The Tax Cuts and Jobs Act (TCJA) will turn one year old this December, an anniversary that should come with some analysis of how it is working. The law did make some important changes. Lowering the corporate tax rate to 21 percent increased incentives to invest, doubling the standard deduction made tax filing much simpler for millions of taxpayers, and curbing several distortive itemized deductions will help address problems in the housing market.
While the TCJA made some historic advances, it also created some new problems. It has increased the deficit and introduced new complicated tax provisions. The most onerous new provision is the pass-through deduction, which allows owners of pass-through businesses (sole proprietorships, limited liability companies, and partnerships) to deduct 20 percent of income from their businesses. While intended to help small businesses, this provision will create little economic growth, while significantly reducing tax revenue and favoring some industries more than others.
The pass-through deduction is projected to reduce tax revenue by $414 billion dollars over the next ten years if it is allowed to expire as scheduled in 2025. If made permanent, as many Republican members are pushing for, the deduction would reduce tax revenue by an additional $100 billion dollars over the next decade. When Kansas created a pass-through deduction in 2012, they experienced massive losses in tax revenue, which led to dangerous budget crises surrounding crucial government services.
There’s also no guarantee that the provision will create economic growth, as similar attempts to spur growth through pass-through deductions have failed in the past. Returning to the Kansas example, Governor Sam Brownback created a 100 percent deduction for pass-through income. Instead of providing more incentive for current business owners to increase investment or making Kansas a more attractive place to form businesses, this deduction solely encouraged tax avoidance. Kansas saw no additional growth and its tax code did not become significantly more competitive.
One guiding principle of tax law is horizontal equity, which states that those with similar amounts of wealth or income should be taxed similarly. The new pass-through deduction violates this principle by disproportionately benefiting certain industries over others. As the Tax Policy Center noted, which businesses are eligible for the pass-through deduction often doesn’t make sense: for example, dental practices cannot, but optometrists can. These awkward distinctions stem from the fact that the pass-through deduction from the TCJA provides more benefits for “non-service businesses” such as farmers and manufacturers than “service businesses” such as doctors or lawyers. Furthermore, the provision means higher-income earners who make their income through ownership of a pass-through business will pay less taxes than someone who earns the same income as wages. These uneven preferences, which could be described as the government “picking winners and losers,” make the pass-through deduction an inefficient way to lower taxes.
Ultimately, the new pass-through deduction is unlikely to grow the economy, arbitrarily picks winners and losers, and greatly increases the deficit. As the $21 trillion national debt continues to grow to dangerous levels, Congress should consider rolling back this new deduction.