Shu-Yi Oei is an Associate Professor of Law at Boston College Law School. Diane Ring is a Professor of Law and The Dr. Thomas F. Carney Distinguished Scholar at Boston College Law School.
This post follows up on our prior post, which focused on the complex provisions of the proposed Senate tax bill. This post discusses some of the key concerns that have been expressed about the new tax bill. (Again, we focus here on the Senate version of the proposed legislation. The specifics of the analysis may change once we get the Conference version, though the broader policy and design questions are likely to persist.)
Why are People Worried?
There are a number of reasons why the proposed Senate bill is causing some concern.
Some people are concerned that the provision might work! One worry is that only employee labor income will now bear higher tax rates: Although the Tax Code has traditionally distinguished labor income (taxed at higher, progressive rates) from long-term capital gain income (taxed at relatively flat rates—with slight progressivity in brackets of late), we are now making, new, explicit distinctions between wage income and other types of income earned through business.
Another worry is costly distortions on taxpayer behavior: Pressure to characterize their income in ways that get more favorable tax treatment may lead workers to make ill-advised and inefficient tradeoffs.
Specifically, the worry is that drawing a distinction between how different types of income are taxed will cause taxpayers to do whatever it takes to get the lower rate, including:
- reclassifying themselves as independent contractors (and losing employee protections);
- incorporating (to get the lower corporate rate); or
- setting up pass-through entities and recasting their income as non-wage income.
An important concern is that the confluence of workers desiring better tax treatment and some firms preferring to classify workers as independent contractors (rather than employees) will cause big shifts towards independent contractor classification for workers throughout the economy.
Yet another worry is the distributional impacts of these distortions. All of these strategies are most available to more savvy, sophisticated, and likely higher-income taxpayers, including those who can afford tax planning, those who can form partnerships with other similarly situated individuals, and/or those who have some factual grounds for arguing that their income is from something other than their own services. In some cases, these taxpayers may instead determine that a move to C corporation status, with the new low corporate tax rate, may be most attractive.
Thus, it is possible that current higher-bracket taxpayers will get the most benefit if they are able to cast their wage income as something else. This is due, in part, to the progressivity of the tax Code: higher bracket taxpayers stand to gain the most by offsetting high-bracket income.
Some of the same people who are worried that the new regime might work are also concerned that it might not work! Remember that the proposed reform is justified on the grounds that it will generate economic growth. But the reform would likely come with significant costs and risks, as suggested above.
At the heart of it all lies these questions: How strongly do we believe that the new lines being drawn and incentives being created will in fact spur growth by creating new economic activity, as opposed to simply causing current workers to engage in certain planning maneuvers solely for the tax benefits? More fundamentally, are there really meaningful distinctions between the taxpayers who will fall on the losing, high-tax side and those who will secure lower net tax rates?
Are the Concerns Overblown?
It’s certainly possible that concerns about these effects of the new tax legislation are overblown. Some commentators express doubt over the extent to which taxpayers can really turn wage income into tax-favored income under the Senate regime. At present, there is some debate as to whether and to what degree the Senate proposal intends to facilitate taxpayers shifting labor income to business income that gets the new deduction. More robust guardrails may be put in place in the Conference version of the bill. We simply do not know.
An important question in all this will be how well the guardrails and limitations placed in the statute will work. For example, in the existing Senate version, important constraints on such tax planning maneuvers lies in the definition of “qualified business income,” the definition on which the deduction depends. (See discussion above.) Taxpayers want a large “qualified business income” number in order to get a big deduction. But the term “qualified business income” does not include “reasonable compensation paid to the taxpayer for services rendered with respect to the trade or business.” The “reasonable compensation” rule thus serves as a guardrail to prevent an employee from setting up an S corporation or partnership, or shifting to an independent contractor designation (i.e. sole proprietorship) and collecting the “wages” through that structure. Income earned by the taxpayer as S corporation shareholder, partner or sole proprietor that was due to his or her services might not count as “qualified business income.”
There are other guardrails based on industry and types of activity as well as income level. The question is whether these guardrails will hold up and whether they’re being put in the right place. Given the potential dollar value of securing the new deduction for passthroughs, many taxpayers may be inclined to restructure and to press the bounds of the tax rules
It’s important to clarify that we are not going from a universe of zero behavioral distortion to a universe of distortion. Make no mistake: the current tax law already creates incentives to structure business, classify workers, and characterize income in certain ways rather than others. The important questions are: what new distortions will the new legislation introduce, and how do they interact with or compare with the existing ones? On a quick eyeball, this new provision does seem to create more lines and gaming points than existing law.
The Risks of Speed
As many have noted, the speed at which the tax reform has been drafted, debated, and offered to the broader tax community for analysis is creating a serious risk of loopholes and (presumably) unintended consequences. The process of making retrospective Technical Corrections is costly and fraught with roadblocks. Potential problems, loopholes, and distortions are better addressed upfront in designing the statute, than painfully, slowly, and unevenly through regulations, technical corrections, and litigation.