The Biggest Source of Inequality That No One Talks About

F or 40 years , a huge number of rich business owners have taken advantage of a tax concept known as pass-through income.

This anodyne-sounding technique allows millionaires and billionaires to exempt their fortunes from the corporate tax and shield large portions of them from income taxation, depriving the government of trillions of dollars in revenue, driving a huge amount of inequality, and creating a powerful political constituency opposed to reform.

“This is arguably the most important development in the tax system since the 1980s,” Daniel Reck, a tax economist at the University of Maryland, told me.

“You can’t understand the rise of inequality without it.” Democrats who insist that the rich must pay their fair share of taxes are unlikely to succeed unless they tackle pass-through income.

In the early 20th century, Congress established a two-tiered tax system for businesses.

The profits of small businesses, at the time mostly farms and mom-and-pop enterprises, were simply treated as income for their owners and taxed accordingly.

But corporations, which in the Gilded Age came to be owned by thousands of shareholders and raised previously unfathomable amounts of capital, were subjected to a new corporate tax, levied directly on a company’s annual profits.

Individual shareholders would pay a separate tax when those profits were distributed.

That system broke down in the 1980s.

During the Reagan administration, Congress slashed the top income-tax rate from 70 percent to 28 percent, lower than the 34 percent corporate-tax rate, and cracked down on many methods corporations had been using to avoid paying taxes on their profits.

Corporations and their tax lawyers realized that they could now save a lot of money by treating their earnings as income instead of corporate profits.

The most obvious way would be to organize as an S corporation, which was identical to a corporation in most ways, but was restricted to a maximum of 35 shareholders (later raised to 100).

Alternatively, they could organize as a partnership, owned by a technically unlimited number of partners who sign a private agreement on how to divvy up profits.

State laws passed in the 1990s made this option even more appealing by granting partnerships limited liability for losses.