A problem with this 'small business' tax provision could sink Republican tax reform

• A key small business group is opposing the Republican tax reform effort, and addressing their objections could cost hundreds of billions of dollars.
• Republicans don't have a good solution to satisfy all parts of their coalition.
• Constituency groups expect more in total tax cuts than Republicans are allowed to give out, which spells trouble for the tax reform package.

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The National Federation of Independent Business, a lobbying group that leans strongly conservative, said it was "encouraged" by the tax reform framework Republicans released in September. But it's not happy with the bill House Republicans released Thursday and can't support it as it's written.

The group said in a statement:

"This bill leaves too many small businesses behind. We are concerned that the pass-through provision does not help most small businesses. Small business is the engine of the economy. We believe that tax reform should provide substantial relief to all small businesses, so they can reinvest their money, grow, and create jobs."

With the caveat that businesses benefitting from "small business" tax breaks often are not small at all - Trump family businesses would be major beneficiaries from this provision - I will note the NFIB is talking about the design of "guardrails" around a tax break for non-corporate businesses, a technical-sounding yet important problem for the bill I wrote about last week.

Revising this provision to satisfy the NFIB and aligned lawmakers is likely to be so expensive as to be impractical - which means this fight imperils the whole tax package.

What kind of business you all in?

This fight relates to the taxation of "pass-through" business income - income from entities like S-corporations and limited-liability companies that do not pay their own taxes, but pass their income through to their human owners, who then pay tax on that income on their individual income tax returns.

Under the Republican plan, certain kinds of pass-through business income would be taxed at rates no higher than 25%. But to prevent abuse - for example, incorporating myself as Josh Barro LLC and selling "professional services" to Business Insider instead of taking a salary - there would be rules setting out what's real business income and what's labor income made to look like business income.

Whatever is deemed to be labor income would be taxed at rates up to 39.6%, as under current law.

Last week I laid out three options for how to design the guardrails separating business income from labor income, all of which are unsatisfactory for one reason or another. Naturally, the tax bill drafters went for a mashup of all three of the unsatisfactory options.

In general, owners who actively participate in their businesses would face a 70/30 rule: 70% of their income from the businesses would have to be treated like a salary (and taxed at rates up to 39.6%) and only 30% of their income would enjoy the 25% preferential rate.

But professional services firms - like Josh Barro LLC - would have to treat 100% of the owner's income as salary, taxable at up to 39.6%. Womp womp.

You could get an exception to either of these last two rules, based on facts and circumstances, if you could show you've made a substantial capital investment in the business that means more of your income should be treated as non-salary income.

What if this works too well?

One problem with this set of guardrails is that it would be quite complicated, creating a lot of work for lawyers and accountants and undermining the goal of tax simplification through reform. But the NFIB's concern with the guardrails seems to be that they might actually work.

In September, when Republicans first released their tax framework, the Tax Policy Center estimated the pass-through preference would cost $770 billion over a decade. At the time, the framework included a top tax rate of 35%. Since Republicans are now proposing to keep a top rate of 39.6%, you would have expected the cost of this tax preference to go up, because the cost of a tax preference is driven by the difference between the preferential rate (25%) and the rate otherwise applied.

But the tax bill drafters say they have estimates from the Joint Committee on Taxation showing this provision will now only cost about $448 billion. That suggests the JCT believes these guardrails will succeed in excluding something like half of all pass-through business income from enjoying the tax preference.

Obviously, this is not what the NFIB was hoping for.

Jack Mozloom, NFIB's communications director, told me they're not looking for the preferential tax rate to be applied to 100% of pass-through income. But they think the 70/30 split should be adjusted downward, and they object strongly to the exclusion of professional services firms from the tax break.

"We don't think it's fair for the manufacturer to get a tax cut while his accountant doesn't," he told me.

Mozloom also noted that about 85% of pass-through businesses wouldn't benefit from the tax break, regardless of any guardrails, because their owners' incomes are already low enough to enjoy a tax rate of 25% or less. He said NFIB was hoping for a graduated provision offering these business owners a preferential rate below 25%.

