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There should not be an exemption of “small business income” from the return of the top tax rates to pre-Bush levels

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There should not be an exemption of “small business income” from the return of the top tax rates to pre-Bush levels

An argument made by proponents of extending the high-end tax cuts is that allowing those tax cuts to expire after 2010 would hurt small businesses.  If the efforts of proponents of the high-end cuts to extend them (either permanently or for a shorter period) fall short, they likely will seek a special “carve-out” for “business income,” under which the top tax rate on that income would remain at 35 percent when the top rate on ordinary income returns to 39.6 percent.

Such a carve-out would encourage substantial tax avoidance.  It would encourage affluent people to reorganize their affairs to convert their income into forms that are taxed at the lower rate.  A carve-out thus would likely carry substantial costs and significantly worsen deficits and debt.  If a small business proposal is deemed necessary, less costly and damaging alternatives are available.

Carve-Out Would Not Generate New Customers

As both the Congressional Budget Office and some business trade associations have recently explained, firms will not hire workers or make new investments unless they have — or expect to have — enough customers to justify the increased capacity.[1] Whether a firm’s taxes modestly increase or decrease matters much less in this regard than the level of demand for the firm’s products or services.

In a recent analysis, CBO noted that some small businesses would profit from an extension of the curent top tax rates, but it pointedly rejected the argument that Congress should extend these tax cuts in order to create jobs.  CBO explained:  “increasing the after-tax income of businesses typically does not create much incentive for them to hire more workers in order to produce more, because production depends principally on their ability to sell their products.” [2]

Carve-Out Would Be Poorly Targeted

Most small businesses are just that — small.  Their incomes are not high enough to face the top marginal rates.  According to the Joint Committee on Taxation, allowing the two top tax rates to return to their pre-2001 levels would have no impact whatsoever on 97 percent of taxpayers with business income. Only the top 3 percent of such taxpayers are in the top two brackets.

Those who claim that raising the top rates would seriously harm small businesses also tend to rely on an extremely broad definition of “small business.”  Most Americans would not describe the nation’s wealthiest 400 individuals, some of whom are billionaires, as “small businesses.”  Yet the “Top 400” have a great deal of money to invest and consequently receive significant business income — which results in their being included as “small business owners.”

The “Top 400” would benefit very handsomely if business income were taxed at a lower rate than ordinary income.  According to the IRS, these 400 individuals received nearly $17 billion in S corporation and partnership income in 2007 (the most recent year for which we have these data) — an average of $83 million apiece.[3]

In essence, a major data gap has distorted the debate on the effect of the top tax rates on small business.  The IRS does not publish specific, satisfactory tax information for small businesses, so analysts are left to examine various sources of business income that individuals receive.  Some analysts define any taxpayer who shows any business income on a tax return — including passive income that very wealthy investors secure — as a small business.  This results in heavy overstatement of the number of such businesses, particularly among households with extremely high income.  Although the use of this skewed definition of “small business” is understandable given the lack of adequate data to support a more appropriate definition, it produces results that can be highly misleading.[4]

For example, in addition to the wealthiest 400 taxpayers, the following types of individuals are commonly included in the definition of “small business” used in tax debates:

• partners in very large corporate law firms,

• partners in lucrative medical practices, and

• Wall Street bond traders who receive multi-million dollar bonuses and invest some of their income in investment partnerships.

The commonly used definition of “small business” also includes wealthy executives of the nation’s largest corporations and financial institutions who rent out their vacation homes.[5]

Carve-Out Would Promote Tax Avoidance

Carving out a lower tax rate for “small business income” would give wealthy taxpayers a powerful incentive to reconfigure various business and financial arrangements in order to reclassify regular income as “small business” income.  For example, if “pass-through” income (i.e., income from partnerships, sole proprietorships, and S corporations) qualifies for the lower tax rate, the opportunities for wealthy taxpayers to avoid paying the top 39.6 percent top rate will be virtually endless.

Even a carve-out just for active income that high-income individuals receive from S corporations would greatly aggravate tax compliance and tax avoidance problems.  The Treasury’s Inspector General for Tax Administration, the Joint Committee on Taxation, and the GAO all have noted that much S corporation wage compensation is underreported and distributions of profits from S corporations — which are exempt from payroll taxes — are overreported.  The GAO calculated that in 2003 and 2004, S corporations underreported approximately $23.6 billion in compensation to shareholders, “which could result in billions in annual employment tax underpayments.”

