Section 199A Deduction: Economic Effects and Policy Issues

Section 199A Deduction: Economic Effects and Policy Issues

Section 199A Deduction: Economic Effects and February 28, 2024
Policy Issues
Gary Guenther
Section 199A of the federal tax code allows owners of pass-through businesses to deduct up to
Analyst in Public Finance
20% of their qualified business income (QBI) from their taxable income in calculating their

individual income tax liability. The deduction was established by the 2017 tax revision (P.L. 115-
97) and is available from 2018 to 2025.

Calculating the deduction can be complicated. The maximum deduction is equal to 20% of an eligible business’s QBI,
provided the deduction does not exceed 20% of a taxpayer’s taxable income, excluding long-term capital gains. The
maximum deduction is subject to two limitations that phase in as taxable income increases between a lower income threshold
and an upper income threshold.
If a pass-through business owner’s taxable income does not exceed the deduction’s lower income threshold, then the owner
may claim the maximum deduction. The threshold is indexed for inflation; in 2024, it is set at $383,900 for joint filers and
$191,950 for all other filers. If an owner’s taxable income falls between the lower income threshold and the upper income
threshold ($483,900 for joint filers and $241,950 for all other filers in 2024), both limitations could apply.
One limitation is based on whether a business is classified as a “selected service trade and business” (SSTB). The other limit
takes into account an owner’s share of an eligible business’s W-2 wages and the unadjusted basis of its tangible, depreciable
assets placed in service in the previous 10 years; this limitation is known as the wage and qualified property (WQP limit).
The maximum deduction decreases as these limits phase in. If an owner’s taxable income exceeds the upper income
threshold, no SSTB QBI is eligible for the deduction, and the deduction for non-SSTB QBI cannot exceed the greater of 50%
of the owner’s share of a business’s W-2 wages, or 25% of those wages plus 2.5% of the owner’s share of the business’s
unadjusted basis of qualified capital assets.
This report addresses what is known about the Section 199A deduction’s economic effects. More specifically, it examines the
deduction’s impact on (1) investment and employment, (2) horizontal and vertical equity in the federal income tax, and (3)
taxpayer compliance and tax administration. The report concludes with an overview of policy options for Congress as it
considers whether to retain the deduction beyond 2025.
There are no studies of how the deduction has affected pass-through business investment. Available evidence suggests that
the deduction may have stimulated no more than a modest rise in investment in 2018 and 2019.
Nor are there estimates of how the deduction has affected job creation among pass-through firms. 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.
The Section 199A deduction appears to have little effect on vertical equity, as it does not appear to diminish the progressivity
of the federal income tax. But the deduction does seem to reduce horizontal equity, as it can result in a lower tax burden for
pass-through business owners than wage earners with the same gross income.
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.
The Section 199A deduction’s complexity also has implications for the IRS. Enforcing the law and regulations regarding the
deduction may be a challenge for the IRS owing to substantial reductions in its audit capacity in the past 12 or so years. This
has led to significant declines in audit ratios for high-income individuals and partnerships. Without enough experienced
examiners, the IRS may be incapable of deterring questionable claims for the deduction.
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Contents
Introduction ..................................................................................................................................... 1
Structure of the Deduction............................................................................................................... 1
Economic Effects of the Deduction ................................................................................................. 3
Use of the Deduction ................................................................................................................. 3
Investment ................................................................................................................................. 3
Employment and Wages ............................................................................................................ 6
Tax Administration and Taxpayer Compliance ......................................................................... 6
Tax Administration .............................................................................................................. 7
Taxpayer Compliance ......................................................................................................... 7
Equity Effects ............................................................................................................................ 8
Horizontal Equity ................................................................................................................ 9
Vertical Equity .................................................................................................................... 9
Impact on Federal Budget ......................................................................................................... 9
Impact Among Industries ........................................................................................................ 10
Worker Classification and Independent Contractors ................................................................ 11
Policy Options ............................................................................................................................... 12
Allow the Deduction to Expire ............................................................................................... 12
Permanently Extend the Deduction with No Changes ............................................................ 12
Permanently Extend the Deduction with Changes .................................................................. 12
Replace the Deduction with a More Efficient Approach to Taxing Pass-through
Business Profits .................................................................................................................... 13

Tables
Table 1. Claims for the Section 199A Deduction Since 2018 ......................................................... 3
Table 2. Effective Tax Rates by Type of Asset ................................................................................ 5

Contacts
Author Information ........................................................................................................................ 14

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Section 199A Deduction: Economic Effects and Policy Issues

