199A’s sunset

Introduction

The Tax Cuts and Jobs Act (TCJA) of 2017 created the most sweeping tax changes in the previous three decades. A key objective was to raise investment in the U.S. To help reach achieve this goal, the act reduced the top corporate income tax rate to 21% from 35%, a 40% reduction.

Most businesses, however, are not standard C corporations. Rather, they are so-called “pass through” entities, earning this title because the income from these businesses is “passed through” to the owners and taxed under the individual income tax, rather than being subject to the corporate income tax. To expand the benefits of lower tax rates to pass-through businesses, the TCJA introduced a temporary 20% deduction for qualified pass-through income.

In the absence of Congressional action, this deduction—referred to as the Section 199A deduction—expires at the end of 2025, along with many other provisions of TCJA. The reduced corporate tax rate, by comparison, was a permanent provision of the TCJA. Policymakers thus face a specific question: to extend or modify the deduction or to let it expire. This policy brief argues that they should use this issue as an opportunity to re-examine the fundamental tenets of business taxation in the U.S.

The paper explores the origins, mechanics, and economic effects of Section 199A and discusses options for the future. Several aspects of the deduction are worth noting. First, the provision is expensive. Section 199A deductions totaled $160 billion in 2019 alone (Goodman et al. 2025a). The Congressional Budget Office (CBO) estimates that extending Section 199A will reduce federal revenue by nearly $700 billion over the next ten years (CBO 2024). Second, the benefits are distributed in an extremely regressive manner; in 2019, for example, 74% of the benefit went to the top 5% of the income distribution (TPC 2020). Third, the available evidence suggests that the deduction has neither spurred investment growth nor raised wages to any significant extent (Goodman et al. 2025a).

The looming expiration of pass-through business tax cuts raises more questions about the best way to increase investment through the tax code. Broad reductions in tax rates are not the most well-targeted policy for increasing investment because these changes benefit income derived from both old and new investment. Instead of reducing tax rates, policymakers might consider a reprisal of business expensing, so-called “bonus depreciation,” which limits tax benefits to new investment, providing a bigger bang for the public buck, so to speak.

Finally, the expiration of the 199A deduction presents a moment to put aside incremental changes in favor of more fundamental business tax reform. Since 1913, when the federal income tax—and pass-through business taxation—was first introduced, Congress has twisted itself in knots trying to maintain two distinct business tax regimes. These efforts have resulted in a patchwork system that generally taxes pass-through income more lightly than corporate income. This disparity affects how businesses choose to organize and distorts the allocation of capital across business forms. This brief concludes by highlighting several options for reforming the tax code through corporate integration, a framework that would tax all businesses under a unified system. 

What is a pass-through business?

Pass-through businesses, which include S corporations, partnerships, and sole proprietorships, account for a substantial share of the economy. In 2015, for example, 95% of all businesses were organized as pass-through businesses, and they earned 40% of total business receipts and 63% of total business net income (less deficit) (see Table 1 here). Moreover, pass-throughs employed 43% of the U.S. workforce in 2021 and were responsible for 35% of total U.S. payroll (Mitchell 2024).

Pass-through businesses are often referred to as small businesses, but this is a common misconception. While the term small business might notionally refer to a business with few employees, limited capital, or moderate income, there is not a consensus definition of a “small business” enshrined in U.S. laws and regulations (Prisinzano et al. 2016). Pass-through businesses tend to be smaller than C corporations when characterized by employer size, but many large employers are organized as pass-through businesses. For example, 78% of businesses with fewer than 10 employees are pass-throughs, but pass-throughs still make up more than one-quarter of employers with over 1,000 employees (Figure 1).

Pass-through income tends to accrue to high-income individuals (Figure 2). The majority of income for individuals in the bottom half of the income distribution is earned through traditional wage employment compared with just 9% earned through pass-through income. Those in the 90^th–95^th percentile of the income distribution earn 12% of their income from pass-through businesses. Moving to the 99^th to the 99.5^th, one quarter of total income is earned from pass-through businesses. Finally, in the top 0.01% of the income distribution, individuals earn 35% of their income from pass-through businesses.

Understanding the differential taxation of C corporations and pass-through businesses

It is generally understood that taxes affect business investment, though there is no consensus on the magnitude of the effect. Moreover, targeted investment incentives—like accelerated depreciation—are likely to have a bigger “bang for the buck” than broad reductions in business tax rates. This is because business tax rate reductions affect the after-tax returns from old and new investment, whereas targeted investment incentives can be tied specifically to new investment. The impact of business taxes extends to employment and output, albeit in a more nuanced way. Increased investment boosts a company’s capital stock, and when capital and labor complement each other in production, this can lead to higher employment and greater labor productivity. Additionally, the expanded capital base increases production, further contributing to economic growth.