This compliance problem flows from the structure of the Medicare tax,[6] which applies to the wages and salaries of S corporation shareholders but not to the shares of the firm’s profits they receive.  This gives shareholders an incentive to convert wages into distributions of firm profits (or to understate their wages and overstate the distribution of profits), since every dollar they receive in distributed profits rather than wages saves them 2.9 cents in Medicare taxes.  The recently approved health reform legislation increased the Medicare tax, levying a 3.8 percent rate on income above a threshold of $250,000 for married couples and $200,000 for singles, starting in 2013.  The increased rate on income exceeding the threshold will apply to investment income as well as wage income, which will generally reduce the incentive for tax avoidance.  However, active S corporation income will continue to be exempt from the Medicare tax, increasing the incentive for shifting to that type of income.

Exempting pass-through income received from active S corporations from the scheduled increase in the top tax rates would more than double shareholders’ incentive to convert wages into pass-through distributions (or to misreport wages as pass-through income): every dollar they received or reported in distributed profits rather than wages would save them not only 3.8 cents in Medicare taxes but also 4.6 cents in income taxes (the difference between the 39.6 percent rate they would pay on ordinary wage and salary income and the 35 percent rate they would pay on their profits).  Instead of addressing a serious tax-compliance problem, Congress would be making it substantially worse.

Carve-Out Is Unnecessary

Providing pass-through entities with a lower tax rate ignores the fact that they already enjoy a tax advantage over competitors that are organized as traditional corporations (known as C corporations): pass-through entities are not subject to the corporate income tax.  Firms often organize themselves as pass-through entities to avoid the corporate tax and reduce their tax liability.  They are free to organize, or re-organize, themselves as Schedule C corporations if that becomes more advantageous for them from a tax standpoint.

It is also important to understand what income small businesses are actually taxed on.  Income tax does not apply to the total revenues of small businesses and other pass through entities.  Rather, it is wage and profit income that flows to the owner, after all allowable expenses have been deducted, that is taxed.

Moreover, history refutes the notion that small businesses would suffer under a 39.6 percent tax rate and need an exemption from it in order to prosper.  During the Clinton years, when the top tax rates were at the levels to which they are slated to return to next year, small business employment rose by an average of 2.3 percent — or 756,000 jobs — per year.  In contrast, during the Bush years when tax rates were lower, small business employment rose at only a 1.0 percent annual rate (367,000 jobs per year) — less than half as much.  The 1990s tax rates did not deter a robust, job-creating economic expansion, and the lower tax rates after 2001 did not prevent a jobless recovery.

An Alternative that Would Not Cause Long-Term Fiscal and Economic Damage

The economic and fiscal case for exempting small businesses from the scheduled return of the top tax rates to their pre-2001 levels is weak.  If an alternative, pro-small business policy is needed politically, Congress could provide additional low-cost loans to small businesses and/or temporarily extend the pending small business jobs tax credit,[7] which (as CBO has indicated) would be much more cost effective in creating jobs to aid the weak economy than an extension of the top tax rates.  As a temporary measure, a jobs tax credit should not materially worsen long-term deficits and debt.

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[1] See, for example:  Michael A. Fletcher, “Obama unveils a $33 billion tax-break plan to boost jobs,” The Washington Post, January 30, 2010, p. A03, http://www.washingtonpost.com/wp-dyn/content/article/2010/01/29/AR2010012900854.html; and “Jobs bill not likely to create many jobs,” Associated Press, February 10, 2010, http://www.msnbc.msn.com/id/35334141/ns/business-economy_at_a_crossroads/

[2] CBO, p. 26.

[3] Some 202 out of the 400 taxpayers with the highest adjusted gross income reported net income from partnerships and S corporations.  IRS, “The 400 Individual Income Tax Returns Reporting the Highest Adjusted Gross Incomes Each Year, 1992-2007,” p. 4, http://www.irs.gov/pub/irs-soi/07intop400.pdf.

[4] See Chye-Ching Huang and James R. Horney, “Big Misconceptions About Small Businesses and Taxes,” Center on Budget and Policy Priorities, Feb. 2, 2009, http://www.cbpp.org/files/8-29-08tax.pdf.

[5] Such rental income would be filed under Schedule E, causing these individuals to be included in the commonly used definition of taxpayers with small business income.

[6] We focus here on the Medicare tax and not the Social Security payroll tax because the Medicare wage tax base is not capped.

[7] The current bill is H.R. 2847, the Hiring Incentives to Restore Employment (HIRE) Act.  The proposed tax credit is scheduled to expire after calendar year 2010. See JCT document JCX-6-10, http://www.jct.gov/publications.html?func=startdown&id=3650.

Tags: Tax Cuts and Small Business

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