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What about Small Business Tax Reform?

2 min readBy: Andrew Lundeen

Corporate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform gets most of the attention in Washington these days, and rightfully so (the corporate tax code is a giant mess and the studies show that it is the most harmful tax to economic growth). But what about small businesses?

In the United States, small businesses, or pass-throughs, earn 61 percent of all business income and make up 30 million businesses across the country. Small businesses – companies organized as s-corps, partnerships, and sole proprietorships – pass their business income through the company to the owner’s individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. return. Because they pay income tax on the individual returns, they often face the high tax rate of 39.6 percent. Such a high rate, like with the corporate tax, damages economic growth.

But Rep. Devin Nunes (R-CA) has a pretty good idea on how to fix that: something he calls the American Business Competitiveness tax reform.

The plan, which he rolled out last fall in an op-ed, would treat all businesses the same, and at an equal and lower rate of 25 percent. Perhaps the most important aspect of the congressman’s plan, though, is how it treats income.

His plan is a cash flow business tax that allows companies to fully expense all costs immediately. Rep. Nunes says this will spur investment and economic growth, and there’s reason he’s right to believe so. Tax Foundation analysis shows that under the current tax code, 100 percent expensing option would boost GDP by 2.28 percent over the long run – and this is under the current tax code. If you rewrite the code as the plan suggests and cut the tax rate for all businesses as well, you could expect to see a couple additional points added to long term GDP.

A big reason for the economic growth from Rep. Nunes’s cash flow tax is because the plan properly defines the income tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. . Current law requires depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. schedules that understate costs and overstate income, treating cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. as tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit (EITC), child tax credit (CTC), deduction for employer health-care contributions, and tax-advantaged savings plans. s. This plan would completely rewrite those rules.

The correct treatment of income is crucial to investment and growth for so many small businesses, and gives them the freedom to invest when it makes business sense, instead of investing for tax reasons.

But with the discussion so fixated on revenue neutrality, people might be wary of the revenue a new system would bring in on a static bases. Fortunately, Rep. Nunes says he’s flexible on the 25 percent rate, because he says he’s confident the reform would bring in more revenue through economic growth, whether the rate needs to be 20 percent or 30 percent.

“You’re going to bring so much money off the sidelines and plow it into the economy,” he’s quoted saying in a Post article. “You’ll have really strong economic growth.”