By John Ricco and Rich Prisinzano
In a recent interview on 60 Minutes, Congresswoman Alexandria Ocasio-Cortez presented the idea of instituting a 70 percent marginal tax rate on income over $10 million. Many commentators have weighed in on this proposal, both with op-eds supporting and criticizing this type of policy.1
A conventional revenue estimate of the new tax rate would incorporate a traditional elasticity of taxable income. An important factor for high-income taxpayers is that a significant share of income above $10 million is earned by owners of pass-through businesses. We project that a significant amount of pass-through business owners will respond to this tax by reorganizing as C corporations to minimize their tax liability. This shift could cause the new 70% tax rate to raise only 43 percent of the revenue that would otherwise be raised.
Representative Ocasio-Cortez has not specified the types of income to which this tax would apply. She has also not provided details on any concurrent tax changes (for instance, an increased corporate income tax rate). As such, all estimates here should be interpreted as illustrative rather than a final analysis. As PWBM has noted in the past, we are reluctant to use the full capabilities of our model without the full details of a tax plan. For the purposes of this post, we assume the tax would be implemented as an additional tax bracket applying to ordinary income only.
Raising the top rate to 70 percent while leaving the corporate tax rate unchanged at 21 percent presents an opportunity for pass-through businesses to reorganize as C corporations to avoid paying higher rates. To demonstrate the incentive created by this rate differential, we construct a simple measure of the relative tax advantage of corporate form. We use the statutory corporate, top individual and dividend tax rates as well as the share of corporate income paid out as dividends to construct the tax wedge:
Tax wedge = corporate rate + (1 - corporate rate) (dividend payout share) (dividend rate) - top rate
We previously used this analysis to explore the incentive for pass-through firms to switch to corporate form under the 2017 tax act. Empirical evidence suggests that business owners react to changes in the tax wedge, with an implied elasticity of approximately -.054.
Table 1 shows this tax-wedge calculation under both current law and proposed law. The table allows for the possibility that the business may or may not be able to use the pass-through deduction (Section 199A). It also shows the tax wedge under two deferral amounts: 0 percent retained earnings and 100 percent retained earnings. It is important to note that even with all corporate earnings paid out in the year they are earned (essentially mirroring a pass-through), the tax wedge suggests there would be a tax advantage for corporations.
| 0% retained earnings | ||||||
|---|---|---|---|---|---|---|
| Current law | Proposed law | |||||
| Type of tax | C corporation | Pass-through with QBI | Pass-through without QBI | C corporation | Pass-through with QBI | Pass-through without QBI |
| Entity tax | 21.0% | 0.0% | 0.0% | 21.0% | 0.0% | 0.0% |
| Individual tax | 20.0% | 37.0% | 37.0% | 20.0% | 70.0% | 70.0% |
| QBI deduction | 0.0% | 20.0% | 0.0% | 0.0% | 20.0% | 0.0% |
| NIIT | 3.8% | 3.8% | 3.8% | 3.8% | 3.8% | 3.8% |
| Net rate | 39.8% | 33.4% | 40.8% | 39.8% | 59.8% | 73.8% |
| Tax wedge | 6.4% | -1.0% | -20.0% | -34.0% | ||
| 100% retained earnings | ||||||
| Current law | Proposed law | |||||
| Type of tax | C corporation | Pass-through with QBI | Pass-through without QBI | C corporation | Pass-through with QBI | Pass-through without QBI |
| Entity tax | 21.0% | 0.0% | 0.0% | 21.0% | 0.0% | 0.0% |
| Individual tax | 0.0% | 37.0% | 37.0% | 0.0% | 70.0% | 70.0% |
| QBI deduction | 0.0% | 20.0% | 0.0% | 0.0% | 20.0% | 0.0% |
| NIIT | 0.0% | 3.8% | 3.8% | 0.0% | 3.8% | 3.8% |
| Net rate | 21.0% | 33.4% | 40.8% | 21.0% | 59.8% | 73.8% |
| Tax wedge | -12.4% | -19.8% | -38.8% | -52.8% | ||
Note: The QBI referenced in the table above refers to Qualified Business Income under Section 199A.
Figure 1 presents the tax wedge over time. The shaded blue (red) areas mark the period of time when the tax wedge is negative and therefore, corporate (pass-through) status is preferred to pass-through (corporate) status. This proposal would create the largest tax wedge in recent U.S. history.
Source: Authors’ calculations based on data from Tax Policy Center. Assumes C corporations retain 50% of earnings.
The proposed law creates a historically large gap between the top two individual marginal rates, both in absolute value and percentage-point gap. As such, applying a traditional elasticity of taxable income to filers affected by this tax likely understates the amount of business income that would shift. Instead, we model individual-level responses, specific to each filer’s tax situation. We assume that any taxpayer whose ordinary income exceeds $10 million and reports ordinary business income will 1) elect to have that business income taxed as a C corporation and 2) defer that income through retained earnings. For this analysis, we do not model other margins of income shifting. As such, our estimates likely represent an upper bound on revenue raised.
Table 2 presents how the revenue effect of business income shifting due to the tax wedge between corporate and non-corporate business income can result in forgone revenue. Holding all economic behavior constant, we estimate Representative Ocasio-Cortez’s proposal would raise $382 billion over fiscal years 2020-2029. After allowing for behavioral responses and applying a traditional elasticity of taxable income,2 the revenue estimate falls to $353 billion.
