Hitting risky business investments is not the smart way to tax millionaires

Senator Sheldon Whitehouse and Representative Lloyd Doggett released a Joint Tax Committee distributional analysis of a provision in the stimulus bill that eases the tax treatment of losses by pass through businesses, like partnerships and S corporations. It concludes that the provision primarily benefits millionaires. This analysis drew widespread media coverage and prompted various commentators and Democratic lawmakers to urge that the provision be repealed, a step previously proposed by Joe Biden.

But repealing it would inefficiently penalize risky business investments by taxing profits immediately while delaying deductions for losses. There is no need to add that distortion to the current tax system. If lawmakers in Congress decide that millionaires should pay more taxes, they need to directly raise their tax rates rather than alter the tax code through ways that penalize risky business investments and create inefficiency.

The story begins with the tax law of 2017. It imposed a limit on deductions for business losses in 2018 to 2025, so individuals who own pass through businesses could deduct no more than $250,000 of losses against other income during the year that the loss occurred, and any extra losses above that limit could be used to offset taxes on income in future years.

Aiming to provide relief for businesses hit hard during the pandemic, the stimulus bill removed the limit for losses that occur in 2018 through 2020. So owners can now deduct those losses from all other current income or can use the business losses to offset income in the five preceding years, and then obtain immediate refunds of previous tax payments.

It is easy to see which income groups directly benefit from the provision. Because the tax law limit applied to taxpayers with more than $250,000 of nonbusiness income, the benefits of removing the limit necessarily flow to those taxpayers. Sure enough, the Joint Tax Committee reported that over 80 percent of these benefits go to taxpayers with incomes of $1 million or higher. Whitehouse denounced the provision as a way to “loot American taxpayers in the midst of an economic and human tragedy.”

In reality, however, allowing the loss deductions only promotes neutral taxation of risky business investments. When risky investments pay off, business owners, whether rich or poor, are taxed immediately on their profits. When business investments go bad, the owners need to get an immediate deduction for all those losses. Taxing profits right away while delaying loss deductions, as the tax law did, lets the government play a game of “heads I win, tails you lose” against business owners.

By removing the traditional limit imposed by the tax law, the stimulus bill levels the playing field. If some business owners are claiming unwarranted deductions for artificial “paper” losses, as some commentators claim, the problem should be addressed by changing the tax rules used to compute income and loss instead of by imposing an arbitrary dollar limit.

But above all, we should not repeal the provision simply to raise taxes on millionaires. If Congress wants to raise taxes on millionaires, it can hike their tax rates. Taking that path would collect additional federal revenue and can help reduce economic inequality, but at the price of amplifying disincentives for saving and other economic activity. A lively political debate about the proper response to that trade off is ongoing.

Regardless of how that debate gets resolved, we should not raise taxes on millionaires in ways that could unnecessarily distort the tax system. Many certainly agree that we should not raise taxes on millionaires by arbitrarily preventing them from offsetting withholding and estimated tax payments against their final tax liability. Similarly, we should not raise their taxes by putting a thumb on the scale against risky investments. Penalizing risky business investments is simply the wrong way to tax millionaires.

Alan Viard is a resident scholar based at the American Enterprise Institute.