We project that the Tax Cuts and Jobs Act (TCJA) will cause 235,780 U.S. business owners---77 percent of whom have incomes of at least $500,000---to switch from pass-through entity owners to C-corporations, primarily to take advantage of sheltering their income from tax by converting to C-corporations.
The biggest switchers include doctors, lawyers and investors, especially if owners can afford to defer receipt of business income to a later year. Other business owners, who are qualified to use the 20 percent deduction for pass-through business income, including painters, plumbers, and printers, are more likely to remain as pass-through entities.
We project that about 17.5 percent of all pass-through Ordinary Business Income will switch to C-corporations.
PWBM previously analyzed the effects of the tax bill passed this December. Most of that bill’s tax cuts for individuals (non-businesses) expire at year-end 2025. This brief reports the budgetary and economic effects of indefinitely extending the individual-side tax cuts.
By 2027, we project that debt increases between $573 billion and $736 billion. However, GDP is relatively unchanged, although slightly contracts, because this standard 10-year budget window covers only two years of tax cut extensions.
By 2040, we project that GDP contracts by 0.6 percent to 0.9 percent relative to current law, where the tax cuts for individuals are set to expire. Debt increases between $5.2 trillion and $6.1 trillion.
The current U.S. statutory corporate tax rate is 35 percent. However, due to various deductions, credits and income deferral strategies, most corporations pay a lower rate, known as the effective tax rate (ETR), which averages about 23 percent under current law across all industries over the next decade. However, this value varies considerably across industries, with mining paying 18 percent and agriculture paying 33 percent.
The TCJA reduces the statutory corporate tax rate from 35 to 21 and the average ETR falls from 21 to 9 percent in 2018. However, by 2027, the ETR doubles in value to 18 percent, mostly due to expiring provisions.
In the short run, the biggest winners of the TCJA are capital-intensive industries like utilities, real estate and transportation, which benefit the most from temporary expensing of equipment. However, over time, several industry ETR’s will actually rise above the new statutory rate of 21 percent in future years.
By 2027, under our standard economics assumptions, we project that GDP is between 0.6 percent and 1.1 percent larger, relative to no tax changes. Debt increases between $1.9 trillion and $2.2 trillion, inclusive of economic growth.
By 2040, we project that GDP is between 0.7 percent and 1.6 percent larger under our baseline assumptions, and debt increases by $2.2 to $3.5 trillion.
Politico’s Ben White and Aubree Eliza Weaver write about the Penn Wharton Budget Model’s projection of business entity classification conversions in the aftermath of the Tax Cuts and Jobs Act (TCJA) in Morning Money: The Big Switch from Pass-Throughs.
As noted in our brief, the Tax Cuts and Jobs Act reduced the direct tax liability of individuals by an estimated $1.3 billion, before considering macroeconomic feedback effects, over the period 2018-27. This reduction was achieved through a number of provisions that changed the individual income tax structure. Table 1 presents the average tax cut received by Adjusted Gross Income (AGI) percentile in 2018. The overall median tax cut is $401, with larger cuts going to groups with larger AGI.