Introduction
A key aim of the tax revision enacted in December 2017 (P.L. 115-97, often referred to as the Tax
Cuts and Jobs Act, or TCJA) was to reduce the federal tax burden on business income. Many
proponents of such a reduction were confident that it would spur businesses to hire more workers
and invest more in tangible and intangible assets, boosting labor productivity. The law sought to
reduce the business tax burden in two ways.
For Subchapter C corporations, the law permanently cut the top income tax rate of 35% under
prior law to a single rate of 21%, a 40% decrease. Corporate profits that are distributed to
owners/shareholders are subject to two levels of taxation: a corporate-level tax and then an
individual-level tax on profits distributed to owners/shareholders as dividends or long-term
capital gains.
To establish parity between the tax treatment of corporate and noncorporate (or pass-through)
business profits, the TCJA also lowered individual income tax rates (except for the lowest rate of
10%) and created a new deduction under Internal Revenue Code Section 199A for pass-through
business profits.1 A pass-through business can take the form of a partnership, limited liability
company, Subchapter S corporation, or self-employed person. Unlike corporate profits, pass-
through business profits are taxed only at an owner’s individual income tax rate.
The maximum deduction is equal to 20% of a pass-through firm’s qualified business income
(QBI).2 For pass-through business income taxed at the highest statutory rate (37%) under current
law, the deduction lowers it to 29.6% (37% x 0.8 = 29.6%), which is 25% below the top statutory
rate under pre-TCJA tax law (39.6%). The TCJA’s individual income tax rate cuts and the
deduction are scheduled to expire at the end of 2025.
This report addresses what is known about the Section 199A deduction’s economic effects.
Specifically, it looks at the deduction’s impact on (1) investment and employment, (2) horizontal
and vertical equity in the federal income tax, (3) tax administration, and (4) taxpayer compliance.
The report concludes with a discussion of some policy options for Congress if it were to consider
retaining the deduction beyond 2025.
Structure of the Deduction
Section 199A permits individuals, trusts, and estates with pass-through business income to deduct
up to 20% of their qualified business income (QBI) in determining their federal income tax

1 For more details on the structure of the Section 199A deduction, see CRS Report R46402, The Section 199A
Deduction: How It Works and Illustrative Examples, by Gary Guenther.
2 Effective tax rates (ETRs) serve a crucial purpose in the analysis of the economic effects of tax provisions. They
measure an individual’s or corporation’s tax burden, which is the percentage of taxable income that is actually taken by
taxes. An ETR does this by applying to a taxpayer’s statutory tax rate any tax preferences the taxpayer could claim in
determining taxable income. As such, the effective rate is typically lower than the statutory rate, because tax
preferences are intended to increase the welfare of designated groups or to encourage individuals or businesses to
engage in certain activities. These preferences can take the form of tax credits, special deductions, exclusions, deferrals,
and preferential tax rates.
Generally, an ETR can be average (AETR) or marginal (METR). In the case of businesses, the former shows the tax
burden on a firm’s taxable income from old and new investments, whereas the latter shows the tax burden on an
additional dollar of income from new investments only. Both approaches are used in this report. Each is clearly labeled
when it is used.

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liability. Pass-through business owners are required to report their share of profits on their
individual tax returns, regardless of whether the income is distributed to them.
The deduction applies to an owner’s QBI, which is the net result of combining the items of
income, deduction (excluding the Section 199A deduction), loss, and gain of every eligible
business he or she owns. Only income items connected to a trade or business conducted in the
United States (including Puerto Rico) are eligible for the deduction.
QBI does not include
• wage income;
• reasonable compensation received by an S corporation shareholder for services
provided to the business;
• guaranteed payments to a partner from a partnership for services provided to the
business; or
• investment income unrelated to a pass-through business.
The deduction is available from 2018 to 2025 and is claimed on Form 1040 after an eligible
taxpayer takes the standard deduction or the sum of her or his itemized deductions. Use of the
deduction depends on a pass-through business owner’s taxable income, the nature of her or his
business, and the owner’s share of a business’s W-2 wages and the original cost (or unadjusted
basis) of the business’s depreciable capital assets placed in service in the previous 10 years.3
The maximum deduction is the lesser of
• 20% of an owner’s QBI, or
• 20% of an owner’s taxable income, excluding net capital gains.
The deduction is subject to two limitations:
• a wage and qualified property (WQP) limitation, which reduces the maximum
deduction an owner may claim based on her or his share of a business’s W-2
wages and the unadjusted basis of its qualified assets); and
• a specified service trade or business (SSTB) limitation, which reduces the
maximum deduction an owner may claim for QBI from an SSTB. An SSTB is
any trade or business primarily engaged in accounting; health; law; actuarial
science; athletics; brokerage services; consulting; financial services; the
performing arts; investing and investment management; or trading or dealing in
securities, partnership interests, or commodities. An SSTB can also be a trade or
business whose principal asset is the reputation or skill of one or more of a firm’s
owners or employees.
The two limitations phase in when a pass-through owner’s taxable income falls between the
deduction’s lower income threshold ($383,900 for joint filers and $191,950 for other filers in
2024) and the deduction’s upper income threshold ($483,900 for joint filers and $241,950 for
other filers in 2024). For taxable income above the latter threshold, there is no deduction for
SSTB QBI, and owners with non-SSTB QBI cannot claim a deduction that exceeds the larger of
50% of an owner’s share of a business’s W-2 wages or 25% of those wages plus 2.5% of an

