A Reduced 'Pass-Through' Rate Doesn't Encourage Wealth Creation
One of the oldest maxims in economics is also one of the truest. If you want a fair, efficient tax code that encourages wealth creation, just follow six simple words: “Widen the base, lower the rate.” But President Donald Trump’s proposed reduced rate of taxation on some small businesses would narrow the base. And it would distort one of the most important components of a market economy – the discipline that is imposed by the need to calculate risk.
Under the pass-through proposal, owners of businesses conducted as sole proprietorships, partnerships and S corporations would pay a maximum 25 percent tax rate, a big drop from the current maximum of 39.6 percent and significantly lower than the proposed top tax rate of 35 percent on individuals. As a result, business owners would actually pay a lower tax rate than their employees.
Lower tax rates make sense – for all, not for some. Just as someone must pay for a free lunch program, some taxpayers would have to pay for the special tax break, in the form of a higher rate for themselves or reduced government services. What would they be getting for their money? A tax environment that encourages people to make investment decisions based on how well it allows them to arbitrage lower tax rates efficiently. But green eye-shade economics is no way to create wealth. It is indeed desirable for people start a small business, if their goal is potential earnings, not a potential tax break.
Some would argue that a lower pass-through rate would encourage risk. But people don’t take the risk of starting a small business because they want a tax break; they do it for the potential financial reward. Potential risk that is counter-balanced by a tax break rather than potential reward just leads to wasted effort and capital. The risk-reward axis imposes a valuable discipline, forcing people to focus clearly on the potential gains vs the potential losses before setting up a business. But if you mitigate the risk, you dilute the discipline. You forego the real value of potential downside risk, paired with upside reward, as a mechanism to ensure the most efficient allocation of capital and energy.
And why should government encourage one form of risk-taking and ignore others? A young woman who decides to pursue a doctorate even though it means living on tips as a waitress for four years is taking a big risk. Should she be given a lower tax rate too? If someone takes a new job even though it pays less than their current one, in the hope it will lead to something better, he is also taking a risk. Should it be mitigated with a tax break? Or what about someone who moves from a low-cost city to take a job in a high-cost one. Should that risk be mitigated through the tax system? Rather than see their risk subsidized, people like this would just end up subsidizing someone else who may well have taken less of a chance and garnered a bigger financial reward.
Providing a special, lower rate for some but not for all is neither fair nor efficient. Instead of widening the tax base, it would narrow it, leaving money on the table for some while snatching it away from everybody else. Rather than forcing risk to be measured, it would encourage taxpayers to take it on recklessly. The goal should be to encourage wealth creation. A reduced pass-through rate does the opposite.
