Small Business Tax Cuts: How Small?

The two parties have found something to agree on: taxes on small business are too high and they are set to go much higher by the end of the year unless Congress acts.  These are the facts:

• Pass-through business entities, such as S-corporations, partnerships and sole proprietorships, account for nearly 95 percent of business entities, 54 percent of business income, and 54 percent of private sector employment.
• They employ more than half the private sector work force in every state except Delaware and Hawaii.
• Pass-through businesses are taxed under the personal code, which is highly progressive, and in fact the most progressive income tax system in the developed world, according to the OECD.  The vast majority of pass-through business income is taxed at the top marginal rate.  For instance, Treasury finds that 39 percent of pass-through income accrues to millionaires, and 75 percent to those earning $200,000 or more.  Limiting it to small business income (as they define it), 18 percent accrues to millionaires and 64 percent to those earning $200,000 or more.
• Similar to the corporate rate, when state/local income taxes are added the combined top marginal rate on personal income is close to 40 percent, making it nearly the highest rate on business income among industrialized countries.  The Bush tax cuts are set to expire at the end of the year, which would push the top rate to over 45 percent, much higher than in any other industrialized country. 
• The following additional tax increases are set to hit small businesses beginning January 1, 2013:
  • The Medicare tax increase from 2.9 to 3.8 percent for those making more than $200,000.
  • The 2.9 percent surcharge on investment income on top of the expiration of the Bush tax cuts means taxes on investment increase 60 percent -- from 15 to 23.8 percent.
• A number of studies have shown such high tax rates on profits are detrimental to investment and economic growth.  For example, a 5-percentage point increase in the individual marginal tax rate was found to reduce the percentage of entrepreneurs who made new capital investments by 10.4 percent and the mean amount of investment by 9.9 percent.
• Small businesses experience higher compliance costs than big businesses, not only because of the multiple business forms to choose from, which often differ from state to state, but also because of the numerous tax expenditures which are often too complicated and too minor for them to deal with.  Most of these are available to all businesses, but economies of scale mean the typical small business doesn't have a tax division to sort them out.

To deal with this, Representative Cantor and Senator Reid have each proposed reducing taxes on small business.  However, rather than simply cutting the rate, or preventing rates from going up at the end of the year, they propose various special carve outs for small business, further complicating the tax code.  One problem is defining small business. 

The Cantor proposal would define it based on number of employees, i.e. fewer than 500.  That's pretty straight forward, but how would a business with 500 employees respond?  If a company can save 20% on their tax bill by not hiring any more employees, that's not the kind of incentives we want in the tax code.  Also, it can easily be gamed: if all it takes is a little business income to reduce one's overall tax bill by 20%, we can expect to see a lot more yard sales and ebay entrepreneurs.  

The Reid proposal doesn't seem fully specified yet, but appears not to define small business but rather provide a 10% tax cut, capped at $500,000, for those companies that expand their payroll by adding employees or increasing wages.  Like the Cantor proposal, this would also introduce some perverse incentives for those companies operating near the $500,000 threshold.  Likewise it can easily be gamed, say by firing and hiring one person, maybe the same person, for a net jobs gain of zero.  Or even easier, simply add $1 to one employee's salary.  The Reid proposal also provides 100% expensing for small business, which if generally applied to all businesses would be a good idea, but again trying to target it for small business is tricky practically.

Even if targeting small business were practically feasible, it would not make sound tax policy in principle.  A better way to ensure that small and large businesses pay the same rate is, first, to have them pay the same rate.  That is currently the case at the federal level: both corporate and pass-through businesses pay 35 percent.  So don't let it go up on either at the end of the year, and, preferably, reduce the rate on both.  Second, resist the temptation to add loopholes targeted for one business or another, and eliminate those that currently exist.

Follow William McBride on Twitter @EconoWill