Marginal tax rates represent the tax paid on the next dollar of additional income. As an individual’s or business’ income rises, so does their marginal tax rate.
Sole proprietorships, S-Corps, LLCs, and general partnerships, are considered “pass through” entities because the profits are pass through to the owner’s individual tax return and taxed at personal income tax rates.
According to the report the number of pass through businesses tripled 1980 and 2010 to 30.3 million, and the amount of income, adjusted for inflation, increased from $320 billion in 1980 to $1.6 trillion in 2010.
These businesses are not only subject to federal income tax, but also in many cases, high personal state and local income tax rates. Maryland sole proprietorships face a 49 percent marginal tax rate, and S corporations face a 46 percent marginal tax rate.
In 2012, O’Malley and the legislature raised income tax rates—again to plug a deficit. Rates on those earning $100,000-$125,000 increased from 4.75 percent to 5 percent, rates rose from 4.75 percent to 5.25 percent for those earning $125,000 to $150,000, rates rose from 5 percent to 5.5 percent for those earning $150,000 to $250,000, those earning over $250,000 saw their rate increase to 5.75 percent.
The Tax Foundation notes that these high marginal tax rates have a negative impact on business activity.
It is often assumed that a tax increase on high-income individuals will have little impact on business activity because only two or three percent of taxpayers with business income are taxed at the highest rates. This statistic is misleading. The more economically meaningful statistic is how much overall business income will be taxed at the highest rates. Treasury data for 2007 indicates that 50 percent of all pass-through income is earned by taxpayers subject to the top two tax brackets that year of 33 percent and 35 percent.
According to IRS data from 2010, nearly 60 percent of pass through income was earned by taxpayers with adjusted gross income of over $200,000.
We’ve already seen the impact of the income tax hikes on Maryland pass through entities. Between 2007-2010 Maryland lost 6,500 small businesses, according analysis of Census Bureau data by the grassroots organization, Change Maryland.
There is a great deal of election year talk about lowering Maryland’s corporate income tax, in order to make the state more “business friendly”. That would be a good start, however, any conversation on fostering a better, fairer business climate must include reducing Maryland’s onerous income tax rates.