As noted above, C corporations and pass-throughs are taxed differently. The profits of pass-through businesses must be distributed to owners each year to face the ordinary income tax, the same as wage income. This distribution must happen regardless of whether the pass-through business chooses to retain some or all profit within the business, for example to fund current and future investment projects. The TCJA provisioned Section 199A, a 20% deduction for certain forms of pass-through income, to provide an additional business tax cut beyond the broad reduction in individual income tax rates. The details for which pass-through income qualifies for this deduction are somewhat complex and are explained in Appendix 1.

C corporate shareholders, on the other hand, can face up to two layers of tax. First, C corporations pay the corporate income tax on their taxable profit in each tax year. After paying the corporate income tax, C corporations choose how much after-tax profits to retain within the organization—for example, to fund future investment—and how much to distribute to shareholders as a dividend.¹ Individuals pay individual income tax on the dividends they receive. Retained earnings, which increase the value of corporate equity, are taxed as capital gains when shareholders sell their shares. These two layers of taxes—the corporate income tax and the individual capital gains and dividend income tax—comprise the potential double-taxation of corporate income.

Over the last 50 years, however, a dwindling proportion of corporate shareholders have actually faced the second (individual) layer of the corporate tax (Rosenthal and Mucciolo 2024). For example, shareholders that hold corporate equity in their tax-preferred retirement accounts are shielded from dividends and capital gains taxes. In addition, some corporate equity is held by foreign shareholders, who often benefit from reduced taxes on distributed profits and are generally exempt from capital gains taxes. Finally, certain institutional investors, such as defined benefits plans and large nonprofit endowment funds, are also generally exempt from dividends and capital gains taxation. Rosenthal and Mucciolo (2024) estimate that just 27% of U.S. equity was held in taxable accounts in 2022, a sharp decline from 79% in 1965.

Appendix 2 provides a stylized example of the relative taxation of corporate and pass-through income to provide intuition for the following facts about the relative tax treatment of C corporation and pass-through business income:

• Prior to TCJA, pass-through businesses were tax-favored relative to corporations;
• If TCJA had cut the corporate rate and individual income tax rate (and not added the 199A deduction), corporate and pass-through rates would be approximately equal; and
• The additional creation of the Section 199A deduction reinstated the tax preference for pass-through businesses.

These differences in the relative taxation of corporations and pass-through entities will distort how businesses organize. For example, businesses must weigh both tax and non-tax factors when deciding their organizational structure. Organizing as a C corporation confers large non-tax benefits such as strong legal protection for owners, flexible ownership structures, and the ability to raise capital through public ownership. These and other benefits are balanced against the cost of the double corporate tax and other tax factors. And while pass-through owners generally face a lower average tax rate, they must balance this benefit against the cost of more limited ownership and restricted access to capital markets. For example, S corporations are limited to 100 shareholders and a single class of stock, which excludes them from public ownership.

Differential tax rates also distort the after-tax returns to investment across ownership form. For an investment to be viable, it must generate enough income to cover ongoing costs, including taxes. Pomerleau (2024) shows that the marginal effective tax rate (METR)—a measure of the tax burden on an investment that just covers its ongoing cost—was more than 4 percentage points lower for pass-through businesses compared to C corporations, thanks in large part to 199A. Moreover, Goodman et al (2025b) show that, between 2018 and 2021, firms organized as C corporations faced higher tax rates than if they had been organized as S corporations, even absent the benefits of 199A. This means that capital may be drawn to the pass-through sector for tax-motivated reasons, even if this allocation deviates from its most productive use.

Reviewing the economic effects of the 199A deduction

Proponents of the 199A deduction argued that this reduction in the business tax rate would lead to increased investment and employment (Hodge 2018). Critics, however, contended that the deduction complicated tax administration and compliance, undermined principles of progressivity, and significantly reduced federal revenues.

Real effects: investment and employment

Assessing the real effects of taxes on investment and employment is generally challenging because it requires estimating what would have happened in the absence of a tax change (Gale and Haldeman 2021). This is made more complicated by the fact that the TCJA was only in effect for two full years before the onset of the COVID-19 pandemic, which fundamentally altered the macroeconomic environment, including investment and employment. Without a true experimental setting, these analyses depend on econometric methods and assumptions, leaving room for interpretation and debate over the validity of the results. This challenge is further compounded by restrictions in access to the type of data that is necessary for these types of studies, such as individual or business tax records, and the delayed availability of such data. For these reasons, the evidence on the broader economic impacts the Section 199A deduction remains relatively sparse.