Using a more sophisticated model that accounts for business income shifting, the estimate falls even further. Assuming all corporate earnings are paid out in the year they are earned, the revenue estimate is $248 billion over the 10-year budget window. Assuming this income is deferred indefinitely, the revenue estimate is $164 billion.3 Annual estimates are shown below.
| Year | Static | With aggregate elasticity | With micro-level business income shifting | |
|---|---|---|---|---|
| Full payout | Full deferral | |||
| 2020 | 26.0 | 23.6 | 16.6 | 10.9 |
| 2021 | 35.6 | 33.0 | 23.4 | 15.8 |
| 2022 | 38.4 | 35.6 | 25.3 | 17.1 |
| 2023 | 40.9 | 37.9 | 27.2 | 18.7 |
| 2024 | 43.1 | 40.0 | 27.7 | 18.1 |
| 2025 | 45.5 | 42.2 | 29.8 | 20.1 |
| 2026 | 35.5 | 32.9 | 23.2 | 15.5 |
| 2027 | 36.4 | 33.4 | 22.6 | 14.0 |
| 2028 | 39.2 | 36.1 | 24.8 | 15.8 |
| 2029 | 41.7 | 38.4 | 27.0 | 17.8 |
| 2020-2029 | 382.3 | 353.1 | 247.5 | 163.8 |
Without careful consideration of the incentives, this proposal, therefore, might fail to raise as much revenue as traditional estimates would suggest. Policymakers interested in raising top individual rates should bear these incentives in mind as they design comprehensive tax proposals.
Year,Net corporate rate,Net pass-through rate,Higher Net corporate rate,HigherTop pass-through rate 1954,0.5800000000,0.9100000000,, 1955,0.5800000000,0.9100000000,, 1956,0.5800000000,0.9100000000,, 1957,0.5800000000,0.9100000000,, 1958,0.5800000000,0.9100000000,, 1959,0.5800000000,0.9100000000,, 1960,0.5800000000,0.9100000000,, 1961,0.5800000000,0.9100000000,, 1962,0.5800000000,0.9100000000,, 1963,0.5800000000,0.9100000000,, 1964,0.5625000000,0.7700000000,, 1965,0.5450000000,0.7000000000,, 1966,0.5450000000,0.7000000000,, 1967,0.5450000000,0.7000000000,, 1968,0.5914840000,0.7525000000,, 1969,0.5929000000,0.7700000000,, 1970,0.5738134000,0.7175000000,, 1971,0.5690500000,0.7000000000,, 1972,0.5749000000,0.7000000000,, 1973,0.5749000000,0.7000000000,, 1974,0.5749000000,0.7000000000,, 1975,0.5749000000,0.7000000000,, 1976,0.5836750000,0.7000000000,, 1977,0.5836750000,0.7000000000,, 1978,0.5836750000,0.7000000000,, 1979,0.5356000000,0.7000000000,, 1980,0.5356000000,0.7000000000,, 1981,0.5356000000,0.6912500000,, 1982,0.5140000000,0.5000000000,, 1983,0.5140000000,0.5000000000,, 1984,0.5140000000,0.5000000000,, 1985,0.5140000000,0.5000000000,, 1986,0.5140000000,0.5000000000,, 1987,0.4324000000,0.3850000000,, 1988,0.4324000000,0.2800000000,, 1989,0.4324000000,0.2800000000,, 1990,0.4324000000,0.2800000000,, 1991,0.4354690000,0.3100000000,, 1992,0.4354690000,0.3100000000,, 1993,0.4448675000,0.3960000000,, 1994,0.4448675000,0.3960000000,, 1995,0.4448675000,0.3960000000,, 1996,0.4448675000,0.3960000000,, 1997,0.4448675000,0.3960000000,, 1998,0.4188675000,0.3960000000,, 1999,0.4188675000,0.3960000000,, 2000,0.4188675000,0.3960000000,, 2001,0.4188025000,0.3910000000,, 2002,0.4187700000,0.3860000000,, 2003,0.4184125000,0.3500000000,, 2004,0.4021625000,0.3500000000,, 2005,0.4021625000,0.3500000000,, 2006,0.4010250000,0.3500000000,, 2007,0.4010250000,0.3500000000,, 2008,0.3998875000,0.3500000000,, 2009,0.3998875000,0.3500000000,, 2010,0.3987500000,0.3500000000,, 2011,0.3987500000,0.3500000000,, 2012,0.3987500000,0.3500000000,, 2013,0.4315750000,0.4340000000,, 2014,0.4315750000,0.4340000000,, 2015,0.4315750000,0.4340000000,, 2016,0.4315750000,0.4340000000,, 2017,0.4273500000,0.4340000000,, 2018,0.3040100000,0.3340000000,, 2019,0.3040100000,0.3340000000,, 2020,0.3040100000,0.5980000000,, 2021,0.3040100000,0.5980000000,, 2022,0.3040100000,0.5980000000,, 2023,0.3040100000,0.5980000000,, 2024,0.3040100000,0.5980000000,, 2025,0.3040100000,0.5980000000,, 2026,0.3040100000,0.7380000000,, 2027,0.3040100000,0.7380000000,, 2028,0.3040100000,0.7380000000,, 2029,0.3040100000,0.7380000000,, 2030,0.3040100000,0.7380000000,,