3 W-2 wages are the total wages paid by a company that are subject to withholding, elective deferrals, and deferred
compensation. The unadjusted basis of depreciable, tangible assets refers to the cost of such assets when a company
acquires them.
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owner’s share of the original cost of capital assets the business placed in service in the past 10
years.
Economic Effects of the Deduction
This section examines what is known about the use of the Section 199A deduction and its impact
on investment, employment, equity, tax administration and compliance, federal revenue, and
industries.
Use of the Deduction
As Table 1 shows, claims for the Section 199A deduction have increased in number and amount
in every year since 2018.4 The average amount per claim was almost the same in 2018 and 2021,
after a 12.5% decline in 2019. Available tax data from the Internal Revenue Service (IRS) do not
indicate which industries have benefited the most from the deduction. The data do suggest,
however, that upper-income pass-through business owners have captured much of the tax savings
from the deduction. In 2021, for instance, taxpayers with adjusted gross income (AGI) above
$200,000 filed 28% of the claims for the deduction, accounting for 76% of the total dollar
amount.
This result is consistent with what is known about the income distribution of noncorporate
business income. The Tax Policy Center’s latest estimate of the distribution by income class of
pass-through business income under current tax law indicated that the top 5% of taxpayers ranked
by income received 79% of total pass-through business income in 2022.5
Table 1. Claims for the Section 199A Deduction Since 2018
Number of claims
Total Amount
Average Amount per
Year
(millions)
($ billions)
Claim ($ thousands)
2018
18.7
150.0
8.0
2019
22.2
155.2
7.0
2020
22.8
166.1
7.3
2021
25.9
205.8
7.9
Source: Internal Revenue Service, Individual Income Tax Statistics, https://www.irs.gov/statistics/soi-tax-stats-
individual-statistical-tables-by-size-of-adjusted-gross-income.
Investment
During the 2017 congressional debate over reforming the federal income tax, proponents of
permanently lowering business income tax rates argued that reduced rates would spur many firms
to invest more in capital assets than they otherwise would, especially during economic

4 https://www.irs.gov/statistics/soi-tax-stats-individual-statistical-tables-by-size-of-adjusted-gross-income. The claimed
amount may be larger than the amount allowed by the IRS after it completes any audits.
5 See https://www.taxpolicycenter.org/model-estimates/distribution-business-income-february-2023/t23-0024-
distribution-business-income.
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expansions.6 The added investment would increase the firms’ capital stock, boosting their
productivity. Over time, rising productivity may propel increases in employment and real wages.7
This scenario rests on the investment effects of taxation. Taxes mainly affect investment through
the user cost of capital and business cash flow. The former represents the after-tax rate of return
an investment has to earn to break even. It takes into account the real interest rate, economic
depreciation for the acquired assets, the marginal effect of taxes on an investment’s returns, and
the opportunity cost of an investment.
Technically, the Section 199A deduction is not an investment tax subsidy. A firm can benefit from
the deduction if it makes no new investments in a tax year. In this case, a firm’s QBI would
consist of returns from past investments and other sources of income.
Nonetheless, the deduction, combined with the reduced individual income tax rates under the
TCJA, has the potential to influence pass-through business investment decisions through its
impact on the marginal effective tax rate (METR) for the returns on new investments and the
amount of cash available to a business. An investment’s METR is its pretax rate of return less its
after-tax rate of return divided by the pretax rate of return for an additional dollar of revenue; it is
the tax component of the user cost of capital. An METR takes into account the real interest rate,
an investment’s financing, an investor’s desired after-tax rate of return, and applicable income tax
rates and tax preferences (e.g., tax credits, exemptions, deferrals, and deductions).
For pass-through business owners in the highest individual income tax bracket under current law
(37%), the maximum deduction (20% of QBI) decreases the METR on the returns from new
investments from 37% to 29.6% (37% x 0.8), all other things being equal. In theory, this
reduction increases the number of profitable investments a pass-through business could undertake
by lowering the user cost of capital and boosting such a firm’s short-term cash flow.
A 2022 paper by Kyle Pomerleau examined the deduction’s impact on the incentive effect for
noncorporate investment.8 According to his calculations, the overall “effective statutory tax rate”
(ESTR) for the returns on pass-through business investment was 37.1% with the Section 199A
deduction and 44.5% without it; the ESTRs for corporate investment returns and wages were
42.3% and 46.1%, respectively.9 The ESTR measures the change in tax liability for an additional
amount of income, taking into account income taxes, self-employment taxes, other surtaxes, and
the deductibility of tax payments. The results suggest that the deduction may boost a pass-through
business’s incentive to undertake new investment.
Similar results were obtained in a 2019 study by Jane Gravelle and Donald Marples. They found
that the TCJA decreased the METR for corporate and noncorporate investment in a variety of
assets financed both by equity alone or by a typical mix of debt and equity (see Table 2). 10
Current-law noncorporate METRs incorporate the combined effect of the TCJA’s individual
income tax rate cuts, the Section 199A deduction, and the availability (through 2022) of 100%
expensing for tangible assets with a recovery period of 20 years or less (e.g., off-the-shelf
software and equipment) under Section 168(k)—a depreciation allowance also known as bonus