Goodman et al (2025a) provides the only comprehensive analysis to date of the broad effects of the Section 199A deduction. Using administrative tax data for pass-through business owners, the study examines the total effect of the deduction on reported pass-through income, the extent to which the deduction induced taxpayers to adjust their reported income to qualify for the deduction, and finally any effects on business investment and employment. Using a variety of rigorous econometric techniques, the authors find little evidence that the deduction increased real economic activity including investment, wages to non-owners, or employment.

Reporting effects: re-classifying business income and expenses

Whenever a new tax preference is introduced into the tax code, there is always some concern about how taxpayers may unintentionally adjust their behavior or reported behavior as a tax avoidance strategy. These behaviors not only undermine the original goal of the tax preference and increase the administrative burden of the IRS but they also reduce federal receipts and create horizontal and vertical inequities in the tax code. Furthermore, they can distort economic decision-making in inefficient and unintended ways.

The 199A deduction created an incentive for workers to shift from employee to independent contractor to re-classify their wage income as qualified business income (QBI) (Duke 2018). Independent contractors are typically ineligible for critical benefits including health insurance, retirement contributions, and unemployment insurance. This shift, therefore, would increase the financial vulnerability of converted workers. Goodman et al (2025a), however, do not find any evidence of such behavior.

The 199A deduction also created an incentive to re-classify certain payments to owners. Generally, owners must determine how to allocate the surplus generated by the firm between compensation for their labor and the portion that constitutes the firm’s profits. In an economic sense, it is difficult to make this distinction. Unambiguous, however, is the fact that compensation in the form of W-2 wages is taxed more heavily than profit, incentivizing owners to classify surplus as pure profit.² The 199A wage (WQP) limitation, however, incentivizes certain pass-through businesses with low wage bills to increase owner compensation to maximize the value of the deduction. Goodman et al (2025a) find clear evidence of affected S corporations increasing shareholder wages to the exact amount that maximizes the deduction.

Relatedly, partnerships often make fixed payments to their partners (“guaranteed payments”) that are functionally equivalent to wages. However, these payments do not qualify as QBI and are therefore ineligible for the 199A deduction. This creates an incentive for partners to shift away from guaranteed payments in favor of profit distributions. Goodman et al (2025a) find a decline in guaranteed payments that is concentrated among owners that are more exposed to Section 199A.

Equity effects: Tax expenditures and the distribution of 199A benefits

Tax expenditures reflect the tax loss to the federal government associated with one or more deductions, credits, or exclusions. The distributional effect of these expenditures describes who benefits the most from these policies and whether they align with broader goals of fairness in the tax system. Generally, economists prefer a progressive tax system that features horizontal equity (similarly situated taxpayers should face similar tax burdens). Tax preferences that disproportionately benefit higher-income taxpayers or certain types of businesses can drain revenue, create economic inefficiencies, exacerbate existing inequalities, and undermine public confidence in the tax code.

Section 199A reduces horizontal equity in the tax code by offering different tax preferences to pass-through businesses based on their industry, the size of their wage bill, and the tax position of their owners. As described in Appendix 1, the distinction between eligible industries can seem arbitrary. For instance, the IRS explicitly allows owners of engineering and architectural firms to qualify for the deduction regardless of income. In contrast, consulting firms, which may overlap significantly with engineering firms in certain functions, face much stricter limitations, raising questions about the consistency and fairness of these classifications.

Section 199A also reduced the progressivity of the tax code by disproportionately benefiting taxpayers at the top of the income distribution. The Joint Committee on Taxation estimated that the total tax expenditure on Section 199A in 2019 was $42 billion (JCT 2023). As shown in Figure 3, only 26% of this expenditure went to taxpayers in the bottom 95 percentiles of the income distribution. In contrast, 18% of the expenditure went to taxpayers in the 99.9th to 99.99th percentile, and 13% was captured by the top 0.01% of earners. While it is not surprising that higher-income households benefited more—given their greater likelihood of earning income from pass-through businesses—the extent of the disparity raises questions about the equity and intent behind this deduction.

TCJA expiration and 199A: Paths forward

The simplest choice: Extend 199A or let it expire?

The 199A deduction is scheduled to expire at the end of FY2025. In 2017, the JCT estimated that the 199A deduction would reduce federal revenues by $414.5 billion over ten years (2018 – 2027) (JCT 2017). This represented a substantial investment in a tax policy aimed at promoting investment and employment. To date, there is little empirical evidence that the 199A deduction has led to meaningful gains in these areas. It is clear, however, that the 199A deduction has added significant complexity to the tax code and that its beneficiaries are disproportionately located near the very top of the income distribution. Finally, more recent estimates from the CBO indicate that extending the 199A deduction will reduce federal revenues by an additional $700 billion over the next ten years (2024 – 2035) (CBO 2024). Given these costs and the limited evidence of its economic benefits, policymakers must carefully evaluate whether extending 199A is fiscally and economically justified.