This idea would be really expensive, but since it was not even contemplated in the September framework the NFIB said it found "encouraging," I suspect the group can live without it.

The guardrails issue is likelier to be a sticking point.

The NFIB has allies, and they'll be hard to placate

NFIB has not written off tax reform. The group has declared its intention to work with House Ways and Means Committee Chairman Kevin Brady to fix the package so it can support it. And it has allies in the House who share the same concerns.

"I want to make sure the pass-through rate for small businesses is actually a pass-through rate for all businesses," Rep. Mark Meadows, who leads the far-right House Freedom Caucus, told Crain's earlier this week. "I'm hearing that may not be the case, and that is a problem."

Of course, an obvious option would be for Republican leaders to give NFIB and Meadows what they want. But this would create three significant problems:

• Cost: Extending the tax preference to a much larger fraction of existing pass-through business income would add hundreds of billions of dollars to the bill's cost.
• Avoidance: Loosening the rules on what counts as business income - especially, allowing professional services firms like Josh Barro LLC to enjoy the preference - would invite taxpayers to find ways to recharacterize their labor income as business income, adding even more to the cost.
• Mission creep: A loose rule that lets nearly any kind of pass-through income enjoy a preferential rate gets far away from the nominal purpose of the provision, which is to encourage business investment and job creation.

Everyone's fighting over a limited pot of money

The tax bill is subject to a binding cap: Under budget reconciliation instructions the House agreed to last week, the Senate cannot use a simple majority to pass any tax bill that raises the deficit by more than $1.5 trillion over 10 years.

And the NFIB isn't the only part of the conservative coalition that wants something out of the bill it's not getting now.

Sen. Marco Rubio, a leading advocate for "family-friendly tax reform," has been pushing for a per-child tax credit of at least $1,800, up from the current $1,000. The legislation released today only increases the credit to $1,600, and Rubio doesn't think that's enough.

A substantial child tax credit increase is required just to offset the loss of existing family-friendly tax provisions that would be repealed by this bill, most notably the personal exemption that allows taxpayers to exclude $4,050 in income from tax for each dependent.

While Rubio fights for a higher per-child tax credit, which would cost money, other members will be pushing to strip out revenue-raising provisions in the plan, which would also cost money. A number of these provisions are likely to draw strong objections in coming days.

For example:

• The bill abolishes the tax deduction for student loan interest paid.
• It ends the adoption tax credit, a favorite provision of pro-family conservatives.
• It lowers the cap on the mortgage deduction.
• It does not change 401(k) contribution limits, avoiding one expected confrontation, but it still abolishes the deduction for state income taxes and caps the deduction for property taxes, which are major issues for Republicans representing high-tax states.

And a key middle-class friendly provision in the bill - a $300 credit for each taxpayer, spouse and non-child dependent - is set to run only through 2022.

There will surely be objections to giving permanent tax relief to corporations while families face a scheduled tax increase in five years. But making that provision permanent would be very expensive.

There is no obvious fix to these math problems

One way to give some of these squawking groups what they want while still fitting within the $1.5 trillion box is not to cut tax rates so much.

For example, instead of cutting the corporate income tax to 20%, they could cut it to 25%. They could offer pass-through businesses a preferential rate of 30%. This would free up money to increase some tax preferences and not eliminate others.

But there are two key problems with this approach. One is that low tax rates are a key goal of tax reform, and the president seems wedded in particular to a 20% corporate tax rate.

The other problem is that smaller rate cuts will only intensify interest group objections to revenue-raising provisions.

This plan would eliminate a lot of business tax deductions and credits. A lot of companies will look at the prospect of the corporate tax rate dropping from 35% to 20% and decide they can live with the loss of existing tax breaks. But if that 20% rate creeps upward, more and more businesses would decide they're better off with the tax code staying as it is.

What we are seeing now is that a lot of people and a lot of interest groups like the idea of tax reform in theory - but that if you add up all their theories, you'll find the tax benefits they expect to get add up to more than the $1.5 trillion Republicans have available to hand out.

Once it becomes clear who's not getting what they want, it will be a lot harder to hold the tax reform coalition together.