6 See Scott Hodge, “The Positive Economic Growth Effects of the Tax Cuts and Jobs Act,” written testimony of Jane
Gravelle before the Joint Economic Committee, Tax Foundation, September 6, 2018, pp. 2-3.
7 See Council of Economic Advisers, The Growth Effects of Corporate Tax Reform and Implications for Wages,
Executive Office of the President, October 2017.
8 Kyle Pomerleau, Section 199A and “Tax Parity”, American Enterprise Institute, September 2022.
9 Ibid., p. 8.
10 CRS Report R45736, The Economic Effects of the 2017 Tax Revision: Preliminary Observations, by Jane G.
Gravelle and Donald J. Marples, p. 17.
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depreciation. Current-law corporate METRs are based on the TCJA’s reduction of the corporate
income tax rate to 21% and 100% bonus depreciation. The study did not address the investment
effects of the Section 199A deduction.
The results in Table 2 from the Gravelle-Marples study indicate that the TCJA has enhanced the
incentive for business investment in tangible assets (e.g., equipment) but has had little effect on
the incentive to invest in intangible assets (e.g., patents). The results also suggest that the
deduction may have boosted the desirability of operating as a pass-through business rather than a
C corporation.
Table 2. Effective Tax Rates by Type of Asset
Pass-through
Pass-through
Corporations:
Corporations:
Firms: Pre-TCJA
Firms: Current
Asset
Pre-TJCA Law
Current Law
Law
Law
100% Equity Financed
Equipment
13.4%
0.0%
14.4%
0.0%
Public Utility
14.2
0.0
15.2
0.0
Structures
Nonresidential
30.8
18.5
32.1
26.2
Structures
Intangibles
-63.3
-63.3
-63.3
-63.3
Debt and Equity Financed
Equipment
-0.9
-9.6
-0.6
-14.3
Public Utility
-0.9
-9.6
-0.6
-14.3
Structures
Nonresidential
19.2
10.7
20.2
15.7
Structures
Intangibles
-116.3
-95.4
-111.2
-109.0
Source: CRS Report R45736, The Economic Effects of the 2017 Tax Revision: Preliminary Observations, by Jane G.
Gravelle and Donald J. Marples, Table A-1.
Notes: The calculations are based on corporate tax rates of 34.14% under pre-TCJA law (including the now-
repealed Section 199 production activities deduction) and 21% under current law; pass-through tax rates of 37%
under pre-TCJA law and 30% under current law (based on information from the Congressional Budget Office); a
real after-tax rate of return of 7% for equity; an interest rate of 7.5%; a 2% inflation rate; and a debt financing
share of 36%.
However, there are no known studies that assess the Section 199A deduction’s actual investment
effects. These effects are difficult to assess, in part because it is difficult to analytically separate
the deduction’s impact on pass-through business investment from the effects of other forces such
as income tax rates, depreciation allowances, interest rates, and aggregate output. Estimating the
investment effects of the deduction may require developing a model of domestic pass-through
business investment and applying it to tax data to determine the sensitivity of such investment to
changes in its tax price and the degree to which the deduction lowers that price.
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Employment and Wages
Some have argued that “the strongest and most coherent policy rationale for the TCJA in general
and for the Section 199A deduction in particular” is job creation.11 But others contest that
argument’s validity. They say that there is no evidence from U.S. employment data in 2018 and
2019 to support it, and that the deduction’s design does not encourage substantial job creation.
Technically, the deduction is not a job subsidy. A firm can benefit from it without creating a single
job. Consequently, its impact on domestic labor demand is likely transmitted through the
deduction’s investment effects. Increased investment expands a firm’s capital stock, allowing for
increased output and labor productivity. The interaction between output and productivity
determines whether the firm’s workforce grows in the short run.
It is not known how pass-through business owners benefiting from the Section 199A deduction
have used the resulting tax savings. There are numerous possibilities, of course. For example, a
firm could use the savings to increase investment, raise employee wages and salaries, or increase
the owners’ personal income or wealth. It is not clear whether many of the firms that have
increased their investment in response to the deduction have added employees.
As some have pointed out, the deduction’s design also affects its job impact. Three features in
particular do little to encourage job growth. First, pass-through business owners with taxable
income below the lower income threshold can benefit from the maximum deduction without
creating a single job. Second, SSTB owners with taxable income above the upper income
threshold cannot benefit from the deduction, regardless of how many jobs they create. Third,
high-income owners of non-SSTBs investing in certain capital assets can benefit from the
deduction without creating a single job.
There is no known study of the deduction’s impact on pass-through business employment. A 2021
study by Claire Haldeman and William Gale that assessed the TCJA’s economic effects pointed
out that domestic employment growth slowed in 2018 and 2019.12 In their view, this slowdown
provided further evidence that the TJCA’s immediate investment effects were not as robust as
some backers of the law had expected.
Haldeman and Gale also found that wages and salaries exhibited a more complicated pattern in
that period. The growth rate for real median earnings of all wage and salary employees fell by 0.2
percentage points from 2016 to 2019, but the growth rate for the employer cost index rose by 0.56
percentage points. The index measures mean wages and salaries. Gale and Haldeman argued that
faster mean wage growth paired with slower median wage growth suggested that high-income
workers’ wages and salaries rose in that period, while lower-income workers experienced no
wage growth.
Tax Administration and Taxpayer Compliance
The Section 199A deduction has implications for the cost of tax administration and taxpayer
compliance.