Alternative tax policies that increase investment

Policymakers can encourage investment more directly by offering partial or full expensing for capital investments rather than broadly reducing income tax rates. Normally, businesses must deduct the cost of capital investment over time using an asset-specific depreciation schedule that is maintained by the Internal Revenue Service, such as the Modified Accelerated Cost Recovery System (MACRS). For example, a business that makes a $100 investment in computer equipment can deduct $20 of these costs in the first year, and the remaining $80 in deductions are spread across the next five years. The total present discounted value of the deduction associated with this investment is about $90; the $10 loss represents part of the implicit cost of capital.

Bonus depreciation, a temporary tax policy that was first introduced in 2001, allows businesses to accelerate these deductions, increasing the share that can be claimed in the first year. For instance, a 50% bonus depreciation permits the business to take an additional deduction of $50 on a $100 investment in the first year, where the remaining deductions follow the appropriate depreciation schedule. Full expensing, or 100% bonus depreciation, allows businesses to deduct the entire cost of the investment in the first year. Bonus depreciation has been available in most years since 2001 and was reintroduced under the Tax Cuts and Jobs Act (TCJA), though it expired in 2022. 

Empirical research has consistently shown that bonus depreciation increases investment (House and Shapiro 2008; Zwick and Mahon 2017; Ohrn 2019; Patel and Seegert 2020). By comparison, and as previously discussed, Section 199A attempts to stimulate similar investment responses through broader, less targeted means, raising questions about its effectiveness and efficiency.

Fundamental reform: Corporate integration

Pass-through business income has been more lightly taxed than corporate income since S corporations were created by Congress in 1958. Over the past 67 years, policymakers have maintained this tax advantage across a series of tax reforms—some incremental and some more fundamental—including the implementation of the Section 199A deduction. The expiration of 199A presents the opportunity for policymakers to consider more fundamental tax reform as an alternative path forward.

A long-standing goal of many tax experts has been to equalize the taxation of business income, regardless of who earns it. These efforts are sometimes referred to as “corporate integration.” By aligning the tax treatment of corporate and pass-through businesses, corporate integration could address many of the inefficiencies and inequities in the current tax system. Corporate integration can be achieved in several ways, some of which would be easier than others to implement within the current tax system.

The simplest of these policies would establish a single “business tax” that applies to all businesses, sometimes referred to as a comprehensive business income tax (CBIT). Under this approach, all business income would be taxed once at the entity level following the current corporate income tax. Individual-level taxes on business income (capital gains on stocks and income from dividends) would be eliminated, removing the second layer of the current corporate income tax. Versions of this policy has been proposed several times over the past few decades, including by the U.S. Treasury Department (1992) and Carroll and Viard (2012).

On the other end of the spectrum, a shareholder allocation tax would create a more comprehensive “flow through” model to tax all business income in a manner similar to the current pass-through business tax treatment. Under this approach, business income would be subject to a withholding tax at the entity level, and all business income would be fully allocated to owners each year to face the individual income tax. Distinct from current pass-through taxation, however, owners would receive a credit for their share of the withholding tax paid by the business.³ This credit ensures that business income is only taxed once.

A third, hybrid option would retain the dual system for taxing corporate and pass-through income while making adjustments to eliminate the current two-layered corporate tax. This so-called “credit imputation” system would maintain a dividend tax on corporate income received by shareholders but would also provide a shareholder credit equal to the corporate income tax paid on distributed dividends. This credit ensures that corporate income is only taxed once, as in the shareholder allocation tax.⁴ Toder and Viard (2016) highlight this approach as a practical way to reduce economic distortions caused by the current two-tiered system. Australia, notably, taxes businesses using a similar approach.

Each of these proposals represent alternative ways to harmonize the tax treatment of business income but with varying degrees of success, as shown by Pomerleau (2024). Pomerleau finds that while the credit imputation system is relatively straight-forward to implement relative to current policies, it only manages to cut the disparity in the tax treatment by just under half. The flow-through model is more effective at reducing this disparity but is significantly more complex to implement and administer.⁵ Finally, the CBIT is the simplest to administer and would fully eliminate disparate tax treatment across business forms, but it would likely require a high statutory tax rate on business entities, which raises other concerns about the relative competitiveness of locating business activity in the U.S. compared to abroad.

These proposals, of course, are illustrative but not exhaustive within the context of fundamental business tax reform. Their consideration highlights an important principle of business tax: The tax code should seek to minimize behavioral distortions and enhance long-run economic growth while raising revenue to fund government operations. Section 199A appears to have failed along each of these dimensions.