The shifting sources of U.S. business income and its contribution to income inequality

Conversations about business taxation in the United States usually center on the corporate income tax. For a long time, this intellectual shortcut made a good amount of sense, as traditional corporations that paid the corporate income tax earned the vast majority of business income. If you wanted to try to tax the capital flowing through businesses then you’d want to focus most of your attention on the corporate side.

But that doesn’t seem to be the case anymore. A new working paper by economists at the U.S. Treasury Department, the University of California-Berkeley, and the University of Chicago Booth School of Business uses administrative tax data to show that the majority of business income is now earned by companies set up as “pass-throughs,” such as partnerships. (With pass-through entities, income taxes aren’t paid at the business level—the income “passes through” the business to the owners’ individual tax returns.)

This new information on the rise of the pass-through sector should help shape our thinking about how business income contributes to income inequality in the United States, and how we tax businesses.

The paper’s authors have access to tax data at the Treasury Department for 2011 that lets them match pass-through entities with their respective owners. Again, this is important because pass-through entities themselves aren’t taxed; the income they earn is taxed as the income of the business owners. Take, for example, a law partnership. The profits from the partnership are dispersed to the different partners and the income is taxed once it shows up as income for the individual partner.

The new research reveals a number of new facts about business income in the United States. First, the share of business income going through pass-throughs has risen dramatically—from about 21 percent of business income in 1980 to 54 percent in 2011. Why is this shift significant? For starters, income earned in the pass-through sectors is much more unequally distributed than income in other business sectors. Sixty-nine percent of all income earned in pass-through companies goes to taxpayers in the top 1 percent, while only 45 percent of income from classic corporations goes to the top 1 percent. When it comes to partnerships, a sub-segment of pass-throughs, the majority of income earned by the top 1 percent is from partnerships in finance and professional services.

Not only are these incomes more unequal, they are also taxed less. According to the authors’ estimates, the average income tax rate for partnerships in 2011 was 15.9 percent. S corporations, another kind of pass-through business, have an average tax rate of 25 percent. That means the pass-through sectors have an average tax rate of 19.5 percent, compared to the average rate for traditional corporations of 31.6 percent. Combine all those estimates together and you get a total business tax rate of 24.3 percent. (All of these rates are from 2011.) The shift to pass-through entities has pushed this rate down—if the sources of business income were the same as they were in 1986, the overall business tax rate would be about 28 percent.

Partnership income is also quite opaque—the authors couldn’t confidently trace either the source or the ultimate destination of 30 percent of partnership income. The fact that almost a third of this income is hidden in one regard or another is, as the authors note, another sign that we should be concerned about businesses trying to hide business income in order to pay lower taxes.

This trend of more business income going to the pass-through sector should be seen in the light of other shifts among kinds of companies in the U.S. economy. The number of publicly traded companies in the United States peaked in 1998 and continues to decline. Firms are increasingly less likely to go public. Private companies are also opaque. And at the same time, start-up rates for businesses are declining, businesses are becoming larger, and workers increasingly work for those large companies.

These changes in the business sector shouldn’t be ignored when we’re talking about business taxation or a variety of other policy areas. The implications for the functioning of the U.S. economy, both for economic distribution and growth, look too important to ignore.