11 Rodney P. Mock and David G. Chamberlain, “Section 199A: Job Creator or Tax Giveaway?” Tax Notes, December
10, 2018, p. 1309.
12 William G. Gale and Claire Haldeman, The Tax Cuts and Jobs Act: Searching for Supply-Side Effects, Brookings
Institution Economic Studies, July 2021.
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Tax Administration
The IRS is responsible for administering and enforcing federal tax laws. Its ability to do so has
been hampered by reductions in the IRS’s budget and workforce and increases in its work load
since FY2010. From that year to FY2021, the agency’s budget (in 2021 dollars) declined by 19%
and its staff by 22%, while the number of returns processed annually grew by 7%.13 In the same
period, the IRS’s budget (in 2021 dollars) for enforcement and operations support decreased by
22%, and its enforcement staff fell by 31%. Of particular concern for the IRS’s ability to enforce
changing and increasing tax laws was a 39% drop in the number of revenue agents to a level last
reached in 1954; revenue agents have the knowledge and experience to audit complex returns
filed by high-income individuals, partnerships, and large corporations. The IRS is trying to
rebuild its staff of revenue agents with the $79 billion in mandatory funding provided by the
Inflation Reduction Act (P.L. 117-169), $4 billion of which was rescinded by the Fiscal
Responsibility Act of 2023 (P.L. 118-5).
Although there are no known estimates of the cost to the IRS of administering the deduction, the
need to audit some claims for it may further strain the agency’s enforcement budget. A possible
focus of audit activity is higher-income taxpayers. In 2021, taxpayers with AGIs above $200,000
filed 28% of claims for the Section 199A deduction but accounted for 76% of the total dollar
amount. Most audits are conducted through correspondence with taxpayers; the more complicated
but higher-revenue-raising audits are done in person. Given the complexity of the deduction and
the substantial amounts claimed by higher-income pass-through business owners, the IRS may
rely more on in-person audits to enforce compliance with the deduction’s regulations.
One issue likely to draw scrutiny from IRS auditors is where to draw the line between business
income earned from SSTBs and non-SSTBs in related industries. While it is believed that the
SSTB limitation was intended to prevent income sheltering by high-income service professionals
who rely on their skills or reputations to generate demand for their services, the distinctions
between SSTB and non-SSTB activities in the same or similar industries seem “artificial and
murky, at best.”14
Taxpayer Compliance
The Section 199A deduction’s complexity and uncertainty regarding eligibility have implications
for the cost of taxpayer compliance. This cost encompasses the time and money spent on
understanding the deduction’s rules, collecting the information needed to file a claim, and filing
the claim. Among the key considerations in claiming the deduction are the number of eligible
trades and businesses someone owns and the amount of each eligible business’s W-2 wages and
unadjusted basis of qualified assets allocable to the taxpayer. The recordkeeping needed to
substantiate a claim for the deduction might be the biggest cost for small business owners.15
According to an estimate by the Tax Foundation, the compliance cost for taxpayers who claimed
the deduction in 2021 totaled $17.8 billion; this covered the costs of hiring tax professionals to

13 See https://www.cbpp.org/research/federal-tax/the-need-to-rebuild-the-depleted-irs#irs_resources_are_depleted.
14 William G. Gale et al., Effects of the Tax Cuts and Jobs Act: A Preliminary Analysis, Tax Policy Center, June 13,
2018, p. 17.
15 One example of this challenge is the difficulty some tax practitioners have had tracking the various losses (e.g.,
passive-activity-loss and disallowed business deduction carryforwards) that can reduce current-year QBI. For more
details, see Eric Yauch, “Tracking Losses and Undue Complexity—Is 199A Even Worth It,” Tax Notes, March 19,
2020.
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prepare claims, as well as a monetization of the hours pass-through business owners spent
preparing claims on their own.16
Take-up of the deduction among lower-income pass-through business owners in 2018 was lower
than expected. In a report on filing for the 2018 tax year, the Treasury Inspector General for Tax
Administration (TIGTA) found that 887,991 individual income tax returns that had been
processed by May 2, 2019, did not claim the Section 199A deduction, even though the taxpayers
seemed eligible for it based on information reported in the returns.17 Each return included a form
associated with a pass-through business (Schedule C or Schedule F) showing a profit. Moreover,
all the returns reported taxable income at or below the lower income threshold for 2018: $315,000
for joint filers and $157,500 for all other filers.
IRS managers contacted by TIGTA suggested several possible explanations for the failure to
claim the deduction without ranking them by probability:
• The taxpayers were unaware they were eligible to claim the deduction.
• The software they used to prepare their returns was unclear about what
constitutes QBI.
• Some of their trade or business income was earned outside the United States.
• The taxpayers chose not to claim the credit because it seemed too complicated to
calculate.
According to TIGTA, the findings indicated that the IRS needed to expand its efforts to educate
pass-through business owners about the deduction.
A taxpayer’s taxable income can affect the compliance cost. In general, pass-through business
owners with taxable income at or below the lower income threshold ($383,300 for joint filers and
$161,900 for other filers in 2024) for the deduction may face the lowest compliance cost. For
many of them, taking the deduction may be as simple as calculating 20% of their total QBI and
20% of their taxable income less any net capital gain, and claiming the smaller of the two
amounts.
Many high-income pass-through business owners likely hire tax practitioners to find ways to
maximize the deduction’s tax benefit. Not all planning strategies may comply with the law. Some
strategies might require combining or splitting pass-through businesses to qualify for the
deduction. Tax planning of this sort can be expensive. In general, large pass-through businesses
are more likely than smaller ones to use tax practitioners to file a claim for the deduction.
Disparities in access to effective tax planning arguably represent one way in which the Section
199A deduction unintentionally picks winners and losers among pass-through business owners.
Equity Effects
Public finance economists analyze the federal income tax’s equity effects from two perspectives:
vertical equity and horizontal equity. Vertical equity refers to the extent to which a taxpayer’s tax
burden increases as her or his income goes up. Horizontal equity refers to the extent to which
taxpayers with similar incomes have similar tax burdens.

