Indirect trade tax of House Democrats
As part of the House Democrats’ reconciliation plan, the top tax rate on passed on business income would exceed 50% in most states.
Intermediate businesses, such as sole proprietorships, S corporations, and partnerships, make up the majority of businesses and the majority of private sector jobs in the United States. The owners of these businesses pay personal income tax on the income earned from these businesses. Marginal tax rates vary for intermediary businesses depending on the state in which they operate, as states tax individual income differently.
The House Democrats’ reconciliation plan would increase the top marginal tax rate on ordinary income from 37% to 39.6%. Additionally, high-income taxpayers would face a 3% surtax on their modified adjusted gross income (adjusted gross income minus interest charges on investments) exceeding $ 5 million.
The plan would make further adjustments to corporate taxation. Currently, qualifying intermediary businesses can use Section 199A, commonly known as the passed-on deduction, to deduct 20% of their qualifying business income from federal income tax. However, the pass-through deduction is subject to limitations for businesses earning above certain income limits that operate in a “specified trade or service business” (SSTB) and other safeguards that limit the amount of income. the deduction. The plan would further limit the deduction by setting the maximum allowable deduction at $ 500,000 for joint filers and $ 400,000 for single filers.
Finally, the plan would change the net investment income tax (NIIT) tax base to include income from the “active” part of a business, for joint filers with more than $ 500,000 in income. taxable and single tax filers with over $ 400,000 in income taxable income. The NIIT currently applies a rate of 3.8% to investment income, or “liabilities,” such as capital gains, dividends, and interest income. The combination of these four tax increases would result in a maximum federal tax rate on pass-through business income of 46.4% (which is also the maximum federal tax rate on ordinary income under the proposal).
The highest marginal tax rates facing mid-level businesses after the changes would vary from state to state, ranging from 46.4% in states without state and local income tax, such as the Wyoming and Florida, at 61.2% in New York. These combined rates include federal, state, and local income taxes in addition to payroll tax. As part of this reconciliation plan, 41 states would see their top marginal tax rate exceed 50%.
Increasing the top marginal tax rate on passed-on business income reduces the after-tax return on investment for those businesses, thereby reducing incentives to invest and hire.
Mid-size companies are responsible for a large portion of employment in the United States In 2019, mid-size companies accounted for more than half of the private sector jobs in each state. The share of private sector employment provided by intermediary firms ranges from 55.3% in Hawaii to 77.7% in Utah.
It can be argued that the proposed tax increases affect only a small percentage of businesses, but economically, it is more important to consider the share of business income that is affected. Our estimates indicate that more than half of the business income passed on would be subject to a tax increase under these proposals.
As midsize businesses make up a significant portion of employment and economic activity, many states would be significantly affected by increases in business taxes as part of the House Democrats’ reconciliation plan. Since many states already impose high tax rates on corporate income, policymakers should keep in mind the combined tax burden imposed on these businesses when considering changes in federal tax policy.
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