Economists want to trash the QBI deduction. What will voters say?

A sizable tax deduction for the qualified business income of pass-through entities faces potential expiration next year. A panel of university economists and one of the most influential think tanks in Washington said lawmakers should either make big changes or let it go away.

Five economists were asked last month at a Brookings Institution event about which action they hope the next Congress and White House will take on the many parts of the 2017 Tax Cuts and Jobs Act that will sunset at the end of next year. Four of the economists called for the elimination of the so-called 199A deduction for pass-through income. The fifth spoke more generally, advocating for "rescinding some of the tax-rate cuts in the upper part of the income distribution," which is a common criticism of the impact of the pass-through deduction.

Policy experts, financial advisors, tax professionals and their clients may know the deduction better as "the small business pass-through giveaway," as the moderator, David Wessel, a Brookings senior fellow in economic studies who is the director of the Hutchins Center on Fiscal and Monetary Policy, referred to it on the panel.

"'Small business' with, like, quotes," Eric Zwick, a professor of economics and finance at the University of Chicago Booth School of Business, said to laughter from the audience. "We should be very clear these [are] like, closely held, potentially quite large businesses with, like, very, very rich owners, many of them. So I think we should be very careful about using that word 'small' in a value-sensitive way."

READ MORE: The QBI deduction's impact is as murky as its rules, report finds

The others advocating for getting rid of the deduction of up to 20% of the qualifying pass-through income included William Gale, co-founder and co-director of the Brookings and Urban Institute's Tax Policy Center; Kimberly Clausing, the chair of tax law and policy at the UCLA School of Law; and Naomi Feldman, an associate professor of economics at the Hebrew University of Jerusalem's Department of Economics, who called the 199A break a policy "that was really put in to placate the small business lobby" that "was really done for political purposes." The speakers pointed out the high cost of extending the expiring provisions of the law — which could hike the federal budget deficit by more than $4 trillion over the next decade.

"I think the main thing is we've got these huge budget deficits, as far as the eye can see," said the fifth economist on the panel, Williams College Chair of Economics Jon Bakija. "We need to do some things that are going to restore enough revenue to pay for the government. And I think rescinding some of the tax rate cuts in the upper part of the income distribution is probably worthwhile for that purpose."

With this year's election looming in the background as the determining factor on what will happen to the Tax Cuts and Jobs Act on its deadline date at the end of 2025, the economists acknowledged that the voters and, ultimately, the elected officials would get the final say. While liberal and left-leaning think tanks have slammed the 199A deduction as too heavily beneficial to the wealthy at a large price tag estimated to be as much as $608 billion on its own through 2033, right-leaning and conservative groups argue that the policy boosts small businesses and provides parity for the rates paid by pass-through entities as compared to corporations.

Limits on the deduction to, say, business owners with less than $500,000 in total income "would result in a tax increase on one of the major sources of jobs in our nation, directly hurting workers and the economy," according to a report earlier this year by the U.S. Chamber of Commerce. The business advocacy organization has called for legislation making the deduction permanent.

READ MORE: QBI tax break — should it stay or should it go?

However, the complicated existing guidelines relating to the types of businesses that can get the deduction and the levels of qualifying income that make them ineligible has contributed to the fact that there are many entrepreneurs who could have claimed the deduction haven't applied for it, according to a February report by the nonpartisan Congressional Research Service. The available research indicates that "the deduction may have stimulated no more than a modest rise in investment" during its first two years in effect in 2018 and 2019, the report said.

"It is unclear whether the deduction, combined with the temporary individual income tax cuts under the 2017 tax law, has boosted demand for labor in the noncorporate sector," it said. "The deduction's complexity increases the cost of compliance for taxpayers who might benefit from it, although it is not clear to what extent. There is also uncertainty about which businesses qualify for the deduction. Some lower-income taxpayers may not claim it because of the complexity and compliance cost. Many upper-income pass-through business owners may claim the deduction, but only with the assistance of tax professionals."

Amid that murky picture of the impact of the policy, the economists on the panel shared some suggestions for potential adjustments to the deduction.

"You could change the deduction, I guess, if you wanted to keep it and make it cost less," Zwick said. "You could make it a smaller deduction. But there are lots of phaseouts and phase-ins of some of the rules. The wage and capital requirements there, some of those could be adjusted to basically exclude more firms. I think there are a lot of firms that are on the barrier between the specified service, skilled types that probably shouldn't get it, versus like other types of firms that, for some reason, like, we think should get it. Those could be tweaked to, like, basically shrink the number of firms that benefit from the preferential rate."

A shift in focus of the tax breaks for pass-through income could further alter the impact of the deduction, Gale said on the panel.

"The general approach would be not to cut the rate — which is what the deduction does — but to switch it to an investment incentive," Gale said. "Making a rate cut just is a nonstarter from an efficiency perspective, so making it an investment incentive instead would help some."

READ MORE: 26 tips on expiring Tax Cuts and Jobs Act provisions to review before 2026

Regardless, the choice in this year's presidential election between former President Donald Trump, a Republican who has indicated he would extend the 2017 tax bill he signed into law, and Vice President Kamala Harris — a Democrat who has called for continuing the provisions only for those with incomes below $400,000 — will exert more influence than any economist. Down-ballot races in Congress add another layer of uncertainty about the deduction.

"You notice, I asked them what they thought should be done," the moderator, Wessel, said. "I didn't ask them to predict what will happen, because if I wanted to predict what happened, I wouldn't get five economists on a stage."

The economists praised some aspects of the law, such as limits to the deduction for mortgage interest payments and a higher standard deduction that has led to less itemization across the board. In general, lawmakers ought to "forget 199A and all the bad stuff" so that they can "get all that revenue back" and "start doing the nice parts of the reform again," Clausing said.

"I'm not sure we can afford the rate cuts, regardless of any silly pledge about $400K or not," she said. "It's not clear Americans will even notice their taxes going up. The vast majority of them — they didn't notice when they went down."