16 Scott Hodge, The Tax Compliance Costs of IRS Regulations, Tax Foundation blog, August 23, 2022.
17 U.S. Department of the Treasury, Treasury Inspector General for Tax Administration, Results of the 2019 Filing
Season, ref. no. 2020-44-07, January 22, 2020, p. 14.
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Horizontal Equity
The deduction may diminish horizontal tax equity in two ways. First, it taxes wage earners and
pass-through business owners with similar income at different rates, even though there is no
apparent economic justification for such disparate treatment.18
To illustrate this point, assume that a sole proprietor and an employee have the same taxable
income ($100,000 in 2024), and that the former’s income comes solely from QBI for a retail
business she owns and the latter’s income is from wages only. Both are single filers. Under the
federal individual income tax rate schedules for 2024, the sole proprietor is eligible for the
maximum Section 199A deduction, which reduces her top marginal tax rate from 22% to 17.6%
(22% x 0.8). By contrast, because the employee cannot claim the deduction, her income is taxed
at 22.0%. Under pre-TCJA tax law, both taxpayers would have been taxed at the same top
marginal rate.
Second, the deduction arguably diminishes horizontal equity by taxing the QBI of SSTBs and
non-SSTBs owned by high-income taxpayers at different rates. An SSTB owner and a non-SSTB
owner with the same taxable income above the deduction’s upper income threshold face different
tax burdens because of the deduction. The former can claim no deduction, while the latter can
claim a deduction equal to the larger of 50% of the firm’s W-2 wages or 25% of those wages plus
2.5% of the original cost of the firm’s capital assets placed in service in the past 10 years. This is
another way in which the Section 199A deduction may unintentionally pick winners and losers
among businesses.
Vertical Equity
The deduction has little effect on vertical tax equity. In theory, it reduces statutory marginal tax
rates by the same factor (20%), leaving a progressive rate structure intact for pass-through
business owners.
Nonetheless, available evidence indicates that high-income taxpayers might capture much of the
Section 199A deduction’s overall benefit. Such an outcome would be consistent with what is
known about the income distribution of pass-through business profits.
According to a 2015 report by Michael Cooper et al., 69% of pass-through business income went
to the top 1% of households ranked by income in 2011.19
A 2023 analysis by the Tax Policy Center (TPC) estimated that the top 1% of taxpayers received
57% of U.S. pass-through business income in 2022; business income accounted for 24% of the
top 1% of taxpayers’ total adjusted gross income, compared with 8.6% of AGI for all taxpayers.20
Impact on Federal Budget
Because the deduction reduces the tax burden on pass-through business income, its net effect on
federal revenue is negative, relative to a baseline revenue projection without the deduction. The
JCT recently estimated that the deduction would produce a $174.2 billion revenue loss from

18 Andrew Velarde, “Passthrough Abandonment of Horizontal Equity Means It’s Game On,” Tax Notes, May 18, 2018.
19 Michael Cooper et al., “Business in the United States: Who Owns It, and How Much Tax Do They Pay?” Tax Policy
and the Economy, vol. 30, no. 1 (October 2015), p. 94.
20 Urban-Brookings Tax Policy Center, Table T23-0024: Distribution of Tax Units with Business Income by Expanded
Cash Income Percentile, 2022, March 1, 2023.
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FY2023 to FY2025.21 The projection extended to FY2027, but the deduction is set to expire at the
end of 2025. Focusing only on the period from FY2023 to FY2025 is likely to present a more
accurate picture of the deduction’s annual revenue cost.
Impact Among Industries
In a 2019 report, the Treasury Department’s Office of Tax Analysis (OTA) estimated the extent to
which taxpayers who reported pass-through business income on their 2016 tax returns would
have benefited from the deduction if it had been available then.22 The study was based on a
sample of 780,000 taxpayers deemed representative of the taxpayers who reported pass-through
business income to the IRS for 2016. OTA also identified the industries that would have benefited
the most from the deduction. In a controversial step, the authors assumed that pass-through
business owners would not have altered their economic behavior in 2016 if the deduction had
been available.
According to the findings, 18 million businesses would have been eligible for the deduction in
2016, 11 million of which would have realized tax savings from the deduction.23 The tax savings
would have totaled $34.5 billion (2018 dollars), after allowing for the SSTB and WQP
limitations. In the absence of the limitations, the tax savings would have been $63 billion.
Taxpayers in the top 5% of the income distribution would have captured 72% of the total tax
savings, with 47% going to taxpayers in the top 1% and 23% to taxpayers in the top 0.1%.
The study estimated that the tax savings from the deduction with the SSTB and WQP limitations
would have been largest for businesses in (1) professional services, (2) real estate, (3)
construction, (4) retail trade, and (5) manufacturing.24 The tax savings without the limitations
would have been largest for firms in (1) professional services, (2) real estate, (3) health, (4)
finance and insurance, and (5) construction.
The impact of the limitations varied among industries. For example, the tax savings with the two
limitations were 54% lower than the tax savings without the limitations for professional services,
but for retail trade the difference was only 10%. This variation reflected differences among
industries in (1) the percentage of firms classified as an SSTB, (2) the income distribution of
pass-through business owners, and (3) the amount of depreciable, tangible assets, and number of
employees.25
The study found that industries differed in the percentage of firms that would have benefited from
the Section 199A deduction. Without the two limitations, this percentage ranged from 43.6% for
mining, oil, and gas to 73.2% for professional services. Three other industries had percentages
above 70%: education (72.6%), wholesale trade (71.4%), and manufacturing (71.3%). Some

