal tax rate faced by business owners and employee earnings. The paper uses a difference-in-differences model and data from the universe of tax records linking firms to owners and workers to study changes in employees’ incomes. The paper finds that $1 increase in business income tax liability following ATRA corresponded to a 11-15 cents per dollar of new tax liability passed onto worker earnings. The tax burden was primarily borne by business owners, who bore approximately 80% of the burden. The workers’ share of the burden was entirely borne by employees in the top 30% of the income distribution, with essentially none of the burden borne by the lower two thirds of earners in affected firms. While workers in exposed firms saw lower relative earnings growth through 2016, firms did not shrink or become less productive. In addition, there was not evidence of skill downgrading, nor was their evidence of changes in revenues, suggesting the firms did not passed the tax burden into consumers through higher prices.

Risch (2024) takes these estimates to estimate the MVPF of taxing private business income. For this estimate, the paper considers a policy in which private business income is taxed directly and estimates the welfare effects considering the associated pass-through to the earnings of lower income employees.

The paper separately estimates the MVPF of taxing business owners through the personal tax income code and the MVPF of increasing the top personal income tax rate in a pass-through system considering the taxation of business owners and non-business-owners.