Small Business and the Personal Income Tax Rates

October 28, 2008

This commentary appeared in The Hill's Congress Blog on October 28, 2008.

Throughout this Presidential election year, confusion has often reigned over the tax policy debate. In particular, the debate over small business taxation has been dominated by Joe the Plumber who for the last couple weeks has personified the issue. The political heat of the moment has obscured an important issue that Americans should understand: How and when do "business taxes" and "individual taxes" overlap?

An under-appreciated feature of the U.S. tax system is that most small businesses are not required to pay the corporate income tax. Instead, small business income "flows through" to the owners who report it on their individual income tax returns. About 35 percent of business taxes are paid in this manner by the owners of sole proprietorships, partnerships and S corporations.

So what have Sen. Obama and some Congressional leaders proposed? They want to restore the higher, Clinton-era tax rates on the top two individual income brackets, increasing the 33 and 35 percent rates to 36 and 39.6 percent. But these higher rates won't just hit high wages; they'll hit business income.

About 1.3 million tax returns would pay an extra $30.1 billion under Obama's plan to raise the top two tax rates. Depending on how we define "small business," these higher tax rates would raise taxes on 45 to 55 percent of small business income.

Using an inclusive definition of "small business"—every individual tax return with any business income (IRS Schedules C, E or F)—a majority of the nation's small business income, 55 percent, would see a tax increase, and the total additional tax collection would amount to $16.4 billion.

Using a more restrictive definition of "small business"—every individual tax return with business income greater than 30 percent of wage income—50 percent of small business income would see a tax increase, and the total additional tax collection would amount to $15.1 billion. If we restrict the definition of "small business" further—including only those tax returns where business income exceeds 50 percent of wages-even then, 45 percent of the nation's small business income would see a tax increase.

So why should we pay attention to the way our tax code treats small businesses? They are an important source of innovation and risk-taking, creating between 60 and 80 percent of net new jobs, employing over half the labor force, and generating more than one half of the nation's gross domestic product. Higher income tax rates reduce the investment spending of entrepreneurs and the likelihood that they invest at all, discouraging the growth or expansion of small businesses.

How will America's entrepreneurial sector fare under a new President and a new Congress? Good question.

Learn more about the Tax Foundation's study on the impact of the Presidential candidates' tax plans on small business here.

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