21 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2023-2027,
JCX-59-23 (Washington, DC: GPO, December 7, 2023).
22 Lucas Goodman et al., Simulating the 199A Deduction for Pass-through Owners, Treasury Department Office of Tax
Analysis, Working Paper 118, May 2019. (Hereinafter referred to as Goodman et al., Simulating the 199A Deduction
for Pass-through Owners.)
23 Goodman et al., Simulating the 199A Deduction for Pass-through Owners, p. 18.
24 It may come as a surprise that the OTA analysis found that professional services would have realized the largest tax
savings (with and without limitations) from the deduction, if it had been available in 2016. The industry encompasses
firms primarily engaged in law, accounting, and consulting, each one considered an SSTB. But Goodman et al. found
that professional services included subgroups that were not deemed SSTBs, such as computer and specialized design
services and advertising. They also noted that many SSTB owners had taxable incomes below the 2018 lower income
threshold for the deduction, allowing them to claim the maximum deduction.
25 Goodman et al., Simulating the 199A Deduction for Pass-through Owners, p. 17.
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industries with relatively large tax savings (e.g., professional services) had many SSTBs. This
happened because these industries had some subindustries with few SSTBs and most pass-
through business owners in these industries had taxable incomes below the lower income
threshold, allowing them to claim the maximum deduction.
Worker Classification and Independent Contractors
The Section 199A deduction applies to qualified business income, not wage income. As a result, it
offers an incentive for wage earners to become independent contractors.
Starting in the 1980s, many larger U.S.-based companies began to restructure their businesses
around “core competencies,” which were activities deemed likely to produce the largest returns
for stockholders. Other activities (e.g., facilities maintenance, accounting, human resources, and
janitorial services) were increasingly outsourced to subcontractors. This process, known as
workplace fissuring, allowed an employer to cut its labor costs. Some individuals who lost their
jobs because of outsourcing ended up working as independent contractors providing the same or
similar services to their former employers but at reduced wages and with reduced or no benefits.26
In the congressional debate preceding the enactment of the TCJA, some expressed concern that
Section 199A deduction would trigger a surge in the number of employees becoming independent
contractors to benefit from the deduction. There is no evidence of such an increase since 2018.
There are several reasons why the Section 199A deduction is unlikely to spur a large expansion in
the domestic pool of independent contractors.
First, the final regulations for Section 199A (TD 9487) make it difficult for a former employee
working as an independent contractor and providing a service to a former employer to benefit
from the deduction. According to the regulations, an independent contractor who provides the
same or similar services to a former employer or a related entity is presumed to be providing
services as an employee. Consequently, this person is ineligible for the Section 199A deduction.
The regulations allow an independent contractor to challenge this presumption, but it is up to that
person to prove to the IRS through records such as partnership agreements and work contracts
that she or he has not worked as an employee for at least three years after her or his most recent
employer stopped treating the individual as an employee for the purpose of the federal payroll
tax.
Second, the tax savings from the deduction may not compensate for the disadvantages of working
as an independent contractor. Typically, there are few legal protections for independent
contractors regarding the minimum wage, overtime pay, sexual harassment, and workplace safety.
Employers that provide benefits to employees (e.g., paid family and medical leave,
unemployment insurance, workers’ compensation, health insurance, and retirement benefits to
full-time employees) are not required to provide them to independent contractors. And
independent contractors are required to pay the entire 15.3% payroll tax, whereas employees
share the tax equally with employers, each paying 7.65%.
Third, the Section 199A deduction offers employers no safe harbor for classifying workers as
independent contractors. Under current law, a company is allowed to classify an employee as an
independent contractor for tax purposes only if the employee’s work status satisfies a 20-factor

26 David Weil, “How To Make Employment Fair in An Age of Contracting and Temp Work” Harvard Business
Review, March 24, 2017, https://hbr.org/2017/03/making-employment-a-fair-deal-in-the-age-of-contracting-
subcontracting-and-temp-work.
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test focused on the degree of control the company has over the services the employee provides
and the method of payment for those services.27
Policy Options
The Section 199A deduction is scheduled to expire at the end of 2025. Congress may consider the
advantages and disadvantages of extending it between now and then.28 Whatever Congress
decides to do may have significant implications for businesses that account for considerable
shares of domestic business income and employment.29
The main options are to
• allow the deduction to expire at the end of 2025;
• permanently extend the deduction with no changes;
• permanently extend the deduction with changes; and
• replace the deduction with an alternative method of taxing pass-through
businesses.
Allow the Deduction to Expire
This option would reinstate in 2026 the tax treatment of pass-through business income that
applied in 2017. If the deduction and the TJCA’s cuts in individual income tax rates are both
allowed to expire, the top marginal tax rate for pass-through business profits would rise to 39.6%,
from 29.6% under current law.
Permanently Extend the Deduction with No Changes
This option would retain the current Section 199A deduction without changing its structure. A key
consideration with this option is its revenue cost. A 2020 TPC study estimated that a permanent
extension of the deduction in its current form would reduce tax revenue by $1.7 trillion from
2026 to 2040, relative to a baseline without the deduction.30 The TPC’s analysis attributed $279
billion (or 16%) of that amount to income shifting, reflecting the deduction’s incentives for wage
earners and corporations to switch to pass-through status.
Permanently Extend the Deduction with Changes
This option would retain the Section 199A deduction with structural changes. Of course, the
changes would depend on lawmakers’ policy aims. One aim might be to make the current

27 For details on this test, see IRS, “Understanding Employee vs. Contractor Designation,” July 20, 2017, at
https://www.irs.gov/newsroom/understanding-employee-vs-contractor-designation.
28 Scott Greenberg and Nicole Kaeding, Reforming the Pass-Through Deduction, Tax Foundation, Fiscal Fact No. 593,
June 2019, pp. 22-23.
29 According to data compiled by the Tax Foundation, in 2014, pass-through firms represented 86% of all U.S. firms
and employed 57% of the U.S. private-sector workforce; in 2012, pass-through firms (as a whole) earned 48% more net
income than C corporations did: $1.63 trillion compared to $1.10 trillion. See Scott Greenberg, “Pass-Through
Businesses: Data and Policy,” Tax Foundation, January 17, 2017, https://taxfoundation.org/pass-through-businesses-
data-and-policy/.
30 Benjamin Page, Jeffrey Rohaly, Thornton Matheson, and Aravind Boddupalli, Tax Incentives for Pass-through
Income, Tax Policy Center, July 15, 2020, p. 8.
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deduction more generous by raising its rate to, for example, 25% and allowing all pass-through
firms to benefit from it, regardless of line of business and an owner’s taxable income.
Another aim might be to lower the deduction’s compliance cost. A 2019 proposal by The Tax
Foundation might have that effect.31 Under the proposal, pass-through business owners would
have two choices for calculating their Section 199A deduction: (1) a “simplified deduction,” or
(2) a deduction based on their investment in the current tax year. The simplified deduction would
allow an owner to deduct his or her QBI up to a certain amount that would be indexed for
inflation (e.g., $6,000 for joint filers and $3,000 for all other filers). Those choosing the
investment-based deduction would be allowed to deduct 20% of their QBI, but the QBI would be
based on the adjusted basis of qualified property a business places in service during the current
tax year. An owner would calculate her or his share of the total amount of this property at the end
of the year and multiply the amount of that share by a fixed rate of return. The resulting dollar
amount would be an owner’s QBI for the year. In this option, the deduction would operate like an
investment tax subsidy.
Others have suggested retaining the deduction but enhancing its job-creation potential. Among
the options are (1) limiting the deduction to pass-through business owners who pay W-2 wages
and (2) making all pass-through business income (including SSTB income) eligible for the
deduction, regardless of an owner’s AGI.
Replace the Deduction with a More Efficient Approach to Taxing
Pass-through Business Profits
Congress might consider replacing the Section 199A deduction with an approach to taxing
noncorporate business profits that avoids the efficiency concerns raised by the present deduction.
Such a change might serve a variety of policy aims, including simplifying business taxation,
raising more revenue, and promoting business activities (e.g., R&D investment) that could drive
faster economic and productivity growth.
Eric Toder of the TPC has proposed two options for reforming the taxation of noncorporate
business income.32 One option would repeal the deduction and instead tax all privately held C
corporations on the same terms as pass-through entities. This would mean that all business profits
except those of publicly held C corporations would be taxed at the same rates as wage income.
Special rules would be needed to tax the accumulated profits of C corporations required to switch
to pass-through status. The profits of publicly traded C corporations would continue to be taxed at
the current corporate tax rate (21%), and their owners would continue to face a second level of
tax on dividends they receive and long-term gains they realize.
Toder’s second option would tax wage income and pass-through business profits at the same rates
but continue to tax privately held C corporation income at the corporate tax rate.33 Privately held
C corporation profits would be allocated to stockholders according to their ownership shares and
taxed under the individual tax, whether or not they are distributed. Such tax treatment already
applies to pass-through business profits. The income tax for publicly held C corporations would
operate as a withholding tax for which shareholders would claim a credit when they file their

31 Scott Greenberg and Nicole Kaeding, Reforming the Pass-Through Deduction, Tax Foundation, Fiscal Fact No. 593,
June 2019, pp. 22-23.
32 Eric Toder, “Eliminate the Deduction for Qualified Business Income and Require Most Firms To Be Taxed as Pass-
throughs,” Tax Policy Center, TaxVox Blog, June 4, 2018.
33 Ibid.
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individual tax returns. A two-level income tax would still apply to the profits of publicly traded C
corporations distributed to shareholders.
Toder’s proposal would not equalize the tax treatment of pass-through business profits and
publicly held C corporation profits. Achieving tax neutrality would require taxing income
received by shareholders from publicly held C corporations on an accrual basis to prevent
shareholders from accumulating tax-preferred income within corporations.
Some proposals would reform the taxation of business profits on a broader scale. For example, in
2020, Jason Furman proposed making broader changes in business taxation to raise more
revenue, foster faster U.S. economic growth, and simplify tax compliance for small business
owners. His proposal would
• retain a 100% Section 168(k) expensing allowance and expand it to include
structures and all intangible assets, make this treatment permanent, and disallow
interest deductions linked to new investment;
• increase the corporate tax rate to 28%;
• require large firms to file as a C corporation, while giving smaller firms the
choice to file as a C corporation or a pass-through entity;
• repeal the Section 199A deduction;
• eliminate “corporate loopholes”; and
• enhance the R&D tax credit under Section 41 by increasing the alternative
simplified credit’s top rate from 14% to 20%.34

Author Information

Gary Guenther

Analyst in Public Finance

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan
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34 Prepared testimony of Jason Furman, in U.S. Congress, House Committee on Ways and Means, The Disappearing
Corporate Income Tax, hearings, 116th Cong., 2nd sess., February 11, 2020 (Washington, DC: GPO, 2020).
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